Penske Auto Group (NYSE:PAG) (20.47, $1.9 billion), which recently changed its name from United Auto Group, is one of the leading car dealers in the world. The company conducts operations in the United States (2/3 of sales) as well as in the United Kingdom (and Germany to a lesser extent). While the company sells a lot of new cars, it has a substantial used car business as well. Additionally, the company derives a significant portion of its profits from service and parts and offers insurance, warranty and finance as well.
I am very bearish on the auto industry, which has already been weak for some time. My thesis is related primarily to the tighter consumer credit conditions that I expect to result from the current mortgage-related problems as well as a weakening economy that could fall into recession. I believe that PAG will not do well in this environment. As far as the auto industry goes, inventories have been rising year-over-year despite the weakness in sales. Sales in the past month pleased economists, but they remain consistently lower year-over-year, but not significantly so. Keeping in mind that the weakness has been at a time of very low unemployment and strong income growth, one has to wonder what would happen should the economy weaken. Traditionally, sales experience a 20% decline in that type of environment, and that isn’t in anyone’s forecast as far as I can tell.
In the chart below, you can see that PAG has had a nice run during the bull market of the past 5 years, though it has clearly had a bad 2007 (-13%). Valuation seems low at 13PE, but the company has a lot of debt (even adjusting for the inventory financing). EV/EBITDA of 12X is at the high end of the range fro the past several years and not particularly cheap. The real story, though, is in the return on capital, which is a very meager 5.4%.
Two other publicly traded car dealers are the well-known CarMax (NYSE:KMX) (22.95, $5 billion) and the more obscure Group 1 Automotive (NYSE:GPI) (35.05, $843mm). These companies have declined 14% and 32% respectively year-to-date. KMX sells used cars only, which have been a much better market (for PAG too, according to their 10-Q) with strong unit and price appreciation. It has a stellar balance sheet. GPI is similar to PAG on the balance sheet and in its business, but it has a history of generating higher return on capital. Unlike PAG, its earnings estimates, though, have been falling.
So, though PAG has been weakening lately, why is it the best performer of the group? KMX, with its exposure to the better market and its pristine balance sheet and high ROC should be the best performer it would seem. Three things come to mind. First, Penske became President of the company earlier this year. Second, the company has a lot of international exposure, which is viewed positively. Third, the earnings estimates haven’t come down. Finally, and what I believe is the main reason: The Smart fortwo.
For those not familiar with this popular European car that will hit our shores next year, it measures less than 9 feet long and comfortably holds two passengers. PAG has the exclusive distribution rights and could sell 20K cars next year. There is a huge buzz, and, no doubt, this gas-sipper will certainly appeal to many in the urban areas due to its “coolness” and its maneuverability in tight parking conditions. With that said, the overall economic impact to PAG won’t be that great. Their GM on new cars is just 8% (car will sell for about $15K) and there could be competitive models on the market in a few years. Personally, I expect that the appeal will be great to a very small segment of the market and irrelevant to most of us.
In the chart below, you can see that the stock has rolled over. I expect 21 resistance to hold and see chart downside to 16 based on longer-term charts. 16 works out to be 10X EV/EBITDA, which would still be quite healthy if the environment I expect materializes
Disclosure: Author is short PAG