Asbury Automotive Travels on Dangerous Ground

At first glance, Asbury Automotive (ABG) looks like it could be a value play. It trades at a discount to its book value, has a P/E of 7, and pays a dividend of almost 7%!

Asbury also does not have its own financing arm, and is therefore relatively shielded from the current situation in credit markets. Its presence in the luxury car segment should also help protect it to some extent from the current downturn, and its largest profits come from vehicle repairs, which consumers require no matter what the state of the economy.

So what's wrong with this company...isn't it a clear buy? Well, there are a few areas of concern.

To me, the company's problems stem from its debt levels. Its operating income is only 2 times interest expense for one thing, yet its payout roughly half its net income in dividends. If things were to turn south, ABG has very little protection to be able to make these payments.

It looks like debt holders have recognized this, and are wary. They have placed covenants such that Asbury has a ceiling on what it's allowed to pay shareholders (in share purchases or dividends), and this ceiling only grows at 50% of net income (as it accrues), minus payouts. At the present time, that ceiling stands at just $13.2 million, which is just about 40 cents a share! Imagine a company so restricted, it is not allowed to pay its owners even half of the cash it has on hand!

Nevertheless, the company continues to pursue acquisitions, which seems a little strange, considering its return on assets (less than 5%) and return on equity (less than 10%) are nothing to write home about, despite leveraging to the hilt! And it doesn't seem intent on paying off its debt, as it continues to make sale-leasebacks, where it sells off its properties, but now have to pay rent on them!

As long as the company makes its sales numbers, it will be fine. But any unexpected hitch, however small, can cause great damage to the small portion of equity that is left after debt obligations are satisfied, making this company not worth the risk.

Disclosure: None

Comments

[notsosmart]

well-lets try to remember this analyst & this co.i will write it down as i begin to keep a history of all these opinions.others should do the same.it might come in handy as you discount these people down the road that are consistantly wrong & pay attention to those who are right.

[Saj]

That's a good idea...it's very important to do your due diligence on analysts. Furthermore, I would encourage you to read up on the company yourself, and decide whether what the analyst is saying makes any sense.

[Barbarossa]

Excellent article. I think these are all valid concerns. I bought a small position of ABG a couple months ago as a "value" play and still think there could be something there. I sold out for a 20% profit shortly after a Barron's article recommending it.

At these levels I had begun to reconsider, but there are so many opportunities available at value prices that we can be picky.

[Saj]

Thanks Barbarossa,

Fortunately you are right about there being other opportunities out there!

[J.G.]

The auto retailing stocks have become incredible bargains, as their cash flow from used car sales, parts/service revenues, and their finance/insurance commissions shield them from lower new car sales. Asbury has the highest proportion of mid-line imports (i.e. Toyota, Honda, etc) of any compay in the group, and this will help shield them from Detroit's mess, compared with their peer group.

The economy may soon plunge into the first moderately severe recession that these companies have faced as publicly traded entities, and I think most investors will be pleasantly surprised by how their cash flow and earnings hold up. Look to relative strength in these stocks following release of 3Q08 earnings. Their 2Q08 earnings may face a bit of additional headwinds from lower vehicle sales margins, due to the relatively sudden shift away from SUVs, but you'll see them hold up well and meet earnings expectations.

[Saj]

You're right JG that parts/service revenues should help shield some of these companies from the downturn. In Asbury's case though, their financial commitments are tight, so if things deteriorate there's trouble for this stock, so it may not be worth the risk. What are some of the other auto retailers you like?

[J.G.]

I like any of them with a highly disproproportionate mix of mid-line import dealerships. Autonation and Lithia have too much of the Big 3 and will suffer disproportionately from the ever-decreasing market share of the domestic brands, while Sonic, Asbury and to a lesser degree Group 1 will outperform. The latter three companies have a much better mix of dealerships. In addition, those 3 companies have purposefully purchased their dealership groups in demographically attractive areas -- i.e. the Southeast and Western U.S.

As for tight financial commitments, these companies have a highly variable cost structure. Their salary payments to salespeople and dealership managers depend on profits. Their corporate staff costs are lean.

In addition, keep in mind that the local repair shop can no longer work on engines of newer model BMW, Mercedes or Lexus cars. The unique tool set alone for a new 328i, 535i, E-Class, etc. costs over $25,000 per model. The manufacturers are engineering their cars to make it increasingly likely that you MUST bring your car into one of their dealerships to be repaired. This is an excellent competitive barrier for these companies that will only increase over time.

[Saj]

Hi JG,

I agree the repair work should keep them more stable than otherwise, but in Asbury's case only just over 10% of their revenue comes from this.

By financial commitments I mean their debt. With interest coverage of only two times, I'm worried about them being able to make payments if times get tough. That doesn't even include the capitalization of their operating leases (another commitment of theirs), which are almost as large as their total equity.

I'll take a look at Sonic and Group 1 when I get a chance, thanks for the notes.