Lithia Motors (NYSE:LAD) is a growing automotive franchise selling new and used vehicles, arranging financing solutions, and providing parts and repairing services throughout 129 dealerships spread across the Western and Midwestern regions of the US. The company's prime focus is the mid-sized regional markets for domestic and imported franchises where it faces weak competition from other dealerships representing the same brands.
Before diving into the company's fundamentals, possible catalysts and investment theses, I want to present you a snap summary of Lithia Motors' revenue streams for the most recent quarter:
Three months ended Sept 30, 2014
The gross profit breakdown identifies four cash flow drivers that I will examine in greater details.
New vehicles: Lithia Motors' catalogue offers 30 automotive brands ranging from budget Japanese names to top-end domestic products. A substantial portion of the company's revenues are generated through iconic American, petrol-thirsty brands including Chrysler, Jeep and Dodge. The future performance of this business segment relies on both organic and growth through acquisitions. The favourable economic conditions combined with the crashing crude oil prices are the underlying determinants for the short- to mid-term success of Lithia Motors. Aggressive expansionary policies of the central banks around the globe, a practice laid and led by the Federal Reserve, pushed the unemployment and interest rates to historical lows. This came as a gift to the capital-intensive and cyclical companies such as the automotive ones. To make the outlook even brighter, political tension, clashes between the OPEC members and record oil drilling in the US toppled crude oil prices.
Source: U.S. Bureau of Economic Analysis
The reverse correlation between oil price and number of vehicles sold is most pronounced over the first decade of this century. An indication of the positive consumer sentiment is the consistent and smooth upward trend in the annual sales figures, which are converging towards the former era of cheap oil.
Source: U.S. Bureau of Economic Analysis
Due to the turbulence in Lithia's earnings during previous economic cycles and market windfalls, it is worth taking a closer look at the supply, demand and inventory held for sale for eventual bubble-creation signs. As the chart above suggests, domestic production is comfortably lower than the sales figures. However, it is not necessarily a signal of rapid vehicle price appreciation as the import/export balance is not taken into account. Instead, such difference combined with normal inventory/sales levels suggests a robust automotive market with relatively high car prices and limited downside risks.
Based on the macroeconomic factors and historical increase of more than 15% in the "same store revenues" (organic growth) over the past three years a conservative assumption, and one incorporated in the valuation model, would be a 15-20% organic growth over the next two years. This percentage will gradually decline towards the target inflation rate as Lithia Motors approaches a mature stage of development.
A second, and even more appealing way of expansion to Lithia Motors is the growth through acquisitions. The highly fragmented US dealership industry offers abundant acquisition opportunities to the few who can afford heavy capital expenditure. In the case of LAD, the company's debt capacity, proven deal record and limited presence in the East and North of the US are all optimistic signs for current and prospective investors. For the first eight months of 2014, LAD has completed 6 small acquisitions together accounting for $84.7 million. The goodwill paid in these transactions is just over 19% (most of the money spent on tangible assets), which is likely to be significantly lower than the value of the synergies and decrease in general expense arising from these acquisitions.
A good benchmark for management's style and ambition is the recent acquisition of DCH Auto. While Lithia is primarily selling domestic vehicles through local dealerships in rural regions, DCH Auto is well positioned in the large metropolitan areas of Southern California, New Jersey and New York - markets in which Lithia is not present. In addition to the strategic geographical expansion, the deal diversified the brand mixture offered by Lithia Motors. Honda/Acura and Toyota/Lexus comprised 82% of the sales generated by DCH Auto compared to total sales contribution of 38% from imported vehicles for Lithia Motors.
As signaled in the most recent earnings call, the executive team is eager to follow the line of aggressive expansion as long as the targets are satisfying certain ROE thresholds. Lithia Motors is currently sitting on $270 million of short-term liquidity ready to be employed. In addition, as Christopher Holzshu, the CFO of LAD, said during the same presentation, Lithia Motors is looking to raise the debt levels from 2.2x to approximately 3x EBITDA. With funding guaranteed and management urged to take advantage of the unconsolidated market, future acquisitions are inevitable and a matter of time. The valuation model below assumes $70 million per annum spent on acquisitions over the following two years, which will gradually decline through the years. These investments are expected to result in a 15-25% increase in the revenues from new and used vehicles.
Used vehicles: According to WardsAuto's report, the market for used vehicles is approximately three times larger than the one I just covered. What is more interesting though, is the strong positive correlation between the two. Consequently, the former macro discussion is applicable for this business segment as well.
At first glance, the used vehicle segment seems more lucrative than the former one due to the considerably higher gross margin and volumes traded. On another hand, the significantly lower retail price of a second hand car leads to the same, if not smaller, absolute dollar profit on unit basis. Moreover, the numerous distribution channels in the secondary market make it harder for a mainstream vehicle dealership to stay competitive and profitable at the same time. What is Lithia Motor's prime edge then? The trade-ins. When buying a new vehicle, each customer is offered a discount in exchange of his/her old one. The process supplies cheap second-hand vehicles while creating loyal clientele. Lithia's corporate presentations claim that 53% of 2013 used retail sales have originated from new vehicles:
Although not specified in details, the management is aiming for organic growth through optimization in this particular segment. The near-term goal is to boost the average units sold per shop per month from 53 to 75, or by slightly more than 40%. In my model, I assume a constant gross profit margin of 14% for this segment. The revenue growth is slightly lower but aligned to one of the new vehicles.
Finance, insurance and service contracts: Now, this is the sweetest part of the pie. The financing, service and insurance contracts are commission based, subsequently sold to third parties on a non-recourse basis. The beauty of this segment is the lack of risk involved; it doesn't require heavy capital expenditure or infrastructure. It is a person-to-person business where the human capital is key. In order to gain an advantage over traditional financing and insurance institutions, Lithia Motors' sales personnel and finance and insurance managers are trained in securing customer financing and possess extensive knowledge of available alternatives. The staff is required to attempt to arrange financing for every vehicle sold and offer customers financing on a "same day" basis. The efforts are paying off - the company has arranged financing on 78% of the vehicles sold in 2013, 2% up from 2012. Moreover, the average finance and insurance revenue per retail unit has risen by 8.6% on the "same store" basis over the past 9 months due to higher retail prices. I believe this trend will continue and the profits from financing and insurance will closely follow the core business sales figures. It is assumed that the revenue from finance and insurance will be fixed on 4.4% of the total vehicle revenues (new, used retail and fleet).
The Service, Body and Parts is the segment that brings the most money to the table. However, it is also the most unpredictable and dependent on the customer loyalty. A useful starting point is the number of new cars sold due to manufacturer warranty commitment that is usually served by the franchiser. According to Lithia's own findings, 47% of the new and 28% of the used vehicle it has sold are returning for additional services:
The development of this segment is vital for the company's well being especially during economic downturns as owners prefer fixing their existing vehicles rather than buying new ones.
Valuation: DCF Analysis
Using the following conservative assumptions that are slightly below the company's guidance from last earnings' presentation, a forward-looking income statement is prepared:
Similarly, balance sheet and cash flow statement are presented:
Finally, the fair value of the company assuming cost of capital of 10% and perpetual growth of 2.5% after 2022 is calculated:
|Change in NWC||-68,536.7||-64,885.6||-64,188.0||-58,786.9||-48,479.2||-33,724.3||-20,000.0||-10,000.0|
|# Shares Outstanding||26,312.0|
The valuation presented above is relevant only if you are considering a long-term investment horizon and the company manages to capitalize on the favourable short-term economic conditions. The logic behind it is that Lithia will take full advantage and expand aggressively before entering into the downturn of the current economic cycle. A possible pitfall might be the cost of capital that I am using in this calculation, as the company's beta is as high as 1.74.
For a shorter investment horizon, it is relevant to consider relative valuation. First, let's focus on some statistics recorded during last quarter at Lithia and its competitors:
Sticking to these peers, the value of LAD could be founded as follows:
Data source: finviz.com
Based on the weights suggested, Lithia Motors' share price should be 76.57 or 4.2% higher than the current levels. The deviation is not big enough for justifying initiation of a position. However, it is yet another sign that the company is reasonably priced no matter its implied growth potential and strategic position.
To sum up, I am bullish on the automotive sector due to favourable economic conditions. I believe that Lithia Motors has good, if not the best, chances to capitalize on the current oil price and record sustainable long-term growth. Lithia Motors' share price has been significantly depressed due to some short-term factors including downgrading of earnings guidance last quarter. This gives potential investors a great chance to enter into a long position, hoping that Lithia Motors won't miss its lifetime opportunity.
Additional disclosure: The opinions of the author are not recommendations to either buy or sell any securities. Please, do your own research and consult with a professional financial advisor prior to making any investment decision.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.