Long-Term Investors Should Steer Clear Of Car Dealership Stocks

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Includes: ABG, AN, GENIX, GPI, LAD, SAH
by: Strubel Investment Management
Summary

Several car dealerships appear on Joel Greenblatt's "Magic Formula" stock screener.

Dealers' two main revenue sources, new and used car sales, are unattractive.

Parts and service is a good business that is benefiting from secular tailwinds but not enough to make the stocks attractive.

Car dealerships are among some of the more capital-intensive, low margin businesses out there so it was surprising to see two companies Asbury Automotive (ABG) and AutoNation (AN) appear as long holdings in the Gotham Enhanced Return Fund (GENIX). The fund holds stocks based on Joel Greenblatt’s “Magic Formula” which looks for stocks with high returns on capital that are trading cheaply compared to their cash flow. Of course, three other car dealers Sonic Automotive (SAH), Group 1 Automotive (GPI), and Lithia Motors (LAD) were among the fund's short holdings. So, which is it? Are car dealership stocks a good buy or not?

Analyzing the Franchised Car Dealer Stocks

I think the reason some of the car dealerships appear in the fund as long holdings is their price. All of the dealerships trade at P/Es and forward P/Es at about half the market average.

Name (Ticker)

P/E

Fwd P/E

Asbury Automotive Group

9.6

9.2

AutoNation

9.4

9.0

Group 1 Automotive

6.6

8.5

Lithia Motors

8.3

7.9

Sonic Automotive

7.3

10.2

(Data: Morningstar)

We excluded CarMax (KMX) and America’s Car-Mart (CRMT) from the analysis because they are not franchised dealerships. It’s pretty easy to see why ABG and AN made the list compared to the other stocks. The margins and returns on capital (ROIC) for both companies are the best of the group.

5YR Average

ROA

ROIC

Gross Margin

Op. Margin

Asbury Automotive Group

6.51%

10.02%

16.31%

4.52%

AutoNation

4.77%

11.92%

15.59%

4.14%

Group 1 Automotive

2.97%

5.55%

14.58%

3.33%

Lithia Motors

6.16%

8.45%

15.20%

4.2%

Sonic Automotive

2.67%

4.94%

14.79%

2.46%

(Data: Morningstar)

What probably accounts for some of the differences is what proportion of revenue each company brings in from new vehicles sales, used vehicle sales, financing and insurance (since this is tied to new and used vehicle sales, sometimes it’s lumped in with those previous categories), and parts and service. Dealers make little to no money on new vehicle sales (profits increase if you count F&I), a small amount from used vehicle sales, and the bulk of profits from parts and service. Take Asbury Automotive for example. Parts and service accounted for only 12.2% of revenue this past fiscal year but over 46% of the company’s gross profit! Both Asbury and AutoNation (44.4%) have some of the highest proportions of gross profits from parts and service. Only Sonic Automotive at 47% is higher. Lithia (32.5%) and Group 1 (37.7%) are both in the thirties.

Problems with the Industry (And One Bright Spot)

The first problem is that dealers have little control over one of their major products, new vehicles. If a major auto manufacturer doesn’t have a competitive line-up, there’s not much a dealer can do. A restaurant can change their menu or hire a new chef to improve the product; dealers don’t have an easy fix. Just look at what happened with Mitsubishi (OTCPK:MMTOF), market share dropped from a high of 2.1% in 2002 to a low of .6% in 2017. If you were a Mitsubishi dealer during that time period, what good, easy options are available for you? Some dealers on the list have a fairly concentrated list of dealerships. For example, ABG derives 55% of its new vehicle sales from just three manufacturers – Toyota (NYSE:TM), Honda (NYSE:HMC), and Nissan (OTCPK:NSANY).

Additionally, there is little brand loyalty amongst customers. According to one study, about 60% of buyers are open to buying a different brand than the vehicle they currently own. If the auto manufacturers the dealers are hitched to stumble, customers will quickly go elsewhere. Certainly, the big publicly traded dealers are in much better position than many small local dealers due to their diversification, but there still can be issues.

The second problem is that profits for both new and used cars continue to fall. The internet and buyers' increasing comfort with buying a vehicle online (e.g., finding a vehicle and completing most of the transaction via email or phone before finally picking up the vehicle in person) have forced profits down. Vehicles are after all commodity items. A new Honda Accord with a certain set of options at one dealership is the same as the similarly spec-ed Honda Accord at the dealership the next town over. The more pricing information a customer has and the more willing they are to go somewhere else means the mark-ups dealers can charge are being whittled away.

The third issue is a long-term one. The dealerships industry is ripe for disruption. Only a little more than 50% of customers report being satisfied with the current process of buying a new vehicle. Additionally, well over 80% of customers disliked at least one aspect of the new car-buying experience. Compare this with the cable TV industry that is currently being disrupted by Netflix (NASDAQ:NFLX). Cable companies have customer satisfaction scores in the 50s and 60s while Netflix ranges from almost 80% to the high 90s depending on how the survey question is asked. Right now, the only thing keeping the traditional dealership model that customers hate alive are local franchise laws. Tesla (NASDAQ:TSLA) has been making an assault on that model and cracks are beginning to show in the old business model. If local franchise laws start to change, the dealership model could get a lot more unattractive very quickly.

The one bright spot for the dealer industry is parts and service, particularly service. Vehicles are becoming more complex and requiring more sophisticated (read expensive) diagnostic equipment and specialized tools. For example, last year ABG saw new vehicle gross profit decline 10% for just a 1% decline in sales. Meanwhile, both sales and gross profit grew for their parts and service division. The more dealerships can specialize in high margin specialized repairs, the better. Indeed, again looking at Asbury as an example, gross margins for the parts and service business (which is predominantly service) grew by over 630bps over the past six years.

Summary

We don’t think car dealerships make good investments. Sure, they all looked pretty cheap based on current valuations and their stock prices may bounce back big in the short term. However, over the long term, we think the industry's structural challenges around new and used vehicles sales will outweigh any tailwinds from the parts and services business. Low return on capital and low margin businesses generally don’t make good long-term holdings and we think that is the case here.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.