AutoNation’s equity is trading materially lower than its 52-week high in what has generally been a fairly strong equity market environment (ex the 4thquarter). The rationale as to why is largely focused on concerns about “peak auto” and the threat of autonomous cars, I guess. Management has been very forthright about the challenges in comparable sales that new vehicles will face and expect U.S. new car sales to moderate from the low 17 millions per year over the past few years to the high 16 million range this year. Management has proactively implemented cost reductions across their business in the fourth quarter and into 2019. But I don’t think it’s a secret that the majority of AutoNation’s earnings do not come from the sale of new cars. Last year, parts and services represented 45.8% of gross profit at AutoNation. And Finance and Insurance represented 28.9% of gross profit. Collectively, the two lines represented only 20.7% of Revenue. While it is true that there is a connection between new car sales and opportunities for revenue in both the parts and services and Finance and Insurance business, it is evident that those business lines have far better economics than selling new vehicles.
AutoNation tends to show up in a fair number of value-oriented portfolios because of its historically shareholder friendly management and their prolific buyback programs. AutoNation has repurchased 22.7 million shares over the last 3 years at average purchase prices between 43 and 47. Today there are only 90 million shares outstanding. AutoNation has two significant shareholders: Bill Gate’s Cascade Investments, LLC owns 23% of the equity. And Eddie Lampert and ESL investments own 17% as of year end 2018.
The Value Creation Opportunity
The presence of Cascade and ESL is where things get interesting. These two have a little bit of history together. Michael Larson, Cascade’s investment chief, has been the lead director of the board of AutoNation up until his recent resignation in December 2018. Eddie Lampert was a member of AutoNation’s board up until 2007. Prior to Sears Holdings bankruptcy, Cascade participated in Real Estate backed loan financings with ESL at Sears Holdings. The two groups clearly have maintained a dialogue with respect to common investments. Why is that relevant? Below is an excerpt from the risk factors section of the 2018 AutoNation 10K (underline emphasis mine):
“Our largest stockholders, as a result of their ownership stakes in us, may have the ability to exert substantial influence over actions to be taken or approved by our stockholders. In addition, future share repurchases and fluctuations in the levels of ownership of our largest stockholders could impact the volume of trading, liquidity, and market price of our common stock “
The reason I suspect that this could be relevant at all is a function of the current situation with ESL/Sears/Transform Holdco. As part of the bankruptcy proceedings, ESL has acquired substantially all of the assets of Sears Holdings. Importantly, the offer also contemplates a mechanism for the new company to retain the historic tax attributes of Sears Holdings. At the time of filing, Sears Holdings had approximately $5 Billion of Net Operating Loss (NOL’s) carryforwards and $900 million of tax credits. AutoNation, because of its domestic focus, has been a sizable U.S. taxpayer. Even post tax reform, AutoNation paid an effective tax rate of 25% in 2018. Below are AutoNation’s last 3 years of Tax expense:
2016: $270.6 million
2017: $201.5 million
2018: $133.5 million
At this point, you are probably seeing where I’m going with this. Just this week, ESL and Transform Holdco (The new Sears entity) offered to purchase another of ESL’s major holdings, Sears Hometown and Outlets (ticker:SHOS) and roll it into Transform Holdco.
An offer to buy the balance of AutoNation, with agreement and cooperation from Cascade, would create significant value via the tax attributes of New Sears/Transform. Even applying AutoNation’s present depressed 8.5x earnings multiple onto their $133.5 million of tax expense in 2018 would result in $1.1 Billion of incremental value on an existing equity market cap of $3.26 billion. It’s hard to imagine how any significant owner of AutoNation could be opposed to such a value creation opportunity, assuming it’s an equity for equity deal.
If you think about it in the context of ESL’s history, it is a fairly similar set-up to the Kmart and Sears combination. At the time ESL took over Kmart, ESL retained a significant holding in Sears Roebuck. Today, the only other holding of ESL outside of the Sears spinoff complex is AutoNation. Shortly after Kmart’s emergence from bankruptcy, they used their newly appreciated equity currency to acquire Sears Roebuck. It is not hard to imagine something similar could play out with AutoNation.
There are other reasons besides tax synergies that the combination of new Sears and AutoNation could make some sense. What’s left of Sears offers at least three other potential items of value to AutoNation’s business. 1. Sears still has a nationwide footprint of Autocenter locations. As discussed earlier, the Service and parts business of AutoNation is very lucrative. Expanding the footprint of service locations and re-branding them with better operators should present a growth opportunity. 2. Diehard- The Sears proprietary brand of Diehard is synonymous with autos. While the brand recognition is quite high, the brand has never garnered more market share because of its limited distribution. Diehard as an exclusive AutoNation brand also presents growth opportunities. 3. Real Estate- Sears has no shortage of Real Estate that they don’t need. The legacy Sears boxes are very large, and mall located. The American Shopping mall is going through massive change. Very few retailers need the large space department store anchors historically occupied. However, as that space continues to get repurposed, one potential use for big spaces could very well be auto showrooms.
There are still countless open questions with respect to the ESL saga and Sears. What will need to happen to affect continuity of Sears Holdings (OTCPK:SHLDQ) tax attributes? Will ESL be able to re-consolidate spin-offs where they are majority holders without any substantial premium to minority holders? Is AutoNation part of the future playbook? Time will tell. But, for now, AutoNation remains an attractively priced, quality business on a standalone basis with some potential synergies for major holders.
Disclosure: I am/we are long AN, SHOS, SHLDQ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
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