Lithia Motors (LAD) has grown into one of the top automotive dealership groups in the United States. Through acquisitions, it has led the way to become a dominant player in its industry and continues to expand further. As the company has been on a buying spree, its earnings power has expanded. While this has come at the expense of increased debt, Lithia is still able to cover its obligations. The problem, of course, with an operator in the automotive sector is the cyclical nature of the business. Should the economy see the inevitable downfall, auto sales typically take a large hit. Despite this, the economy is currently still strong and sales are occurring at an increased pace. I now view the risk in that the shares have appreciated but headwinds are mounting. With the economy already at such a strong level, it is hard to see the potential for future growth outpacing the potential for a decline in the economy. At this time, we would hold off on purchasing shares until there is a better picture of the future.
Lithia Motors has become the third-largest automotive dealership by revenue in the United States. This is up from the fourth largest the last time we reviewed the company.
(Source: Earnings Slides)
Lithia Motors has grown immensely in the last few years, with revenue growing from $4 billion in 2013 to $11.3 billion in 2018 revenue. Tripling the size of its sales in less than 5 years is no small feat. It was able to do this because of a strong and growing economy, large acquisitions and, of course, new dealership openings. As the company becomes larger, it should notice an incremental margin improvement due to moving of vehicles within its network of dealerships instead of purchasing from others. Lithia will also be able to optimize used vehicle trade-ins by sending them to the corresponding branded dealership. As the company grows its presence, it inherently grows its risk. The more dealerships it operates, the more likely it is to suffer in a recession, as the communities it owns dealerships in could suffer harder than others and a significant loss of vehicle sales could cause losses.
On a positive note, Lithia has managed to make it through recessions before, and being one of the largest dealerships in the country, it will probably be able to secure better terms from manufacturers. Investors need to take much into consideration when looking to purchase shares, and we try to analyze a few of them here.
Going forward, the company may be looking to acquire competition located in the southeastern section of the United States.
The potential targets that would lead to a quick expansion are limited and would come at a cost of increased debt. Particularly, there is Hendrick Automotive Group, which is a privately held company with 143 locations. A majority of these are in North Carolina and South Carolina.
(Source: Auto News)
Hendrick sold $8.6 billion worth of cars in 2017, with over 263,000 units sold. This compares to Lithia with 344,000 units sold. Based on what it paid for DCH, a 27-dealership group with sales of $2.3 billion in 2014, the acquisition would cost Lithia about $1.4 billion. With the company's limited cash position, this would greatly increase its debt. However, this is just a scenario for the quickest expansion into the southeast. There are smaller dealers; that would be a slower process for expansion, but certainly more affordable.
The company likes to identify underperforming dealerships it can boost profitability with once acquired.
(Source: Investor Presentation)
This obviously leads to a strong ROI, as the price paid was less for an underperforming business.
It is this strong process that allows the company to continue to increase same-store sales and profits.
(Source: Earnings Slides)
Lithia saw 7% revenue growth in the quarter, and 3% of this was same-store sales growth. Furthermore, gross profit continued to increase as the company improves its service division.
More interesting is that while only 4% of the revenue is driven from financing activities, more than a quarter of the company's profit comes from this division. The most profitable part is now the parts and service division, which is important to note.
(Source: Earnings Slides)
The service division can continue to drive revenues and profit during a recession because it is something that cannot be neglected. Additionally, I like the broad source of revenue mix driven from different brands. Many dealership groups are overexposed to certain manufacturers, which can be a nightmare. Currently, with impending tariffs on various countries at any given time, a rise in vehicle prices could cause quite a headache for dealerships.
First, let us review the stock's trading behavior.
LAD shares have seen several declines and bounces in the past 3 years. Each time it built a higher bottom before returning to new highs. Our expectation was this would once again happen when we wrote about the shares in September, and sure enough, it did. The stock now trades at a higher-than-average forward P/E and has a lower-than-average yield. This could be the market just adjusting for the dependability in earnings, or it could be gearing up for the next down draft. The company is operating fundamentally well, but there are other plays in the sector that have not seen their shares rise and offer similar prospects.
Taking a look at current and historical valuation metrics, we find the following:
The company is trading below its average P/S ratio for the past 5 years, as well as below its P/E, P/CF, P/B, and forward P/E ratios. This tells us the recent upswing in share price was an adjustment for increased performance. And despite the increase in share price, the stock is still trading below its 5-year average valuations. This implies that it could actually move higher.
Also, reviewing the balance sheet to see if debt is a concern, we can see the following:
Lithia ended the first quarter with $45 million in cash and $235 million in availability under its credit facility. Additionally, approximately $330 million of operating real estate is currently not financed, which is estimated to be able to provide $247 million in capital. This gives the company total potential liquidity of approximately $527 million.
I prefer to see more cash on hand for a cushion and the ability to continue to acquire without using debt. The company has a current ratio of about 1.2x, meaning it can pay off any immediate obligations, ensuring it is protected in the future, which is absolutely crucial. However, this could change quickly with another large acquisition.
There is a larger portion of short-term debt. What is important to understand, and may be missed by the market, is the following. Approximately $2 billion of this debt is due to floor plan vehicles. In other words, the dealerships do not actually own the new cars on the lot, but rather, they are given to them in the form of a loan. So, the car becomes part of the debt owed to the manufacturer until it is sold. Once it is sold, the money collected goes towards paying down the debt, and the profit is kept for the dealership. This is debt that bears no interest.
The above statement gives a better picture of the debt profile. It is important for investors to monitor this going forward. Management should be reducing debt and increasing its cash position at this point in the cycle. Furthermore, I believe that while it would slow down growth for now, it would give the company the opportunity to make more lucrative acquisitions in a downturn. It would also leave Lithia better suited to handle a recession, especially since it is a much larger company than it was during the recession of 2008. More than growth, investors love balance sheet management. A frugal and prepared management team shows they are dedicated to the survival of the company, not just the growth in the bottom line.
The company does, however, have lower leverage than its competitors. This would make LAD a more attractive investment.
And yet, as we can see, the company trades with the highest forward P/E in its peer group as well as the lowest yield. The last time we reviewed the stock, this was not the case. This makes me a bit more skeptical that it has less upward price potential, due to already being at the top of the range versus peers.
Industry and Company Sales Overview
Looking at the last 3 months of sales data on an annual selling basis, we see a decline:
(Source: Trading Economics)
This is a sign that the market has peaked and there is limited room for growth without acquisition or new dealership openings.
Lithia makes a good pitch that it generates most of its profit from parts and sales. However, it does not point out the decline in sales of these items or the switch to non-OEM parts during times of financial duress.
New vehicle sales make up a majority of revenue due to their high selling prices; however, they have low profitability in comparison to the other segments of the business.
The company does continue to be shareholder-friendly, increasing dividends and capital return.
With 17%+ dividend CAGR, investors with a long-term view may be able to grow yield on cost. Currently, the yield is not that enticing at 1%. Especially now that rates are not predicted to rise, higher-yielding stocks will see more attention. Share repurchases have so far generally been at higher levels than where shares trade now, at least for the past 3 years. However, the company is not allocating significant capital to repurchases at this time.
For investors looking to put money to work in the automotive sector with a company whose fundamentals are intact, Lithia may be worth investing in. As we can see, the company continues to expand, grow earnings, and grow its presence, while maintaining a stronger capital position than competitors. An economic recession would certainly cause shares to dip along with revenue and profit, but this may be a few years out. With shares trading at the top of their range for the past 3 years but below 5-year valuation trends, they could move slightly higher. However, I believe there is downside risk due to the possibility of a peak in economic growth. There is also the prospect that the company makes a large acquisition, further vaulting its position up the ranks as one of the largest dealers in the country.
The investment thesis would change once a recession comes, but it would depend upon how bad the recession really is. If shares did see the typical pullback they usually experience, I would be interested in adding shares to my portfolio, so long as this pullback is not due to material weakness in the operating fundamentals or environment.
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.