Penske Automotive Offers Value With Or Without The Dividend

Summary

• PAG shares are still well off their highs despite a huge rebound rally.
• Investors appear to be pricing in more weakness than I see as reasonable.
• With the stock at just 8.8 times normalized earnings, I see valuation upside with or without resumption of the dividend.

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The COVID-19 outbreak has disrupted many industries, not the least of which has been automobile production and sales in the US. Penske Automotive Group (NYSE:PAG) is a big player in the car retail space in what is a very fragmented market in the US. The company's shares plummeted from $53 to just $20 in the space of a few weeks earlier this year, but have since rebounded to $40. While I wish I had bought Penske at $20, I still think there is value to be had today, and despite the suspension of the dividend, I think Penske is worth a look.

Diversification and a strong track record

Penske has a fairly diversified portfolio of automotive-related businesses and investments in similar businesses.

Source: Investor presentation

This diversification works as it sells new cars, used cars, and has a sizable trucking business that offers a variety of services. Penske, therefore, is not a pure-play car dealer that is entirely dependent upon US consumers, but rather a more diversified way to gain exposure to transportation in general.

Source: Investor presentation

Revenue isn't particularly diversified because the company's 250+ automotive dealerships generate enormous revenue relative to the rest of the business. However, on an EBT basis, the scales are much more balanced. While diversification isn't a panacea against downturns by any means, I like the fact that Penske has meaningful exposure to trucking via its retail truck business, and its JV ownership in Penske Transportation Solutions.

The model has certainly worked in the past with results since the Great Recession below showing strong growth over time.

Source: Investor presentation

Revenue grew from 2010 to 2019 at an average rate of 10% annually, which is impressive for any business, but in particular, for one that gets the majority of its revenue from car sales. Operating earnings have grown even more quickly - at a 16% average annual rate - given margin improvements that have accrued over time. Note that 2017 and 2018 saw significant tax reform benefits, and that 2019's operating income declined slightly against 2018 on a normalized basis. These things happen in cyclical industries, and we'll see that again for Penske in 2020. However, I'm not bullish because I think 2020 is going to be stellar; I'm bullish because on normalized 2021 expectations, the stock looks relatively cheap.

Evidence to suggest the decline is temporary

First quarter earnings were pretty ugly, but this is to be expected given the environment that persisted during the last couple of weeks in the period. Indeed, the damage can be seen below.

Source: Investor presentation

Revenue was down 10% in Q1 to $5 billion as new and used retailed units fell 16% to 106k. However, we can see that in January and February, sales were quite strong, adding 8.3% in the US and 2.9% internationally for a 6% consolidated gain. Only in March did the situation deteriorate as stay-at-home orders cascaded across the country and indeed the world.

The interesting thing is that Penske also reported some additional stats subsequent to the end of the quarter given the extraordinary situation.

Source: Investor presentation

There are two sets of data here, one that compares the last ten days of April to the last ten days of March, and then the last ten days of April to the first ten days of April. In both cases, gains are enormous, showing that while the drop off in March was swift and devastating, it appears things were getting back to normal quite quickly. This suggests that while there was significant disruption, the impact should be transitory, and in all likelihood, largely contained to the first two quarters of the year.

To be fair, I'm not suggesting Penske is back to pre-crisis norms by now - although it could be - but what I am suggesting is that investors not overreact to a very temporary exogenous shock. Given this data represents the overwhelming majority of Penske's total revenue, I think there is significant evidence for optimism for a relatively swift recovery.

COVID-19 actions

Penske is doing its part to ensure it survives this crisis and can live to see another day, which is prudent. I mentioned the once-ample dividend has been suspended, which will save ~$34 million in cash for each quarter it isn't paid.

I happen to think Penske will get back to paying its dividend rather quickly as it should remain comfortably profitable this year, and given I expect a rebound back to some level of normalcy next year, there should be ample cash to distribute to shareholders once more.

In addition, the company has increased its cash position via credit agreement drawdowns, deferred $150 million in capital expenditures, reduced advertising, and furloughed 15k employees. Penske also cut pay for executives and management team members, as well as working with its creditors to defer servicing payments.

All of these things have costs associated with them, whether it is direct expense, lost pay for workers, etc., but the steps taken should ensure Penske can come back in a strong position later this year and into next year.

Reasonable valuation is attractive

Penske shares have rebounded very sharply in the past couple of months, so the valuation was much better a few weeks ago. However, as we can see below, on next year's normalized earnings - or close to it - shares trade for less than 9 times earnings.

Source: Seeking Alpha

For a company with a track record of 10% annual revenue growth and 16% operating income growth over the long-term, that's a very reasonable price to pay. For all the reasons I've laid out above, I think Penske offers attractive value at today's price, even after the massive rebound rally.

That said, there are some risks. The primary risk in my view is that the ~40 million people that have recently become unemployed in the US won't be able to find new jobs and at some point, fiscal stimulus will run out. If there is a U-shaped recovery, or something worse, new car sales may suffer, and Penske along with it.

In addition, consumers are saving record amounts of income in the US given the extreme uncertainty of the current situation, so even if people can find jobs, it remains to be seen if they'd be willing to spend their money on a new car.

These are risks and should not be ignored, but a less than 9 times earnings, I see them as priced in. I think we'll see Penske trade back towards 11 or 12 times earnings, which provides ample upside from today's levels. When the dividend is reinstated, that will be a further bonus for investors, but I think the stock offers value either way. If you can stomach the potential risks, Penske is a buy.

Analyst’s 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.