Penske Automotive Group Makes A Pit Stop On Dividend Growth

Summary

• Penske Automotive Group suspended its dividend after 9 years of steady growth.
• Penske's P/E is low, but the company has a higher debt than its peers. Other dealers have better growth prospects.
• Overall industry sales improvement expected in 2021 will still leave sales below 2019 levels.
• The stock can be a speculative play on COVID-19 recovery but is not recommended for income or dividend growth investors.

End Of A Dividend Growth Era

Penske Automotive Group (NYSE:PAG) paid its last consecutive quarterly dividend in March 2020 ahead of the COVID-19 related shutdowns that impacted many industries. The company announced on May 13 that it would suspend the dividend to conserve cash and mitigate the impacts of the government-mandated shutdowns. The company also initiated a hiring freeze, deferred $150 million in capex, and furloughed 57% of its worldwide work force, among other actions. Penske has suspended its dividend once before, starting in 2009 with the financial crisis. It took 2.5 years until June 2011 for the company to resume the dividend at a level of $0.07 per quarter, a 22% cut from the $0.09 paid before the financial crisis. Penske began a rather unusual dividend policy at that time, increasing the payout by 1 cent each quarter until the $0.42 dividend in March 2020.

Source: Seeking Alpha PAG Dividend History page

Penske's dividend yield and payout ratio were at the high end for its industry, but its debt levels are high as well. The company grew and diversified by both capex and acquisition, buying truck dealerships, used car superstores, and an expanded equity share in Penske Truck Leasing. While the dividend looked well covered by free cash flow, long-term debt issuance was often needed to support the acquisition strategy. Short-term debt also grew as Penske expanded the use of floor plan financing.

Data Source: Seeking Alpha PAG Key Data Pages (Cash Flow Statement)

Data Source: Seeking Alpha PAG Key Data Pages (Balance Sheet)

Penske's long-term debt is currently rated B+ by S&P and Ba3 by Moody's, several notches into junk territory. Compared to similar-sized peers Lithia Motors (LAD) and AutoNation (AN), Penske has lower interest coverage as defined by Operating Income/Interest Expense. As of Q1 2020, Penske's interest coverage is below 3. As Moody's considers <3.5 a downgrade trigger, Penske's debt has a negative rating outlook. For comparison, Lithia is at 3.7 and AutoNation is at 3.4. As measured by Net Debt/EBITDA, Penske is also more levered at 8.5, while AN and LAD are at 6. (Floor plan debt is included here. The ratings agencies do not include it in their leverage calculation.)

So, while Lithia has had a much lower dividend yield than Penske historically, it has not had to cut it in response to COVID-19. AutoNation does not pay a dividend.

Others on Seeking Alpha have suggested that Penske stock is still a buy in the absence of a dividend based on its expected 2021 growth and its diversified business model (truck sales and leasing, international dealerships, used car superstores). It is questionable whether these factors will work in Penske's favor at this time. Also, focusing back on the core auto dealership business, Penske has not stood out. Lithia, for example, has been a better performer. In any case, industry forecasts still do not show a large enough recovery in 2021 to get back to 2019 sales levels or better. I will explore these factors more below.

Penske stock has enjoyed a nice run since the COVID-19-induced market crash in March, especially following the surprisingly good May employment report issued on 6/5/2020. The company's leverage makes the stock a potential speculative play for those who want to bet on a continued sharp recovery. For those looking to invest for the long term with a bit more safety, I would avoid PAG and perhaps the whole industry for now.

Few Advantages From Diversification

Penske Automotive Group is different from its peers in its geographic and industry diversification. The company gets over 40% of its revenue from outside the US, mostly from the UK. Penske has been expanding its truck sales and service business, but it remains a small part of the portfolio at 10% of sales and 19% of pretax income. Nearly a quarter of pretax income is from PAG's equity stake in the separate company Penske Transportation Solutions, best known for its truck leasing business.

Source: Penske Automotive Q1 2020 Earnings Presentation

I expect Penske's European business to be a drag on 2Q performance compared to more domestically focused peers. Most European dealerships were subject to stricter and longer-lasting COVID-19-related lockdowns than the US.

In March, it began to impact all our markets. Many of our U.S. and Germany dealerships faced shelter in place orders. All operations in Italy, Spain and the UK were closed. As a result, our overall same-store automotive retail unit sales for the month declined 40%.

Source: CEO Roger Penske, 1Q 2020 Earnings Call

Penske later noted that US dealership sales started picking up again at the end of April, but when asked about the UK, he mentioned a goal to reopen for service and parts on May 11, but full reopening for car sales did not happen until June 1.

Penske's foray into used car supercenters may not be helpful in this environment either. Manufacturers are beginning to ramp up incentives on new cars, increasing trade-in inventories. Bankruptcy of rental car company Hertz (HTZ) could also add used car inventory to the market. Penske was planning to complete construction of 4 used car supercenters this year but has deferred opening to 2021.

On the truck side, sales were already expected to be down in 2020 even before the pandemic hit, as I wrote in my last article on Penske. The latest outlook has not improved. On the bright side, service and parts make up an even bigger part of total profits in the truck business compared to cars. As long as the trucks are on the road, service and parts demand should not be impacted as much as sales. I had mentioned in my previous article, the opportunity for Penske to acquire more dealerships from smaller players more affected by an economic downturn. However, with Penske in capital conservation mode, it is hard to envision them making acquisitions at this time.

Valuations and analysts' estimates do not seem to imply that the market values Penske's business model more highly than a pure-play auto dealer. Going back to its two similarly-sized peers, Penske looks a little better than AutoNation, but behind Lithia Motors. While Penske's EPS is expected to recover strongly in 2021 compared to 2020, it is still expected to be lower than the last 12 months. The same is true for AutoNation. Lithia, on the other hand, is expected to show EPS in 2021 better than the last 12 months. This makes Lithia more worthy of its higher P/E ratio. Note that Lithia is actually cheaper than Penske on an EV/EBITDA basis due to Penske's higher debt giving it a higher enterprise value.

Historical share price performance also favors Lithia. This is a 1-year chart, but Lithia has outperformed Penske over longer periods as well. AutoNation has done both better and worse than Penske depending on the starting point.

Source: Seeking Alpha PAG Chart Page

Industry Outlook Remains Tepid

A recent study by Moody's (published 5/13/2020) showed they revised down their 2020 global car sales outlook to a 20% drop. As suggested by Penske and AutoNation's earnings expectations, that drop will not be fully reversed in 2021, with only an 11.5% gain. Even in 2022, Moody's expects 85-88 million global car sales, still below the 90.2 million sold in 2019 and the peak of 95.3 million reached in 2017.

For the US, Moody's sees a 25% drop in 2020 followed by a 16.2% increase in 2021. For Europe, they expect a 30% drop in 2020 followed by a 17.5% gain in 2021.

Source: Moody's Investors Service (available with free subscription)

A faster recovery from the COVID-19 recession as suggested by the surprise May US employment report could provide some upside to this forecast. The pandemic may even bend the longer term trend away from city living and ride-sharing, both long-term positive for individual vehicle ownership. Lower oil prices may slow the electrification trend, allowing dealers to continue earning profits on the relatively higher service and parts sales associated with IC engines. Nevertheless, all these outcomes are speculative at this point. Given base case expectations, I would avoid the industry at this time or select a company with stronger fundamentals and less debt than Penske.

Conclusion

Penske Automotive Group's distinguishing features versus other auto dealers have been its diversified business model and its high and steadily growing dividend. This. unfortunately. left Penske with higher debt and necessitated a dividend suspension following the COVID-19 pandemic. Share price has rebounded strongly of the March bottom, but as it approaches pre-pandemic levels, it appears to be pricing in a better industry environment than most analysts forecast. Penske's non-US and non-auto portions of the business do not appear to be an advantage when comparing valuations and historical performance to a more pure-play dealer like Lithia.

If the general economy is recovering faster than expected from the pandemic-induced recession, Penske may be a good trade. Stocks of companies with higher leverage that are not best in class often outperform in that scenario. As a long-term buy, however, I would avoid Penske at this time. I recently sold Penske and would want to see a less leveraged balance sheet and a safer and more sustainable dividend before getting interested again.

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.