Turning to some specific equity ideas, what’s behind your interest in Group 1 Automotive (GPI)?
SR: Group 1 is the fourth-largest automobile retailer in the U.S., with a better-than-average product mix consisting of 65% Asian brands. We own about 7% of the company but we haven’t made it as big a holding as we might because of our concerns about the macro sell-through of automobiles in the U.S.
Auto sales are obviously volatile and sensitive to the economy. If you look back in time, new-auto unit sales declined 31% in 1982 from the high in 1978, 23% in 1991 from the high in 1986, and this year are expected to come in around 14.2 million units, which is 18% below the most recent peak of 17.4 million in 2000. Our thesis for Group 1 isn’t that new-car sales have hit bottom – we don’t think they have – but that the upside for the company over the next five years more than offsets the downside we believe exists. We think the market is missing just how profitable and well-positioned the parts and service side of the dealer business is.
Over the past 35 years the auto retail industry has never lost money in an individual year, largely because parts and service is not nearly as economically sensitive as unit sales. If your car breaks down you have to get it fixed. Group 1 earns about 40% of its gross profit from parts and service and we consider that to be a growth area, for a few key reasons. The electronics in cars are increasingly complex, so the neighborhood mechanic can’t afford the specialized service equipment that each make of car requires. At the same time, new cars are being sold with longer warranties, which will make it more likely that customers will get their servicing done at the dealer. Finally, the increasing number of used cars having gone through a multi-point inspection and being sold as certified will make those cars eligible for extended warranties – Toyota’s is for up to eight years and 80,000 miles – all of which will also improve the dealers’ warranty business.
Does anything in particular distinguish Group 1 as an operator?
SR: The company under Earl Hesterberg, the CEO since 2005, is very well managed. They’ve made the entire operation more efficient and more focused on driving sales. The efforts haven’t really shown up yet in the numbers because of the struggle with declining unit sales, but we expect to see real operating leverage when sales eventually pick up again. Normalized for a reasonably good economy, I believe Group can earn as much as $5 per share. For that to happen, annual sales would have to increase from roughly $6 billion today to $7 billion – roughly half from getting back to normal and half from acquisitions – and EBITDA margins would have to increase from around 3.5% to 4%.
That earnings estimate makes the shares, recently trading at $19.30, look cheap.
SR: None of the publicly traded auto dealer roll-ups have been public through a true consumer recession, which makes the market understandably concerned about what’s going to happen to profits in the current downturn. But as they get through this cycle – we’re not smart enough to say when that happens – we do think these companies will not have suffered as much as the market seems to expect. That would justify a higher P/E valuation than in the past, but even at a 13x multiple – in line with the past – Group 1’s shares would be worth $65 if they make our $5 per share earnings estimate.
How are you looking at downside?
SR: We stress tested our model to see what would happen if units declined another 20% from current depressed levels. Even if that happened we’d expect Group 1 to still earn $1.00 to $1.50 per share. At a 10x multiple of trough earnings, that’s maybe a $10 share price on the downside. If I think the shares can get to at least $65 over the next five years, that’s an upside/downside ratio we can live with.
Does the large short position in the shares concern you?
SR: The shorts have been right so far. This sector understandably has been heavily shorted given its economic sensitivity – we’re short ourselves other companies in the industry – but we’re looking through the cycle and betting on what we think is the best-run player in the sector.
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