AN - AutoNation: Leveraged At A Good Point In The Cycle

Summary

• AutoNation has used the pandemic-related windfall profits to aggressively buy back shares.
• I like the long term buybacks, but fear leverage if the market reverts.
• Net debt is a bit too high for my taste at this extraordinary point in the cycle, which shows clear signs of cooling down.

It has been a very long time since I covered AutoNation ( AN ) as my last take on the business goes back to the first week of 2016, when I concluded that I was not a buyer of the dip.

The company is a huge automotive retailer, selling new and used goods, and related goods and services and while the underlying business has been stable, it is evident that much attention and funds went into buybacks, rather than the underlying business, or its growth.

A Quick Recap

In 2015, the company generated sales of around $20 billion which marked a steep recovery from a low of $11 billion in 2009, after the company already posted $20 billion in sales in 2005. The company has been quite stable in terms of its margins, having posted operating margins around 4% of sales on average in the decade leading up to 2015, with exception to a loss in 2008 for obvious reasons.

With margins posted around 4% and net debt reported at $2.2 billion at the time, leverage was reasonable at 2.2 times EBITDA with that latter metric coming in around a billion. The 111 million shares outstanding traded at $50 at the time and with earnings power trending at around $4 per share, valuation multiples were non-demanding at just 12-13 times earnings.

While the growth in the operations was not that impressive, with 2015 sales being flat compared to the level a decade before, real growth is driven by serial share buybacks. In fact, the company bought back 60% of its shares over the same period in time, resulting in rapid growth in revenues per share, but not revenues themselves. Being mindful of the fact that demand was strong already there was a debate if the automotive market was ready for a correction or not, yet AutoNation's long term track record has been quite solid, yet I felt no need to get involved with the shares at the time.

Strong Returns

Fast forwarding from early 2016 to the end of 2022, shares of the company have essentially doubled over this nearly seven year long time period. Shares have actually traded range bound around the $50 mark until the start of 2020. This came as revenues came in flat around the $20 billion mark from 2015 until the start of the pandemic as the company kept posting earnings between $4 and $5 per share. The underlying business has seen some margin pressure, but the company reduced the share count to less than 90 million shares in the process.

After an initial setback, the pandemic was a blessing in disguise as shares quickly recovered to $50 during the year, rose to $100 in April 2021, and ever since have traded pretty range bound between $100 and $125 per share.

Forwarding to February 2022, the company posted very strong 2021 results. Full year revenues rose 27% to $25.8 billion, but that was just part of the story. Strong demand for cars and limited supply resulted in sky high margins as operating earnings more than tripled from $563 million to $1.90 billion, as earnings per share rose from $4.30 per share to $18.31 per share, numbers almost unthinkable.

Part of the strong earnings per share growth was driven by very aggressive buybacks as the company cut the outstanding share base to 62 million shares. Non-vehicle net debt of $3.14 billion rose as a result of the aggressive buybacks, translating into a 1.48 times leverage ratio. This is a bit low, but remember that the profitability is so high, that this is not representative in the future. The optics of a low leverage ratio are a key danger in my eyes.

In April, AutoNation posted very strong first quarter results with sales up 14% to $6.8 billion as earnings per share more than doubled to $5.78 per share. Second quarter sales fell 2% to $6.9 billion as the operating momentum stabilized with earnings per share still up 34% to $6.48 per share amidst continued buybacks, as the company cut the outstanding share base to 56 million shares, which marks that the share count has been cut in half compared to 2015.

Third quarter sales were up 4% to $6.7 billion, with operating performance again flat, as earnings rose 23% to $6.31 per share again on the back of buybacks. Net debt was pretty flat at $3.1 billion with leverage ratios flat around 1.5 times EBITDA.

What Now?

After posting resilient numbers so far this year, with 2022 performance in line with the same period in 2021, the company continues to aggressively buy back shares here. Besides buying back stock, the company announced the purchase of some automotive dealers as well as other investments. In November, AutoNation acquired a 6.1% minority share in TrueCar ( TRUE ), what appears to be a minor investment. In December, the company announced the purchase of RepairSmith as well, a full-service mobile automotive repair and maintenance service in a $190 million deal. This is a bolt-on deal, equal to 3-4% of the market capitalization of the firm here.

The issue with AutoNation in my eyes is the aggressive capital deployment. Current earnings power trends around $25 per share which results in very low earnings multiples, yet these margins are clearly not sustainable. If the company saw a reversal and generate $20 billion in sales and historical operating margins around 4%, profits could fall in a huge way. This means that even if the cycle reverses, earnings per share should still hold up quite well compared to historical standards on the back of hugely aggressive share buybacks.

The issue is that of leverage. Right now net debt comes in far above $3 billion which is fine as EBITDA now trends around $2 billion, yet EBITDA only came in at $500-$600 million in the not too distant past. This results in a 5 times leverage ratio if earnings simply revert to their long term average. There are clear signs that this is happening amidst rising interest rates and car price deflation.

The concerns on leverage and the cycle turning, outweigh the appeal seen by a mere 4 times earnings multiple, even as I recognize the long term value creating track record of the business following the strong share buyback program. Hence, this remains a show me story in 2023, albeit that this is a very interesting long term play, but now does not seem the time to be involved.

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