LAD - Buy Asbury And Lithia To Profit From A Return To Normal In The Car Market

2023-11-22 13:17:24 ET

Summary

• Car dealerships, including Lithia Motors and Asbury Automotive, have fallen out of favor with investors due to pandemic-related issues in the automotive industry.
• Asbury Automotive is more profitable than Lithia Motors, while Lithia has been growing at a faster rate.
• Both companies are trading at significant discounts to historical valuations, presenting a buying opportunity for investors.

Due to many well-known pandemic problems in the automotive industry, car dealerships have fallen out of favor with investors. Lithia Motors and Asbury Automotive have been tossed out with the bathwater. Both companies own several hundred automotive dealerships with a similar mix of new and used cars sold. While most of their revenue comes from these car sales, an outsized portion of profits comes from the high-margin repair and servicing business. Below, I argue that Asbury is a stronger business with a better balance sheet in a preferable part of the industry, but that Lithia has a stronger management history and faster growth. I recommend buying both stocks now.

Growth and Profitability

Lithia has been growing faster than Asbury, but Asbury is more profitable.

Lithia Motors and Asbury Automotive have been two of the fastest-growing and most successful companies of the last several decades. Lithia has grown revenue by almost 20% per year since 2014. While Asbury's top-line growth has been slower, its higher profitability has led to even better earnings growth over time. I have not been able to access data going back beyond that but share price appreciation in the 1990s and 2000s suggests that these trends have been continuing for decades. Moreover, for both firms, revenue growth has driven improved profitability over time. This is shown first in the fact that diluted earnings per share have grown faster than revenue. They have also grown faster than their two main competitors, AutoNation and CarMax (except for Asbury's dip in EPS growth over the last three years).

Both companies have also progressively increased margins over time. But for Lithia, returns on assets, equity, and invested capital have come down from their pandemic heights. This has not been true for Asbury.

Lithia Motors

Asbury Automotive

Asbury's superior profitability has enabled it to generate more consistent cash flow and maintain a stronger balance sheet than Lithia. Asbury has stayed cash-flow positive in the face of a challenging economic environment over the past year, unlike Lithia. Its interest coverage and current ratio are over 50% greater than Lithia's, and its debt/equity ratio is about 50% lower. In short, Lithia and Asbury have maintained high growth and profitability over at least the last decade. While Lithia's top-line growth has been faster, Asbury has had faster earnings growth over the longer term and has significantly higher margins and returns on capital invested in the business.

Valuation and Upside

Both companies are trading at significant discounts to historical valuations.

We would normally expect a growth business like this to generate amazing investment returns and trade at high price/earnings multiples, but this is not the case.

Investment Returns

*Asbury didn't reach the end of its pandemic run-up until April 2021, so I calculated returns from that date, which is about 2.5 years ago.

Lithia and Asbury have generated returns commensurate with their growth rates over the last ten years. Lithia's growth rates have been slightly higher, and so has its share price appreciation. Both have been incredibly good investments for long-term shareholders. Over the last three years, however, their share prices have been flat. CarMax, with its lower growth rate, is also now trading at pre-pandemic levels. AutoNation is up.

During the same period, Lithia and Asbury's revenue and earnings growth have continued. As a result, both company's valuations have contracted.

Lithia Valuation

*includes 2014, when cash flow contracted and the ratio was over 300.

Lithia's valuation now stands at significantly below long-term averages. A return to the 10-year average valuation would imply a 100% upside to the current share price. Excluding Price/Cash Flow, which has been slightly more volatile, the implied upside would be 81%, yielding a price target of $500. Over my standard three-year investment time horizon, this would equate to an annualized return of 22.6%, similar to the 21.9% 12-month return expected by analysts.

Asbury Valuation

Asbury's valuation is slightly lower than Lithia's, perhaps due to its lower growth rates. By two of the four metrics I assessed, it is trading at a significant discount. A return to the 10-year average valuation would imply a 69% upside to the current share price, or a price target of roughly $350. (If we excluded Price/Cash Flow, the implied upside would be 100% for a price target of $420.) The more conservative figure would equate to an 18.6% annualized return, below the 24.8% 12-month return forecast by analysts.

Why have their multiples contracted, even as business has continued to grow? Mathematically speaking, this has happened because their share prices have been flat as earnings have increased. In market terms, we could explain this in two possible ways. First, it is possible that their growth prospects have dimmed significantly. Asbury's growth has decelerated over the last three years, while Lithia's has accelerated. Second, it is possible that the market is ignoring their potential. Below, I will argue that this is probably the case.

Sentiment

Lithia is a favorite of long-term value investors

These stocks are not market favorites, but analysts who follow them remain optimistic. Seeking Alpha contributors have been consistently bullish on both companies, but there has been little analysis of both on Seeking Alpha recently. Only a handful of Wall Street analysts follow them. Over the last year, according to Smart Consensus, the number of analysts covering their parent industry of "other specialty retailers" has fallen from 32 to 18. Only a few analysts have issued reports and price targets for either company in the last quarter.

Nonetheless, both stocks remain favorites of long-term value investors. Lithia and Asbury are the #1 and #2 largest holdings in David Abram's portfolio. Abrams, the "wealth machine" value investor whose fund returned 15% per year between 1999 and 2014 ( link ), holds around 40% of his portfolio in the two companies, and slightly increased his stake in Lithia in the third quarter (WhaleWisdom). He initiated both positions, it seems, around 2017, and has held them through the pandemic for significant gains. Impactive Capital and Simcoe Capital each also have over 20% of their holdings invested in Asbury, according to Morningstar. Conifer Management, run by Sequoia Fund alum Greg Alexander, has 23% of its assets in Lithia. Lithia is also the second-largest holding in the Oakmark Select Fund according to its Q3 13-F filing. Both companies (especially Lithia) have attracted a few value-oriented hedge fund investors but remain mostly ignored by the broader community of analysts.

The quantitative trend rankings are bearish, which I take as a positive indicator. The MarketEdge technical analysis is bearish. And the MarketGrader recommendation is to sell Lithia. For context, MarketGrader recommended selling the stock as it rose in spring 2019, recommended holding it as it spiked in 2019 and 2020, recommended buying it as it fell from 2021 to early 2023, and recommended selling it as it rose this spring. The ratings for Asbury have similarly served as a contra-indicator of future stock performance.

Leadership

Lithia has the advantage of being a founder-led company

Lithia is a classic founder-led company. It was started in 1946 by Walt DeBoer. When he died suddenly in 1968, his son Sidney took over the company. He oversaw its growth and took it public in 1996. After he retired in 2011, his son Bryan took over as CEO. Sidney remains Chairman of the Board and Bryan is still CEO. Bryan started working in the business in 1989 as the manager of a dealership and worked his way up through the family company before taking over. According to Dwell, he still lives in the small town of Ashland, Oregon where Walt started the company, and lives across the street from its main park: Lithia Park ( link ). He is currently 56 and thus presumably has at least a decade left at the company. Apparently, his daughter is currently also working at the company ( link ).

Additionally, Bryan DeBoer owns a large and stable number of shares. According to recent filings he currently holds about $60 million dollars' worth of shares. According to wallmine, since 2020 he has owned his largest number of shares ever, at around 220,000 ( link ). This was up from the period c. 2017-2019 when he owned around 100,000 shares. Most of his income comes in the form of stock-based compensation, further aligning his interests with those of shareholders.

The leadership of Asbury is less remarkable but has likewise consistently executed their growth plan.

Business

Asbury gets much better employee reviews.

Lithia is especially unpopular with employees. In the industry, CarMax is the clear winner in terms of customer and employee satisfaction, whereas AutoNation, Lithia, and Asbury are less well-liked. But among them, Lithia is the most widely disliked by its employees, whereas Glassdoor ratings for Asbury rival those of CarMax.

*also from Glassdoor **Better Business Bureau

Industry Trends

Asbury is better positioned

There are three major changes happening in the automotive dealership industry, and each of them plays into Asbury's hands.

The first is consolidation. According to IBISWorld, the market for new and used cars totals between one and two trillion dollars. The only companies which have notable market share are CarMax (12% in used), Lithia (2% in new) and AutoNation (2% in new). In other words, this industry remains very fragmented. There are tens of thousands of auto dealerships, and there have been for decades. According to Warren Buffett, in 2014 there were 17,000 dealers, as opposed to more than 30,000 40-50 years ago (Fortune interview link ). According to Buffett, there are very few economies of scale among automotive dealerships (2015 report link ). Morningstar analyst David Whiston disagrees, making the classic argument that scale enables dealers to lower administrative overhead. Regardless of the reason, the decreasing number of dealerships indicates that there has been a long trend towards consolidation in the industry, as more successful operators use their excess profits to buy up their competitors and increase the scale of their businesses. Nonetheless, there is still a huge amount of room for future consolidation. This, I believe, plays into Asbury's hand, because Asbury has a stronger margin profile and less debt, and thus will continue to generate more excess cash to fund acquisitions over the medium term. Lithia has been benefiting from the same trends, but is in a weaker financial position.

The second major change is the normalization of car demand, supply, and prices after the pandemic. According to data from the Fed, domestic auto inventories hit their lowest level in at least three decades last year due to a drop in the supply of new cars ( link ). As a result, after being basically flat for over twenty years, the prices of new and used cars jumped for the first time since 2000 ( link and link ). These price jumps coincided with a rise in share prices and profits for Lithia and Asbury in 2020-2021. Since then, inventory has gradually started to climb again, and prices are coming down. Nevertheless, they remain about 35% above their 21st century average. Everyone expects (reasonably, in my view), that over the next few years, supply will continue to increase, driving prices down to more normal levels. Since both companies take a cut of sales as their profits, lower prices will presumably mean lower earnings. This drop can be mitigated by the more stable profits derived from services and fees, but it will likely weigh on earnings over the next few years. Again, I think that Asbury will be better able to weather this storm than Lithia. Lithia has already gone cash flow-negative over the last 12 months, whereas Asbury has not. Over the next few years, Asbury's ability to continue generating cash flow should enable it to continue expanding as smaller and less profitable competitors struggle to deal with falling vehicle prices.

Asbury's superior profitability is driven by its higher proportion of new luxury vehicles, which is a portion of the market more insulated from competition and other trends. Buying a used car is risky for consumers because the car may be damaged, and because its price is difficult to determine. This is one reason why CarMax has been so effective in taking market share in the used vehicle space. Another is that their prices are low and transparent, which (I would imagine) is what price-sensitive used car buyers are more likely to want. Lithia has historically specialized in selling less expensive cars to poorer buyers in more rural areas. While their geographic isolation has given them some protection against competition (according to Morningstar), I would imagine that many rural customers will be willing to travel longer distances to get better prices at CarMax or another dealer.

By contrast, I think that Asbury's luxury business will continue being more insulated from competition, because its customers will be less price-sensitive. I think that buyers of new imported luxury cars will be more likely to want to buy their cars in person from reputable local dealers and then have them serviced at the dealership. These cars are not quite as commodified as the used and cheaper cars which Lithia and CarMax specialize in. And given how well-run the Asbury dealerships seem to be (at least judging by employee satisfaction), I think that they will probably continue to provide a value-adding buying experience for their customers. It doesn't hurt that, due to persistent high inequality, it is precisely these richer buyers who are more likely to continue spending more over the coming months and years.

Why Now

Several recent events make this a good time to buy. First, autoworker strikes ended last month, which means that production will resume on repair parts that are a particularly profitable part of the automotive dealership business. As the Wall Street Journal noted, this should have a positive effect on dealership companies, but the market seems not to have noticed yet ( link ). Second, the stocks sold off almost 10% last week after Amazon announced that it would begin selling cars on its platform. As numerous thoughtful investors have noted, this is probably an overreaction. Even Amazon would be challenged by the logistics required to ship and deliver cars to homes across America. And again, it is a trend which will probably hurt Lithia more than Asbury. And third, as strikes end and car production ramps back up, there is probably still significant pent-up demand for cars. Although inventory levels have recovered somewhat since the end of the pandemic, they remain at historic lows ( link ). All of these conditions make this a great time to invest in Asbury or Lithia.

The Risks

I have mentioned several possible risks to these businesses, especially falling car prices and the entry of new competitors more capable of selling online. The most serious long-term risks to the dealership business, however, come from regulatory change, electric vehicles, and sales declines. Most dealers are protected by regulations which limit competition. If this were to change on a state or national level, this could seriously damage the profitability of dealerships. I do not see any immediate reason that this would happen. Another potential medium-term risk is that electric vehicles become dominant and require less servicing, significantly driving down the profitable parts and repair business. EVs are forecast to become a very significant portion (if not the majority) of new car sales over the coming decades. But conversely, this has not happened yet, and many car makers are having problems producing EVs. Electric vehicles also still have many of the same parts which need regular maintenance as gas vehicles, and it remains unclear how their batteries and related parts will need to be serviced. For now, it does not seem like the transition to EVs will significantly damage the profitability of dealerships. Finally, new car sales could decline. Even optimistic forecasts only see them rising by a few percentage points per year over the next 5 years. I do not see this as a major long-term risk, since over the last fifty years, car sales have remained basically flat at around 12-15 million units per year ( link ).

Asbury vs. Lithia

As explained above, I think Asbury has a stronger balance sheet, a better execution record, and a stronger market position than Lithia. Conversely, value investing experts are more optimistic about Lithia, and it is growing faster. Asbury is 20% more expensive relative to sales, but since it has higher margins, its price/earnings ratio is 40% lower. I think that its lower growth rates are compensated for by its stronger business profile, and that this will lead to better long-term results. While I am impressed with Lithia's founder-led growth story, it also has worse employee reviews, a less advantageous market position, and a weaker balance sheet. Both companies have ambitious growth targets for 2025, but I think that Asbury is more likely to meet them. If earnings increase as much as management expects, and this return to growth also inspires multiple expansions back to the long-term average of about 10, prices would double from current levels. I see that as a very tangible possibility in the next 2-3 years, and the corresponding 25-40% annualized return is well worth the risk for both companies.

Bottom Line

People will continue buying cars from auto dealers, and the best companies will continue capturing increased market share. This market share expansion will drive revenue and earnings growth, which will continue to pave the way for share price appreciation for Asbury and Lithia. The automotive dealership industry is very large and very fragmented, so there is a huge growth runway for successful acquirers. Even if EVs take market share, Tesla and Amazon find ways to sell cars directly to consumers, and people buy fewer cars, there will still be enough of a market opportunity left for these companies to grow significantly. I see no fundamental reason that growth will slow over the coming decade.

Given the attractive valuations of these two companies, I see this as an excellent investment opportunity. Even if growth decelerates further, the significant discount to historical valuations provides investors with a significant margin of safety.

Note: all valuation calculations are based on prices on 11/19/2023.

For further details see: