2023-10-27 12:44:40 ET
Summary
- AutoNation, Inc. shares have steadily fallen since August but traded marginally higher in response to a solid earnings report.
- The company's earnings beat expectations, with revenue rising by 3% and gross profit down 1% due to normalized gross margins.
- AutoNation's buyback program has been a significant driver of value creation, with the company reducing its share count in half since the end of 2020.
- After-sales service is really the core of the business, and even as new car margins normalize, AutoNation can earn over $14/share.
Shares of AutoNation, Inc. (AN) have been a solid performer over the past year, rising about 28%, though they have steadily fallen since August. Shares did trade marginally higher on Friday morning in response to a solid Q3 earnings report . The stock has also rallied by about 28% since I recommended investors buy the stock last October . With these most recent results in hand, now is an opportune time to see if there is further upside or if investors should look elsewhere. I see further upside even as the business is normalizing.
In the company's third quarter , AutoNation earned $5.54, beating consensus by $0.04 as revenue rose by 3% to $6.9 billion. EPS was down from $6.00 last year as gross margins normalized. Gross profit was down 1% with 90 of margin compression while higher interest rates also led to increased interest expense. Helping to offset these pressures, AutoNation's share count is down 21% thanks to its ongoing buyback. This has been a large part of AN's value creation over the past three years.
Looking at segment results, new vehicle revenue rose by 11% to $3.2 billion as supply chains normalized, with manufacturers able to deliver more units to AN. As such, units sold were up 12% to 62,289. Last year when there was a shortage of cars, dealers were able to sell cars at full price, or at times above the suggested price. As volumes have recovered, pricing power has softened a bit.
As such, gross profit per car was down 30% to $4,025-this is still a healthy level as will be discussed more below. With production improved, AN has nearly doubled its new vehicle inventory to 27,500 vehicles. This provides a 31-day supply of cars, from 14 last year. This is a healthier position to be in, and inventories still remain light from a historical perspective.
Because new cars were so hard to buy for several years, there was a well-documented surge in used car prices. As new car supply has improved, we have seen a moderation in used car activity, as one would expect. Used vehicle revenue was down 9.6% from last year, but it was up 4% sequentially, so we may be seeing a bit of a bottoming. Units were down about 4% to 72,516, implying about a 5% reduction in selling prices. Gross profit per car was down about 7% to $1,746, given normalized pricing. Gross margins for used cars have held in better than new cars because wholesale prices for used cars have fallen alongside selling prices, providing an offset. AN has a healthy 33 days supply of inventory.
In the short term, the UAW strike at the Detroit automakers could reduce new vehicle deliveries somewhat, tightening supply and supporting pricing. However, with the strike having been targeted, and Ford (F) just reaching a deal with the union, I expect any benefit to AN will be small and very short-lived in Q4. I do not see it as a material investment thesis.
When we think of auto dealers, we always focus on the car sales. There is the flashy showroom, all of the salespeople, the lots filled with vehicles, and so forth. However, it is important to emphasize that car sales are not the primary driver of AN's profits. While new and used car sales account for 78% of revenue, they generate just 29% of gross profit. The most important unit for AN is parts and services. The most important part of car sales is creating that relationship for future service activity, which is why rising volumes, even at a lower margin, is a good thing.
Critically, after-sales revenue rose 12% to $1.2 billion. Gross profit was up 14% to $546 million as an increased technician headcount gave it more capacity. AN is seeing increases across all categories, from warranty to collision, and with new car prices elevated, consumers may be choosing to keep and service their existing cars for longer. Additionally, financial services gross profit was up 2% to $370 million, due to higher volume with gross profit per vehicle essentially flat at $2,741 from $2,755. Service and financing activity is really the base of the business; it is also far less cyclical than new and used car sales.
The base of the business is continuing to perform solidly, while the windfall from excess gross profit on auto sales due to supply chain issues is normalizing. As such, free cash flow has fallen from last year but remains very healthy at $737 million this year. With strong cash flow, AN has done $712 million in buybacks this year, $286 million of cap-ex, and $271 million of M&A. This has modestly increased debt, but financial leverage is just 2.0x, well inside its 3.75 covenant.
The magnitude of AN's buyback is really breathtaking. With 43 million shares outstanding at quarter end, AN has bought back half of the company since the end of 2020. Higher car gross margins have allowed the company to massively lower its share count and have structurally increased EPS. This is one benefit of the stock trading at just 5x earnings; at such a low multiple, the share count reduction is extremely powerful.
Now, shares trade at such a low current multiple because earnings will continue to normalize as gross profits return to long-run levels. AN has a long-term average of $2,467 gross margin on new cars and $1,608 on used cars. Relative to Q3 levels, this would be a $75 million headwind to net income from new cars and $9 million from used cars. That still leaves the company with ~$3.63 in quarterly earnings power. That is also at today's share count, but given earnings-supported capital returns, the share count can continue to decline 5-8% per year. Moreover, inventories, while up, are lighter than average, so I suspect it will take time for margins to fall this much, meaning the share count reduction is likely to be closer to 10% over the next year.
With each share it repurchases, AutoNation, Inc.'s run-rate earnings rise further, now safely around $14/share and on its way to $15 just given buybacks over the next two quarters. Ultimately, I think this stock should trade at least 10x its sustaining earnings level given the stability provided by services revenue. I would look for shares to get to $150, pointing to about 15% upside. I would stay invested in AutoNation and let the buyback continue to work for you.
For further details see:
AutoNation: A Solid Q3, Aided By An Accretive Buyback Program