2023-06-27 07:34:12 ET
Summary
- AutoNation's current share price is close to an all-time high, while facing potential issues ahead, such as slowing demand and declining margins.
- The company underperforms relative to other automotive businesses in growth and profitability, and its poor cash flows make rectifying this difficult to achieve.
- Economic conditions are compounding the headwinds the company faces in the near term, implying a sharp adjustment to financial performance is ahead.
Investment thesis
Our current investment thesis is:
- AutoNation is likely trading at its financial peak. Supply chain issues have boosted its growth and margins. As this impact subsidies, we believe the company will experience a reversion to its prior levels.
- Economic conditions are expediting this process, as demand slows and the cost of debt increases, making financing a car unattractive.
- AN's attractiveness as an investment more generally is questionable, as it underperforms other automotive businesses in both growth and profitability, while poor cash flows make investing in growth difficult.
- AN's share price is close to an all-time high, which we believe is unjustifiable given the issues ahead.
Company description
AutoNation ( AN ) operates as an automotive retailer and provides new and used vehicles, associated parts, and repair services. AutoNation sells vehicles primarily through its dealership network, which includes both new vehicle franchises and used vehicle operations.
The company operates through three business segments: Domestic, Import, and Premium Luxury.
The company also offers various services, including automotive maintenance and repair, vehicle parts sales, and extended service contracts.
Share price
AN's share price has performed well in the last decade, generating the majority of its gains in the post-Covid period, when changing economic and industry dynamics contributed to an impressive increase in financial economics.
Throughout this period, AN has performed well, built on a resilient business model and defensible position.
Financial analysis
AutoNation financials (Tikr Terminal)
Presented above is AutoNation's financial performance for the last decade.
Revenue & Commercial Factors
AN's revenue has grown at a CAGR of 5% in the last 10 years, significantly influenced by its performance in FY21. When excluding this period, growth has been relatively mild, with 4 fiscal years of zero/negative growth.
Business Model and Competitive Positioning
AN's business model revolves around providing a comprehensive automotive retail experience to customers. It is one of the largest automotive retailers in the US, having sold over 14m vehicles .
The company operates a traditional model of a network of franchised dealerships, representing various brands, as well as a large fleet of second-hand vehicles. AN's objective is to reach a large share of the US population, with a clear focus on customer service, convenience, and building long-term relationships with consumers.
AN is deeply entrenched in the automotive industry, providing various related services. We generally prefer this approach, as the opportunities to cross/up-sell are significant while ensuring the business remains within its area of expertise, easing expansion.
A key competitive advantage relative to peers is the company's impressive scale. The automotive dealership industry is relatively fragmented, with a large number of local dealerships. This expansive network allows the business to develop a superior brand, gain scale economies, and reach a wide customer base. This diversity allows AutoNation to cater to different customer preferences and all those undecided to shop around.
Automotive retailing is not an industry in which developing a significant moat is possible. The primary forms of differentiation are the quality of service provided and the brand. We believe AN does well in this regard but the nature of the industry leaves the business susceptible to competition, as consumers have little incentive to remain loyal if AN is uncompetitive on price.
Automotive Industry
The automotive industry has been materially affected by supply chain disruptions, including semiconductor shortages, which have impacted the production and availability of vehicles. This contributed to a once-in-a-lifetime demand/supply mismatch within the industry, contributing to a rapid rise in the price of second-hand vehicles, as well as marked-up new vehicles with long lead times. The following is a second-hand car price index, illustrating the rapid ascension.
Second-hand car market (Autotrader)
This is the primary reason AN has performed so well in the last few years, benefiting handsomely as this has occurred. Pricing pressure has begun to ease, as supply slowly moves toward equilibrium , and demand softens. Our expectation is that semiconductor supply will continue to lag, however, this will not have the impact previously experienced. Automakers are far more prepared and production issues caused by lockdowns will no longer be an issue. This will contribute to a near-term deterioration in AN's performance, as it likely reverts to its mean historical level.
The growing demand for electric vehicles will likely have a significant impact on AN over the coming years, especially in conjunction with an aging vehicle fleet in the US. Our expectation is that we will see increased vehicle purchases, relative to historically normalized levels, as consumers transition away from aged vehicles to new electric ones. Electric in particular represents a key catalyst to encourage said purchases, as consumer awareness of sustainable living improves, and socio-economic signaling motivates purchases.
The automotive retail industry is witnessing a shift towards online car shopping and e-commerce, similar to many other retail industries. AN is potentially losing ground to its peers in this regard, as competitors such as CarMax ( KMX ) have experienced increased growth relative to the business.
Margins
AN's profit margins have been underwhelming, although fairly consistent. The company currently has a GPM of 20%, EBITDA-M of 8%, and a NIM of 5%. Across the historical period, AN achieve very little improvement despite the improving scale, implying a consistent marginal cost.
Since Covid, however, margins have noticeably improved, driven by improved economics as both new and used vehicle prices have soured. Given this is linked to industry supply, we suspect margins will begin to erode over the coming 12-24 months, as the market returns to "normal". This is problematic for various reasons, namely the lack of visibility over where the business will land. Given the inflationary pressures of recent years, AN is not certain to return to its pre-Covid level.
Economic conditions
Current economic conditions represent a key near-term headwind. With high inflation and elevated rates, we are seeing consumers face unprecedented financial struggles. This is contributing to reduced discretionary and large purchases. Elevated rates represent a compounding negative impact, as the risk of default increases and the amount of loans issued declines.
From AN's perspective, this is a serious issue. It is facing the potential of reduced demand, as well as a reduction in financing activities, a key earnings avenue for the business.
Revenue declined 5% in the most recent quarter, implying the business is already feeling the impact of this. Used car sales were down (15)%, with new car sales down (2)%. We suspect the pain will increase if new car sales begin to decline at a greater rate.
Balance sheet & Cash Flows
The increased demand is reflected in the company's inventory turnover, which has almost doubled since Mar23. This has only marginally ticked down in Mar23 relative to Dec22, implying a descent may be in progress.
AN's historical cash flows have been mild to say the least, making it difficult for the business to fund enhanced growth alongside distributions. Management's choice has been buybacks, with current levels unsustainable for the reasons discussed above.
Outlook
Outlook (Tikr Terminal)
Presented above is Wall Street's consensus view on the coming 5 years.
Analysts are expecting softening growth, but importantly positive, in the coming years. This is a reasonable estimate as although we suspect the industry will decline in FY23 (More than analysts, however), there is not sufficient visibility beyond this point to assume a decline is a certainty for FY24. Flat growth between FY22 and FY24F looks reasonable, if closer to the optimistic case.
Further, margins are expected to contract although will remain above pre-Covid levels. This assumes AN will maintain a degree of superiority as a hangover, which is possible if it is able to maintain pricing.
Industry analysis
Automotive retail (Seeking Alpha)
Presented above is a comparison of AN's growth and profitability to the average of its industry, as defined by Seeking Alpha ( 23 companies).
AN's growth weakness, despite the recent improvement, looks to be a reflection of its scale, as the company underperforms relative to the market. Importantly, both Lithia Motors ( LAD ) and CarMax outperform AN, implying a noticeable underperformance relative to direct peers.
AN's profitability is better, but in many key metrics, the company still lags. This is a reflection of its business model, as its dependency on vehicle sales leaves the business with slim margins. We expect this delta to increase in the coming years given the company's direct exposure to vehicles (compared to say its parts peers).
Valuation
AutoNation valuation (Tikr Terminal)
AN is currently trading at 6.4x LTM EBITDA and 8x NTM EBITDA. This is a discount to its historical average.
For a business at an all-time high, one may not suspect it would trade at such a deep discount. This reflects significant investor caution around how the coming years will develop, fearing multiple expansion through a decline in EBITDA/NI (trading at a premium on a Revenue basis).
The FY25 forecast EBITDA currently implies a forward multiple of 8x, a high level given it is over 2 years away and the business may normalize at a valuation of 9-10x. Analysts currently see an upside of just 3%.
Key risks with our thesis
The risks to our current thesis are:
- Margin resilience, which would support an elevated future multiple. The lack of visibility contributes to uncertainty.
- An unanticipated shortening of when rates will decline could support resilience in the market.
Conclusion
AN has many attractive qualities, such as its scale, brand, and resilient financials. However, we believe the company is at a peak from which a decline will occur. With a decline in revenue and margins likely ahead in FY23, we believe the business is unjustifiably trading at its current level.
For further details see:
AutoNation: Trading At A Peak With Headwinds Ahead