2023-10-26 07:05:04 ET
Summary
- Penske Automotive Group's diversification makes it deserving of a slight premium to competitors.
- The company made sustainable improvements to its cost structure and balance sheet over the last few years, helping it withstand any upcoming economic headwinds.
- Roger Penske's majority ownership should provide a floor on the shares, as a management buyout looks feasible if he wanted to do one.
A Different Kind Of Automotive Dealer
I have covered Penske Automotive Group ( PAG ) semi-regularly on Seeking Alpha since 2019. A key theme in most of those articles was the unique diversification of the company compared to its peers in the Automotive Retail industry. Penske Automotive is diversified by geography, with 61% of sales in North America, 31% in the United Kingdon, and 8% elsewhere, mainly Australia and New Zealand.
PAG is also diversified by business segments. Auto retail is the sole business for most of its peers, but it makes up only 62% of the PAG's pre-tax earnings so far this year. 15% comes from commercial truck dealerships (sales and service) in the US and Canada. 3% comes from its Australian power system and commercial truck business, and 20% comes from its equity stake in Penske Transportation Solutions, the truck leasing and logistics business.
Penske's diversification allowed it to hit on "all cylinders" during the Covid pandemic. After the initial shock in March 2020, Penske scrambled to cut costs and even suspended its best in class dividend . At the time, no one expected the company to be positively impacted , but the company soon started posting a string of record results. The "work from anywhere" trend and flight to the suburbs increased demand while government stimulus payments provided consumers the cash needed for discretionary purchases. Penske was able to navigate the chip shortage better than many dealers because of its premium brands and substantial used car business. The trucking side benefitted from added demand for shipping caused by the shift from in-store to online shopping.
While it took a few quarters for the market to see the value, by mid 2022, Penske surpassed its peers on total return performance off the March 2020 bottom. The company has remained in the lead despite an apparent peak last quarter.
This over 5-bagger return (over 6-bagger at the July 2023 peak) in only three and a half years was impressive in a mature industry, so it is reasonable to expect some pullback, especially considering 3Q 2023 results . Both YTD and 3Q results are down over 20% from the same periods in 2022. Let's look at the income statement to see what is driving the decline and how much we should worry.
3Q Earnings: Off Record Pace But Not A Crash
Net income was down about $77 million in Q3. These are the key drivers:
- Gross Profit: +$34 million
Penske is doing well on the sales side. In terms of units sold, new car sales are up around 8% while used car sales are flattish. Commercial truck sales are more variable. These were up 7.2% year to date but were down 7.9% in 3Q, however the company attributes this to production timing and delivery delays. Pricing on both cars and trucks remains strong. The premium-branded new cars that Penske sells are less sensitive to economic conditions and will help cushion sales in a downturn. The brand mix also insulates Penske almost completely from the impact of the auto workers strike in the US. Service and Parts, which have higher margins than vehicle sales, are also holding up well.
- SG&A Expenses: -$61 million
Penske made a clear step change downward in SG&A as a percentage of gross profit starting in 2020, cutting costs during the pandemic and implementing technology to enable more sales activity online. While this metric has been creeping back up this year, some of it was due to a $6 million hit from hailstorms in Texas this quarter. Higher cost of service loaner cars was also cited as a component of the increase. The company views service loaners as a positive, as they can be used as marketing tools and a source of used car supply. Most of the cost cuts since 2020 should be sustainable.
- Interest Expense: -$28 million
Most of this increase is due to floor plan interest rates which are variable and tied to short-term interest rates. Outside of floor plan debt, which the company uses to finance inventory, Penske has low leverage and mostly fixed rate debt issued at lower rates. Floor plan interest will continue to be higher as long as rates are high, but this could be partially mitigated by sales moving to the agency model as some manufacturers are doing in Europe. In that case, the manufacturer continues to own the vehicle until it is sold to the customer and pays the dealer an agency fee for the sale. The dealer does not need to finance inventory under this model.
- Equity in earnings of affiliates: -$51 million
This line represents PAG's equity interest in the Penske Transportation Solutions truck leasing business. Higher maintenance expense of $40 million was the primary component of the decline. Rental utilization was also lower and gain on sales of used vehicles was also down. Penske is partially "hedged" on maintenance costs as the commercial truck dealership business benefits from higher service and parts revenue.
- Income Tax Expense: +$34 million
This is simply lower taxes due to lower pre-tax income. The effective rate did not change significantly.
While net income was down 23.6% in the quarter, EPS was down only 15% due to a strong reduction in share count from buybacks. This has been a regular activity for PAG, and share count is down 20% in the past 5 years.
Putting it all together, there are clearly some parts of the business that are impacted by economic cycles, but Penske has shown that it can really take advantage of the up part of the cycle as it did in 2021 and 2022. Current earnings performance, while off the peak, is still on pace for $16/year EPS, valuing the company around 9 P/E, a modest premium to its less diversified competitors.
There is another unique attribute to PAG that should support a higher valuation, which is its ownership structure and ease of realizing a management buyout to take the company private.
Easy To Take Private
Penske Automotive Group is more than 50% owned by 86-year-old racing enthusiast and Presidential Medal of Freedom winner Roger Penske. Roger owns 49.5% of PAG through his privately held Penske Corporation and owns another 1.4% of PAG directly. The second largest shareholder is Japanese trading company Mitsui ( OTCPK:MITSY ) ( OTCPK:MITSF ) with 19.3%. Mitsui has an agreement to vote their shares in-line with Penske Corporation on up to 14 board candidates.
Proxy Statement (Penske Automotive Group)
Roger's majority interest would make it easy for him to sell the company if he desired, similar to Berkshire Hathaway's ( BRK.A ) ( BRK.B ) purchase of Van Tuyl Automotive in 2015. (Today, Berkshire Hathaway Automotive is about 45% the size of PAG by sales, based on information in Berkshire's latest 10-Q .) However, that appears unlikely, as Roger's son Greg Penske was named vice chair of the board in January 2023 indicating plans to keep the company controlled by the family for the next generation. A management buyout would be a more likely case.
PAG has the debt capacity to facilitate a go-private transaction, keeping Mitsui as a private minority shareholder. Penske has low leverage of 1.0x EBITDA excluding floor plan debt which is secured by inventory.
There are 20 million PAG shares outstanding not owned by Penske or Mitsui. (29.9% of 67.217 million) At $150/share, the company would only need to raise $3 billion to buy out the public shareholders. If they took out debt to do this, it would increase leverage to 2.75x EBITDA. As the CFO often states on earnings calls, PAG has flexibility from its lenders to go up to 4x leverage.
Penske was fortunate to issue debt in the past at low coupon rates of 3.5% and 3.75%. Given the increase in rates, these bonds are now trading at yields to maturity of 6.3% for maturity in 2024 and 7.6% for those due in 2029.
$3 billion of new debt yielding 7.6% would increase interest expense by $228 million per year pre-tax, or about $180 million after tax given the incremental US corporate tax rate of 21%. PAG's interest coverage (operating income / interest expense) would be between 4 and 5 times assuming current year earnings (excluding floor plan interest). Partially offsetting this, PAG would avoid paying the dividend on the 20 million currently public shares, improving cash flow by about $64 million per year.
PAG had free cash flow over $1 billion per year from 2020-2022. Over the trailing 12 months, it has come down to around $850 million. Let's say this further normalizes to around $750 million per year in 2023. In the case of a buyout, PAG would no longer have to worry about further share buybacks or the dividend to public shareholders. If we subtract the net cash impact of the takeover financing ($116 million) and the dividend still due to Mitsui ($43 million) PAG would still have $591 million per year of cash flow. This would allow them to conduct M&A at their typical levels with a couple hundred million per year left over to pay down the debt.
This buyout analysis is just math, not a prediction of what I expect Penske to do. Nevertheless, the possibility of such a transaction should provide support for the shares relative to those of competitors.
Conclusion
Like many companies that saw earning boosts from the pandemic, Penske Automotive Group is now backtracking a little from the record earnings it had in 2022. This does not mean a return to 2019 levels as Penske has made sustainable improvements to its cost structure and balance sheet since then. The company has also continued to grow through acquisitions of car and truck dealerships as well as building of new used car superstores. While not immune to cyclical pressures, PAG's more diverse business mix makes it a fair value at the current 9x P/E, a slight premium to most competitors. If the shares get too cheap, the possibility exists for Roger Penske to take the company private. I would not buy the shares just to speculate on that outcome, but I am satisfied to hold them even with oncoming economic headwinds.
For further details see:
Penske Automotive Group: Supported By Privatization Possibility