2023-10-04 04:18:28 ET
Summary
- I owned a small number of shares in Penske Automotive that I'm now selling.
- Penske Automotive has overperformed in the past but not likely to replicate that in the near to medium term.
- I believe that the company's valuation is inflated and expect a decline in revenue growth and margins in the coming years.
Dear Readers/followers,
I actually do have, or had, shares in Penske Automotive ( PAG ). These were a small number of shares bought many years ago - before COVID-19. Due to the position being so small and having had other opportunities that I viewed as better at the time, I have neither expanded nor sold my position - at least until now.
Going by the company's performance, I obviously do wish that I had gone "deeper" into the company here - the outperformance over the past few years has been significant. But going into the next few years, I don't believe this is very likely to be replicated, and I also don't see this valuation as being justified if it's not at least providing growth.
Why?
That's something I'll show you in this article on Penske stock.
Penske Automotive - An interesting player, but Overvalued now after a significant valuation expansion
So, I actually haven't covered Penske automotive before, despite owning stock in the company. That's because this company was actually a tip from someone I trust, and up until a few months ago, I hadn't done the type of deep dive that I typically do for a company that I invest in.
Given my small position in the company, I'm fine with this - but it's not something I intend to repeat in any other position I have, and I'm correcting it here.
So, what exactly is Penske Automotive?
The company, headquartered in MI, is a business operating both commercial and consumer automotive and truck dealerships - not just in the USA, but in Europe, Australia, and New Zealand as well as Canada. The company is also a large shareholder of Penske Transportation, with a 28.9% stake, which manages a fleet of over 400k trucks, tractors, and trailers. It's a relatively new company - less than 30 years under its belt and hasn't been listed until right before the GFC in 2007.
Here is where the company's current operations can be found.
So, not your "typical" dealership, which I've elected very strongly not to invest in here in Europe, even when the dealerships technically look like good deals. There are many changes happening in the industry at this time, and I don't necessarily feel that many of the current dealership operators are prepared for what changes including a more direct-sales model are going to bring. I don't personally believe this will be a net positive for consumers, and some consumers may even fight this change (by voting with their wallet, as it were), but I see and I do believe that this change is coming.
That being said, the company is perhaps one of the best-diversified operators I have ever seen in terms of brand mix. 25% of the retail brand sales are BMW ( BMWYY ), with the next large brand being Audi at 11%, Toyota at 10%, Benz at 9%, Jaguar at 8%, Porsche at 8%, Lexus at 3%, and so forth. In short, the company has every appealing non-American-made brand out there (and it also has American brands like Jeep, Dodge, Lincoln, and others. The only brand I can see that it doesn't have in this segment is Rolls-Royce - which makes sense, as the brand doesn't "Mix dealers" as such.
So on a fundamental basis, based on this mix, I expect better than a junk-rated BB+ (albeit close to IG). The company is on the path towards IG with leverage that from 2019 at 2.9x is down to 0.9x in 2Q23 (though debt/EBITDA is still high), which also represents the latest set of company results we have for the company.
The company's operations are split into 2 segments - retail automotive and retail trucking, with obvious splits/differences between them. Out of that, retail automotive is by far the most important.
Why is that?
Take a look at the business model.
Penske Automotive Business model (GuruFocus)
Now, are those good margins?
Both yes and no. The company is slowly improving its margins, but a 4-5% net margin is average for the industry the company is considered to be a part of, in this case, Vehicles/parts. This "average" view also includes the company's debt fundamentals, where the debt/EBITDA of 3.65x is actually significantly less positive than the overall sector average, though improving on a sequential basis for the company. The fact that the company is improving most of its fundamental and profitability-related KPIs is a positive here, given the overall inflation and cost-increase trends we're otherwise seeing. However, there's a massive COGS position of over 82% for this company. Typically, any company with this amount of expenses is going to have a hard time managing their already slim margins, and if one part or another starts pressuring the company, even slimmer margins can result. 4-5% net is comparable to European groceries, or healthcare products/supplies, neither of which from a margin perspective is very attractive.
And obviously, cyclical automotive can't be compared to everyday food/grocery items in terms of their fundamental nature.
So, it's not that I am finding flaws in the company's business model - I just think that as a whole, there are more attractive businesses to be in. Penske has also, in terms of cash, taken on significantly more debt over the past 10 years...
But on a positive note, and what gives me confidence here, is that the company has turned ROIC-positive (in relation to WACC), which it has not been since 2017 before 2021. Many things for Penske are going in the right direction and there are positive signs across the board.
Some management decisions give me pause. The buyback of significant amounts of shares at a relatively high valuation is one of those decisions.
And there are other risks as well. When looking at this company, I see a significant potential for slowing revenue growth and margin decline in the next 1-3 years, and I am not the only one.
Why would this be the case, you might ask.
Because of macro trends. Coming into the supply chain issues we saw a year ago and are still seeing the tail end of, the transport industry was completely unable to meet demand. That is no longer the case. New supply and new vehicles are coming, and overall the logistical issues we've been seeing not only in Europe, but the US as well are fading.
This will impact, as I expect it, Penske and similar businesses. And not just the commercial trucking part of the industry. Rising inflation and costs will impact consumer spending . We're going to, as I expect, see a rise in payment delinquency on the leasing portion of the business, and we're also, likely, going to see fewer customers being inclined to lease in the first place with today's rates. The cost of debt is up, and this is yet another headwind not only for customers but for the company in itself.
Penske offers primarily premium vehicles - exactly the sort of vehicles customers have been encouraged to lease more and more. Much of BMW's and Benz's sales growth has come from making their products available to a wider audience through the use of financing.
I believe this will turn around.
When we take this into account and look at what the company offers and what makes Penske "good", I see substantial potential for a significant decline in this business.
Current analyst expectations are for a double-digit EPS decline in 2023 . We're also expecting that to continue going into 2024, as I believe the market will soften even further than that.
Penske is riding a wave of post-SCM issue-EPS into what I would describe as being a figurative brick wall. That brick wall comes in the form of decreased demand and lower margins as things normalize because let's make one thing clear.
What's happened in the last few years is not the "new normal".
Let me show you in valuation.
Penske Valuation - it's very inflated if we look at anything historical.
So, first things first. Here is how the company's earnings look historically, and how they have looked in 2021 and 2022.
Penske Automotive EPS/Valuation (F.A.S.T graphs)
I respect your opinion if you believe this is the new normal, but I would disagree with that. I believe we're already in a decline, as evidenced by the quarterly results, and I believe the company will see a significant decline moving forward - even more than before and more than we're seeing here. We're talking, as of 2Q23, a 20% decline in income from operations, and a double-digit EPS decline on a YoY basis.
If pressed to value Penske, I would value the company at 8-10x P/E - but I would expect earnings to decline at least below the $16/share mark, then discount it another 20% to make up for the macro risk and the relatively low margins.
Currently, we're seeing a PT range of $106 to $205 for this company. This is a massive spread, and it can be compared to a PT range of $25-$60/share around 3 years ago. In my experience, companies do not get legitimately worth more than 3x as much in less than 3 years, unless something very, very significant happens.
This, to me, does not qualify.
I view every target above $110/share as inflated, and I even view a triple-digit share price as somewhat difficult for this company and what may happen to it due to macro. The junk-rated credit and less than 2% yield is only a small part of that equation, but a relevant part as well.
Penske Valuation up/downside (F.A.S.T graphs)
The question, as I see it, should be:
What would you pay for a junk-rated 1-2% yield company in a slowing industry with a negative estimated EPS growth for the foreseeable future, in a rising interest rate/rising cost of debt environment, which also due to customer financing trends is likely to see increasing delinquencies and muted potential sales?
I believe the answer to that question lies implied in the question itself.
If you're positive on this stock at over $150/share, I would look over your valuation and return targets.
I am at a "SELL" due to my selling of the shares - and here is my thesis.
Thesis
- Penske Automotive is really a good business, but only if you manage to pick it up at a cheap or relatively decent price. It's currently inflated due to, as I view them, non-recurring post-COVID-19 SCM trends. When these normalize, I believe we're in for a massive reality check in this company. The current valuation, when looking at any sort of normalized EPS levels, implies a P/E valuation of over 30x.
- I don't consider this to be valid in any shape or form. I am selling what few shares of Penske automotive I have, and officially initiating coverage on this company.
- My PT would be closer to $105/share, allowing for some outperformance, but nothing close to what we're seeing here.
- I say "SELL" here, and would caution you greatly to not go into this company with any sort of fervor without considering the valuation.
Remember, I'm all about:
1. Buying undervalued - even if that undervaluation is slight, and not mind-numbingly massive - companies at a discount, allowing them to normalize over time and harvesting capital gains and dividends in the meantime.
2. If the company goes well beyond normalization and goes into overvaluation, I harvest gains and rotate my position into other undervalued stocks, repeating #1.
3. If the company doesn't go into overvaluation, but hovers within a fair value, or goes back down to undervaluation, I buy more as time allows.
4. I reinvest proceeds from dividends, savings from work, or other cash inflows as specified in #1.
Here are my criteria and how the company fulfills them ( italicized ).
- This company is overall qualitative.
- This company is fundamentally safe/conservative & well-run.
- This company pays a well-covered dividend.
- This company is currently cheap.
- This company has a realistic upside based on earnings growth or multiple expansion/reversion.
The company fulfills none of my valuation-related requirements and qualifies as a "HOLD" here, no more than that.
Thank you for reading.
For further details see:
Why I'm Selling My Small Position In Penske Automotive