2023-09-14 10:12:07 ET
Summary
- Asbury Automotive Group's shares have performed well despite economic uncertainty, with potential for 15+% upside.
- The dealership business is less cyclical than expected, with a focus on service centers driving profits.
- The market is pricing in a significant decline in the new and used car business, which is not justified by the fundamentals.
Shares of Asbury Automotive Group (ABG) have been a strong performer over the past year, though they are off over 10% from their 52-week high. Given how cyclical the auto sector is, there may be concerns about owning an auto dealer stock after such a run given the economic uncertainty. However, the dealership business is not as cyclical as one might expect in my view, and shares screen attractive. I would be a buyer, seeing 15% upside.
For those unfamiliar, Asbury operates 138 new car dealerships, along with associated service centers, collision centers, and used car sales operations. The company has a favorable geographic mix, concentrated in the faster-growing Southeast and Mountain West. It has no more than 15% exposure to any single brand, meaning its sales are not particularly exposed to taste shifts between brands, so much as overall auto activity. Given its geographic orientation, ABG is positioned to grow somewhat faster than the overall auto market.
Undoubtedly when one thinks of a "car dealership," we think of that large showroom of new cars, or the stereotypical slick used car salesman, but that is not the primary source of value to the business. While new and used car sales account for over 80% of revenue, they account for just 36% of profits. 41% of gross profits come from parts and service, and 23% from financing and insurance fees. The service center is really the primary driver of the business, and this is less economically cyclical than sales. In many ways, the sales platform exists in order to form the relationship with customers that leads to service activity in the ensuing years.
Now, the surge in auto prices during COVID certainly helped to boost profits in recent years, but these are really supplements to the base profitability, and this boost has peaked. Accordingly, in the company's second quarter , revenue fell by 5%, led by a 20% drop in used car sales. New vehicle sales did rise 4% as supply chain issues have faded. Given normalizing vehicle pricing, margins have contracted from a record 8.3% last year to 7.7% year to date, still above the ~5% pre-COVID norm. Adjusted EPS was $8.95, and adjusted earnings are down about 11% from last year. Still, they leave the company on track to generate about $34 in EPS this year for a 6.5x multiple, suggesting the market is expecting EPS to fall quite sharply.
Well, if we eliminated all used vehicle profits, that would reduce quarterly earnings by about $2.43. That still leaves $26-$26.50 in run-rate earnings. That translate to an 8.5x multiple. Even if we add in a 50% reduction in new vehicle profits, there is $14 in earnings, and that assumes no savings in SG&A expense. Shares are trading less than 16x the service, financing, and impaired new vehicle EPS.
I believe that is an appropriate multiple for those less cyclical businesses, so at the current share price, you are essentially getting the used car businesses for "free". While it will not be as profitable as they were at the peak, it is still a profit center, and a 50% contraction in new car profits is quite a conservative baseline. Moreover, there are some encouraging fundamentals here.
Used car prices soared during the pandemic as new car production was challenged with supply chain issues, and prices have reversed over the past year. Interestingly, the Manheim used car price index actually registered a small gain in August, suggesting the worst of the declines may have occurred. Additionally, they noted that tight inventories and "slightly stronger than expected" sales should support prices remaining at current levels.
This would point to used car profitability holding around Q2 levels, not falling ever further. On the new car front, while they have been slowly normalizing, the auto inventory to sales ratio is still well below the pre-COVID norm, and in general, tight inventories support prices and profit margins. Relatively tight margins should help to protect new car sale profitability and guard against a bit of a slowdown in sales.
Given the potential for a strike by the United Autoworkers against some of the Big Three as the labor contract expires, I would note that in 2019, US auto production declined by about 11% when General Motors (GM) faced a strike. This would further tighten inventories, which would be supportive of both new and used car pricing, though this would likely be a relatively short-term phenomenon.
I am not arguing that will see used and new vehicle profit margins return to their peak - I doubt anyone would forecast that. With the stock trading at 6.5x earnings (that are already below the peak), one does not need peak earnings to see a strong return. What I would argue is the market is pricing in a very significant decline in the new and used car business - one that does not appear justified given the fundamentals.
Moreover, Asbury has been doing what you would want during a boom. It is generating substantial free cash flow - $160 million this year so far. It is $468 million when adjusted for working capital movements, as inventories have risen by $240 million. With this surge in cash flow, it is aggressively buying back stock, $211 million year to date. Having completed its previous authorization, the board approved another $250 buyback during Q2 . The company should repurchase 8-10% of its outstanding shares this year alone.
It has also deleveraged its balance sheet. Debt to EBITDA is 1.7x, well below its 2.5-3x target. As you can see below, it also has few near term maturities, limiting its exposure to higher interest rates.
With leverage so low, it recently announced the acquisition of the Jim Koons Automotive Group for $1.2 billion , which is 0.4x 2022 sales. ABG trades at 0.32x sales, so there is a 25% premium being paid. ABG has proven to be a strong acquirer that reduces debt and leverage after acquisitions, and so I am comfortable with the purchase and the premium paid, as Asbury will undoubtedly find some synergies as it brings these dealerships onto its larger platform.
If we value ABG at 15x its base new car, service, and financing driven EPS of $14, that provides a stand-alone value of $210 per share. If we assume a 50% reduction in used car profits, that is an additional $5 per share of EPS. Given it is a more cyclical business, it deserves a lower multiple, at 10x, that generates a fair value of $260/share for ABG, even assuming a 50% decline in both used and new car profits.
That represents about 18% of upside for shares, under what I view as a conservative scenario, and if run-rate profits from vehicle sales units fall 25%, fair value would be about $300 per share. Plus, with the free cash flow the business generates, ABG is poised to reduce its share count over 8% a year, further boosting EPS.
ABG is pricing in an overly dire auto market environment, particularly given the nature of its profits, and even with shares up over the past year, I think they still represent a compelling value and should be bought.
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With A Compelling Valuation, Asbury Automotive Can Drive Higher