Auto Retail: Industry Evolves with Steady Bolt-Ons and Expanding Services
Excerpt from Footnotes and Flashbacks Week Ending Feb 17, 2023
Auto retail and franchised dealers: the rest of the Big 6 weigh in…
The past week the remaining 3 of the Big 6 franchised dealers posted their earnings as AutoNation (AN), Lithia (LAD), and Sonic (SAH) reported after the prior releases earlier in reporting season from Penske (PAG), Group 1 (GPI), and Asbury (ABG). The week included two of the remaining top 3 players in Lithia and AutoNation. PAG is #1 by market cap and based on quarterly revenue run rate for 4Q22, just edging out LAD on 4Q22 revenue but more comfortably ahead based on PAG’s market cap of $11.0 bn, ahead of LAD and AN who hover around $7.4 billion in market cap at last count.
The franchised auto retail business is still smoking hot after the supply chain delays and shortages of new vehicles. The disruptions to operations and supply chain issues had created many inflation distortions in used car valuation on supply-demand imbalances between available new and used cars. We had looked at Penske and the peer group in our last weekly as well. We also looked at the backdrop of SAAR rates with the sharp sequential move higher in January (see Footnotes and Flashbacks: Week Ending Feb 10, 2023).
Earlier we took a look at GM and Ford as they enter capex-intensive years including outsized investment in EVs. That comes after two years of near recession-level production volumes on the supply chain problems and notably in chips (see Footnotes and Flashbacks: Week Ending Feb 3, 2023). In other words, a lot of moving parts is not a new condition for the auto and related services story lines.
Auto retail sees very strong demand but a mixed picture in new vs. used…
The auto retail sector is running alongside a virtuous cycle of supply-demand that drives pricing power at a time when the consumer sector had shown solid demand for both new and used cars. The rapid shift had sent inventory management into total turmoil but strategic plans cannot turn on a dime as seen with Carvana and used car strategies at Lithia and Sonic. The good news is high demand with unemployment recently setting a new 50-year low at 3.4% or the lowest since the late 1960s (the all-time low was 2.5% back in Eisenhower’s first term).
Demand is stronger for new vehicle dealers than used right now on a relative basis. On the other hand, the more cars that get traded in, the more used cars the dealer can resell or, alternatively, that they can recondition as certified and sell at higher price with warranty programs. The timing is all, and the midyear stretch of 2023 will hold a lot more clues on how some of the names in the stock charts herein will react.
The lurking headwinds are higher financing costs and concerns around recession risks. The intermediate and longer-term risks that the industry chatter debates is changing car ownership patterns that might direct business away from dealers, the potential for EV start-ups to reject the dealer model, EVs as a rule needing less parts and service work (a high margin business for dealers), the theoretical threat of changes in Federal laws that overrule state franchise laws, and shifts in laws at the state level that threaten traditionally protective laws that support dealers.
The total return stock chart above tells an impressive story about recent returns on franchise dealer stocks. The recent earnings season and YTD numbers show franchised dealers trouncing the broader market. The franchised used car dealers are very strong free cash flow generators and have both organic expansion opportunities and the ability to “buy revenue” by continuing to roll up successful private dealerships of various sizes. The vast majority of dealer entities are private, but the market share and revenue share of the majors just keeps on growing.
The boutique banks operating in the car dealer M&A space show up a lot in trade literature as that business promises to keep on growing as dealers reassess the future and their estate planning for so many family-owned operations. There will be a lot of opportunity ahead in the space but also a lot of challenges in product strategies, risks of shifting business models (notably around EV growth), and uncertain variables around legislation and OEM game plans. The generational wealth factor is likely to lead to sustained M&A ahead as one of the capital allocation strategies to drive stock value.
The stock chart also highlights the recent struggles over in used cars as trailing 6 months and 1 year show the carnage for Carvana as loss generating digital retail channels were repriced. Since 2021, the crypto-esque journey from a $370 stock price in Aug 2021 to the current $11 handle at Friday close is something you don’t see very often. The used car operations of the highly profitable franchised new vehicle dealers also showed the setbacks for used car profitability but were overwhelmed at the revenue and earnings line by the strength of other dealer operations whether new vehicles sales, parts and service revenues (“P&S”), or finance and insurance operations (“F&I”).
A quick summary of the latest auto retail earnings wave…
We highlight some of the specifics in the earnings releases to help draw the picture on the moving parts of results that saw the word “record” used in abundance.
AutoNation: AN lit up the screen Friday with its results and saw a +11.4% pop in its stock to over $157. The full year and 4Q22 record in revenue and earnings went along with record free cash flow of $1.7 billion. The cash generation allowed AN to reduce its share count by 25% on buybacks. The share count has been reduced by around half since the pre-COVID period. The EPS number was +30% YoY so AN has been making sure the shareholders stay happy in a space where the Big 6 are all doing well. The past two years has seen AN buy back more than $4 billion in shares.
AN is doing all it can to take advantage of conditions that are extraordinary in terms of demand and pricing power for the OEMs. Such numbers are not sustainable, so AN just keeps on reducing the share count. The SAAR lift we already saw in January is before the spring selling season has even arrived. The near-term demand outlook remains positive subject to production rates and supply chain consistency in what could be a vulnerable year with China that leaves the auto supply chain on edge.
The new vehicle volume increase feeds the used car supply for trade-ins at what will presumably be more attractive inventory carries that will reflect that market shifting into deflationary mode. AN’s used car operations “self-sources” around 94% of its vehicle acquisitions. Used vehicle revenues rose 12% for FY 2022, but gross profit per unit declines by over 12%. Total gross profit for used vehicle declined by almost 20%, but the gross profit of $553 million was still a material contributor in total gross profits of $5.26 bn for FY 2022. Parts and Service brought in $1.9 bn in gross profit and F&I $1.44 bn in a reminder that the auto retail story is about a lot more than new car sales.
Lithia & Driveway: Whether you still call the company Lithia Motors or Lithia & Driveway, LAD has been one of the most aggressive in expanding its operations via acquisition and via investment in online channels and its Driveway operation established in 2020. LAD stock had been flying high on its growth plan across its businesses including a more ambitious set of online retailing plans. The company printed cash acquisitions as detailed in its cash flow statement to the tune of $5.1 billion across the period from 2020 to 3Q22 with $2.7 bn in 2021 and $1.5 bn in 2020 before just under $1 bn through 3Q22. In revenue terms, LAD acquired $3.5 billion in annualized revenue through deals done in 2022.
The hectic growth strategy is reflected in LAD results with record revenue and material increases in used vehicles sales (+29.9%) in FY 2022. Gross profit per vehicle was +7.6% and F&I per unit was +12.3% so growth has been successful even if unnerving for some shareholders given the relatively greater focus on M&A vs. buybacks such as at AutoNation. Driveway has been aggressive in finance operations, and that will require some monitoring ahead with a portfolio now over $2 bn.
Sonic Automotive: Like the peer group, SAH posted up very strong 4Q numbers with record quarterly revenues and gross profits that added to a record full year for 2022 in revenues and gross profit. Looking back across the trailing time horizons from 1 year, 6 months, and 3 months, SAH was somewhat like Lithia in seeing its stock underperforming peers as those two were among the most aggressive in pursuing expansion in used and pre-owned.
For Sonic, the EchoPark unit generates negative EBITDA, and the Carvana headlines are not friendly to those companies pushing used car online retail. Pressure on used industry leader CarMax and its strategy is not supportive of Sonic in picking the best positioned dealers to stay the course. CarMax is well established in the space and is massive in scale. Away from the valuation debate in any given quarter, one school of thought is that there are better positioned names in franchised dealers to play this sector and stronger more established operators in used vehicles.
EchoPark has dialed back its goals as used car supplies were tight and as the dynamics of new vs. used has been shifting quickly into 2023. The expectation of more volatility and headwinds that will preclude the originally planned growth trajectory is something the equity markets are wrestling with at this point as rates rise, inventories stay lean, and used cars seek an equilibrium level vs. new.