Credit Crib Note: Lithia Motors (LAD)
We look at the credit quality, operating profile and financial fundamentals of Lithia Motors as LAD continues to dramatically expand its operations.
CREDIT TREND: Stable
LAD has been swinging for the fence in terms of its relative M&A aggression vs. the peer group. That brings more debt to go along with a much-enlarged business mix and asset base. The strategy also brings more execution risk across its various initiatives in used cars, international expansion, growing its captive finance capabilities, the rollout and integration of more digital retailing, and new services operations (fleet management) along with data and tech-centric businesses (dealer management systems and software).
The good news for LAD’s credit risk profile is that financial policies have been prudently managed with a 3x leverage target (2Q24 weighed in at 2.3x). LAD has set a very well contained set of balance sheet parameters given the cyclicality of its end markets and intensifying competition in the broader auto retail peer group. The consumer driven business is naturally cyclical, but the real-world stress test over the past two cycles includes a systemic credit crisis, a pandemic, supplier chain disruptions on a global scale, and the first inflation spike and protracted FOMC inflation fighting cycle since the Volcker years. In other words, LAD has been tested.
Overall, leverage is low and financial flexibility is exceptionally strong, but revenue and profit trends on a same-store basis are under pressure for a range of reasons, some cyclical and some tied to one-off events such as the CDK meltdown that derailed transaction volumes for many dealers.
LAD equity has underperformed peers, but the multiyear growth strategy is rational and defensible even if LAD contrasts with the now #2 player (former #1) AutoNation in terms of the capital allocation balance between M&A and stock buybacks. LAD vs. AN is interesting, but both are focused on expanding captive finance operations and will be bigger factors in the credit markets as ABS and securitization counterparties.
For credit risk, LAD is a solid core crossover in the upper BB tier. LAD has voiced its interest in achieving IG ratings “over time.” That would be consistent with its growing captive finance operations. AutoNation, the other major dealer expanding in captive finance, is currently IG rated.
For equities, the execution risk and used car market turbulence has been part of a lagging performance vs. peers. That difference comes down to time horizons and gut-checking the timing and magnitude of the growth initiatives and when LAD will hit an inflection point in profitability for these potential growth business lines. LAD is clearly moving in line with the secular trends even if international expansion is a riskier gambit. Their use of the term “unique and unreplicable mobility ecosystem” captures the flavor of the ambition.
OPERATING PROFILE
After a cycle of M&A and heavy investment in growing revenues, LAD ranked #1 in 2023 in unit sales ahead of AutoNation among the franchise dealership peer group (i.e. excludes CarMax and Carvana). Lithia was #1 in total new retail vehicles sales (by units) as well as #1 in used vehicle sales (ranked by units). They also ranked #1 in total number of dealerships.
The M&A strategy had originally expected $50 bn in revenue by 2025, but that timeline has been dialed back by a mix of headwinds over the last few years from new vehicle shortages (chips, supplier chain, etc.) to the tightening cycle to less attractive valuations on dealerships.
It is safe to classify the auto retail operations of Lithia as the most complex of the public dealer peer group given the combination of aggressive M&A, high investment in digital retail, expansion in the UK and sustained growth in “strategic adjacencies.” The broader business mix folds up under the term “mobility ecosystem” and is reflected in the name “Lithia & Driveway.” One can simplify the Driveway moniker by framing Lithia as the vehicle operations and “Driveway” as a national brand that effectively is the sales platform. The “adjacencies” include growth in the captive finance unit (Driveway Finance Corp or “DFC”), fleet management, and such more recent target businesses as Dealer Management Systems (“DMS”).
This expansion program across recent years is reflected in their use of balance sheet (debt and equity issuance) that grew all parts of the balance sheet (inventories and other dealer assets, total debt, and the total equity base). We look at that growth in the sections below. The company has been active in both the debt and equity markets with a focus more on M&A than stock buybacks.
LAD is one of two major dealers to aggressively expand their captive finance operations along with AutoNation (see Credit Crib Note: AutoNation 6-17-24), so both LAD and AutoNation will be more important credit counterparties across more credit markets (bonds, ABS, credit agreements) as ABS activity will step up with inventory growth.
LAD presents one of the more complex mix of products and services in auto retail names in debt and equity markets with its range of services in new and used retail, digital retailing commitments, a captive auto finance business that just turned profitable. LAD calls some of its services “strategic adjacencies” (e.g., fleet management). Used cars were the hot business line in 2021-2022 but have faced some market challenges into 2024.
LAD has also taken stakes in international retail (notably UK) as seen with major peers including Penske and Group 1 with AutoNation looking at opportunities. LAD has been very active in their GreenCars initiatives to educate potential buyers. This will be an area to watch for evolving risks from the inventory line on new EVs to challenges in used EV valuation and remarketing.
FINANCIAL TRENDS
LAD’s expansion timing unfolded during a volatile period in the markets from COVID and then on across an aggressive Fed tightening cycle. With the growth of Driveway Finance Corp (DFC), the balance sheet has a more complex and diverse range of funding activities with a growing mix of non-recourse debt across warehouse facilities and ABS to fund auto loans and the intrinsic growth of inventory financing as the dealership network grows.
The balance sheet layers require the use of more angles beyond total debt and net debt in the analytical framework. Floorplan financing is a much lower risk form of debt as is non-recourse expansion. DFC has its own distinctive balance sheet dynamics. We look at those issues below.
LAD provides detailed leverage reconciliation for adjusted net debt to EBITDA with leverage posting a 1x handle from the end of FY 2019 through FY 2023 with adjusted leverage rising to 2.3x at 2Q24 vs. almost 2.1x for LTM 2Q23 and 1.8x at the end of FY 2023.
The DFC operations will be a core strategic asset and profit generator in the future as part of the plan to build out gross profit per vehicle with a wider array of Finance and Insurance products (F&I). The growth in F&I and expansion of the highly profitable parts and services operations offer a means of driving higher revenues from the steadily growing base of transactions in the new and used retail business.
The short end of the curve is the sweet spot for dealer activities so the FOMC actions ahead will be important variables for both the cost of funds at LAD and customer affordability. The threat to those favorable outcomes could come from tariffs, trade partner reactions, and supplier chain challenges. The scenarios around tariffs in cost structure and disruptions from trade conflict carry a range of impacts (almost all bad), potentially hurting volumes and UST expectations but also driving vehicle prices higher on any new shortages.
Recent years offer a template on how LAD could navigate such market turmoil. Slower sales growth that drives inventory liquidation would be bad news for earnings and would pressure margins. In portfolio context, however, the supplier chains and OEMs with all their fixed costs would feel it more.
The growth in the LAD top line is straightforward enough with total vehicle sales being the main driver on the back of a solid post-COVID consumer recovery that saw varied performances across time in new vs. used retail given how new and used vehicle markets were influenced by shifting conditions.
The combination of constrained new auto availability during COVID and other factors such as semiconductor supply chain problems saw shortages of new vehicle production that in turn flowed into rising prices for all vehicles both new and used. Used car lots were clearing out in the scramble for vehicles. Used prices soared.
Rising volumes and high prices and steady M&A have sent revenues higher but same store revenues and gross profits have struggled recently as we detail further below.
LAD had very ambitious revenue growth goals with $18 bn in revenues added from 2019 to 2023 and is on pace to almost triple revenue by from 2019 to then end of 2024. During 2024, the headline tech problems at CDK had undermined revenues across all the major dealers.
For LAD, new car prices peaked in FY 2023 at $48.2K, up from $37.7K in 2019. For used cars, LAD jumped from $20.7K in 2019 to a peak over $30K in FY 2022. For 1H24, we see prices dipping in both new and used.
The vehicle retail sales rebound came in waves with outsized price moves in new and used cars and notably with the dislocations in used car availability across 2020-2022 that took prices into unprecedented inflation territory and notably into 2022 (see Automotive Inflation: More than Meets the Eye 10-17-22).
We have looked at the used car sector dynamics in our work on used car industry leader CarMax (see CarMax F1Q25: Ringside Update on the Used Car Market 6-26-24, Credit Crib Note: CarMax (KMX) 2-21-24, CarMax: Credit Profile 7-9-23) and digital leader Carvana (see Carvana: Counterattacking in Style 5-6-24,Carvana: Credit Profile 3-6-23, Auto Retail and Carvana: Shifting Auto Retail Dynamics 2-25-23). The used car subsector has seen stunning structural change and volatility.
The volume growth in used cars at Lithia is tied into its expansion in digital retail and the buildout of its omnichannel capabilities and F&I products. Between 2019 and 2023, used vehicle volumes almost doubled.
The above table tracks the gross profit trends across the various business lines with gross margins on new and use vehicle retail much improved from 2019-2020 but well below the double-digit peaks of 2021-2022 when shortages ruled.
The table details gross margins, gross profit per unit (GPU), and gross profit mix by business line. The disproportionately high gross profit share of “service, body, and parts” is an eye catcher at over 37% while F&I weighs in at over 25% of gross profit.
The time series for GPU in total highlights how far total GPU per unit has come since 2019 with current levels materially higher than 5 years ago even if down from the exceptional peaks of 2021-2022. Those peaks were not sustainable.
Growth in parts and services operations and F&I are positive variables looking forward even if LAD is unlikely to recapture the 2021-2022 vehicle sales margins into 2025. The threats to supplier chains are certainly not going to disappear in 2025 if trade clashes unfold.
Consumers were in heavy spending mode for goods during the early timeline of the COVID rebound before affordability was soon derailed by the continued tightening cycle that drove short-dated funding costs for LAD and contract rates for customers higher as the inversion of the curve grew more pronounced into 2023.
Without those industry leading stats in the franchise dealer new and used volumes, LAD obviously would not have the opportunity to exploit these other high-margin businesses in F&I or in the aftermarkets (parts and services) on such a large scale. All the add-on margins roll up to a total gross profit line. In the case of the “vehicle sales plus F&I” we see a total vehicle GPU still well over $4k per unit vs. $3.6K in 2019, but down from $6.3K in 2022.
We conform to the gross profit disclosure for F&I in the above chart and detail gross margins as 100% (basically revenue is gross profit). We break out more operating metrics for financing operations in a separate chart focusing on the loan portfolio at DFC further below.
F&I more broadly (beyond loans) as a growth opportunity cuts across many types of products beyond loans (notably service offerings, warranties) that also feed into Parts and Services operations. F&I and Parts & Services are very attractive to dealers as they seek to keep more of the F&I and services value chain in-house rather than working with third parties. Dealers such as LAD and AutoNation are well positioned to do that. F&I gets a lot of attention and column space in the industry trade rags and dealer conferences.
Service, body, and parts (some dealers call it Parts & Service or “after-sales” among other names) posted an impressive gross margin over 50% across the timeline, and we see those high margin trends in place at other dealers.
The above table is one of those “follow the bouncing ball” charts that shows the heavy M&A driven growth across the business lines as M&A grows the dealership ranks for retail sales but also serves the targeted expansion in high margin business lines such as “Service, body, and parts” and F&I.
The parts and services operations require skilled manpower, facilities, and equipment that are more of a barrier than many might appreciate as the new generation of “Mr. Goodwrench” entails skill sets in the areas of diagnostics for the software and tech-heavy vehicles of today.
The need for labor was one reason why maintenance and repair inflation are soaring during this cycle given the competition for personnel. That challenge has been ongoing. We recall one dealer exec more than a decade ago bemoaning the loss of personnel to the fracking sector (also tech and diagnostics intensive) back when energy hiring was booming.
We also see some new areas of expansion such as fleet management and other services that could in theory offer material upside under some scenarios (including EV transition, autonomous vehicles, etc.). Growth expectations there could be tempered or even stall if the clean energy trend fades or such initiatives are undermined by Washington (election and policy risk). We would expect these types of services to have growth in many states regardless, but the expectations have faded somewhat relative to the early buzz.
The above table runs through the “same store” metrics that are very useful for LAD considering how active they are in M&A. We include FY 2022 and FY 2023 and the interim periods of 2024 for a more recent look at how LAD’s same store numbers look coming off the strong markets of 2021-2022.
The methodology on “same store” per Lithia: “Same store measures reflect results for stores that were operating in each comparison period, and only include the months when operations occurred in both periods. For example, a store acquired in November 2022 would be included in same store operating data beginning in December 2023, after its first complete comparable month of operations. The fourth quarter operating results for the same store comparisons would include results for that store in only the period of December for both comparable periods.”
The negative variances in same store numbers in 2024 and 2023 tell a story of adverse trend lines in both revenues and gross profits and notably so in used vehicles. That is not news at this point given the direction of the used car business lines for numerous dealers and weaker used car price trends.
LAD cited CDK’s DMS problems a factor in same store setbacks and indicated it was running positive before that point for same store sales. For those not familiar with CDK, they were hit with a ransomware attack in June that severely disrupted major dealer operations. LAD indicated that “CDK drove after sales down almost 40% during the 12 days of the outage” but indicated that some delayed business would just spill into later weeks in 3Q24.
LAD has kept on rolling with its growth plan, and that is requiring some adjustments on the cost front and a slower pace of M&A ahead (in theory). LAD will keep getting grilled on the topic, but weak same store performance could be among the reasons why the company has lagged AutoNation in the equity markets.
The praise of AutoNation by some in the market highlight that dealer acquisition prices had been getting too expensive, so the better value is buying back shares such as what we see at AN and not chasing as much dealer M&A expansion. LAD echoed that valuation challenge for acquisition targets in tempering its revenue growth timing.
The time horizon on acquiring higher quality assets may have been pulled ahead of ideal timing, but cycles change, and LAD is positioning itself for maximum operating leverage in future cycles.
Trends still point to sustained M&A by the major players even if some get penalized for execution risk in such areas as international and/or too much expansion in used vehicle retail.
The growth in the balance sheet as detailed above shows a much-enlarged asset base, higher debt, and growth in the equity base.
Adjusted leverage is low, and LAD only has 3 unsecured bonds in the BB tier index totaling $1.75 bn of the $13.5 bn total debt line in its debt footnotes for 2Q24. Floor plan notes, revolvers, warehouse facilities, and non-recourse notes dominate the outstanding debt picture.
LAD shows a more evolved set of capital structure layers that reflect massive growth in inventory across the cycle as well as the sustained expansion in dealer and customer finance activities at Driveway Finance Corp.
Inventories as of 2Q24 are 2.6x what we see at the end of 2019 while floor plan notes payable have grown 6-fold during that time frame alongside the growth in inventory.
We see a soaring “franchise value” line that shows an 8-fold increase vs. 2019 while goodwill is well over 4x higher since 2019. Franchise value is an intangible asset value allocated in the context of the M&A accounting process and is routinely tested for impairment under accounting rules. Despite the accounting rules, franchise contracts have very tangible revenue generation value that comes with the rights.
The manageable leverage levels show Adjusted Net Debt/EBITDA posting 1x handles for each calendar year since 2019 within a band from 1.9x to 1.1x until it crossed the 2x threshold in 2024. The target leverage is under 3x. For a frame of reference, the bank requires 5.75x, so that is a lot of covenant room.
Those Net debt/EBITDA numbers are low, but some context is provided by the fact that LAD seeks to acquire dealers at 3x to 6x EBITDA. In other words, 2x leverage is low but not as low as it might look at first glance.
Detailed reconciliations of leverage are provided each quarter in the disclosure that make adjustments for various non-recourse financing, floor plans, and DFC debt. The adjustments are fair.
The consolidated debt analytical framework has some similarity to how one looks at captive finance operations of the Auto OEMs and their captive units with a matched book asset coverage backed by high quality liquid assets.
We look at the DFC asset base and loan portfolio quality in a chart further below. The use of nonrecourse notes grew materially from 2021 onward to over $2.0 bn at 2Q24 ($1.96 bn long term).
The above table underscores how busy LAD has been in capital deployment since before, during, and after COVID while also investing in organic growth and notably expansion of its financial services operations.
We see over $8.0 bn in acquisitions (net of cash acquired) with more muted buyback activities of around $1.2 bn that end up modestly below the stock issuance of LAD.
LAD common stock issuance amounted to over $1.9 bn in 2020-2021 as M&A and new debt ramped up.
The acquisitions run in size from smaller store counts to larger auto retail groups with LAD averaging 55 stores per year across the 3-year period ending in FY 2023. Details are provided in the LAD SEC filing footnotes.
The above table drills into the financing operations and how rapidly Driveway Finance Corp has grown as it crossed breakeven rates ahead of schedule after ramping up both its auto loan portfolio and its range of funding operations in the ABS market and via warehouse facilities.
The average managed finance receivables balance reached $3.6 bn in 2Q24 for a 7-fold increase since 2021 and more than doubling since 2022.
Origination are running at an annualized run rate above $2 bn as steady growth in the portfolio continues even as penetration rates have dipped into the 9% range from 11% in FY 2023. LAD has cited a target of 15% to 20% penetration rate over time.
Increasing the balance sheet through organic growth with the potential to increase penetration rates provides the main area of growth for the DFC operations, and management has cited opportunities in leasing as well.
Asset quality has been steady with 730 range credit scores a consistent number across 2023 and into 2024.
Allowance for losses is comfortably higher than actual loss experience while past dues are stable in the low 4% range. LAD has highlighted that it expects charge-off levels to peak in 1H24. Loss provisions on finance receivables on the income statement exceeded net charge-offs (net of recoveries) in 1H24 and 1H23 as well as both 2023 and 2022. That tells a good story on accounting quality and allowance adequacy.
Loss exposure on repossessions has been picking up of late across the industry as recovery rates decline into the mid-40% range from the used car recovery rate peaks of 2021 near 75% and near 60% in 2022 as used car deflation has been a setback during 2024.
Contract rates of 9.9% reflect the above average quality mix and UST curve. Lower interest rates could help LAD into 2025 on consumer affordability, but recession risks will remain a top worry into 2025.
HISTORY & HIGHLIGHTS
Lithia Motors Inc. is the legal entity, but LAD has been essentially rebadged as Lithia and Driveway to capture the combination of a traditional dealer network with an evolving sales platform and services operation using the “Driveway” logo.
LAD is #1 ranked in new and used vehicle sales among franchised dealers. To underscore the fragmentation in the market and LAD’s ability to continue to grow by acquisition, LAD as the #1 dealer held only 1.1% share of the combined new and used car market. It is targeting 5% longer term. That is a very large fragmented market.
LAD has a well-diversified range of “brand revenue” with 44% of its mix classified as “import” brands, 25% “domestic” and 31% “luxury.” The only brands with a double digit share as of 2Q24 were Toyota and Honda with each at 12%. Ford, Stellantis, and BMW/Mini are each at 9%. Next down the list is Hyundai and GM at 6% each with a long tail from there below 5%.
Lithia has been the most aggressive of the largest franchise dealers in building out its “mobility ecosystem” and digital operations. Outside the franchise dealer peers, the largest used car operators include CarMax as a major omnichannel player and Carvana as by far the largest digital retail used car operator.
LAD has generated an impressive 10-year revenue growth rate that shows CAGR at +23% with a heavy reliance on store acquisitions. Store count since 2014 has grown over 3.5x fold.
While the timing of the $50 bn sales target has been pushed back beyond 2025, the $40-$50 bn revenue target for “mid-term” realization remains in place with auto retail consolidation still the primary driver.
LAD’s “commercial” around its range of offerings includes the fact that the company retails vehicles from 0 to 20 years and that its “value” autos generate the highest gross margins and have the fastest inventory turns. The “Value” segment is for used vehicles of 9+ years. LAD is also distinctive in its major rural presence.
LAD has been expanding in the UK as highlighted by its acquisition of Pendragon’s UK motor and fleet management divisions (approx. $480 million when announced, 430 million sterling prelim price). LAD had earlier acquired the Jardine Motors Group deal in 2023. With its international expansion program in the UK ongoing, LAD is now up to 19.5% of revenue generated in the UK during the 2Q24 period and 14.3% of gross profits.
LAD took a minority stake (under 20%) in Pinewood Technologies (legacy Pendragon operation) to expand in dealer management systems (DMS) after that unit was spun off in the Pendragon deal. That is one more sign that LAD is full speed ahead in selling a growth story to get its stock multiple pushed higher. The array of business lines makes LAD an even more complex name to frame in the dealer peer group.
LAD is expanding in fleet management as highlighted by its recent announcement of a minority investment in Wheels, Inc. in partnership with Marubeni and Apollo for $205 mn. Wheels is one of the largest fleet management operators in the US. Apollo is seen as very strong (and active) in the mobility services space. LAD has indicated that “fleet and other” could eventually generate $1 bn in revenues. The Wheels deal was cited by management as reflecting the potential for “transformative synergies between our retail and their fleet platforms.”