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AutoNation and Archimedes
Posted by: Invest E Gator (IP Logged)
Date: June 25, 2012 10:04AM
Give me a lever long enough and a fulcrum on which to place it, and I shall move the world. - Archimedes
This quote, attributed to Archimedes, came to mind as I was working through AutoNation (AN). There are various versions of it floating around the Internet, but the one above most closely fits for the purpose of this analysis. Let's hope that the comment section of this report doesn't get flooded with miffed historians. This AutoNation situation is so appealing, I am almost loath to write a report about it and feel inclined keep this all to myself. But doing something like that wouldn't be nearly as fun, so I just can't hold back.
You want to move your financial world? Allow me to show you how...
The gist of the situation here is that there is an extremely powerful culmination taking place in the automobile arena, and AutoNation has been long taking steps that serve to further amplify the future financial benefit from this. This is why I pick owning them over other potential contenders in this business. In the long term, the economic winds are blowing so strongly in their favor that AutoNation is a bet-worthy and rest-easy windfall. In the medium term, there may be a bit of a storm along the way that investors need to be aware of.
Successfully navigating this storm will make the windfall afterwards that much sweeter on the other side. As an investor, if you have a strong understanding of the driving forces, playing this stock becomes quite easy and predictable. It is in situations like these where many investors find their bravery, and thus massive profits, when hard times come — it's because it has been anticipated. So get a notepad and a pen out and let's get started, the important points to keep in mind are placed in italics.
A Bit of an Intro
AutoNation is an automotive retailer in the U.S. They own and operate 258 new vehicle franchises from 215 stores, mostly located in the Sunbelt region, selling 32 different brands of new vehicles, along with used vehicles from prior trade-ins, parts and automotive repair and maintenance services, and automotive finance and insurance products. They do not provide direct financing but arrange for it through third-party finance sources. It's all pretty simple and mundane, and the pictures of their locations look great!
Here is what you need to know so far:
1. AutoNation sells (mostly new) cars and they do some other related things too.
When considering the company we should also take some note on management and their compensation policies. Along with the considerable amount of share buybacks, covered later in this report, the compensation policies, as discussed in the proxy statement, are very investor friendly and the current chairman and CEO, Mike Jackson, has been working in the auto industry for 41 years. That's a lot of experience! To further assure an investor in this regard, both Eddie Lambert and Bill Gates have large holdings, and Gates has been heavily increasing his holdings over the past couple of months.
Fulcrum, n., the support, or point of rest, on which a lever turns in moving a body.
In itself, the fulcrum in this situation is strong enough to make some money. Due to the government's failure at successfully applying more failing regulations on top of the already failing regulations, along with leaving us with what is now a police state and the highest per capita prison population on the planet, people are continually getting poorer and the economy hasn't been doing so well. As a rippling side effect from this, consumers have been holding back on purchasing that new vehicle, and our cars are continuing to get older. It also seems that newer-built cars are a bit more durable than ones from prior years, but coffee still spills and cigarettes still fall, so they are not going to last indefinitely.
2. The need to buy a car is increasing.
Meanwhile, an interesting thing has been going on is that car dealerships have been closing down steadily over the years.
3. Competing dealerships are closing.
What we have here is a situation where demand is building up, and the places where a customer can choose to satisfy that future demand is concentrating into fewer and fewer providers. Sooner or later, unless the U.S. is bullheaded enough to take the Cuba route and bring us all to where we are living in a vehicular time warp, this situation is going to have to rebalance itself. According more recent reports coming in, the rebalancing is already starting to happen. In the meantime, there is a bit of a hump in the way that may interrupt this process, but these potential interruptions would only be temporary.
Over the years, the company has been taking on considerable amounts of debt and buying back boatloads of shares. This lever(age) is serving to concentrate the future profits into the pockets of fewer and fewer owners for when people eventually start trading in their cars and the money comes rolling in.
As we can see above, the number of shares outstanding has dropped more than in half over the past 10 years. We can also see that in the period of 2008 and 2009, instead of concentrating on share buybacks, they instead paid down debt as the cost to borrow increased.
4. Outstanding shares are getting bought up at artificially low interest rates.
In a perfect world, the economy will (magically?) improve, competing dealerships will continue to close, people will trade in their old cars for new ones, with many of those transactions happening through one of AutoNation's dealership locations, all while management continues to buy up shares and concentrate ownership into fewer and fewer shares outstanding. The result: Investors who stick with them through this will stand to make a lot of money. I don't know how much, but it is starting to happen with recent increases in new car sales. This earnings spree will last until that average car age chart, posted above, stops decreasing, it will be a wild guess to say how long that will take. With these positive factors in mind, it is paramount for any investor, who wishes to invest wisely, that he understand potential inconveniences that are likely to manifest along the way.
Please remember that, for this report, I am only outlining two potential storm scenarios that strike me as having particular importance in the intermediate future. Certainly, anything can go wrong in a business. Zeus himself can always decide to launch lightening bolts out of the sky and bring any business that he so pleases immediately to its knees. It happens. As investors, we should weigh the possibilities and adjust ourselves calmly and accordingly to events as they present themselves. While this little clunker bubble continues on its path of rebalancing itself, two (out of many) things can happen along the way.
Storm Scenario A: Interest rates go up
There is a direct correlation that, as interest rates go up, the cost to take a loan to buy a car increases, and thus car purchasing slows as a result. Not only does this make purchasing a car more expensive, but interest rates only went from 1% to 6% and the entire economy went into a financial crisis as companies dependent on cheap debt went imploding left and right. Such events not only temporarily decrease profits for AutoNation, but also increase the cost of servicing their debt. The combination of slowing business and increasing bond yields elsewhere distracts investors to other things and the stock price likely drops as a result.
The good news here is that, as interest rates go up and business slows, the stock price will likely go south for the winter all while an (already old) population of vehicles will continue to age, thus making the future new car buying spree that much more intense at some later date. In such a situation, buy more shares.
The big warning here is to watch out for a potential bankruptcy scenario. We can see from their debt levels, and digging deeper into their cash flow statement, that they handled 2008/2009 marvelously but, although unlikely, there is always the possibility that interest rates increase to some level that is beyond their reach and they are thrown under the bus into bankruptcy. If interest rates go too high that bankruptcy looks more than likely, then an investor can always consider his understanding of this developing situation and switch ownership over to another car dealership with less debt and wait it out with them. It's not worth our time to dig into a deep analysis of this possibility because both their debt levels and interest rates are moving targets. What matters for now is that, as interest rates increased, they quickly brought debt down from $1.75 Bil to $1.11 Bil, and this serves well enough for the time being.
5. Interest rates may go up, but this creates an even better buying opportunity. Do consider their debt and watch out for unlikely event of getting pushed into bankruptcy.
Storm Scenario B: They keep holding interest rates down and financial system crashes.
Havoc! Mayhem! Run for your lives! Should this happen, it may look like Mad Max, but when you have ownership of such companies who are taking on so much debt to buy themselves back, and we then crash the financial system off an inflationary cliff, thus wiping away the value of the underlying debt that they are holding: you get significant discounted ownership in what are only temporarily damaged companies. Cars will keep getting older and life must go on, so business will eventually recover. With a Federal Reserve that not only insists on holding interest rates down, but continues looking for creative ways to keep pushing them even lower (to hide the problem that they have caused)... unless the people in control over this come to a sensible epiphany, a financial system crash is exactly where this is taking us.
6. Interest rates stay low, the financial system implodes, business will slow for a while, but cars continue to age and people must replace them sooner or later.
This might explain why, when you read his earlier writings, Buffett was very accurate about inflation and very much against it, but lately he has been soaking up massive quantities of the low-interest debt. Meanwhile, conveniently, he is waving the inflationary (and big bailout) pompoms. Benjamin Franklin, his historical idol, would be rolling in his grave if he knew what was happening.
Storm Scenario C: No storm at all
Neither of the above happens, interest rates stay down and and the financial system holds together long enough for people trade in those aging cars for shiny new ones. In such a scenario of "none of the above," profits for AutoNation continue to increase and investors make a lot of money.
In both scenarios A and B, people will stop buying cars for a while, but what needs to be kept in mind is that such slowing only serves to age them further, thus intensifying what will be a delayed buying spree. If these storms send us into a stock market panic and discounted share price, it will only equate to a greater investment value increase at a later date. The price of the stock now is just fine assuming that there is no storm. Some day the storms will rage but we can't tell when and if the clunker bubble will rebalance before then. Over the past couple of years, since recovering from 2009, EPS have gone from $1.31 in 2009 to $1.48 in 2010 and $1.93 in 2011, a 13% and 30% increase, respectively.
The underlying fundamentals of this situation are excellent, and it's a fine purchase at the current PE of 17.74; just make sure that you understand the company well and are comfortable with what you are doing. Some temporary things may come up along the way as an interruption to progress and, like all investments, it is paramount that an investor attempt to consider and maintain a firm grasp on such probabilities even before they unfold.
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