Who knows what changes a person would undergo if his or her wealth increases to the point that he or she is a billionaire? Some such people are particularly enjoyable to follow. One who has only been familiar to me for maybe two years is Edward Lampert of ESL Investments, a fund that has been labeled as activist. Mr. Lampert really made his fortune as a director of AutoZone (AZO), and anyone who is familiar with him knows that he has insight into the auto industry and stock repurchase programs. AutoNation (NYSE:AN) is another of his profitable holdings. It is isolated from European economic problems that affect the wider automotive industry. As the stock has run up and out of analyst favor, it may become a contrarian pick, despite the fact that it sports a high valuation.
Widely-followed money is behind AutoNation. Not only does ESL Investments maintain a sizable position that comprises over one third of its portfolio, but Bill and Melinda Gates are onboard too. However, ESL Investments and Joel Greenblatt have been trimming back and locking in gains. All of these parties are exceptionally well-advised.
Let's take a closer look at the business. AutoNation, the largest auto dealer in the USA, sells new and used cars and trucks. It has some 263 new vehicle franchises. Its core brands, accounting for 96% of new vehicles sold on March 31, are Honda, BMW, Toyota, Ford, Mercedes-Benz, Nissan, Chrysler, Volkswagen, and General Motors. The company is concentrated in the Sun Belt and continues to expand, growing within its footprint across the geographic south. Its most recent earnings report underscores the growth and success, and its newest monthly data is also encouraging.
AutoNation has four main divisions. A graphical display of them and their respective Revenue and Gross Profit percentages follows. The source for the data is the May 19, 2013 10-Q.
Overall, the stock makes sense for investment due to numerous reasons. We know from recent data that vehicle sales revenues are continuing to rise. The chart shows that AutoNation enjoys its highest percentage of gross profit from its Parts and Service division. Per the 10-Q:
The number of recent-model-year vehicles in operation, our primary service base, has stabilized due to increases in the annual rate of new vehicle sales in the United States since 2009. As a result, our parts and service business has begun to benefit, and we expect that it will continue to benefit over the next several years as this service base is expected to gradually return to pre-recession levels.
Goldman Sachs's most recent research includes comprehensive information about conditions that may affect the auto industry, and a table summarizing pertinent background information for car sales follows:
These figures, adjusted for inflation, show that consumers are widely expected to have increasing amounts of pocket change and to be using it for the remainder of 2013 and 2014. My own inclination is to say that, while these figures bode well for vehicle sales businesses, they are not predictive for the behavior of an individual stock. However, it probably is not surprising to anyone familiar with Lampert that the corporation's capital allocation policies set it apart. The company prioritizes its use of money in the following way:
- Maintain a strong balance sheet.
- On facilities, strategic, and technological initiatives.
- To repurchase common stock, or debt, or to complete dealership acquisitions.
Data regarding the program may elicit smiles from anyone familiar with share repurchase plans. First, the 10-K shows how regularly, copiously, and successfully the company has bought back stock each year since 2010:
The buyback has continued in 2013. The firm's current market cap is under $6B. AutoNation's 10-Q shows $317M remaining under its authorization.
The average paid is $39.85 so far this year, slightly higher than the $39.21 figure for 4Q 2012, indicating the company has taken stock away from the marketplace at lower prices than it trades at. The share price is now $45.22, after close on Thursday, June 6th.
While it might appear that all systems are "Go," high margin Finance operations have a looming issue that deserves discussion. It is one of several reasons to label this stock a Contrarian pick. Others, in no particular order, follow
Credit Suisse, $50 target price:
- There has been insider selling at share prices above $44.
AN has lacked a growth dynamic relative to peers, which coupled with its premium valuation has left us Hold rated. It seems M&A, dealer point additions have become more of a central focus in 2013 - or perhaps prior year efforts have come to recent fruition. We are supportive of this growth, and believe it is critical to extracting further operating expense leverage from an already lean model. In terms of April sales, domestic brands were obviously a bright spot, but we also believe AN core geographies are outpacing the broader U.S. market…it is worth noting AN domestic sales growth of +20% y/y outpaced the +10% y/y growth in the U.S. market.
- Analyst estimates show a mean 2.9 recommendation.
- Stifel Nicolaus (May 2), Credit Suisse (April 19), and Goldman Sachs (May 20) have hold, neutral, and neutral ratings, respectively (it is not common for large financial institutions to rank a stock any lower).
UBS has a Sell rating (May 30), alongside only 11% of stocks it covers
Stifel, target price N/A:
:Goldman Sachs, $57 six month target price:
We believe AN is well positioned to grow earnings in the mid-teens percent in 2013, but we do not see as much upside to numbers versus others and see better relative value in Outperform-rated Lithia Motors, Inc. (NYSE:LAD) and Neutral-rated Group 1 Automotive Inc. (NYSE:GPI). In addition, as highlighted in our industry report earlier this week, as [Seasonally Adjusted Annual Rate] SAAR growth moderates in coming Quarters, the group could see multiple compression, which AN would not be immune to given its industry leading valuation.
UBS, $39 target price (and thorough note):
Upside/downside risk would be a steeper/flatter pace of volume recovery…even with the recent rally in auto equities, the equity risk premium as suggested by our Fed Model continues to remain significantly above historical average implying further upside potential in auto equities.
UBS's sell rating is alarming. The CFPB has issued a bulletin saying that loan markups are considered discriminatory, and specifying flat fees per transaction as a way to ensure compliance with the Equal Credit Opportunity Act. UBS considers several different scenarios and finds that the probability weighted hit to EPS is $0.17, a $2 price risk (using 50% odds of flat fees, meaning new and used vehicles would have the same 1% markup fee on loans, as opposed to 2% on used). This issue does not offer upside, and I am appreciative of UBS’s equity research. However, not everyone is worried about it, nor is concern about "A rotation" echoed. In order to begin discussing the issue of changing interest rates, a table showing some key financial statement data through AutoNation's past five quarters follows.
We are downgrading the automotive dealer AN…from Neutral to Sell on mounting risks to earnings from three sources - possible new regulation from the Consumer Financial Protection Bureau (CFPB), a rotation away from European defensive names, and an eventual rise in interest rates. The stock [has] rallied over 50% over the last 12 months outperforming the overall equity market. However, given these risks ahead, we believe the near peak valuations are not sustainable and current multiples will likely contract…
Cash has declined. Current liabilities increase. Further, $920M in long term debt is due in 2016. As maintenance of a strong balance sheet is the company's top priority for capital allocation, it may make sense to anticipate reduced buyback activity. A portion of its debt is used toward the vehicle floor plan, though past results have been remarkable.
Interest rates matter because of borrowing necessary for dealerships to have vehicles on their lots. According to UBS
:The Swiss firm models a 25bps interest rate rise as resulting in a 1% drop in 2014 EPS. Inventory has increased quarter after quarter amidst acquisitions, and not completely in sync with seasonal sales trends. There is a 63 day supply of new vehicles this quarter, compared to 55 days' worth for December 2012; and a 35 day supply of used vehicles, compared to 29 days in the prior quarter. President, COO, and Director, Michael E. Maroone has said during the 1Q Conference Call that "There is…opportunity in [the used vehicle] business for recovery." The company continues to earn funds with new vehicles occupying its floor space, though used cars are strategically a greater proportion than in the past. The 10-Q shows a -$0.5M benefit change:
AutoNation's average floorplan interest rate fell ~450 bps from 2006 to 2012. Net of floorplan assistance from automakers, the net cost of carrying inventory at AutoNation fell from expense of $30m in 2006 to income of $30m in 2012.
In order to value the stock, data from the financial institutions cited thus far can be used to form a consensus price target. My preference is to use estimates for 2014 in order to create a twelve month figure, this allows for forward looking financial markets and unpredictable occurrences in the course of a year. Goldman Sachs is using an equally-weighted averaging of valuations based on EPS and EV/EBITDA; which is fairly easy to present and agreeable for the most part. Necessary data is not included in other firms' research, however.
Using these four 2014 EPS estimates and multiples a $48.11 target price is obtained.
It is notable that neither Goldman Sachs nor Credit Suisse forecast a smaller share count. Recalling that AutoNation has repurchased a sizeable amount of its stock at weighted average prices just under $40, a CFPB hit to used car financing profit alone is unlikely to compromise the program's success and benefit to shareholders. Stifel's forecast models repurchasing activity at only $100M spent per year through 2015. However its 2014 weighted average diluted share count is 117.5M, followed by 113.5M for 2015. UBS forecasts $100M in buyback activity. While firms anticipate a dramatic slowdown from over $500M, the program should support the stock into the future. It is my impression that all four research reports underemphasize the success observed by FactSet. With over three times their projected amount remaining under the authorization, $100M seems to be drawn from the extreme right, rather than a conservative estimate.
Vehicles should continue to sell amidst parts and service acceleration. However, I am not in a hurry to buy this stock. CFPB action may adversely affect it, does not appear to be priced in, and therefore only presents downside risk, as stated by UBS. However, Credit Suisse notes: "We were encouraged to hear CEO Mike Jackson indicate that he sees little risk to F&I profitability due to potential regulations." Here is Jackson's response to questioning about it during the Q1 Conference Call:
A risk, not mentioned in the institutional research cited, is that Lampert may continue to unwind his holdings. Recent SEC filings show him controlling 33.7% of voting power, having sold over 3M shares in February. Those familiar with AutoZone know that he can sell at an astonishing rate; and that company success and an aggressive buyback may conceal his exit's downward pressure on share price.
Don't expect any developments. We're very confident of our added value...We negotiate great wholesale rates for our customers because we have -- we can offer the financial institutions a very cost-effective way to acquire a lot of loans. We have a very reasonable margin on that business of 125 basis points…I do not expect any changes in that business that would materially affect our performance or resuls.
Another consideration is technical: the 52 week high is $48.92. If the stock drops as low as $43.30, there would be 11% upside before a consensus EPS target based somewhat on indifference to the company's coruscating capital allocation. Goldman Sachs's $57 target and research appear to lead the group, so upside may be understated. In fact, Yahoo! Finance shows a consensus 19.17% five year growth rate, reflective of Parts and Service prospects. OptionMonster is also reporting a 2,500 contract option trade betting that the share price rises over $50.65 by October (reliable short interest data is not available). A $2 pullback, in light of UBS's estimate of CFPB action, would provide a reasonable entry point. However, the downgrades and neutral ratings create value.
AutoNation is the country's biggest automotive dealer. Well-advised billionaires are behind it. Its share count has decreased substantially and the program responsible for it may continue to reward investors. A position in opposition to institutional research makes sense; and there would also be the chance of repurchase activity with a dip in price. Perhaps most importantly, Lampert's presence can not be overlooked--or counted upon.