The auto industry might be in danger, but AutoNation, Inc. could still be a buy
According to Bloomberg, Ford Motor Co. and Fiat Chrysler Automobiles NV’s U.S. light vehicle sales fell more than analysts estimated in July as the US auto market slump continued into its fifth month. After a bumper 2016, and after nearly six years of growth, the auto market now looks to be stalling with analysts predicting total annualized light vehicle sales of 17 million in July, down from 17.9 million a year earlier.
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It seems that after loading up on debt to buy new vehicles over the past six years, consumers are now starting to pull back. What’s more, a glut of nearly new used vehicles poses competition for new car sales and it seems consumers are struggling to meet their existing liabilities. According to Reuters, car shopping website, Edmunds said the average length of a car loan reached a record high of 69.3 months in June. Meanwhile, there are growing concerns about the state of the auto lending market. Last year around $26 billion in financing agreements were made, and some lenders are not vetting as many as nine out of ten financing applications, which has sparked uncomfortable comparisons with the 2007 financial crisis.
AutoNation, Inc. Valuation
As a storm brews over the US auto sector, investors have started to abandon ship, dumping shares in any company with a connection to the industry. Shares in Autonation for example, have lost 19.6% over the past 12 months and a third since mid-2015.
However, recent declines have attracted value fund Black Bear Partners to Autonation. Black Bear Value Partners is a fundamental and value-oriented investment manager lead by Adam Schwartz. The firm invests with a long-term outlook, looking for a sizeable margin of safety with every investment.
At the Valuex Vail conference held at the end of last month, Black Bear laid out its thesis for the contrarian Autonation.
The US auto dealership market is a highly fragmented market with 90% of the market is privately owned and 10% owned by public companies. Ongoing consolidation brings bolt-on growth, but ultimately the sector is subject to cyclical trends.
AutoNation, Inc. derives most of its gross profit from parts and servicing. Selling cars accounts for 80% of revenues but just 30% of gross profits. Meanwhile, parts and servicing accounts for 15% of revenue but 43% of gross profit. Finance/insurance has a 100% pass through rate and is purely commission based so while it only accounts for 4% of revenue, finance income is a third of gross profit. This revenue mix does not make the company immune from auto market trends, which Black Bear acknowledges. Nonetheless, the company appears to be run by a conservative management team which can be trusted to steer it through tough times if and when they emerge.
Throughout the financial crisis the company remained free cash flow positive, and over the past five years, Autonation has achieved a return on capital of 25% and 20% over the past ten years including the financial crisis. The auto sales/distribution side hides the higher margin finance & parts/service business where EBITDA as a percentage of gross profit is 30%. Over the last five years, the company has turned out an average free cash flow per share of $3.44.
Autonation’s management has used this cash to dramatically reduce the group’s share count by 50% since 2007 and looking backward; the firm is trading at a 9% free cash flow yield.