Not many people relish the car-buying process: The glad-handing, the price-haggling, the warranty-pushing are all hurdles to enjoying your new ride. The dread of doing all that behind a mask has many car buyers—and investors—increasingly shopping online. But for both, the real value still might be found at the dealerships.
Traditional dealerships, such as
Group 1 Automotive
(KMX), continue to have some spark. Each offers a compelling play on a recovery—bumpy as it’s likely to be. AutoNation and Group 1 are both contrarian ideas, hinging on company-specific catalysts to lift sales. CarMax, the largest used-car dealer, has the wind at its back as used-car prices hit record highs and sales strengthen as shoppers tighten their grip on their wallets, buying pre-owned, rather than new, in the recession.
Shares of AutoNation, the largest national dealership chain, have more than doubled off their 52-week low, to a recent $52.53, but still trade at just nine times estimated 2021 earnings. Group 1, a regional chain that has invested heavily in parts and service, looks even cheaper, at seven times 2021 profits, or around $90 a share. CarMax, at a recent $98, is pricier, but that’s because it’s at the center of the hottest retail trend: used cars.
None of these multiples comes close to those of online newcomers
(VRM). Carvana, dubbed the
of dealerships, is up 67% this year, while Vroom, which went public in June, has more than doubled from its initial offering price of $22. Revenues are surging for both, as online car buying accelerates with the pandemic. But the stocks don’t offer much for value investors, trading at tech-stock multiples of revenue, with no profits in sight for years.
“The digital upstarts are addressing a pain point for the consumer—going to the dealership and sitting through a tough process,” says Bank of America Securities analyst John Murphy. “But a lot of people will still shop for cars at brick-and-mortar stores.”
While dealerships face a tough road back to 2019 levels of sales and profit, monthly trends show signs of a recovery. New-car sales, which were running at an 11 million annualized rate in the second quarter, hit a 13 million pace in June. Production has stabilized after nearly halting in the spring. And financing is exceptionally cheap.
These trends helped every major dealership report a profit in the second quarter. And while new-vehicle sales are down sharply, year over year—partly due to lack of inventory—wholesale auction prices for used cars recently hit record highs.
That’s a good leading indicator for new-car sales, says Michael Ward, automotive analyst for The Benchmark Co., a boutique research shop. Higher used-car prices cut the cost of new-vehicle transactions (since buyers get more for a trade-in), and lower lease payments by boosting a vehicle’s “residual value” (its worth at the end of a lease). “I’m very positive on the dealerships overall,” says Ward.
Dealers have far more leeway than manufacturers to cut costs, and they are using it to turn a profit. Capital expenditures as a percentage of revenue are less than 1% for dealerships, versus 6% for manufacturers and suppliers, says Ward. Dealers have long maintained an average gross profit of around $3,000 per vehicle. “It’s probably the best business in the auto sector because of its low capital intensity,” he says.
Coming out of the Great Recession, dealership stock multiples expanded by 20%, Ward adds. A similar bump should emerge as the industry comes out of this downturn.
AutoNation’s shares have been rising after the company beat consensus estimates in the second quarter and announced plans to build 20 used-car dealerships over the next three years. CEO Mike Jackson says the pre-owned market will consolidate into large dealership groups, as consumers increasingly shop online at companies with national brands. “We have the digital capacity that matches anyone,” he says.
AutoNation also has invested in digital dealerships, taking a 7% equity stake in Vroom, worth about $440 million.
While digital dealers are growing faster, AutoNation has some advantages. One is its used-car pipeline. By selling both new and used autos, pickups, vans, and SUVs, the dealership can source more vehicles through trade-ins than through auctions, maintaining more control over pricing. Jackson says that 75% of his used-car inventory comes from trade-ins and sales by consumers. “Our cost of acquisition, reconditioning, transportation, and branding are all lower,” he contends. The used-car stores that his company is building will be largely distribution and service centers; sales will be negotiated online. This will keep capital expenditures for each store relatively low.
AutoNation could help its case with investors by issuing sales guidance, like other dealerships, and resuming regular stock buybacks, which it suspended recently, to lift earnings per share. Jackson says he doesn’t believe in “pathological, systematic” buybacks and says the company doesn’t intend to issue mid-quarter updates because “we run the business for the long term.”
Nonetheless, Wall Street appears increasingly bullish on AutoNation. Earnings per share are forecast to rise 15% in 2021, to $5.78, on an 8% increase in revenue, to $21.1 billion. Murphy expects the stock to hit $62, based on a 12 times earnings multiple, which he considers warranted by AutoNation’s resilient model and efforts to “future-proof” sales and profit.
J.P. Morgan’s Rajat Gupta, who recently upgraded the stock to Overweight, expects it to reach $70 by December. Building the AutoNation brand should lift used-car inventory and fuel revenue from higher-margin financing, parts and services, he says. Gupta also expects gains in earnings from additional cost-cutting and a potential revival of share buybacks, suspended at the end of the first quarter.
Group 1’s stock looks even cheaper, partly because of its heavy exposure to Texas and Oklahoma—states hit hard by the energy downturn and recent spikes in coronavirus cases. Group 1 also operates dealerships in the United Kingdom and Brazil; they accounted for 14% of sales in the second quarter—and pose another risk. The company booked “asset impairments” of $1.11 a share in the quarter.
While revenue fell 29% from the level in 2019’s second three months, the company said its U.S. business recovered steadily in May and June, fueled by used car sales and service. It also benefited from its online shopping platform, Acceleride, as digital sales accelerated.
The energy sector, while critical to Texas’ health, has become less of an economic driver as the state has diversified its economy. Group 1 has invested heavily in online sales via Acceleride, and is seeing steady growth in parts and service, and at its collision centers. Combined, these three account for nearly half of gross profits. One of the biggest obstacles to services growth is a shortage of technicians, but Group 1 recently launched an innovative, four-day work week, helping reduce turnover and boost employment. “That should translate into meaningful parts and services growth at attractive margins,” says Morgan Stanley analyst Armintas Sinkevicius.
Trading at seven times 2021 profits, the stock is well below the average multiple of nine times earnings for traditional dealers. Benchmark’s Ward expects it to hit $130 over the next 12 months, valuing it at 11 times earnings, about average historically.
CarMax should benefit from the strength of pre-owned vehicles in the recession. With new-car prices hitting record highs, consumers increasingly are opting for lightly used vehicles. CarMax also runs a wholesale auction business.
While sales dried up in the early days of the pandemic, they’ve improved since April. Sales in the first two weeks of June were within 10% of last year’s, CarMax said in its latest update.
CarMax faces stiffer competition from digital dealerships, but it also has advantages: Like AutoNation, it sources many more vehicles from consumer trade-ins than from auctions. The company reported gross profit per unit (including service, financing fees, and auction sales) of $3,270 in its latest full fiscal year (versus $2,852 for Carvana).
CarMax may also have an edge as the average age of used vehicles increases. With declines in vehicle production, there won’t be as many one-to-three-year old cars for sale over the next few years, says Murphy. Older vehicles are tougher to price and need more reconditioning, benefitting a full-service operation like CarMax. “For that, you want a knowledgeable dealership that isn’t just playing the trading game for commodity-like assets,” he says.
CarMax looks pricey based on 2021 earnings multiples. But Murphy sees 30% upside in the stock, assigning it a $130 target based on a multiple of 20 times 2022 profits, the mid-point of the shares’ historical range. CarMax is transitioning from a traditional to an “omni-channel” retailer, including more digital sales, which should improve profitability, lift its addressable market, and generate more cost savings. Massive lots, packed with vehicles for sale, might look like relics of a pre-pandemic era, but they aren’t driving away anytime soon.
Write to Daren Fonda at email@example.com