This article is part of our Rising Star Portfolios series.
Despite its boring veneer, my purchase of Asbury Automotive Group
Really, now?
You might ask yourself: Why now? The recovery's still tentative at best -- Wall Street's pondering the consequences of eurozone instability, the consumer's balance sheet is hardly repaired, and cars aren't exactly an affordable luxury -- and U.S. markets are cresting two-year highs.
But Americans need cars, and in recent years, they haven't bought enough of them. The scrap rate, the rate at which cars are retired, is currently estimated at 14.8 million vehicles. For the past few years, sales have run below that figure -- 13.3 million in 2008, 10.4 million in 2009, and by the U.S. Bureau of Economic Analysis' guess, 12.2 million to 12.3 million in 2010. I believe that's a categorically unsustainable condition.
Better yet, Asbury shares aren't pricing the prospect of any recovery to auto sales. That makes an investment in Asbury a potentially lucrative gambit, in my opinion, with multiple sources of upside potential: a recovery in U.S. auto sales and replenishment of dwindling auto stocks, unrecognized earnings power in the company's parts and services and finance and insurance divisions, and improved profitability from recent cost-cutting and productivity measures.
A road to profits
Asbury makes its living selling luxury and midline automobiles, by the company's description. It does about $4 billion in revenue and sold more than 100,000 vehicles in 2009. Of the 37 vehicle brands it retails, the top five are Honda
Before we get much deeper, don't let Asbury's name fool you. Yes, it's a car dealer, but the majority of its profits come from parts and services (basically, repairs), and peddling loans and insurance to buyers. So despite the industry's stomach-turning cyclicality, Asbury has a very profitable and reliable source of cash flow in its parts and services division, which provided 47% of year-to-date gross profits. It's basically an annuity stream, because -- as you're painfully aware -- car repairs are hard to defer. The finance and insurance division sells insurance policies and offers loans on car sales. Because Asbury does not process or hold the loans/insurance policies on its books, the gross margins are 100%.
Add it all up, and year-to-date gross profits split 22% new car sales, 14% used cars, 47% parts and services, and 17% finance and insurance.
The rubber meets the road
There are several ways Asbury's profits, and shares, will move higher: a recovery to car sales, unrecognized earnings power in the company's parts and services and finance and insurance divisions, and improving profitability.
Car sales: In case you missed it, Americans aren't buying cars. Well, they are, but not enough. Unless this fine country intends to subsist on fewer cars, despite a growing population, it's not a matter of if, but when sales recover to match the scrap rate. By my estimation, Asbury's sales could move almost 20% higher on this prospect alone. Also consider: A recovery in auto sales will improve vehicle gross margins, as manufacturers and dealers move away from recent years' generous incentives.
Parts and services, finance and insurance: Credit markets were frozen a year and a half ago. While they've loosened considerably, banks aren't exactly handing loans out. An improvement in car sales, continued recovery in credit markets, and ongoing repair of consumer balance sheets should culminate in more auto loans. For Asbury, that's a very profitable source of incremental revenue.
Though parts and services revenue has held up reasonably well over recent years, they're not bulletproof. Declining vehicle sales and penny-pinching consumers put a little bit of downward pressure on parts and services revenue. They're likely to lag a recovery in vehicles sales, but they'll eventually turn higher as newer vehicles need repairs. Because gross margins average 50% or higher, that'll do good things for Asbury's bottom line.
Cost cutting, debt reduction, and productivity initiatives: Despite the stability afforded by parts and services profits, the Great Recession hit Asbury hard. The cliche goes that necessity is the mother of invention, and the company responded by cutting its corporate staff by 25%, moving its headquarters from New York to Atlanta, and renegotiating its debt covenants and credit facilities. Though expenses will increase as sales recover, the former two should produce some sustainable cost reduction, and the latter bought Asbury some breathing room on an otherwise onerous debt load.
The company has recently undertaken actions to implement a common dealer management system -- fancy speak for building one information technology platform that all its dealers can use. That should streamline overhead costs, and allow management to keep a lid on costs at the dealer level.
Taken together, the company has taken $100 million out of selling, general, and administrative expenses in recent years. That, coupled with a little operating leverage as sales grow and productivity initiatives continue, should boost operating margins in coming years. By my math, the market doesn't seem to be pricing that potential.
Valuation
As it stands, Asbury shares trade at 11 times my estimate of normalized free cash flow. In a market dominated by optimism, that's a nice value. I've examined a range of valuation scenarios, the details of which are below:
- Scenario 1: Sales muddle along at current rates, despite the seeming implausibility of this prospect, and operating margins remain stable at 3%. Valuation Estimate: $16.
- Scenario 2: Sales recover to scrap rates (adjusted for population growth) over a three-year period, and margins recover to pre-credit crisis levels, or 3.2%. New and used car gross margins remain depressed by historical standards. Valuation estimate: $25.
- Scenario 3: Sales recover to scrap rates (adjusted for population growth) over a three-year period, and productivity initiatives, cost-cutting, and higher new and used car gross margins contribute to operating margin expansion, which eventually reach 3.6%. Valuation estimate: $29.
Put it all together, and I think the shares are worth something around $26-28. That's enough to get my motor humming.
Risks or bumps in the road
The list of risks is fairly straightforward. Atop them is the risk the economy takes a dive and auto sales fall yet again. For Asbury, this would likely hit new and used car sales and finance and insurance revenues -- and profits would follow. Viewed across the long run, this doesn't seem like a sustainable condition, but there's no telling how long it may persist. Dependent on the surrounding circumstances, this could present a buying opportunity.
It's also worth watching the parts and services business. There's no shortage of repair shops, and consumers can take their business elsewhere. Parts and services revenues remained fairly stable through 2008 and 2009, and so if recent years are indicative, it's not likely.
Asbury has spent on acquisitions in the past, and as the economy recovers, will continue. Done well, this can accrue value to shareholders. But at the wrong price, it won't be so sweet.
Last is debt. Asbury got in trouble during the financial crisis, and it seems that management's gotten religion. Renegotiated debt covenants, refinancing, and debt reduction have made the debt more manageable, but Asbury still carries a lot of debt, so it's something I'll be watching.
The bottom line
For value-types, a solid business and a cheap macroeconomic catalyst are the investing equivalent of driving excitement (RIP, Pontiac). And with my $750 investment, I'm off to the races.
Please join me on my discussion board, where we’ll discuss all things Pontiac, and maybe a little bit on stocks.
