This Auto Stock Is No Crash-Test Dummy

What doesn't kill you makes you stronger, right? Lithia Motors (LAD +0.20%) has certainly proved the old adage to be true. After a really rough time during the economic downturn, the auto retailer's outlook is bright -- meaning now is the right time to hitch a ride to with Lithia.

Someone call AAA
As automakers struggled through 2008-2009, so did auto dealers. Though income from service operations created a small cushion, vehicle sales were at historical lows, creating tough environments for dealers. Lithia was no exception.

Lithia's model is unique in comparison with other public dealer groups. Instead of choosing to compete in metropolitan markets, which tend to have customers with more discretionary income, Lithia focuses on rural markets.

The company's strategy to operate the dominant brands in those areas has paid off. By being the only dealer selling customers' favorite brands , Lithia was able to leverage a heavy concentration of domestic brands in its markets at a time when imports ruled the road nationally. This approach highlights one of the company's philosophical strengths -- going against the grain with confidence.

However, during the financial crisis, Lithia had to contend with not only manufacturers restructuring, but also the housing collapse. The markets it operates in are heavily reliant on the housing industry , which drives truck sales for Lithia. So when construction seized up, so did the vehicle sales it had supported.

Carrying around extra weight can be bad for your health
Though Lithia had already planned to restructure, the crisis forced it to shift into overdrive. By taking a hard look at inefficiencies and extra costs of running its operations, Lithia was able to not only reduce operating overhead (yes, that's a nice way to say it laid off employees), but also increase productivity and standardize various processes. The company sold numerous dealerships that were underperforming or not in line with its core strategies.

On top of cost-cutting initiatives, Lithia was able to restructure a critical debt facility in 2010 -- resulting in a reduced interest rate, higher credit line, and extended maturity . Continued refinancing efforts have resulted in a lighter debt load , reducing the company's projected interest expense for 2011 and 2012  by 25%,  a reduction of more than $5 million. A reasonable interest coverage ratio (measuring how well a company can "cover" its interest payments with its earnings) is 5 times -- Lithia's is 15 times. Refinancings have the company's balance sheet firing on all cylinders.

Let's get back to business
The resurging auto market offers a myriad of opportunities.

With consumers holding off on vehicle purchases during the recession and slow-moving recovery, the national average age of the cars on the road is seven to 10 years, with trucks trending higher at 13 years. New technology and fuel efficiency improvements are attracting car buyers in droves.

As a result, the projected seasonally adjusted annualized rate, or SAAR, for new vehicle sales is 15 million to 15.5 million for 2013. For perspective, the SAAR was 10.4 million new vehicles in 2009 .

Consumer financing is rebounding along with vehicle sales. When the financial crisis hit, it was no surprise that banks were reluctant to lend money for auto loans. With the recovery, auto loans are more available, reaching as high as 91% loan to value -- the highest rate since 2008.

The subprime section of consumer financing is also returning, with 11% of Lithia's financed vehicles falling in this category. With subprime returning to the "normal" 20% of financings, the company could benefit by as many as 1,500 additional vehicles sold each quarter -- a meaningful impact to Lithia's operations.

As the auto industry continues to rebound, it's inevitable that the auto dealers will as well -- none so efficiently as Lithia. By trimming the fat out of its operations, Lithia has positioned itself to be a lean, mean driving machine going forward.

Just the facts, ma'am
Going through rough times made Lithia turn a critical eye on its operations, and the company's recent results show the efforts are paying off.

The best measure for dealership improvement is same-store sales, where Lithia improved across the board:

Source: Lithia Q3 2012 earnings press release. *F&I represents warranty, insurance, and extra packages sold with vehicle purchases -- pure profit!

While there has been a resurgence for all of the auto dealers, Lithia has outperformed many of its competitors, as well as the national average. In the new vehicle sales category, Lithia's growth left its competitors in the dust:

New Vehicle Revenue Year-Over-Year Improvement (2011-2012)

Sources: Lithia earnings call; Asbury and AutoNation earnings press releases.

It must be doing something right, huh? And those cost-cutting initiatives? SG&A expenses as a percentage of gross profit are at an all-time company low, a level that none of its competitors came close to during the same time period:

Source: Companies' earnings press releases.

The company had $44 million in free cash flow at the end of the third quarter, giving it flexibility to continue expansion plans, pay its dividend, and reinvest in its business.

On sale, for a limited time only
A rebound is evident with Lithia's operations, and investors can expect continued improvement. Lithia's EPS growth hit a record-breaking level for the company, with a 54% increase from 2011 to $2.31 per share. Even with unmatched earnings growth, the company has the lowest P/E ratio of all the public dealer groups:

Source: Companies' earnings press releases.

The auto retailer is attractive for both growth and dividend investors (1.2% yield), who should expect to see continued increases in most revenue segments, continued improvement of expenses management, and strategic acquisitions that add to the company's operations. With the company's exceptional growth and the lowest P/E of the public dealer groups, Lithia's shares may be undervalued, giving investors an opportunity to buy in on the momentum the company's built up.