Auto Dealers -- Sonic Automotive (SAH) used as example

Long – June 2013

See with charts at: https://docs.google.com/file/d/0B6RZm3GPDn8nTnNNY2FqNDQycEk/edit?usp=sharing

Note – this was a bunch of notes from March-May timeframe compiled in June.  Stock prices aren’t all that different and looking at 100-200% type upside from here over 2yrs.  The only thing to mention on this latest quarter is you are starting to see the P&S thesis below play out in the numbers (P&S SSS this last quarter accelerated for every dealer, this can be lumpy with warranty work but it’s been a multi-quarter trend of consistent acceleration).  Also very importantly, AutoNation is starting to talk about this.  They haven’t put real numbers around it yet and sell-side certainly isn’t modeling this upswing, but think AutoNation will start educating people which should be good for the multiples.  You should certainly listen to AN’s call and you’ll notice the sell-side asking a lot of questions around this on all the other dealers’ calls for the first time. 

I think the auto dealers are very attractive longs right now.  There is enormous potential for profit growth on deceptively high quality businesses that are local monopolies with high ROIC, big barriers to entry and generate lots of free cash flow.  There is modest upside on the front-end (car sales) part of the business with increased SAAR, but more importantly I think investors are overlooking a huge multi-year ramp up coming in the parts and services business which is the real profit engine of a dealership but not where investors/sell-side concentrate their analysis. 

While P&S is only 12-15% of sales, it generates roughly half a dealer's gross profit.  P&S is driven by the number of 0-5 year old cars on the road (so right now depressed levels ofSAARduring the downturn).  Due to the lag on historical car sales, this fleet has been steadily declining straight into early ’12.  Starting in late ’13/early ’14, this headwind will turn around and become a powerful source of growth as ’08, ’09 lowSAARyears cycle out.  Ultimately the 0-5yr fleet normalizes 35% higher than it is today, a huge growth tailwind to P&S departments that should continue growing 3-5%/year in excess of the fleet.  This dynamic hasn’t been seen since the mid-80s, long before the dealerships went public.  In the 1980s the fleet of 5-yrSAARgrew 22% over the decade, industry-wide P&S grew at an 8.5% CAGR for the entire decade (with even higher same store sales due to net dealership closures). 

With big growth in the dealers core P&S profit engine, incremental EBIT/GP around 50% (vs. 20-30% starting point), and redeployment of a ~10% FCF yield into accretive acquisitions and buybacks, earnings per share should grow 20-30% for the next few years and in the mid-teens for many years thereafter.  There is great visibility to this growth given P&S’ lag toSAAR(i.e. analyzing history instead of the future), yet these stocks seem cheap at ~11-12x.  I think SAH’s EPS can be 70% above consensus FY15 estimates and multiples should expand as investors start to pay attention to what is happening in parts and services and price in a growth trajectory that should last through the end of the decade well afterSAARstops growing. 

I use SAH as an illustrative example whenever we’re talking specifics because it’s a very simple business.  I think the best places to play are SAH, ABG and GPI, for reasons discussed below. 

There is a lot I want to include here, but want to keep it manageable.  So Section 1 is a three page summary of the opportunity.  Since I have it already, I’m sharing a lot more detail in Appendices with charts/graphs that I think are useful. A lot of the charts and tables don’t paste in VIC, best way to see it is here:  [https://docs.google.com/file/d/0B6RZm3GPDn8nTnNNY2FqNDQycEk/edit?usp=sharing].  It’s jamming thoughts collected over a few months together, so apologies if there is some repetition. 

1)       Section 1 – Summary

2)       Appendix 1– Overview of the business

3)       Appendix 2 – P&S and the 5yr fleet historically – the key thing to understand

4)       Appendix 3 – What’s normalSAAR?

5)       Appendix 4 – Comparison of the dealers

6)       Appendix 5 – CFPB – the key risk

7)       Appendix 6 – Cyclical upside in dealers vs. OEs?

Easiest way to break down SAH is into 3 key levers – P&S growth, use of cash, multiples:

1. Parts & Service (P&S) upside -- consensus is missing a huge upswing coming in parts & service (P&S).  Only young (0-5yr) cars are brought back to the dealer for service, so P&S is really driven by the service base - how many cars were sold in the last 5 yrs (0-5yr fleet).  P&S departments then consistently grow sales 3-5% in excess of fleet growth due to a number of factors – increasing retention of service stream, more expensive repairs on more complex cars. 
   1. P&S generates half the gross profit of a dealership and incremental P&S gross profit falls through SG&A at ~50-60% incremental EBIT/GP margins vs. existing 20% EBIT / GP margin (look at margins EBIT / GP b/c reselling cars is a lot of pass-thru cost into revenue).
   2. P&S is driven by three things:
      1.                                                    i.      How many 0-5yr cars are there to serve? - fleet
      2.                                                   ii.      How much of that service stream can the dealer capture (vs. losing to independent garages) - retention
      3.                                                 iii.      The amount of service per car – increases on price & increasing car complexity/ more components to break, offset by better quality cars that lower rate of problems per car
   3. Fleet(35% cyclical upside) -- Right now trailing 5yr SAAR consists of cars sold 2008-2012, the worst 5 year period since 1979-1983, when the US had lots of problems and a population of ~220m
      1.                                                    i.      This 0-5yr fleet dynamic means P&S revenue lagsSAAR
         1. The decline is this fleet has been a big headwind for dealers, and was still a negative impact in ’12 even thoughSAARhad already been recovering off the bottom for 4 years. 
            1. Hist. 0-5yr fleet growth - 2008: (4%), 2009: (8%), 2010: (8%), 2011: (6%), 2012: (3%)
            2. But late in 2013 it starts to turn positive as it begins rolling late 2008SAARand rolling on current levels.  It then becomes a huge tailwind in ’14 and beyond through the end of the decade.
               1. Forward 0-5yr fleet growth – 2013: +3%, 2014: +8%, 2015: +7%, 2016: +5%, then +3% for multiple years. 
            3. In total 5yr SAAR fleet bottomed at 64m at end of ’12, it starts growing for the first time in the back half ’13, and ultimately grows 35% to regain the 85m levels at normal SAAR
      2.                                                   ii.      This P&S lagging SAAR dynamic basically means today you can buy the dealers off the nadir of the biggestSAARdownturn in 50 years, and with total visibility on the recovery.  Buying in at 12m SAAR going to 17m SAAR instead of buying OEMs at 15.5m SAAR going to 17m SAAR, and you’re getting more operating leverage in the dealer model than the OEs. 
   4. Retention(ongoing secular shift) – On top of the growing 0-5yr fleet, dealers are increasing the % of that fleet’s service stream they are capturing. 
      1.                                                    i.      Dealers made a big push in downturn to keep customers in the service bay, everything from better CRM, proactively contacting customers, offering new services (oil, tires, collision).  These initiatives have made big headway and should continue improving retention. 
      2.                                                   ii.      There is a relatively recent trend towards OEM-included maintenance (standard on BMW, Volvo, Toyotacare introduced 2yrs ago, GM just expanding its included maintenance program).  This makes life easy for dealers.  Since the service/repairs are free to consumers at the dealer, the dealer retains 100% of the service stream.  Meanwhile OEMs pay dealer full rate by law in the vast majority of states, so this is full profit work.  Where OEMs don’t include free maintenance with the car, consumers are increasingly buying 100% maintenance/repair plans with the car purchase (in this case a 3^rd party insurance co pays the dealer for service instead of the OEM, again full rate). 
      3.                                                 iii.      Increasing complexity of cars (particularly all the proprietary onboard computer systems), require expensive OEM-specific tools and diagnostics, which is freezing the independent mechanics out of the repair market on the newer models.  I think a few years from now this could add a few percentage points to P&S growth for a long time as this extends the period in which cars get serviced at the dealer. 
      4.                                                 iv.      All of this is fully supported by the OEMs.  They want service done at the dealer, which leads to higher customer satisfaction and less brand churn at car replacement, higher residual values, more opportunity to sell OE parts, etc. etc. 
   5. High incremental margins–
      1.                                                    i.      With the auto dealers focus on EBIT over Gross Profit margins instead of EBIT over sales margins (with dealers reselling $30k cars, most of revenue is just buy/resell pass through, the starting point is really gross profit). 
         1. I expect P&S gross profit moves in tandem with P&S sales, in other words P&S gross margins will be flattish – COGS is almost entirely labor hours and cost of parts, so you won’t get any gross margin leverage. 
      2.                                                   ii.      P&S generates over 50% of Sonic’s gross profit, despite being only 16% of sales. 
      3.                                                 iii.      SAH’s starting EBIT over GP margin is 20% (e.g. earn 20c for every $1 of gross profit generated). 
      4.                                                 iv.      Incremental EBIT / GP margins are ~40-50% in the dealer business as a whole, with incrementals on P&S higher than incrementals on the front end (more SG&A/commissions tied to a new car sale than to incremental service gross profit).  From discussions with dealers I think P&S has 60-70% incrementals, but just assume 50% in the analysis to be safe. 
      5.                                                  v.      All in all, when P&S grows, it hits 50% of your gross profit and drops through EBIT with incremental margins 2-3.5x your company average, so 1% P&S growth generates 1-2% EBIT growth on the whole business. 

1. Use of cash.Consensus estimates are too low partly because they don’t utilize the cash.  These businesses generate a ton of cash which is put into high return investments -- acquire at 4-5x EBITDA vs. trading at 7x multiples, buy out underlying real estate at a 20-25% ROE, or buy back shares.  
   1. Most of the buy-side doesn’t factor in a use of cash since its not clear how it will be used (except for AN which will buyback shares).  For instance MS projects SAH building up $350m of cash over the next 4 yrs, or ~30% of the market cap
   2. Turning on buybacks increases ’15 EPS 20%, more if you assume acquisitions instead. 

1. Multiple expansion.  Stocks trade ~11x forward earnings right now, vs. a market multiple of ~15x.  I think they deserve at least a market multiple as investors start to understand the coming growth – If we’re in 2014 looking forward there is still a lot of growth ahead – on what I think are conservative assumptions (no growth on the front end, MSD-HSD growth in P&S and use of cash), you’re already in excess of 20% EPS growth, which I think is sustainable for a long period even once we’re past the peak in P&S ramp up. 
   1. Sell-side just looks at historical multiples – for all of 2000s when these guys were public, 5-yr fleet was flattish/shrinking slightly, so they had to grow P&S despite a stagnant fleet, and investors were constantly expectingSAARto fall off.  Not really a comparable situation for today.  In late 90s, car fleet was growing at about half the rate it grows going forward and the stocks that were public got 15-20x multiples. 

1. Other– there are a few other possibilities that could create upside, but I’m not personally convicted enough in either to underwrite them
   1. Credible bull case forSAAR(see appendix 3) – would be upside on front & back end
   2. Used car economics could get much better as used car supply loosens up.  Right now dealers can’t get enough high quality cars (very few 3yr leases entered in ’09).  They make the most money on these younger cars, certified pre-owneds etc.  Dealers are excited about this, I’m a bit more skeptical they’ll just compete it away somewhere between trade-in values offered and prices given to buyers. 

What upside does this sketch out?

I can’t share projections, so will just sketch out Sonic’s sensitivities to these drivers:

• P&S is 50% SAH’s gross profit.  EBIT is ~20% of total gross profit and 50% of incremental gross profit falls through to EBIT (dealers talk about 40-50% incrementals company wide, I think this is ~35% on front end due to high salesperson commissions, ~60-70% on P&S due to lower commissions, but I just use 50% for P&S for now). 
• This means ~10% P&S growth alone drives 10-15% EBIT growth for all of SAH. 
• ~10% cash flow yield directed to buybacks/acquisitions provides another 10% EPS growth. 
• The front-end car sales side of the business drives 50% of gross profit, used should grow more than new but if we just assume a ~7% growth in transactions (in line with SAAR), and lower 35% incrementals, that drives another ~5% EPS growth
• All in all I think that leads to a few years of 25-30% EPS growth ahead while the P&S growth is highest.  Followed by another 3-4 years of ~15-20% EPS growth as growth in the 5yr fleet slows to ~3% and the new car market flattens out
• This is very different than consensus expectations for ~10% EPS growth, or what the market seems to believe with these stocks trading 11-13x vs a 15x market multiple. 
• I think SAH could earn over $4 in FY15 (70% above consensus).  If SAH maintains today’s 11x forward multiple, that’s a double for the stock in the next 18mo. 
• But I think it’s reasonable to expect multiple expansion as this P&S growth trajectory is better understood. At 13x, the stock would be up 130%, at a 15x market multiple, the stock is up 170%. 

Why the opportunity exists:

1. P&S opportunity is not being followed closely, and its never happened before
   1. See Appendix2 inback – the 0-5yr fleet hasn’t grown since the 1990s.  We first hit 17.4m SAAR in 1999, thenSAARbounced around between 16-18 for the following decade, maintaining a flat 0-5yr fleet.  You need to look back to the mid-1980s to see the last period of such strong growth in this young fleet, well before these companies were rolled up and taken public in the late 90s/early 00s
   2. Mgmt teams are also skeptical to commit to this growth.  When you lay out the math, they all kinda agree what this should mean for P&S, but respond that they’ve never seen growth that high in P&S, would need to see it before they commit to investors.  (they’ve never seen it because growth of this magnitude hasn’t happened since the 1980s, when P&S grew at an 8.5% CAGR for a decade! see Appendix 2). 
2. The dealers don’t really fit in any sector, so coverage/investor focus is weak – not retail, not auto manufacturing/supply, not financing.  It’s a pretty unique business that sits on the fringe of any coverage universe.
   1. On the sell-side its mostly covered by auto analysts and is a sideshow to the OEMs & Tier 1s where all the market cap is.  Most bulge bracket firms only cover a random few of the dealer names, presumably where their investment bankers did some deal way back when.  Questions typically focus on front-end of the business, which is more relevant for their coverage universe. 
   2. Doesn’t fit buyside coverage either -- always a random smattering of retail / industrial folks taking a peek, in joint meetings I hear a lot of intro type questions.  But have noticed more familiar hedge fund faces recently.
   3. All the dealers are small caps.  Biggest is AutoNation at a whopping $5B, only half of which is free float.    
3. Stocks screen weirdly, so doesn’t pop up on the radar
   1. Leverage looks enormous due to floorplan financing
   2. Free cash flow looks funky due to swings in inventory (funded by floorplan, but not visibile in CFO-capex)
   3. Very low margins – % margins on sales are very low, but kinda irrelevant when you’re reselling $30k cars.  Gross margin per car is a better starting point for revenue when you look at this industry.  .
4. Sell-side targets pegged to historical multiples.  They keep looking back and saying this space traded 10-12x in the 2000s.  Of course back thenSAARwas flat and always expected to fall, the P&S department was servicing a full fleet of 85m 0-5yr old cars which was more likely to fall than grow.  So 10-12x was a peak multiple reflecting the constant expectation of a fall off.  In the late 90s the 0-5yr fleet was still growing and the dealers traded at 15-20x EPS (and ‘90s growth only a fraction of the growth it will see going forward).  Its very different now in the first year of a huge cyclical P&S upswing that will last 8 years given the lag toSAAR, with the profit driver of your business standing to benefit from a 35% cyclical recovery in the fleet on incremental margins 2.5x the group average.  This situation deserves a different valuation. 

Biggest risks:

1. CFPB & auto finance.  CFPB is changing the way auto lenders compensate auto dealers for origination -- dealer interest rate markups will be changed to flat origination fees instead.  This is a crucial piece of profit for dealers and something that deserves a lot of attention.  After talking to a lot of dealers, lenders, CFPB watchers, lobbyists etc, I feel pretty comfortable there is limited risk to dealers’ profit due to the way CFPB implements changes.  This change will be forced on the 4 biggest auto lenders first, with the expectation other lenders will transition to the CFPB-blessed model.  But dealers still choose financing options based on where they make money.  So lenders I’ve spoken to expect the flat fees will have to offer as good or better economics to the dealers, or else the four first-movers will lose all their market share quickly.  Going forward, lenders will still compete for dealer referrals, using this fee instead of markup – see Appendix 5 for more discussion.
2. Interest rates.  Big durable good purchases benefit from low interest rates, and this is certainly helping housing and autos right now.  Rising rates make cars more expensive.  Could certainly squeeze out some F&I ancillary products, but in reality these transactions have so many different facets its squeezing a balloon – as interest rates have fallen, we’ve seen profit shift from the car margin to F&I b/c dealers can get more aggressive on the upfront car price when they know they’ve got a big bucket of F&I profit attached to it.  If rising interest rates offer less F&I profit per car, you should expect that trend to reverse.      
   1. The good news – cars are consumed so they need to be bought.  I don’t see go-to-zero type risk like you could in existing home sales. 
3. SAAR is always a macro risk here, but it does seem clear today’sSAARlevels are too low to replace car consumption unless US miles driven goes significantly lower

General overview

Auto Dealer attractiveness

• Franchise agreements with exclusive geographic areas create mini-monopolies or mini-oligopolies in densely populated areas.  Some customers may drive50 milesto save a few hundred bucks on a new car, but they won’t drive50 milesto get their car serviced, which is where the real value of a dealer lies.  And dealers aren’t incented to compete irrationally on new car sales outside their natural area since it won’t lead to recurring profit on the backend
• No internet disintermediation threat, all new car sales (including fleet) have to go through the dealer network by law. 
• The public players combined only make up ~10% of the market.  There are a few private groups that operate at scale as well, but vast majority of dealers are mom & pops with lower margins who often under-invest in their businesses and generally have a tougher time.  Competitive market is shrinking (# of dealers down 20% in 5 years, down 33% over 30 yrs), which means revenue increases for dealers that are left standing that pick up the free P&S revenue and takeover the share of new/used sales. 
  • DespiteSAARbeing only 12.8m in 2011, new car sales per dealership were already higher than the’07 peak due to all the mom & pop closures (which are not coming back)

• Scale advantages for public chains – purchasing, management systems, CRM systems, advertising etc. drive cost and efficiency advantages for the chains versus mom & pops.  In particular, there is an advantage to having a number of dealers near eachother as you can hook used cars into the same inventory system and sell much more off the lot (instead of wholesaling at zero profit) with significantly improved inventory turns.
• OEMs focused on improving dealer health.  Want fewer, larger dealers, with better facilities and customer satisfaction .  These attributes are largely found at the larger public market dealer groups, after years of OEM fear of the public dealers (don’t want customer concentration), they now appear to be embracing and promoting them.  Dealer chains are earning special incentives to reward their investment in the dealerships and customer experience
• Deceptively good returns – adjusting out floorplan-financed inventory, ROICs are in the high teens to 20% range
• Ample high return investment opportunities in acquisitions, real estate and stock buybacks

Segment overview / Business Model (using SAH’s splits as guidepost, but generally similar across industry)

Front-End

Note: while front-end is contributing ~50% of gross profit, it’s EBIT contribution is substantially lower as the majority of SG&A can be attributed to front-end sales (new & used sales commissions, advertising, floorplan interest etc). 

New Car Sales - 53% of  sales, 21.3% GP

• Car dealers earn a $$ profit per car on sales, for SAH this is ~$2.1k per car, that’s probably ~$1.5k for a midline import, ~$3.5k for a luxury car.  These per car margins are lower than historical norms (b/c F&I profit growing see later – if dealers know they can make more $$ on F&I when a car closes, they are willing to be more aggressive on price, it’s all managed to a total $ per transaction metric)
• Dealers hold ~2mo of new car inventory.  However, this is financed 100% with floor plan programs.  And new cars are delivered with interest credits worth 45-60 days that make them close to interest-free.  Arguably the inventory risk on new cars really lies with OEMs (as demonstrated in the downturn) who need the dealers to keep buying cars and will fund incentives if needed to get the dealer inventory off of lots so dealers will keep accepting new cars. 

Used Car Sales  - 28% sales, 12.1% GP

• Used cars are sold retail (~$1600 of profit per car) and wholesale (no profit). 
• Quick turnover is crucial for used cars, which advantages scale networks (better inventory turns on larger breadth of inventory/customer pull), used cars not sold after 30 days are dumped on the wholesale market for no profit
• Used car inventory is also financed using floorplan programs
• Within used car sales, increasing volumes of certified pre-owned vehicles are leading to greater service retention (discussed later) and earning greater per car profit for franchised dealers than are possible through non-dealer channels.  This has been a secular trend for a number of years, but lately hasn’t been possible as we lapped ‘08/’09 when almost no cars were leased so very little supply of used cars was available.  Dealers have a real advantage sourcing desirable supply at good prices through trade-ins and off lease vehicles. 
• Dealers I’ve spoken to are very excited about profit improving meaningfully in the used car business with the recovery in offlease availability.  I’m skeptical, but can see why dealers expect this business to improve. 
  • Best used car business for these guys is ~3yr old off-lease vehicles where they can make a lot of money, do a lot of certified-pre-owned, get higher F&I off higher purchase prices.  This should be a sizable step up in profit per car, but I have trouble believing dealers keep all this money – when a sale is closing, the dealership is trying to manage for $x of profit in a transaction to make it worth their time.  I’m not sure they have the discipline to make more money on this (certified pre-owned maybe being the one exception as that freezes out the rest of the used car market since CPO can only be done by the dealer, so I think they can sustainably make more money there).  Anyway, dealers seem to be convinced this will help them, I’m less convinced. 

Finance & Insurance (F&I) - 2.6% sales, 16.2% GP

• Dealers earn fees/spreads on car loans and leases, about the same on loan or lease.  About 40% of F&I is financing spreads & flat fees paid to arrange the loan, 60% is stuff like gap insurance, extended warranties, oil service for life etc, which have all been growing significantly
  • Strong growth in service plans are particularly important as a $1k service plan sale not only books upfront profit for the dealer, but provides a long tail of high retention service revenue (OEMs/issuing warranty company retains the liability to pay dealers as the service is performed, most states have laws specifying this service is done at full market rate.)
• F&I is realized on a lag, typically over 6mo from the purchase.  The fees earned can be given back if a customer immediately prepays a loan.  However the dealer’s holdback is only limited to the fees received, and typically released fully after 6mo. 
• F&I has high SG&A dropthrough as the finance department gets less sales commissions than the car sales department. 
• CFPB is a big question now and important enough to get its own section in Appendix 5

Back End

Parts & Services (P&S) – 16.4% sales, 50.4% GP

• This is the real profit center of a dealership.  Gross margins are typically ~50-55% (half is service at ~70-80% margin, half is parts at ~35% margin). 
  • Gross margins are almost all variable – Parts COGS are of course variable, Service COGS are surprisingly variable, as service tech are essentially paid based on the work they perform (e.g. a Mercedes dealer bills $100-120/hr for labor, pays techs ~$25/billable hour).  Service techs are closer to independent contractors than you would expect, even responsible for their own core tools (though the dealer provides OEM-specialized tools and diagnostics that are increasingly complex and a complete barrier to entry to the service techs opening their own shops)
• A few big pieces of business in here:
  • Warranty / customer pay work – this is the standard service department, is ~85% of gross profit, maybe 90% of sales
  • Reconditioning / internal work – this is mostly refurbishing used cars before they’re sold.  Customer is the dealer itself, profit from this work recognized in P&S, revenue recognized in cars – so for most guys, this is 0% revenue, ~10-12% of gross profit (but Autonation & Sonic take revenue for the work out of used car sales and puts it into P&S, Lithia puts the gross profit from refurb into the used car segment with the car sale). 
  • Other – wholesale OEM part distribution, collision work etc, is the remaining ~5% of gross profit. 
  • >>>It’s the warranty/customer pay that will be driven by this fleet dynamic we’re looking at, and that’s the vast majority of the P&S business.  If you want to look at relative sizes of these pieces, ABG breaks out gross profit by these lines, with GPI you can get a good idea from the earnings slides. 
• Main driver of parts and services is the young (0-5yrs) stock of cars on the road under warranty which are taken back to dealers for service.  Dealers I’ve spoken with estimated that out of the gate ~80% of new cars come back to the dealer for service (missing 20% voids warranties through laziness or otherwise), 3-4 years in that could have dropped to 60% at a BMW dealer, 35% at a Hyundai dealer, but as retention falls on older cars, the cost of the repairs retained increases. 
  • Very few older cars on their 2^nd or 3^rd owner are brought back to the dealer, revenue is tied directly to recent car sales. 
  • Lower-end brands, particularly the domestics have a shorter relevant range, so they should see a cyclical uplift inSAARquicker (you can see this already in Lithia which has the worst brands which should be shorter cycle (maybe 3yr?) and grew P&S 8% last quarter). 
• There should be a huge cyclical tailwind coming for P&S
  • Tied to 5yrSAAR, which was declining double digits, last year slowed to single digits, is now turning around and starts growing HSD going forward (see Appendix 2)
  • Given 3-5% P&S same store sales growth in a flatSAAR(as seen in the 2000s), this should argue for P&S organic growth touching double digits, and staying in the high single digits for an extended period. 
  • Normalized run-rate fleet size is ~35% higher than what’s currently being serviced
• A number of factors are driving up the dealers capture of parts and service revenue, above and beyond the cyclical impact of normalizingSAAR
  • Structural increases in dealer’s service share
    • Increasing service packages sold upfront with new cars – e.g. BMW unlimited service for 3 years, similar programs at Mercedes, Volvo, VW, Toyotacare (this trend appears to be increasing, was only BMW recently).  GM just announced an extended service plan to be included. 
      • This is OEM/warranty-paid work gets the same rates and margins as customer pay (usually mandated by state law, but have spoken to contacts where its not mandated and they charge out $120/hr to customer $110 to OEM, but that type of delta at worst). 
    • Elongating length of warranties, leases, finance programs, which require dealer service (6-7 year leases now possible where before only 4 year leases offered, certified pre-owned programs giving a second round of warrantied, dealer-mandated service)
    • Increased complexity/electronics of newer cars is shutting out mom & pop garages – requires bigger investments in specialized tools / software / lifts that are brand-specific, which usually don’t make sense for a typical garage that may only have 10% of its business in a given brand.  This basically freezes out mom & pop service competition and should become a powerful driver of elongation when today’s computerized cars hit the age where they’d normally transition to independent garages
  • Strategic increases in dealer’s service share
    • Better CRM by dealers, particularly larger chains who have invested in better CRM software solutions
    • Dealers have become more competitive on off-warranty work such as basic oil changes, wiper changes, brake work etc. 
    • More dealers (particularly the public guys) have pushed into collision work.  This makes a lot of sense for car-owners, especially with cars under insurance and the legal right to choose your own repairer
    • This was a big push for the dealers in the downturn. 
• The incremental margins (EBIT / gross margin) appear to be huge in P&S judging from discussions with private dealerships.  Below the gross margin line it is mostly fixed costs – front office service managers, real estate, equipment depreciation.  Little advertising, smaller sales commissions for the parts department etc.
• P&S departments usually nowhere near capacity utilization, ABG says they could double or triple their P&S work without having to add capacity

What could be missing here?  I’ve done a lot of work to try and tease out the counter-arguments, as this is the core of the thesis.  I haven’t found anything too compelling.  The best arguments this P&S growth are:

• Haven’t ever seen double digit P&S growth before (the caution I hear most from dealers and it makes me excited – because they shouldn’t have seen this type of growth since the mid-80s which was the last time you saw the fleet grow like it will in the coming years, see Appendix 2)
• Cars are being made better, and warranty spend has come down (this is from sell-siders who mostly look from OEM side of busines) – this is true, but when SAAR falls to 10m there are fewer cars so of course warranty dollars come down.  Here’s a chart from Wards – the # of recalls (bar) hasn’t gone down at all, but the number of cars affected has (line), which is largely a function of fewer cars on the road

• There is a valid point that cars are made better, last longer, you can change oil less frequently etc.  But at the same time that’s more than offset by the huge increases in car complexity, computer systems, sensors etc. that become more expensive to repair, and adding all this content makes it more likely for things to break.  Another plus is all these computers now monitor the car, so the driver knows when something is wrong, and the car directs the driver back to the dealer for service.
• Lag before new cars need service (this is true, don’t need service for first 6-18mo, so maybe this really should be a 0-5yr fleet with 1yr lag which would mean this thesis happens but takes another year to really hit). 

SG&A Cost Structure

People generally view gross profit as a revenue approximation here, as dealers think about things on a $margin per car basis rather than a percent basis (not that helpful to look at sales when you’re reselling $35k cars).  The key line item below gross profit is SG&A, so I think of the SG&A to Gross Profit margin is similar to the way we’d think about an EBIT margin in a typical company. 

• Current EBIT / GP margins are 20-30%
• Across the industry the public companies are talking about ~50% incremental EBIT / GP margins over as they grow (ABG says 40-50%, achieved 70% last year, GPI says 50%, Lithia says they’ll get total gross profit less SG&A margin from 30% to 40% which implies ridiculously high incrementals, PAG is the only holdback, saying they see ~35% incremental margins which is probably a reflection of how much they over-invest)
• Dealers I’ve spoken with think incremental margins are particularly high in P&S (potentially 70%?) and lower in car sales (pay small commissions to service managers, big commissions to salespersons).  This would argue for more upside than envisioned.  Some of the public dealers agree P&S incrementals are higher, some say they think its pretty much the same drop through across the business. 
• The dealers took out a lot of fixed cost in the downturn which should give them great leverage in a recovery

Use of Cash

EPS to cash conversion is high in this industry most of these companies generate ~8-10% FCF yield as they trade ~10-12x earnings.  There are a lot of high-return ways to utilize the cash

• Acquisitions – acquisitions can be very accretive with public co’s offering some synergy opportunities by bringing the smaller dealers into their purchasing network, eliminating back office, bringing better management / software etc, and perhaps most importantly bringing the new dealer into an inventory network (expand on-hand selection in network while reducing inventory carrying costs).  There is also some multiple arbitrage on acquisitions, depending on what you buy (domestics can be purchased for 3-4x plus assets, Japanese typically 5-6x, luxury 5.5-7.5x). 
• Buybacks – this is pretty high return at current share prices.  Autonation has been the most aggressive, reducing sharecount 37% over 5 years.  ABG & PAG have also bought back a log of shares, and SAH has recently started bigger buybacks. 
• Real Estate – the public dealers have been buying-in real estate at very accretive prices during the downturn.  While I typically wouldn’t be too excited about this, I see the logic in choosing to buy in a lease at an 8-10% rate, fund it 80% with non-recourse mortgages at 4-5% interest.  You’re essentially getting a 20-25% return on the 20% equity investment, and not adding any risk to your business with the non-recourse debt (no riskier than a lease)
  • The reason dealers can buy it in so cheaply at an 8-10% cap rate is because the real estate is purpose built.  At end of lease life they have total leverage over landlord b/c they offer to buyout the property or they’ll move to a new location (and landlord stuck with a vacant dealership they can’t do anything with)
  • I’ll use ABG as an example because I have the data at my fingertips:
    • ABG owns roughly 60% it’s stores at this point, and has put ~$78m towards real estate purchases in the last two years (roughly half of FCF, but largely funded with non-recourse mortgage)
    • ABG also has significant unencumbered real estate, some of which it intends to mortgage to take advantage of low cost financing (and free up cash for acquisitions or buybacks).  I estimate there is ~$527m of real estate vs. only $119m of mortgage financing at year end.  You could view them as essentially debt free if they went back and retied more of their $435m debt to mortgages (which they are doing to get lower rates). 

Valuation / How they trade

• Metric – the key metric here is P/E, and EV (adjusted for floorplan debt) /EBITDA (after floorplan interest).  It’s also helpful to look at EBITDAR and owned real estate.  I like to look at EV/EBIT (after floorplan interest) and adjust for a) hidden cash in floorplan (if floorplan debt is less than inventory like it is at ABG & GPI, that means they had excess cash and they stick it their b/c it’s a better rate than a checking account), b) real-estate linked debt (risk-neutral capital arbitrage discussed later with ~20% ROE). 

Leverage

• Take out the floorplan financing which is basically funded by the OEMs so dealers can hold cars. 
  • Also pay attention to companies where floorplan < inventory, specifically ABG & GPI.  That’s just extra cash.  Instead of carrying a cash balance, dealers will not utilize all their flooplan b/c that’s at a higher rate than what you can earn in a bank account. 
• Actual leverage is 1.5-2.5x for the dealers (AN at 2.9x), but some substantially less when you takeout mortgage debt on real estate they bought in (same economics as a lease its just own vs. lease), and the hidden cash stored in undrawn floorplan.  For instance ABG had $1.75B non-floorplan debt at 12/31, when you make those adjustments its actually $1.25B of real enterprise debt – I look at it this way to think about leverage / risk, but not as much to think about valuation. 

Dealers make most of their money off of P&S, and this business has the highest incremental margins.  This is directly tied to the population of relatively recent new car sales, which still come back to the dealer for service.  P&S revenue potential on a car grows as it ages, but retention rates on those customers declines over time (retention rates highest and increasing most on luxury cars, lowest on low-end cars --- Dealer estimated for me a Hyundai might be 35% retention out of the gate vs. a BMW still has 60% retention year 5). 

A couple of things to call out in the table above:

• P&S consistently grew 3-5% in excess of the fleet size during the 2000s, due to organic growth from price increases, increasingly complex cars with more to repair, and retention initiatives.  In the downturn P&S grew well in excess of the fleet as dealers pursued a number of initiatives to improve retention.
• Fleet declines were a high single digit headwind in the downturn, and are about to flip to a high single digit tailwind going forward, which could set the stage for double digit organic P&S growth.  Assuming 50% incremental margins over SG&A, 10% growth in P&S alone equates to 10-15% EBIT growth on the entire businesses, before factoring in growth in upfront business and the use of free cash flow generation. 
• What’s most interesting is the biggest concern the public dealers have about committing to this growth is that they’ve never seen it before --- but you’d have to stretch back to the 1980s to see the last time this dynamic played out and these dealer groups weren’t assembled until the late 90s. SAARwas remarkably stable in the 90s and 00s throughout their operating history. 

Additional factors that should help dealers retain a larger % of service stream:

• Warranties are lengthening – what used to be standard 3yrs is stretching to 4-5yrs, which should help dealers retain customer longer
• Dealers (particularly the scale public guys) have gotten much better at retention in the downturn.  Focused more on retaining a customer for the simple stuff – oil change, wiper change, battery change – run promotions on that, make sure customers are coming back to the dealer.  Have installed CPM software to keep in touch with a customer, email reminders for service, warranty work, etc. 
• Cars are increasingly being sold with all inclusive service plans.  BMW pioneered this as a freebie included,Toyota, Mercedes, Volvo have followed.  GM just announced an expanded free service program on new cars.  Dealers are also getting much better about selling unlimited work upfront into the car. 
• Certified Pre-Owned programs are secularly growing.  These cars elongate the service life a customer goes back to the dealer.  If they were sold on a used car lot, that P&S stream would likely be gone, if sold in a CPO program with an OEM extended warranty you get service retention that is not too far off a new car sale. 
• More car complexity, electronic systems, software etc is pushing more service back to the dealers.  These systems are all proprietary to the car brand and require specialized service.  OEMs will purposefully design things that require specialized tooling/software/diagnostic machines.  Independent garages can’t afford to purchase this specialized equipment for all brands of cars, whereas a dealer with 100% of its business coming from one brand can buy them without a problem. 

That Chart above may not be readable it is so small, here it is in two pieces:

1980 - 1999

2000-2019

• Can also see good momentum building in the recent P&S SSS growth results for the dealers.  1Q13 had 2 fewer days than prior year (1 day calendar shift, 1 day leap year) which was a 3% impact as called out by AN.  With or without that impact the numbers are starting to look pretty good but there can be some volatility here and the fleet doesn’t go positive until back half, really starts to get good in 2014, so think there will be a few quarters of ramp up, and there’s volatility here on how many warranty recalls are made etc. etc. so I’m planning on being patient and seeing how this looks towards the end of the year without putting too much weight on any given quarters between now and then

• Also interesting to see Lithia’s growth has ramped further and faster than anyone else.  They do mostly D3, a lot of Chrysler, junkier cars and lower quality customers that are retained by the dealer for a shorter period of time.  So you would expect this to hit Lithia first, which appears to the be the case.

Yes we’ve seen it before, just before the professional lives of most of today’s investors / sell-siders

I’m always thrilled to hear the pushback that no, P&S only grows mid single digits, even during boomtimes in the 00’s.  The auto cycle is its own cycle.  Car sales peaked in ‘99/’00 and were roughly flat/down a bit through the rest of the 2000s.  As such, P&S has a flat / negative tailwind for most of the 2000s, as seen in the red line below.  Industry P&S bounced around flat and went negative in downturn.  But going forward there is huge growth in the 0-5yr fleet coming – this is much bigger than the modest fleet growth in the ‘90s, and well beyond the growth in the ‘80s to (growth doesn’t look as sharp in projections b/c I layout a gradual SAAR recovery, but it extends longer – total growth in 0–5yr fleet is 33.5% from 2012-2020 vs. 22.5% in the 1980s). 

What is very interesting here is you saw big, sustained growth in industry P&S revs in the 80s because that fleet was growing.  P&S revs CAGR’s 8.5% growth for the entire decade, and stayed around 10% for most of the decade (this is not inflation-driven, inflation sub-3% from ’83 onwards).   

Finally, I’m feeling better this dynamic will increasingly get broadcast by the dealers to investors.  Auto Nation started showing a chart in February that shows some of this 0-5yr fleet.  Think this should start getting talked about more as P&S trajectory really picks up, but dealers are afraid to get out in front of it, want to see the actual numbers coming through first. 

Lithia this past Q also included a chart that shows their gross profit earned on a car over time, which should get people thinking about how dollars are driven as we roll throughSAARyears.