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Three Auto Dealer Bond Picks

Jeremy Glaser

Jeremy Glaser: Three auto dealer bond picks. I am Jeremy Glaser with Morningstar.com. I am joined today with Equity Analyst Dave Whiston and Credit Analyst Rick Tauber to talk about the auto dealer sector and to see if there is any opportunities for investors in bonds.

Gentlemen, thanks for joining me today.

Rick Tauber: Thank you.

David Whiston: Thanks.

Glaser: So, first-off, we've heard a lot about the plight of the auto manufacturers with GM's bankruptcy and Chrysler's bankruptcy, but how have the auto dealers been faring throughout the economic downturn?

Whiston: Well, unfortunately, the stocks did get pounded because they are cyclical just like the rest of the supply chain, but really if you break down the financial statements a little bit, you can see what happens is all the dealers, they really benefit at the gross margin line from a favorable mix shift to a very lucrative parts and service business, but they get hurt a lot at the operating margin level because they don't sell enough vehicles to cover their overhead. But compared to the lot of part suppliers that went bankrupt, for example, we didn't see that in the dealer space.

Glaser: So these are a little bit better. What do you think of the view of the dealerships going forward?

Whiston: I actually think it's a great time to be at one of this large publicly traded dealership companies, like Group 1 and AutoNation, even a smaller firm like Lithia Motors that has a rural geographic market niche. They've all done tremendous jobs improving their balance sheets, deleveraging and drastically reducing their costs.

So, when you see auto sales go from, say, 10.4 million last year back up to a more mean reversion type level of, say, 14, 15, 16, maybe even 17 million units, I think these dealers are going to be making a lot of money.

Glaser: Many of these dealerships, are they very focused on one brand, do they have a lot of risk there or do they tend to spread out across a lot of different makes.

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Whiston: Well, with the public franchise dealers, that's one of the great things is they are not tied to one brand. Penske on one extreme only gets about 3% from the Detroit three, and they are heavily towards the luxury and import mix, whereas AutoNation has about 32% from the Detroit three.

Glaser: So you don't necessarily need to be guessing which cars are going to be selling better just as long as auto sales in total continue to rise?

Whiston: Not as much as, say, that's sole proprietorship-dealership in your community that's been a Ford or a Chrysler dealer for 70 years. Unfortunately, a lot of them didn't make it through the recession.

Glaser: Rick, we recently issued credit ratings on many of these companies. Where do they kind of shake out in terms of credit quality?

Tauber: Sure. We've leveraged off of Dave's work on the equity side and came up with credit ratings on the five dealers with public debt. AutoNation was heads-and-shoulders above the rest of the group. We rated them BB plus, followed by Group 1 at BB minus, Penske at B plus, and then Sonic and Asbury both at B.

Glaser: And after you gave these ratings and then look to the bonds, were there any that looked like they are mispriced and there could be an opportunity there?

Tauber: I guess there are three bond issues I'd like to highlight for a different that could satisfy the needs of different investors. One is AutoNation. Again, we rated the highest BB plus. They have a senior unsecured bond, which we'd probably assign the same rating to, and if you want exposure to this space, that's a nice – kind of a safer place to do that. The rest of the space is primarily subordinated debt, which is going to be deeper in that capital structure.

But the next name I wanted to highlight was Group 1, which actually has two convertible bonds outstanding, one of which is a 3% bond due in 2020, which is currently trading below par, yielding about 4.5%. So you're getting a decent yield, but you're also getting some strong equity sensitivity. You're getting about 80% equity sensitivity. So, if the stock goes up 10 points, these bonds should also go up about 8 points, plus you'd capture the yield on the bond. We have a favorable view of the industry, and our fair value estimate on Group 1 is over 30% higher than where it is trading. So that's an opportunity to get bond-like downside protection with some good equity upside.

And then the final bond is Penske's 7-3/4 of 2016. We rate Penske a notch above Sonic and Asbury, and yet these bonds are trading a little bit behind, a little bit longer dated – Penske and Sonic bonds. These bonds are yielding about 9.2% versus 8.9% on the Sonic's 2018 bonds and 8.6% on the Asbury. So we think these should be trading inside of those, and that could lead to some price appreciation as they work their way down there.

Glaser: Dave, it sounds like there's certainly some opportunities in bonds, what about on the equity side?

Whiston: Yeah. Unfortunately, no 5-star picks as of today, but there's a few names that I really like that are getting cheap, in particular AutoNation. They are the best operator out there, majority owned by Eddie Lampert and Bill Gates too. So there's some smart money there.

On the other end is – one of the smallest is Lithia Motors, which – people tend to stay away from because of their heavy Chrysler exposure, but really if you believe – one, if you believe Chrysler is going to stick around, it's a great play to be with; and two, when you look at their Chrysler sales, 86% of it, if I remember right, is all from Ram and Jeep. So, even if Chrysler were to go away or get sold, the Ram and Jeep franchises would stay around. And again, both firms have cleaned up their balance sheets, and I think are in much better position than a couple of years ago.

Glaser: Dave, Rick, thanks for talking with me today.

Tauber: Thanks a lot.

Whiston: Thanks.

Glaser: For Morningstar.com, I am Jeremy Glaser