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No Need to Haggle for This Auto-Dealer Bargain

Erik Kobayashi-Solomon

Erik Kobayashi-Solomon: Hi, I'm Erik Kobayashi-Solomon, Co-Editor of Morningstar's OptionInvestor. Today, it's my great pleasure to welcome Dave Whiston, who is the auto analyst here at Morningstar to talk about Lithia Motors.

Dave, thanks for coming.

David Whiston: Thanks, Erik

Kobayashi-Solomon: Dave, as you know, just recently I did an option strategy on Lithia, a bullish option strategy and just want to find out a little bit more about this company.

So, Lithia Motors is a publicly traded dealership group, and I think probably people would know like the Penske Group, racing fans would know the Penske Group a little bit better. Can you just talk about the publicly traded dealership groups, and what their difference in let's say geographical and business focus is?

Whiston: Sure, starting in the late '90s, a lot of ambitious entrepreneurs started to take their dealerships public.

Kobayashi-Solomon: Mainly these are kind of like family-owned businesses really, right?

Whiston: Yeah, in some cases, yeah. Sonic Automotive was controlled by the Smith family; Lithia Motors is controlled by the DeBoer family. It's a really interesting business model though because they grow mostly through same-store sales growth and primarily through tuck-in acquisition.

So they are always looking at – the dealership industry is incredibly fragmented. So, these larger players like Lithia, AutoNation, Penske, they are always looking for acquisition targets and they just slowly keep growing.

Kobayashi-Solomon: So, when you say a tuck-in acquisition, this is basically, let's say a Penske Group or Lithia Motors sees a mom-and-pop dealership and they buy that dealership from the private owners?

Whiston: Exactly. It's usually one store at a time, so it's very gradual. You don't see Penske looking to go and buy one of the other big publicly traded dealership, for example.

Kobayashi-Solomon: So when you think about the dealership groups, how do you think about their geographical dispersion or their business focus?

Whiston: Really, the only big differences are the balance sheet, the brand mix and store geographies. So, when you look at all the publicly traded dealers, you see a little bit of diversification in that. AutoNation, for example, is a very California and Florida focused; Group 1 based in Houston, they are big in Texas and Oklahoma and also on the East Coast; Sonic and Asbury are big on the Southeast, but all the publicly traded dealers except for Lithia are very common and they are focusing on suburban large metro areas, Atlanta, Chicago, East Coast, Houston, LA.

Kobayashi-Solomon: Lithia really has carved out its own niche in the rural – amongst rural owners, right, can you talk a little bit about that? It's all West of the Mississippi and mainly kind of rural focused, right.

Whiston: Right. Lithia is a really interesting story in that regard because they are so different from their peers. It's about 84, 85 stores now, and they are all West of the Mississippi, but they are primarily almost exclusively with the exception to say the BMW Seattle store, they are in very rural areas or very small cities like Boise. They are actually very big in Anchorage Alaska for example, Montana, they are in California too, but mostly in the Central Valley, not LA or Bay Area. Their biggest market is Texas, but it's not Houston and Dallas, it's places like Odessa…

Kobayashi-Solomon: …Odessa, Midland, right.

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Whiston: Exactly. So that's a very different strategy and they don't have any competition from the AutoNations of the world.

Kobayashi-Solomon: Let's talk a little bit about that. They have got this nice niche business. What prevents let's say an AutoNation or let's say a Penske Group, or somebody like that from coming and barging in on their turf?

Whiston: Really, theoretically, there isn't anything stopping them other than the OEMs have to – the automakers. They have to grant all new franchises. So they certainly don't want to get too many dealership in one city. They want to have the right number of say Toyota or Chevrolet stores in a particular metro market.

Kobayashi-Solomon: So in other words like Chrysler, for instance, because I know Lithia has Chrysler exposure. They are not going to let AutoNation start a Chrysler dealership right across their street from a Lithia, because it's a kind of that head-to-head price competition between the dealer groups doesn't help move cars.

Whiston: There is really no interest at this point in cannibalizing the brand. What you are seeing on the Detroit three side is more the -- especially with GM and Chrysler is the opposite due to their bankruptcies. They are looking to drastically reduce their dealer network.

But really also a key thing here is that although nothing is theoretically stopping a competitor from coming in into Lithia's turf, really AutoNation and Penske and Sonic, they don't want to. They are not interested in Boise, Idaho and Alaska and Eastern Washington State, they are focused on these Metro suburban markets.

Kobayashi-Solomon: One thing that really struck me when I was first researching this, was just how good the business model is and I thought actually of like a restaurant that sells T-shirts, kind of, souvenir T-shirts and they actually make more money of the souvenir T-shirts than they do on the food that they sell. And for the auto groups, for these dealership groups, it's the same thing. I mean they are making a lot of revenues from car sales but they are actually making a lot higher margin, a lot more profits from the service side. Can you talk a little bit about that dynamic?

Whiston: Sure. It's really interesting if you take the time to look – take any publicly traded dealer's 10-K and look at their revenue mix versus the gross profit mix. You'll see that they really need to sell new and used vehicles to cover overhead, but the real gravy so to speak is on their parts and service business. It's a very lucrative annuity. It's only about 15% of the dealers sales generally, but it makes up 45% to 55% of their gross profit. It's just astounding.

Kobayashi-Solomon: Just incredible. So, I know that Lithia really was over-levered going into the downturn. They had some problems, and I know that they have cleaned up their balance sheet some since then. Can you talk a little bit about how they got over-levered and what they've been doing lately, maybe some of their valuation metrics?

Whiston: Sure. The stock if you take a look at the chart, Lithia did have really a rough '08 and '09. You could argue they are over-levered, because they were starting a CarMax-type model, used cars.

Kobayashi-Solomon: This is the L2 concept?

Whiston: L2, right. They've now pulled the plug on that completely due to the recession. So they were taking on some more bank debt to fund the CapEx to grow stores. Unfortunately though, when you have a severe recession hit and you have a revenue decline in consecutive years of over 18%, that can cause some serious problems paying your debt obligations.

Now, Lithia's management was actually really smart here and they actually owned a lot of their real estate going into the recession. Most dealers did not do that, and it actually helped Lithia raise cash during recession and avoid further distress.

Kobayashi-Solomon: So, they took a mortgage out on their dealerships and paid some of that expensive bank debt back.

Whiston: Or they sold the dealer, if they could find a buyer too and they've still got some land for sale.

Kobayashi-Solomon: So, let's talk about valuation, how does the valuation look to you?

Whiston: Well, I just raised my fair value on Lithia to $19 a share, which is rather contrarian call right now. I think the street doesn't like the Chrysler overhang. They get about 27% of their new vehicle in sales from Chrysler. Chrysler so far is defying my expectations. They are doing better than I thought.

Kobayashi-Solomon: Lithia is actually exposed to kind of the better part of Chrysler, right?

Whiston: Right. I think that's a great point, because I don't think a lot of the street understands that. If you take the time to look at their investor slides that on their website, you can see that a lot of the Chrysler mix, about two-thirds of it comes from Dodge Ram Pickups and Jeeps. It doesn't come from the car models of Chrysler, which aren't doing as well because Daimler really deprived Chrysler of new car model development.

So, even if Chrysler were to get in a lot more trouble, I think there would still be a buyer for Ram Pickup trucks for examples.

Kobayashi-Solomon: Especially in these rural markets that they serve.

Whiston: Absolutely. Some other valuation metrics. They are the only dealer that pays a dividend. I think that's remarkable in this economy. To be fair though, one of their competitors, AutoNation never pays a dividend because Eddie Lampert runs them so to speak. On a forward P/E basis, you are looking at I think 9, 9.5 times earnings.

Kobayashi-Solomon: That sounds attractive.

Whiston: Absolutely.

Kobayashi-Solomon: And you were telling me that actually there has been some management share buybacks or share purchases by management. Can you talk a little bit about?

Whiston: The DeBoer family does have a dual share-class structure, so the Class B shares are controlled by the CEO, but the shares are trading at the open market at the Class A shares. And if you look at the insider buying here, I think this is a really good sign. The CEO, Sid DeBoer has been about batches of about 5,000 shares at a time. He's been buying Lithia shares on the open market. Certainly, a very good sign.

Kobayashi-Solomon: Thanks for coming in and talking about. It sure is an interesting story.

Whiston: Thanks, Eric.

Kobayashi-Solomon: Thank you for joining us. Please stop by the Morningstar OptionInvestor website, where we have many more option ideas based on Morningstar's fundamental research.