Name That Trade – $LAD: Yeah, but that TrueCoat

by CC August 28, 2015 11:13 am • Commentary

The turmoil in the U.S. stock the past week came from fears of slowing global growth and emerging market contagion.  U.S. economic data has been generally strong in the past 3 months (particularly the employment data, while the manufacturing data has been weak).  Corporate revenues and earnings have been less stellar, especially for multinationals with significant foreign exposure.

But the broad based selling this past week spared few stocks.  Even for domestically-focused companies, demand for their underlying share certificates was simply lower than supply, and prices went down as a result.

One area of the U.S. economy that has been doing quite well is the auto market.  In fact, summer auto sales have been the highest since 2007.  You wouldn’t know it from looking at the share prices of GM or Ford, which have been hit by global growth fears given their significant foreign exposure (especially GM, which gets more than 20% of its revenues from China).

The better performers have been purely U.S.-focused automotive companies, such as Lithia Motors (LAD).  LAD is a car dealership franchise worth nearly $3 billion, headquartered in Oregon.  What’s interesting about the auto dealership sector is that Warren Buffett bought a couple large auto dealerships in the past year.  From Forbes in March 2015:

Investment guru Warren Buffett and the auto retail industry had a lot of nice things to say about each other at an auto conference today.

“It’s a huge industry. It can be, if run properly, a very good business,” said Buffett, chairman and CEO of Omaha-based Berkshire Hathaway Inc.

The mutual admiration society was no surprise. Buffet closed a deal earlier this month to buy the nation’s largest, privately held auto dealership chain, the Phoenix-based Van Tuyl Group, the fourth-largest auto retail chain in the United States based on 2014 new-vehicle retail unit sales of 139,538, according to Automotive News.

The move was Buffett’s first acquisition in auto retailing, and it was seen as a big seal of approval for the auto retailing business model.

In buying the Van Tuyl Group, Buffett said he intends to keep buying more dealerships. “I think we’re likely to make some acquisitions,” he said today. “We always do what we say. We will make more deals.”

Aside from Buffett’s entry into the industry, LAD has many other attractive qualities as a stock:

  • Founder Sid DeBoer (72) is still the Chairman, while son Bryan (49) is the President and CEO. However, both own very little stock and are paid several million dollars per year.
  • The stock nearly doubled from the Oct low to the July high, but has now pulled back slightly:

Screen Shot 2015-08-28 at 8.55.51 AM

The longer-term trend, evident from the rising 200 day moving average, is still up.  That comes into play around $98 and the stock ever so briefly tested that level on Monday .

  • The company has achieved greater than 20% sales and EPS growth in each of the past 3 years.  Even if growth slows and LAD has 10-15% EPS growth and 10-15% sales growth continue over the next few years, then valuation at a P/E multiple of 16.5 is still fair to cheap.
  • The company makes 24% of revenues from new vehicle sales, 22% from used vehicle sales, 22% from financing purchases for customers, and 30% on service revenues.  This revenue diversification demonstrates LAD’s effective strategy of cross-selling to customers.
  • Service and financing have the highest margins, and are more effective with scale.  Management has grown aggressively through acquisitions and opening new franchises in the past few years.
  • In 2014, we purchased 35 stores, including 27 stores on October 1, 2014 through the acquisition of DCH Auto Group (USA), and opened one franchise.
  • There is somewhat of a competitive moat for LAD given its Franchise Agreements with manufacturers (that restrict the number of dealerships in a given area for a given manufacturer) and strict state dealer laws that restrict direct selling of cars to consumers (though Tesla is trying to change that)
  • Auto dealers and mechanics are one of the few areas that have not seen corporate consolidation take out the smaller players over the past few decades, which gives LAD plenty of room for growth and market share gains.

So the positive case is solid, but there are some potential negatives.  Here are 3 issues that are cause for some concern:

  • While a P/E of 16.50 looks cheap on a relative basis compared to the rest of the market (especially considering sales and EPS growth of 20-30% over the past couple of years), it is actually high on a relative basis compared to LAD’s own history (which has historically been in low teens), and that’s after a strong 5 year performance in a cyclical industry (auto dealerships).
  • Car ownership is down dramatically in the U.S. in the past 5 years. Only 28% of 18 year olds have a license today, vs. 43%. Car ownership for 18-34 year olds is down 30% in the past 10 years.
  • Retailers have significant operating leverage, particularly as they expand, but that works quite negatively on the downside, particularly for a retailer like LAD that deals in high-priced inventory.

Even with those negatives, LAD certainly seems like a better value than the majority of stocks in the market today.  Warren Buffett’s stamp of approval is no small matter either, as he’s a potential acquirer, but his purchase also expresses confidence in the long-term potential of the industry.

Given the recent sell-off, a move back towards the 200 day moving average around $98 might be a spot to target for a long-side entry.  The options market is wide without a ton of volume, so if we were to execute any trade in the future, it would be with strict limit orders. A call spread risk reversal (selling a put to buy a call spread) closer to the levels we saw earlier this week is probably the way to go as it would offer some cushion below while playing for a move to new highs. We’d likely target a month like March if we saw a good entry point but we won’t chase here.