Description

Note: Net debt of 4,008 million is gross debt minus cash and floor plan financing related debt.

Thesis 

Lithia Motors, Inc (LAD) stock offers a compelling investment opportunity. At $227/share, it trades at a depressed 5.0 x 2022E consensus EPS, 6.3x 2023E consensus EPS, and 3.8x to 4.5x management’s 2025 EPS target of $50 to $60. The valuation is low because the market does not believe that current earnings are sustainable and that management can deliver on its 2025 targets. Although there is uncertainty around 2023 earnings, I believe management’s targets are a realistic indication of the Company’s earnings power two to three years out.  Once we get through 2023, the  stock’s multiple is likely to revert to its historical median of 12.5x forward earnings  yielding a  $625 to $750 share price in two years. I think the downside is low considering the historically low multiple and the skepticism around near term results which are, to a large extent,  discounted in  the stock price. 

Description 

Lithia Motors, Inc. was founded in 1946 and was listed in 1996. It is the leader in the highly fragmented but rapidly consolidating US automobile retail market. It generates $28 billion in revenue and has an estimated 1.5% market share of the roughly $2 trillion annual US retail market for new and used cars, including aftermarket services and financing. 

Consolidation Opportunity 

There are approximately 17,000 auto dealerships in the US. Lithia is the largest player with 300 dealerships. Under the leadership of CEO, Bryan De Boer since 2012, the company has pursued a methodical  consolidation strategy which has resulted in an eps cagr of 32% over the past decade and a 25% return on acquisitions. 

The top ten players control about 8% of the industry. Lithia operates across all segments of the industry. It has new car franchises with 30 OEM brands. It sells used cars, 75% of which are sourced through trade-ins. It finances about 10% of vehicles internally through its captive finance company, DFC. It generates 4% of revenues from online sales through its nationwide e-commerce brand, Driveway. New car sales generate 43% of gross profit. Used cars sales generate 27% of gross profit. Services and parts generate 29% of gross profit.  The captive finance subsidiary, DFC, and the e-commerce national brand, Driveway,  are in a ramp up phase and do not contribute to earnings.

The following is an industry breakdown from  Lithia’s third quarter results presentation:

Unlike typical consolidation plays where early success attracts capital and drives up acquisition multiples, the auto sector benefits from inherent barriers to entry. OEM agreements and franchise laws for new car dealerships dictate that transactions must be approved by the OEM. OEM’s are more concerned with the buyer’s ability to execute and provide a good service than with the transaction multiple that will accrue to the seller. Lithia’s management is highly regarded by the OEM’s. This has meant a rich pipeline of transactions at  reasonable multiples for Lithia and a historical average ROIC on acquisitions of 25%. OEM’s recognize that subscale players will not be able to compete long term, and this plays to Lithia’s hand.  For example, Lithia's consolidated  SGA/Gross profit was 60% in 3Q22. However, less productive stores have an 80% SGA to gross profit ratio and large, productive stores are closer to 50%. Lithia often acquires stores with a 90% SGA to gross profit ratio and improves performance through consolidation of back office functions. Lithia’s management approach to consolidation is very methodical. Of the roughly 17,000 dealerships in the US, Lithia has already identified the ones that are desirable for its strategy, roughly 2,700 dealerships.  Management has  established relationships with the owners and waits for them to be ready to sell. This approach generates a robust pipeline of growth opportunities.  In 2021 Lithia acquired $3.5 billion in revenues. In 2021 it acquired $6.9 billion in revenue. And, in 2022 it acquired between $2 and 4 billion in revenue (final numbers have not been disclosed).  Management’s goal is to reach $50 billion of revenue in 2025, approximately a 2.5% market share and to eventually reach a 5% marekt share. Management’s goal is to have dealerships within 100 miles of 95% of the US population. 

Why does the opportunity exist? 

Skepticism about  near term earnings and skepticism about the sustainable base of earnings

The company’s earnings went from $11.60/share in 2020 to $37/share in 2021 and likely $45/share in 2022. Part of this growth was driven by  COVID driven supply chain issues. A shortage of new vehicles resulted in used vehicle price appreciation and an unsustainable step up in industrywide gross profit per unit. This trend is now unwinding rapidly as used car prices drop. The uncertainty about the company’s ability to navigate the adjustment in 2023 is being exacerbated by management’s staunch unwillingness to provide short term guidance. This is evident in the Q&A section of  the 3Q22 results conference call. 

I do not have a strong view on  2023 earnings, but  I am confident that we are not going back to 2020 numbers for several reasons:

• At the beginning of  2020, Lithia had 180 locations. At the beginning of  2023 Lithia had 300 locations. 

• Two initiatives, DFC (captive finance sub) and Driveway (online national brand),  were loss making in 2020 and approached breakeven in 2022. 

• There is a lot of operating leverage from SGA, and there are ample synergies between the online business and the physical stores. Management believes that, over time, the SGA/gross profit ratio will trend from the current 60% to 50%. This trend is apparent in results. 

• The finance subsidiary has scaled and reached breakeven, but only represents 10% of vehicles financed. Managment's goal to reach 25% in two years will be highly margin accretive. 

• The pipeline of acquisitions continues to grow, and the prospective ROIC’s seem attractive as per managment guidance. 

Fears of disruption 

There are several sources of disruption which  this company is likely to face in the coming decades. 

• E-commerce is just beginning to ramp in this industry, and investors fear that, like in other verticals, physical stores will become a drag on profitability. 

• Electriic vehicle penetration will continue to grow, and they have less moving parts than internal combustion engine powered vehicles. For example, they do not require an oil change. Investors fear that this will be a drag on Parts and Services which accounts for  ⅓ of Lithia’s gross profit. 

• Cars are highly underutilized, and we are eventually going to move towards driverless cars. This will challenge the idea of car ownership as we know it.  We will move to a mobility as a service (MAAS) model, and traditional OEM’s and their dealerships will be completely disrupted. The market will be controlled by Apple, Google, and Tesla. 

Here are a few counter arguments:

• Disruption will come, but it  will take longer than expected. Today the age of the average car is 12 years. The average used car sold by Lithia is 9 years. The economic reality is such that the average buyer has a negative equity of $5,000. This needs to be covered by financing. The barrier to people buying new cars is mostly economic. The move towards electric and driverless will be gradual.  There are  legal, bureaucratic, and infrastructure barriers,  which will delay the full adoption of driverless vehicles for a couple of decades.

• Lithia is in a better position than 90% of the industry to adapt and adjust to these changes. Management has proven to be adept at adjusting in the past and is well aware of these threats. Management owns a lot of stock and thinks like an owner. 

• Lithia is in a much better position to benefit from the move to e-commerce than the pure play companies like Carvana. The biggest challenges to selling cars online are sourcing used cars and managing the logistics of refurbishment, storage, and delivery. Lithia has the same gross margin but much lower costs of storage, logistics and delivery. It can leverage its existing stores, existing employees, 200 refurbishment/storage centers. And, it will soon have locations within 100 miles of 95% of the population, giving it an edge over the pure play ecommerce players in terms of delivery cost.  Furthermore, Lithia has a much easier time sourcing inventory of used cars than the pure plays.   

The following presentation is from Lithia’s 3Q22 results presentation: 

Conclusion 

Lithia Motors Inc (LAD) stock is undervalued due to concerns over short term earnings and long term disruption. The company is a cyclical growth company that has grown eps at a 32% cagr over the past 10 years while maintainining a 20%+ ROE. Management is capable and has significant ownership in the company. The industry is highly fragmented, and Lithia is in a unique position to grow profitably through acquisitions for the foreseeable future. 

Risks

Disruption comes faster than expected from driverless cars

Managment fails to continue to execute and adapt. 

2023 is much worse than expected in terms of volumes and margins. 

Catalyst

As 2023 progresses, the company's sustainable earnings power becomes evident.