Description

Lithia is an auto dealer creating value through significant corporate activity driven by a historically tested and successful management.  The significant corporate activity is the transformational acquisition that Lithia did last year.  Specifically, Lithia bought a large private auto dealer, DCH, which dramatically enlarged the company and expanded and diversified its geographic and product footprint.

Lithia’s share price closed at $112.40 on 7/21/15.  It has a $3.0bn market cap and TEV of $3.6bn and trades at 17.6x consensus 2015 earnings of $6.38. Historically, Lithia operated dealerships in rural markets, principally in the North West and Texas, and it mainly sold the domestic auto brands.  It was an incremental acquirer, occasionally buying stores in its existing geographic and product foot print.  In buying DCH in the summer of 2014, Lithia expanded into urban markets in the New York City area and in Southern California.  Equally significant, the DCH acquisition diversified the product footprint, reducing Lithia’s exposure to the domestic brands by adding many stores focused on foreign brands.  Total dealerships climbed from 102 in 12 states to 129 in 14 states and revenue went from $5.3 billion to $7.6 billion.

We see five discrete sources of value creation at Lithia.  First, in our view, the deal itself generates accretion of $2.00/share over the next two years (please note that the pre-deal earnings base of the company is $5.00/share).  The average Lithia store generates $50 million in revenue and a 4.8% operating margin.  The average DCH store does $78 million in revenue and a 1.9% operating margin.  We believe Lithia can substantially reduce this margin gap through a set of initiatives to both take costs out of the corporate functions and to improve the sales efficiency on the showroom floor.  DCH’s elevated cost structure reflected both its culture, its preparations for a failed public offering and the fact that its owner was a passive investment syndicate who had been satisfied by the mediocre returns the company generated.

A second key source of value creation is acceleration in earnings from the Parts and Services area of the business.  The demand for new parts and car servicing will grow as the overall domestic fleet ages.  A particularly important aspect of this aging dynamic is the rapid growth of cars that are specifically one to five years old, as that is the age cohort where dealers tend to capture most of the parts and service spend.  In addition to this secular tailwind, Lithia has numerous company-specific initiatives to grab more of their customers’ service spend.  An example would be dedicated bays for “small” jobs such as oil changes, a task historically shunned by dealers as unprofitable, but which Lithia views as something of a loss leader to gain more, higher margin business.  We see Parts and Services adding $1.30/share of earnings over the next two years.

Increased sales of used cars will be a third source of value creation.  Used car sales generate twice the margin of new car sales.  Lithia has an initiative to increase the number of used cars sold per dealership by 35% or from 55 to 75 units/month. The opportunity is even greater at the DCH stores.  We assume that management makes just half their goal or an increase of 10 cars/month which would add another $0.70/share in earnings.

Fourthly, we see continued acquisitions, at a more normal rate of $250mm of acquired revenue/year, adding at least $0.50/share in earnings over the next two years.  The dealership industry is very fragmented with the top dealers owning a mere 6% of the 17,000 total.  Through the DCH purchase Lithia now has access to dealer acquisitions in the DCH territories which expands their base of potential targets from 1,230 dealers to 2,660.  There is ample room to grow.

Finally, there is opportunity to increase insurance product attach rates since Lithia still has a gap to close versus its best in class peers.  Increasing insurance gross profit by $50 per unit sold (which will still not fully close the gap) can add $0.25/share to earnings.

Taking all the value drivers above, we get to earnings of $9.75 in 2017, or a CAGR of 24% from 2014 earnings of $5.11. It should be noted that our numbers do not depend on continued increases in new car units sold in North America.  Given superior growth, putting the high end of the peer multiple of 16x on $9.75 generates a target price of $156 or 39% upside. 

Our confidence in this outlook is substantially bolstered by our positive view of management. The company is run and controlled by the DeBoer family who started the company in 1946.  Over the years management has successfully integrated numerous acquisitions.  In addition, under Bryan DeBoer, Lithia regularly puts up the best metrics, from same store sales and gross profit growth, to net profit margins and sg&a as percentage of gross profit.  When significant acquisitions are undertaken by a company, it is always good to see a management with a successful playbook, especially when a substantial improvement in the performance of the underlying assets is critical to making the acquisition successful.

One interesting aspect of the auto dealer business model requires explanation.  Most investors assume auto dealers generate the majority of their profits from new car sales, which are 56% of revenue for Lithia.  Actually, new cars sales generate only 24% of gross profit for Lithia.  76% of gross profits are generated by 44% of revenue that comes from parts & services, used units, and finance & insurance.  These are generally more stable businesses and enjoy better growth prospects than new car sales.  This revenue mix gives us comfort that, even as new car sales in the US plateau, earnings should continue to accelerate.

Among the larger risks to a Lithia investment are: 1) executions missteps in the integration of DCH, by far the biggest transaction they have done; 2) large interest rate increases which would impact the very strong finance and insurance part of the business; and 3) declines in used car values which would mark down Lithia’s substantial used inventory.

Catalyst

Earnings releases and guidance updates

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