Buy AutoNation on Continued Strength in Consumer Spending and Pent-Up Demand

Brendan is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

As the economic recovery continues to chug along it seems likely that pent-up demand will benefit certain sectors of the economy. Specifically, consumers may be ready to consider buying larger items that they postponed purchasing due to economic concerns. With the current rebound in the stock and housing markets, many consumers are feeling wealthier and more secure, which may translate into increased consumer spending.

While the U.S. auto market has seen good momentum over the past several years (Figure 1), the average age of a vehicle on the road remains at an all time high of over 11 years. Due to this fact, auto-parts dealerships such as AutoZone (NYSE: AZO) and Advance Auto Parts (NYSE: AAP) have been strong performers coming out of the recession. However, if consumer spending continues to improve, the conditions seem ripe for a transfer of leadership from auto parts chains towards dealerships that profit from the sale of new and used automobiles. Several names in this space include AutoNation (NYSE: AN), CarMax (NYSE: KMX) and Penske Automotive Group (NYSE: PAG).

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Several other factors should provide notable tail winds for new car sales. First, the cost of financing for the purchase of a new car remains extremely low at below 5% (Figure 2). Second, the comparative cost of purchasing a used vehicle is very high relative to a new vehicle. As consumers have become more cost-conscience and have driven their cars longer, the combination of tightening supply and increased demand has pushed prices for used cars to very high levels relative to new cars.  In total, there has probably never been a better time to purchase a new car--thus the market should continue to be robust.

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Indeed, both General Motors and Ford reported increasing year over year sales in the high single digits this February (9% and 7%, respectively). Considering the harsh winter weather on the east coast compared to the milder weather from 2012, this trend seems all the more impressive.

The table below provides a comparison of key statistics for the five stocks mentioned above. AutoZone and Advance Auto Parts are in a somewhat different sub-industry and boost superior profit margins. Among the auto parts dealerships AutoNation and Penske Automotive have comparable margins, but AutoNation boosts a larger market capitalization and a superior return on equity. During the prior five year run for auto parts shops, AutoZone boasted superior total returns compared to Advance Auto Parts, in part due to its larger size leading to economies of scale and improving profit margins. Thus, it seems likely that AutoNation may have similar benefits and is my favorite pick within the group.

<table> <thead> <tr><th> </th><th> <p>AAP</p> </th><th> <p>AN</p> </th><th> <p>AZO</p> </th><th> <p>KMX</p> </th><th> <p>PAG</p> </th></tr> </thead> <tbody> <tr> <td> <p>Market Cap</p> </td> <td> <p>$6.063 billion</p> </td> <td> <p>$5.327 billion</p> </td> <td> <p>$14.65 billion</p> </td> <td> <p>$9.541 billion</p> </td> <td> <p>$3.011 billion</p> </td> </tr> <tr> <td> <p>PE Ratio TTM</p> </td> <td> <p>15.83</p> </td> <td> <p>17.36</p> </td> <td> <p>15.97</p> </td> <td> <p>22.91</p> </td> <td> <p>16.27</p> </td> </tr> <tr> <td> <p>EV/EBITDA</p> </td> <td> <p>7.168</p> </td> <td> <p>9.961</p> </td> <td> <p>9.798</p> </td> <td> <p>13.37</p> </td> <td> <p>14.4</p> </td> </tr> <tr> <td> <p>Price to Sales</p> </td> <td> <p>0.9869</p> </td> <td> <p>0.3527</p> </td> <td> <p>1.748</p> </td> <td> <p>0.9107</p> </td> <td> <p>0.2289</p> </td> </tr> <tr> <td> <p>Price to Book</p> </td> <td> <p>5.008</p> </td> <td> <p>3.155</p> </td> <td> <p>N/A</p> </td> <td> <p>3.156</p> </td> <td> <p>2.288</p> </td> </tr> <tr> <td> <p>Gross Profit Margin</p> </td> <td> <p>49.90%</p> </td> <td> <p>15.20%</p> </td> <td> <p>51.90%</p> </td> <td> <p>13.30%</p> </td> <td> <p>15.30%</p> </td> </tr> <tr> <td> <p>Return on Equity</p> </td> <td> <p>36.90%</p> </td> <td> <p>19.00%</p> </td> <td> <p>N/A</p> </td> <td> <p>15.00%</p> </td> <td> <p>15.10%</p> </td> </tr> </tbody> </table>

Looking over AutoNation’s most recent annual report, the company appears well positioned to benefit from the tail winds described above. More than 50% of the company’s revenue is derived from new vehicle sales, but the company has also diversified its product mix to focus on selling parts, insurance, and financial services. There are 265 franchises with a high concentration in Florida, Texas and California (67% of revenues combined). Because the housing market is recovering substantially in California and Florida, and because the economy of Texas has performed relatively well, this geographical bias seems desirable.

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AutoNation does not pay a dividend, though the company has consistently repurchased shares and dramatically shrunk its outstanding share count as a result. Incredibly, the share count has been reduced by nearly two-thirds over the previous ten-year period. This aggressive repurchasing policy utilized $581 million to purchase 16.6 million shares in 2012, or over 10% of the outstanding share count. Given continued share repurchases and higher year over year auto sales, AutoNation seems poised to outperform analyst expectations . For example, the First Call median earnings expectation for 2013 is $2.89 per share, which is 12% above the 2012 result of $2.55 per share. The current pace of share repurchases seem adequate to realize earnings expectations even without improving auto sales. Since improved auto sales are already evident from the sales data mentioned above, it appears that the market is insufficiently discounting performance that should exceed expectations in the coming calendar year. Furthermore, margins have improved each year since 2009 as sales have increased.  

The current earnings multiple of AutoNation is somewhat depressed (~10%) compared to its average valuation in the prior 3 years by TTM P/E or Price/Sales.  My expectation is that annual earnings will exceed $3 per share, and upon exceeding expectations AutoNation's P/E multiple will expand to its long term average of 17.4x, corresponding to a price of approximately $53 per share, or 22% upside, to the most recent close of $43.44.

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An added reason to purchase AutoNation shares at this moment is the seasonality of the business. Auto sales are usually strongest during the summer months, as consumers tend to make purchases when the weather is warmer for practical reasons and to enjoy the summer driving season. In the past twenty years, shares of AutoNation have outperformed the S&P 500 index the most during the months of April and May. Thus it appears that now is an excellent time to purchase shares, particularly given the recent pullback.

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In closing, I would like to highlight the largest holders of AutoNation's shares. The largest institutional investor in AutoNation is Eddie Lampart’s hedge fund RBS Partners, which owns $1.37 billion, or approximately 25%, of the company’s float. Mr. Lampart is a former director of the company, and while the holding has been reduced somewhat it still represents over 35% of his portfolio’s assets. Mr. Lampart’s continued investment in AutoNation is a positive sign given his understanding of the business and prior history. Furthermore, his diversification of the portfolio seems to be a moot point given how highly concentrated the holding still is. It is also refreshing to note that only six other funds count AutoNation among their top 10 investments, meaning that the trade is not a very crowded one. The next largest holder of the stock is the CEO Michael Jackson, who holds 1.14 million shares or $49.9 million, a value representing 5.8 years of his gross income. Apparently Michael thinks AutoNation is a great company, and I happen to agree.

Brendan O'Boyle has a position in Autonation. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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