AutoNation Takeovers Changed the Game (NYSE:AN)
AutoNation, Inc. Shares (NYSE: ONE) have lost approximately 13% of their value over the past year; not a great result, but certainly much better than competitors like CarMax, Inc. (KMX), which have been cut in half. Next this society poor income reportinvestors may worry about what AN will say when the company reports third quarter results on October 27e. However, given its more diversified sources of income, I expect AN to do well and stocks look attractive here.
CarMax gets 77% of turnover used car sales, and so the drop in used car prices we’ve seen in recent months has been a particularly strong headwind. This is much less the case for AutoNation. Last year, used cars generated just 14% of profits. Its parts and service unit is actually the biggest contributor to profits. This positions AN better for periods of economic volatility, which is why I struggle to see earnings falling much below $8 per share, even in a moderate recession.
For now, however, AutoNation is doing much better. In the business second quarter, it brought in a record $6.48, up 34% from a year ago. This growth per share is truly eye-catching considering that revenue fell 1.6% to $6.87 billion and operating profit rose 5% to $558 million. In fact, net income was down 2.2%. This EPS increase speaks to the power of AN’s share buybacks. With the excess profits it made from skyrocketing car prices, it aggressively returned capital to shareholders.
Last year, the company repurchased $2.3 billion in stock. In the second quarter, AN repurchased $404 million of stock, or 6% of the company, and authorized another $1 billion. These buybacks were funded by free cash flow, which totaled $750 million in the first half, leaving relatively low net leverage at 1.4x. Over the past year, shares outstanding have fallen 23% to 56 million. That’s why EPS has risen so dramatically even as net income has fallen. The decline in the number of shares will continue to support earnings per share even if results at the company level moderate.
AutoNation bought out so much of the company so quickly that it’s important to keep that in mind when looking at a longer-term stock chart. At the end of 2019, the stock was around $50 and there were 90 million shares outstanding with a market capitalization of $4.5 billion. Although the stock has doubled, its market capitalization is only 25% higher at $5.7 billion. A return to its market value in the fourth quarter of 2019 would represent a 20% drop for the stock, and not the 50% that one might think by simply comparing prices. The stock squeeze is one of the ways AutoNation has used the boom of the past eighteen months to permanently improve shareholder value.
Looking at the second quarter results, performance was strong across all segments. In total, new cars accounted for a tailwind of $33 million, while used cars accounted for a headwind of $46 million. SG&A expenses were 55.4% of gross profit, down 110bps as technology investments reduced costs.
Profits per new vehicle increased from $4,153 to $6,106. Volumes increased approximately 2.5% sequentially to 57,890. Domestic brands represent 29% of sales, imports 41% and high-end luxury 30%, giving AN access to a wide range of consumers. New car inventories remain low, which should help minimize the margin squeeze. Indeed, the value of all of AutoNation’s inventory has increased by less than 3% since the beginning of the year. It has not been confronted with an oversupply that it will have to depreciate.
Used car profits fell from $2,239 to $1,915 per vehicle while volumes fell 3% from a year ago to 77,080. Finance and insurance profits were flat year-on-year at $368 million, as higher profit margins offset a 15% decline in sales. Aftermarket gross margins remain strong at 46%, generating $482 million in gross profit, or about one-third of total gross profit. Maintenance work is an essential and underestimated part of AN’s profitability.
Now, we know used car margins will moderate, and as the economy slows, new car margins will also shrink, even with tight inventory. Actions already actualize this. At a $6 EPS run rate, AutoNation only has a 4x P/E, so clearly investors expect earnings to fall and its P/E to normalize. So where will earnings normalize? Very simplistically, his lowest net income in the last 10 years was $317 million. On June 30e number of shares, that would be $5.66 in EPS, giving the company a P/E of 18x.
Since 2012, it has completed over $1.6 billion in cash acquisitions. These new dealerships should bring profits, even in a downturn. That’s why I prefer to look at business units. If we operate used cars with fixed gross profits and cut new car gross profit in half, operating profit would drop by $330 million, or about $250 million after tax. Again, this assumption indicates that the company is no longer making money on used cars, entirely canceling out the boom benefit of the last eighteen months. This represents $2.18 of remaining revenue from its funding and secondary market activities.
In practice, during a downturn like this, the company would likely be able to moderate its SG&A spending, as it could likely reduce its workforce. A 5% reduction in general and administrative expenses would allow gross profits in finance, insurance and secondary markets to fall by more than 8%, and the company would continue to generate earnings above $2 per share. Now, when the company reports its third quarter results, it will likely show even more buybacks that have reduced the number of shares by at least 1.5 million, bringing that figure to around $2.05 in earnings per share. trimester.
In this downside scenario, I still get an AN with over $8 in earnings power, which means it’s trading at just 13x P/E and could continue to buy around 5% of the company annually. In practice, I expect new and used car earnings to hold up better than my downside scenario given tight inventories, which should keep earnings per share above $3 per quarter.
I would be a long here and think stocks can go to at least $120 or 10 times my base earnings and 15 times trough earnings. Its diversified business model means that AutoNation still has ample earning power if used car profits disappear and its stock buybacks are incredibly powerful in limiting declines. AN is an attractive stock to own.