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Dealing On a Large Scale

When famed American novelist John Updike let his philandering anti-hero Rabbit Angstrom finally improve his life in Rabbit is Rich, he had Rabbit inherit a Toyota dealership. Before long the Angstroms did well enough to purchase not one, but two vacation homes. Updike knew of what he wrote when he cast the car business as a lucrative one. Revenues at automobile retailers now approach $1 trillion annually,

When famed American novelist John Updike let his philandering anti-hero Rabbit Angstrom finally improve his life in Rabbit is Rich, he had Rabbit inherit a Toyota dealership. Before long the Angstroms did well enough to purchase not one, but two vacation homes.

Updike knew of what he wrote when he cast the car business as a lucrative one. Revenues at automobile retailers now approach $1 trillion annually, or about one-fifth of total domestic retail sales.

But more important to investors is the fact that this monstrous industry is in the process of consolidating, and that spells opportunity.

“Automotive retail is not only the largest consumer sector, but also the most fragmented,” says Stephens analyst Rick Nelson. The best-capitalized companies are enlarging their dealership groups but have absorbed a scant 7 percent of U.S. auto dealers, leaving plenty of room for further consolidation.

“In the history of retailing, whether it was Wal-Mart or Home Depot or Gap, you made money betting on consolidation,” says Peter Siris, money manager at Guerrilla Partners, who maintains positions in a basket of auto retailers.

Hitching a Safe Ride

Dealerships also offer a highly defensive business model, which should appeal to conservative investors: Auto dealers are protected under state franchise laws, which essentially ensure, for instance, that another Toyota dealership is not likely to open next door to Rabbit's.

During recessions, auto retailers are far more cushioned than auto manufacturers, given their more variable cost structure. For starters, dealers can lay workers off, something far tougher at more unionized manufacturers.

And since consumers tend to keep their cars longer during lulls, the effect on brand retailers is to increase service and parts revenues, which is exactly where the fattest margins are.

The gross margins for service run about 50 percent. New-car margins, by contrast, are just 7 percent, and used-car margins only around 11 percent. Though competition for service revenues is intense, the bigger dealer groups enjoy a growing advantage over independent mechanics and chain stores, given the growing complexity of new vehicles. The upshot is that service, insurance and used-car sales are far more important to the bottom line than new-car sales. As Nelson notes, about 90 percent of net profits at the average dealership come from non new-car revenues.

Good business models don't always get fancy multiples, however. Even though many of the public retailers are growing per-share earnings at double-digit levels, the market accords mainly single-digit multiples.

You can get the idea by comparing the successful home improvement retailer, Lowes, with United Auto Group. Over the past year, Lowes grew earnings per share 27 percent and now receives a 15 multiple, while United grew EPS 33 percent and trades at just 9 times. As Rodney Dangerfield used to say, sometimes you can't get any respect. Asked why the multiples are still so low, Nelson claims the group is misperceived to be highly cyclical, adding that, “considerable misunderstanding continues.”

The Track Record

Several key auto retailers produced strong second quarters. United Auto Group, for one, posted a 38 percent rise in earnings, missing expectations by a penny and selling down. Not to worry. If a tad light on the bottom, the quarter was spot-on in new-vehicle sales (up 4 percent) and increased service and parts business (up 9.5 percent) — contributions which handily offset a 1.4 percent decline in used-car sales.

Along with Lithia Motors, United is the most aggressive consolidator, typically buying franchisers offering luxury and imported brands. Of late, foreign nameplates are growing faster than domestic and account for 40 percent of U.S. auto sales, up from 31 percent five years ago. The luxury brands also are growing, claims Nelson, who says, “consumers are migrating to vehicles above $30,000, particularly to the SUVs.”

United's biggest nameplates are Toyota/Lexus, BMW and Mercedes, and this luxury focus helps drive service revenues.

“Compared to lower-priced vehicles, if you have a Mercedes you're more likely to take it back to the dealer for preventive maintenance,” Nelson asserts.

One of the ways the consolidators are strengthening their positions is through the establishment of mega dealerships. UAG's version is the luxury “auto mall.” Its flagship dealership, located in North Scottsdale, Ariz., boasts 11 automotive brands, each with its own showroom. It also features two test tracks and a race-car museum.

United recently raised its full-year earnings outlook to a range of $2.30 to $2.39 — about a dime higher than earlier guidance. The current multiple on shares is just over 10. Nelson's price target is $38, and he rates shares overweight.

The auto retailer that most surprised analysts with its extra horsepower was Lithia, which grew per-share earnings 24 percent and produced gross margin of 17 percent, as compared to 14.3 percent at United. That difference reflects alternative strategies. Where United cherry picks the dealer universe in the quest of lucrative businesses, Lithia seeks average performers, then applies common operating systems to improve margins.

In July, while United was adding one Mercedes dealership in Arizona and a three-quarters interest in Continental, Europe's largest luxury auto retailer, Lithia acquired a Toyota store in Odessa, Texas — its first purchase since closing on two Alaska Chevrolet dealers at quarter's close.

The more modest nameplates serve Lithia well. On the quarter, management flagged their ability to increase margins “in a volatile vehicle sales environment” and pointed out, that despite a 5.3 percent decline in same-store sales, gross margin in “service and parts” improved almost 2 percent. Nelson ranks Lithia shares overweight and maintains a $32 price target.

A third option is Sonic Automotive, which met expectations, maintained its guidance for the year and raised its quarterly dividend, which sent its shares soaring more than 10 percent. Sonic is in recovery: After being the fastest-growing auto group, Sonic stumbled in 2003 and now also accepts the religion of margin improvement.

Commenting on the quarter, CEO Bruton Smith stated, “The second-quarter results reinforce the appropriateness of our current strategy to reduce the acquisition pace and focus on expense control.”

One way Sonic is driving margins is by working hard to increase the percentage of certified preowned-vehicle (CPO) sales among its used-car sales. In the minds of consumers, CPO, now nearly 40 percent of used-car sales, means “more reliable,” in part because of dealer-provided warranties.

Sonic's strategy is purchasing underperforming dealerships in high-growth markets. Its top brands are Honda, BMW and Toyota, and its top markets are Houston, Los Angeles and Dallas. Despite adding dealerships at a less rapid clip than in prior years, Sonic still makes plenty of money and recently reiterated a target range of $2.65 to $2.80 per diluted share for 2004. Nelson, who rates shares overweight, cites Sonic's industry low multiple of 8, adding, “We think the risk/reward is attractive here.”

Rolling Along

Some dealership groups that get it done.

United Auto Group

Ticker: UAG
Recent Price: $24
52-Week Range: $22-$32
Forward PE: 10
Earnings growth (latest fiscal, from Yahoo data): 33%

Lithia Motors

Ticker: LAD
Recent Price: $22
52-Week Range: $20-$31
Forward PE: 9
Earnings Growth: 10%

Sonic Automotive

Ticker: SAH
Recent Price: $21
52-Week Range: $18-$29
Forward PE: 7
Earnings Growth: Negative, due to last year's earnings misses.

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