Lithia Motors
Disclaimer
Black Opal Research is a financial newsletter that provides our take on different publicly traded businesses in order to obtain feedback and test our own thesis. We find this process keeps us accountable to make educated investment decisions with our own money and no one else's. Nothing in our articles should be taken as financial advice. We will always ask our readers to seek qualified financial advice before investing in any of the companies that we complete analysis on. Do your own research, fact check, and evaluate.
Summary
Management
Owner oriented
Pay for performance (85% variable)
Founder/Family lead business
Sidney B. DeBoer - Chairman
Bryan B. DeBoer - CEO
Competitive advantage
Disruptive consolidation
Incredibly large in fragmented industry
Margin of Safety price point
Ten Cap - $270.05
DCF -$205
Intrinsic Value - $410
Current stock price - LAD 0.00%↑
The Company
Lithia & Driveway builds, and acquires auto dealerships in the United States and more recently Canada. The company was started in 1946, had its IPO in 1996 , and has been growing steadily since its inception. Looking back at the 1998 annual report, a paragraph really tells the entire story of what this business is all about. "Management has developed and implemented its acquisition and operating strategies which have enabled the Company to successfully identify, acquire and integrate dealerships, achieving profitability superior to industry averages … The Company intends to continue to take advantage of the consolidation opportunities in the $640 billion automotive retailing industry." Its not often that a management team does exactly what they say they are going to do for the better part of three decades. In this case they have and it has been a winning strategy.
Lithia now operates 278 locations representing 40 different brands. They ranked 158 on the fortune 500 list in 2022. Their business encompasses the entire vehicle lifecycle including new and used vehicles, financing, insurance, automotive repair and maintenance. Lithia has also has built out their ecommerce platforms as well to capitalize on shifting consumer purchasing trends. This is significantly larger in size and profitability than Carvana.
There are four different segments of the business that generate revenue, New vehicle Sales, Used vehicle sales, Financing and insurance, and service body and parts. In 2021 the business generated ~$2.1b gross profit from the sale of vehicles, ~$1.0B from financing, and ~$1.1b from service revenues. They ended 2021 generating ~$4.2b in gross profit. From 2019 - 2021, total gross margin increased from 15.4% to 18.7%. This was mostly driven by increases to new vehicle sales which is expected to decrease in a recessionary market.
Lithia also measures same store sales growth. This transparent approach allows us to see that both the existing store base as well as the acquisitions are leading to revenue and earnings growth. Based on the numbers in the 2021 from same store sales, it looks as though Lithia generated around 1bn of their 2021 gross profit from acquisitions. We expect that Lithia's same store sales growth will have increased due to 2020 and some 2021 acquisitions now included in the numbers. Lithia states that they target a 25% after tax return by the third year post acquisition. This would mean that 2024 would see a significant earnings increase due to the substantial acquisitions in 2020 and 2021.
The Evaluation
10 Cap Evaluation
At Black Opal we value businesses as if we were going to buy the entire thing. Our Ten Cap analysis is very simple. It ensures that if we purchased the whole business, we would get a return of our entire initial investment over a ten year period. This analysis does not include any growth metrics and assumes that the business will be steady and constant throughout time.
For our analysis of Lithia & Driveway, we will utilize their 2019 annual report to avoid the Covid inventory and demand surges. We can then adjust this owner earnings number using the historical growth prior to covid of 44% annually.
In 2019 Lithia & Driveway generated $524.5m in cashflow from operating activities. They spent a total of $463m investing in the business of which only a portion would have been considered maintenance capital expenditures. The details are clearly spelt our in the annual report. Lithia spent $366.6m on the acquisition of businesses. Therefore Maintenance Capital Expenditures are $96.4m. $463-$366.6=$96.4m.
In order to get the owner earnings number we use the Operating Cashflow, then subtract the Maintenance Capex, and add in the taxes. This will represent the pre tax free cash flow of the business as if we owned it in its entirety. $524.5-$96.4+103.9=$532.00m.
Adjusting the 2019 owner earnings is not something that we would normally do but we feel that as this business is a growth through acquisition type business that the adjustment is warranted if we expected the same strategy to continue. The average owner earnings growth rate since 2013 is around 70% and is a little inconsistent from year to year. For that reason we will adjust using the average earnings growth rate of 21%. This is significantly more conservative and realistic considering the environment we are in.
Using this as an adjustment to owner earnings for 2020, and 2021 gives us a owner earnings number of $778.9m. Breaking this out on a per share basis using the 2021 shares outstanding gives us $778.9/28.8=$27.05 /share.
If we are looking to recover our investment over a ten year period, then our 10 cap entry price per would be$270.05/share. If Owner earnings continue to grow as we have projected, then in 2022 we would expect owner earnings around $950.00m for 2023. Looking at the Q3 2022 numbers it looks like the business has already surpassed this level.
DCF Evaluation
Lithia & Driveway is an auto dealer disrupting the industry through consolidation. The retail both new and used vehicles and we expect In an inflationary environment this business will be largely unharmed. They may experience a shift in where their revenue comes from but we believe that they will continue to have a growing business well into the future. Their current long term goal is $50n revenue within 5 years.
We believe that Lithia & Driveway is well positioned to continue its dealership growth by acquisition and may be able to get better valuations in a lower demand market. We believe as their reach grows, their ecommerce business will be set up and accelerate growth. This is a management team that has done exactly what they have said they would do for 30 years and they are optimistic about the future.
Lithia has been growing earnings at a Compound Annual Growth Rate of 21% since 2013. We believe that this business will continue to grow at roughly 15% per year for the next decade. There will be years that are in excess of 15% but some of the short term headwinds will cause a slower economy. This will, or should, slow or reduce same store annual growth. As same store sales growth slows, we would expect Lithia to ramp up more opportunistic acquisitions that continue earnings growth every year. Our growth assumptions leads to an end result of Lithia owning roughly 6% of all dealerships in the US. We think this is achievable given the management team currently in place.
Assumptions for DCF
Discount rate-15%
Earnings Growth-15%
Normalized earnings (2019 EPS normalized @21% growth rate from 2013- 2019) - ~$20.50
Future PE - 20
Intrinsic Value - $410.00
Margin of safety @ 50% - $205.00
Summary
We think Lithia Motors is a fantastic business. It's not often that management teams say what they are going to do and then do it for decades. We like that this is still a somewhat founder run business and we also are hopeful that the ecommerce side of Lithia flourishes and becomes the largest online retailer of new and used vehicles in North America.
This is a simple and somewhat boring business model driven by industry consolidation. There are risks in this industry and they have increased now that Lithia has utilized DFC for the financing of the vehicles they sell. If done right however, this could be the catalyst that propels their value and growth exponentially. We like Lithia and are opening a position prior to the Feb 15, 2023 Earnings call.
Our entry strategy
Today we opened a position via derivatives. We used a strangle at $270. This means that we Bought To Open both Put and Call contracts at a strike price of $270. Our thought process is that we are buying this business right before an earnings call with an uncertain macroeconomic environment. We want the protection of the call to avoid missing a gap up in price (which we expect), and the put to capitalize on the gap down in price (if it occurs). If we get a negative Q4 Earnings or something that spooks investors tomorrow we will still make money on our trade and can enter our investment at a lower price that we could today. The cost per contract of our strangle was around $1700.00.
As Always we welcome and encourage feedback from our readers. If any of you have businesses you are interested in learning more about please let us know.
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