Catching Up To The Pack
Penske Automotive Group (NYSE:NYSE:PAG) was a great pick since my last analysis was published in June 2021 near the lows of the past year at $75. Since then, the stock hit my price target of $112 in November, just before Morgan Stanley (MS) downgraded or lowered price targets on the entire retail automotive group. Although the stock has traded basically sideways following the big drop on that downgrade, Penske was still the best performer of the group since the June 2021 article.
Penske has a diverse set of businesses that differentiate it from these competitors including UK car dealerships, commercial truck sales, and truck leasing. Penske is also growing its CarShop used car superstore business at a perfect time when new car sales have been limited by supply chain constraints. There are now 23 CarShop locations compared to 17 at the beginning of 2021.
The company rolled out a plan at the start of 2021 to reach $1 billion annual income before taxes by 2023. This has already been surpassed with $1.356 billion in calendar 2021 and $1.539 billion over the previous 4 quarters. Some of this result is due to unusually strong margins, which may decline in the future as supply chain issues get resolved. This margin outlook is probably the reason for the low P/E multiples across the entire industry. Still, Penske is also delivering its growth plan, which will pay off even in a lower-margin environment. As noted in the 1Q 2022 earnings release,
Year-to-date we have added approximately $665 million in annualized revenue through acquisitions and a new open point. These acquisitions consist of four commercial truck dealerships located in Ontario, Canada, three BMW/MINI dealerships and a collision center in the U.K., and one BMW/MINI dealership and a collision center in the U.S.
Penske’s diversified sources of income should give it an advantage over pure-play US car dealers if new car margins decline. Meanwhile, the company has been wisely using its current strong cash generation capability. In addition to delivering the growth plan, Penske has continued its best-in-class dividend with the unique $0.01 increase every quarter (2.0% forward yield). They have also reduced share count by 4.2% in the past year, all with no increase in long-term debt. With a P/E of 6.7 times 2022 earnings, any slowdown in the retail auto business is already priced in, and Penske’s balance sheet is in good shape to deal with it.
Shortages Not Hurting
The new car supply shortage due to lack of semiconductors and other components has been widely discussed. In terms of inventory, Penske noted on the earnings call that they have only 16 days of new car sales in stock. For non-premium brands like Honda and Toyota, inventories are even lower at 5 days of sales. The company expects this tightness of supply to last another 9-12 months. The shortage has resulted in 1Q unit sales of new cars 13% lower on a same store basis and 9.7% lower overall. Due to strong demand however, gross margins per unit are up 67% for new cars so that total new car gross profit is up 52%.
When it comes to used cars, the inventory picture looks much better with 41 days of sales in stock. While the increase in margin per car was not as large, the higher unit sales allowed gross profit to increase 38% on a same store basis and 42% overall.
Roger Penske noted on the conference call that he is not seeing any softening of demand as some competitors have reported as the premium mix attracts customers more able to handle inflation and economic uncertainty.
Strength From Other Businesses
The retail automotive business is still the biggest part of the company at 86% of the revenue and 62% of the pretax earnings, but Penske’s other businesses are growing fast enough to take an increasing share. Most significantly, PAG’s 28.9% equity stake in Penske Transportation Solutions (PTS) earned $118.5 million in Q1, up 121% from 2021, now comprising 24% of PAG’s pretax earnings. PTS leases the well-known yellow trucks to consumers as well as providing other trucks and logistics services to businesses.
The commercial truck dealership business is also benefitting from higher demand. New unit sales increased 45% from last year on a same-store basis and 78% overall due to acquisitions of dealerships. Total pretax earnings of the group have doubled two years in a row, from $14 million in 1Q 2020 to $28 million in 1Q 2021 and $59 million in 1Q 2022. Looking forward, industry order backlog for heavy duty Class 8 trucks is still about 1 year of production. This is about double the average level, which should allow for continued record sales and margins at Penske’s dealerships.
Earnings Estimates And Valuation
Since my June 2021 article, analyst earnings estimates have grown considerably. Consensus EPS estimates for 2022 stood at $14.82 ahead of the latest earnings report, up 69% from $8.77 in June 2021. For 2025, analysts are now expecting EPS of $15.59, up 43% from June 2021 estimates. Despite these revisions, the share price is only up 33% indicating some multiple contraction. At $100, the stock is trading at 6.7 times this year’s earnings and 6.4 times 2025 earnings.
Penske’s peers have also undergone multiple contraction since June 2021. With PAG stock outperforming since then, however, it is no longer one of the cheapest in the group. Nevertheless, the 6.7 P/E is cheap on an absolute basis and reflects excessive pessimism about forward earnings.
With such a low valuation, it is still important to consider the risks of the business to understand the reasons why the stock is so cheap. First is increasing interest rates. Penske relies heavily on floor plan debt to finance its inventory. With the previously low rates and low number of cars in stock, Penske’s floor plan interest expense was only $7.5 million in 1Q, or 1.9% of operating income. If inventory levels were to double from here and short-term interest rates go from 0.5% to 2.0%, Penske would see floor plan interest increase to a much more significant $60 million per quarter.
Second, while current demand and backlog for truck sales are strong, some indicators are signaling a downturn in the freight market. While new truck orders and leasing demand are still strong, these would fall off quickly if shipping demand declines.
Finally, from a longer-term viewpoint, car dealers could face pressure from OEM’s moving to direct sales business models or agency models where the manufacturers capture a larger share of the value. Transition to electric vehicles is also a concern due to the lower need for service and parts which earn much higher margins for the dealers than vehicle sales. Penske’s EV sales make up only 2% of total sales in the US but 22% in the UK.
The cash flow statement is not available as the 10-Q is not out yet, but based on the CFO’s comments in the earnings call, Penske had $400 million of operating cash flow in Q1 and spent $36 million on capex. Share buybacks were $119 million, and the $0.47 dividend used about $37 million. There was little change in debt during the quarter. From the balance sheet, we see cash is up $70 million, so acquisitions were probably around $138 million. The company has deleveraged considerably over the past 2 years, with long term debt / EBITDA now only 0.7 (This does not include floor plan debt).
Based on the cash build in the quarter, and the dividend payout ratio of around 10% whether you use net income or free cash flow, Penske’s best-in-class 2% dividend yield looks safe. The company should not have problems continuing the $0.01 per quarter increase it has been doing since the brief pandemic-related suspension in 2020.
Penske Automotive stock has been one of the best performers in the retail automotive industry since I last reviewed it in June 2021. With those gains, the stock is no longer valued below most peers, however on an absolute basis, the 6.7 P/E on 2022 earnings is still cheap. This reflects concerns about peaking sales and margins although analyst estimates do not show big EPS declines on the way.
With M&A and organic growth, Penske is increasing its earnings power in any economic environment. It is also increasing its diversification compared to peers with more income in the truck sales and leasing businesses. Even if earnings are nearing a peak, the cheap absolute valuation and the best-in-class, growing, and well-covered dividend still make Penske a good buy.