We’re going short Lithia Motors (LAD) and think that the stock has ~50-60% downside over 12-18 months down to ~$125 per share from its current $291. LAD is one of the largest Auto dealers – both new and used – in the US and has been a huge beneficiary of auto inventories touching general lows while used car prices blow through new all-time highs (Exhibit 1). Simply put, the past two-year period has been the perfect environment to be Lithia – and for anyone selling used or new vehicles, for that matter. Traditionally a razor thin EBIT margin business (sub-4%), the pandemic and the subsequent surge in auto demand drove margins on new and used vehicles materially higher, resulting in EBIT margins going from 3.9% to ~7% this year. Pre-pandemic, this company earned about $12 per share, and with soaring same store sales, pricing power, temporarily higher margins and what we think will ultimately prove to be an ill-timed acquisition binge, the company is currently sitting on about $38 in EPS power. We think that over a TAIL duration (by FY23) EPS reverts to ~$22, with the Street sitting at $34. In sum, as the supply of vehicles normalizes, which Hedgeye’s Industrials Analyst Jay Van Sciver thinks will happen in 2H22, we should see dealer margins normalize as well, and should see a major negative earnings revision cycle. This is hardly discounted in the stock nearing $300 – and sentiment on both sides of the Street is universally bullish. In fact, short interest is at a historical trough of 4% vs historical norms of 12-14%, and the only bearish analyst has a target 5% ABOVE current levels. The only reason this is not a Best Idea (it sits at the top of our Short Bias list) is that we might be early with our call. Again, inventories are still outrageously tight and favorable for auto dealer margins. The stock screens cheap at 8x earnings, and we could see LAD surprise on the upside for the next 1-2 quarters. But knowing what we know today, we’d definitely have at least a partial position short side, and would scale up as we either de-risk time, or the research call strengthens.
While we think that the cyclical call is enough to be a meaningful stock driver, we think that the longer-term bullish call here is flawed. That call is believing in management’s 50/50 Plan – which is $50bn in revenue and $50 in EPS by 2025. It’s got a nice ring to it, but if management actually gets to $50bn in revenue, we think that the acquisitions needed to get there will destroy the leverage in the model. By our math that means that the company will need to do another equity offering – likely in the vicinity of $1.5bn in addition to ~$3.5bn in added debt. That equity deal is likely to be at a much lower price than where the stock is today, and the added debt on lower EBITDA is likely to take leverage up almost 2x where it is today – getting to about 3.6x Net Debt/EBITDA per our model. Let’s not forget what this company is – a roll up of auto dealerships – nothing more, nothing less. To be clear, we hate roll-up stories. They rarely create long-term sustainable value that you see in organic growth stories. This company invests the minimum capex in its existing infrastructure (about 1.2-1.4% of sales) and then about 3x that amount on deals. Over each of the past two years, however, the company has spent 11% of sales on acquisitions – when dealer profitability was at peak. Not an optimal time to step on the accelerator to do more deals.
That brings us back to valuation…as noted, the stock looks ‘cheap’ today at 8x earnings and 7x EBITDA. But with the balance sheet levering up to meet unrealistic top-line goals, we need to stress test the EBITDA multiple where this name could trade. In a downward revision cycle with increasing leverage, there’s no reason why this stock can’t trade at 5x EBITDA. Every EBITDA turn equates to about $50 per share based on our model. If that 5x multiple happens, which is likely if our FY23 estimates are right, then there’s only $100 available to equity holders. That price is completely supported by the RNOA Rapdmap for LAD below. The best businesses – the ones deserving of sometimes nosebleed multiples – see tax-adjusted EBIT margins go up while operating asset turns simultaneously improve. To be clear, that is incredibly difficult to accomplish. Any company can improve asset turns at the expense of margins, or vice versa. Simple trade-off. But to improve them both at the same time is something special (as most of our Best Idea longs are doing). But then there’s the inverse – those special dogs that bloat the operating asset base WHILE revenue growth slows and margins erode. It’s just as difficult to find these losers as it is to find the winners – but by our model, LAD is emerging as one of the losers. Ultimately, the combination of lower asset turns on a lower margin rate should equate to an 8-9% RNOA rate over a TAIL duration vs ~19% today. If we’re right on this trend, then it’s supportive of a collapse in the multiple. This name has Best Idea written all over it – all we need is to get past the next two quarters. Stay tuned…
