I first covered Penske Automotive Group (PAG) in June 2019 in my article “Penske Automotive Group – Not Your Average Car Dealer“. At that time, I noted the diversified businesses that make Penske unique among its peers, such as non-US car dealerships, commercial truck dealerships and leasing, and used car superstores. Roger Penske has done a good job acquiring these assets at attractive prices when additional US car dealerships were not available at a fair price. Nevertheless, I was concerned in June about peaking auto sales impacting growth going forward. Since then, sales and gross margins do appear to have topped out, although some short-term positives have limited the impact. Additionally, Penske has seen some SG&A cost pressure, particularly in the UK. The company has offset some of these negatives with higher ancillary income from Finance & Insurance and Sales & Parts. Penske also grew by acquisition in the commercial truck segment. The net result of these impacts was still a 10.8% drop in net income in 3Q 2019 vs. the prior year. Despite this, PAG shares enjoyed a nice run-up during the month of October, breaking above $50 following the earnings release at month-end and staying around that level ever since. At these prices, I am concerned the stock is getting ahead of itself especially given declining fundamentals. I maintain my bearish outlook on Penske and would still look to trim my position if the stock reaches $52.
Non-US Dealerships: Good News and Bad News
Penske Automotive generated 38% of its revenue outside the US in 3Q 2019. Most of this foreign revenue comes from Europe, particularly the UK. On the bright side, Europe appears to be having a great fourth quarter, with October registrations up 8.7%. This is helped considerably by the fact that the industry is now caught up on complying with the new emissions testing procedure, WLTP (Worldwide Light Vehicle Test Procedure) mandated by the European Union. Unfortunately, year-to-date numbers are still flat to down and the outlook for 2020 is also flat to down.
Source: Autocar Pro News Desk
Brexit continues to be a drag on Penske’s UK-based dealerships. As seen on the chart above, the UK was one of the few countries to see registrations decline in October, which does not bode well for 4Q results. With UK elections coming this month, we may finally see a Brexit resolution and a brighter outlook for the overall economy in 2020, but the forecast is still uncertain at this point. The impact of Brexit fears on the UK pound has also continued to reduce PAG’s earnings when converted into US dollars.
Used car supercenters in the UK were hit particularly hard with oversupply and cost issues on top of Brexit-induced demand destruction. In 3Q, gross profit per used vehicle in the UK declined $388 or 21% to $1,450. Additionally, SG&A as a percentage of gross profit increased 7% in the UK. Penske is undertaking some cost-cutting initiatives but also expects to benefit from operating leverage on increased sales going forward.
“Let me, first talk about costs in the U.K. We have an action plan, Darren Edwards, our Managing Director. We’ve got a plan to take £20 million out of the cost base by the beginning of 2020. That’s under way now. We established that probably over the last 60 to 90 days. So that’s an action plan, because when you look overall at our business, the SG&A to growth in the U.K. was up 700 basis points and part of that was comp to gross up 400, and our margins, of course, were down £500 on new and £300 used. So looking at that, I think that with the action plans we have and from the standpoint of all actions, I think we’ll see the cost base come down, and we certainly know that the margins will go up. But looking at the used car business separately, we had a double-digit increase in our SG&A to gross during the quarter. And when you take 16,000 units, times a negative £225 per unit, it’s about $4.5 million. So significant impact. So that impacted obviously the SG&A to gross. But when you look at actions what’s taken place, if you go back to week 30, we had 8,000 vehicles in our superstores’ inventory and 37% of those were over 60 days.
What’s happened since week 30 to where we are today, we’ve got approximately 7,100 units that’s down about 11% and 16% of our vehicles are over 60 days.”
Source: CEO Roger Penske, 3Q 2019 Earnings Call
Finance & Insurance, Service & Parts are Bright Spots, But For How Long?
Looking at the main part of the business, Retail Automotive, we see that the total number of cars sold was up slightly, with new car sales down 2.9% and used car sales up 2.9%. Gross margin per vehicle was flat in the US, but down outside the US and for the company as a whole. It was the increase in Finance & Insurance and Service & Parts that helped limit the decline in total gross margin. Gross profit was up 4.7% on Finance & Insurance and 3.8% on Service & Parts.
Source: SEC Filings
Looking forward, the long-anticipated decline in US car sales has been slow to arrive, with sales basically flattish vs. 2018 and expected to stay flat into 2020 in the 16.5-17 million range. One potential downside to this forecast would be the increase of tariffs on cars imported from Europe to 25%. Some analysts estimate a total reduction in US sales in the range of 1 to 2 million car sales. This would be especially bad for Penske given the mix of brands it sells. The seriousness of this threat has moved up and down over the past year, but seems to be heating up once again. The tariff threat will remain a key variable heading into 2020.
Source: 1Q 2019 Earnings Presentation
On the Service and Parts side, the upcoming threat is from electric cars, which require much less regular maintenance than internal combustion powered vehicles. With Penske’s high exposure to Europe, it would be impacted the most of any US-based dealer given the faster EV adoption rate by European manufacturers. Longer-term threats from advanced driver safety features and eventually self-driving capability could also lower demand for insurance and body work, although Penske would not be advantaged or disadvantaged versus other dealers in this regard.
Truck Dealerships Growing Inorganically But Cycle Could Turn Down
Commercial Truck Sales make up 12% of Penske’s revenue and 19% of pretax income. Penske grew this segment inorganically with the purchase of Warner Truck Centers, with six dealerships in Utah and Idaho. Gross profit of the truck sales segment increased almost 50% in 3Q vs. the prior year. On a same-store basis, new truck sales were little changed and used sales were down. However, Service & Parts are the most important profit source in the truck segment, even more so than for cars.
Looking forward, November was a particularly weak month for truck orders and shippers are cautious headed into 2020 due to the cloudy economic outlook. While this will likely limit this segment’s organic growth for Penske, I do not see it becoming a big drag due on the overall company due to the probability of continued Service & Parts income and the capacity it has to acquire new dealerships opportunistically. The truck leasing business has also been growing slowly and steadily with the opportunity for PAG to increase its equity ownership in the future.
PAG has continued to increase the dividend by 1 cent per share each quarter, and if the trend continues, it works out to a dividend yield of around 3.4% based on current share price and expected 2020 dividends. While this is the highest yield of its peer group, payout ratio has remained below 30%. On a trailing 12-month basis, free cash flow was $433.6 million for a very reasonable P/FCF multiple of 9.4. Penske bought back $187 million of stock and paid $129 million in dividends. The company also made $467 million worth of acquisitions, which is a typical pace for the last several years. The shortfall vs. free cash flow was made up by issuing debt. Debt excluding floor plan notes has been increasing over the last few years and now stands at $2.38 billion which is about 3.2 times EBITDA. Interest expense is covered 3 times by operating income. These debt levels are common for the industry and are manageable in the current interest rate environment. Still, they are getting toward the high end of what I like to see and could cause problems if interest rates increase.
With a P/E below 10, Penske is at the low end of the range for its peers; however, the lower P/E is justified based on its low growth rate and lower return on assets and total capital than any of its peers.
Data Source: Seeking Alpha Peer Comparison Page
Considering the near-term margin issues with international car sales, the economic and tariff concerns for 2020, and the longer term challenges from electric vehicles, I do not see a big potential for margin expansion.
Penske Automotive Group is a well-operated company with diversified businesses that make it different from other US-based auto retailers. Nevertheless, Penske has experienced headwinds from declining margins in Europe, a problem which could spread to the US especially if tariffs increase. In the long term, Penske faces challenges from electric cars which are greater due to its European exposure. The dividend appears safe, but debt has been on the increase and could become an issue if interest rates rise. The growing debt ratio could also present an obstacle to Penske’s history of growing by acquisition as free cash flow cannot cover both M&A and growing the dividend. Although Penske’s P/E is below 10, I believe this is justified based on lower growth and return on capital as compared to peers. At this point, the risks outweigh the opportunities and Penske could see downside in 2020. The stock is now trading near the $52 target I set in June, and I will strongly consider selling it if it hits this target.
Disclosure: I am/we are long PAG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.