AUTOCANADA – IT’S TIME TO BACK UP THE TRUCK, LITERALLY

Share Price: $39.22 CAD | Market Capitalization: $961,269 CAD | Adjusted Enterprise Value: $1,072,499 CAD | Idea Type: Growth at a VERY reasonable price

Note: As I was writing this up the stock has gone up nearly 30% since the panic low last Friday. I believe the shares still remain very undervalued and provide a highly asymmetric risk/reward scenario. All calculations are based on a $39.20 share price.

”Be fearful when others are greedy and greedy when others are fearful” – Warren Buffett

Synopsis and Elevator Pitch:
AutoCanada is what Peter Lynch would call a “fallen angel” and one of the fattest pitches I see today in my small-cap Canadian stock universe. I had bids set last Friday as the shares plunged to around $32 that unfortunately were not filled; that was a very costly mistake, as the shares have surged up nearly 30% since then! AutoCanada was a high-flying Canadian stock market darling that experienced an atmospheric rise last summer on the back of a string of accretive acquisitions and strong growth in Canadian retail vehicle sales. The main headline risk now is that the precipitous fall of oil prices will have a negative effect on the Alberta economy and consequently falling employment in that region. In fact if we compare AutoCanada’s share price history over the past several months you’ll notice that it’s largely been trading in sync with WTI. Although I believe a slowdown in the Alberta economy is very likely, I believe investor fears over AutoCanada’s exposure are way overblown. Mr. Market’s overreaction and manic depressive behaviour has rewarded us with a current share price which provides a tremendous opportunity for investors to buy shares in an extremely well-run auto retail growth business at a large discount to intrinsic value. Even in the unlikely event that nationwide new vehicle sales decline double-digits and AutoCanada closes no further accretive deals in 2015 (very unrealistic, nearly impossible based on a confluence of factors that I will explain) – shares are still worth between $47 to $51, providing 19% to 30% upside one year from today. In my more realistic but still rather conservative base case scenario, the shares are worth $61 to $65, providing 1-year upside of 56% to 65% upside.

 

Quick Company Summary:
AutoCanada is a high-growth story and the only publicly-traded Canadian franchised auto dealership group. The business was taken public in 2006 with the thesis of tapping into the public markets to consolidate the fragmented Canadian automotive retail industry. Since the company’s IPO, AutoCanada has acquired or opened 34 additional dealerships and expanded its lineup of partner OEM brands to 19. Last year alone the company acquired/opened 16 dealerships as growth accelerated. The founder and new chairman, Patrick Priestner, was a university dropout who started his career in the industry as top salesman selling Chrysler branded cars at the age of 17 in Alberta.

Thesis – The Devil is in the Details:
1) Despite AutoCanada’s relatively large dealership exposure to the vulnerable Alberta economy, I estimate that only 33% of AutoCanada’s current 48 dealerships are truly “at-risk” to Alberta’s slowing oil sands’ economy and consequently weaker employment. Furthermore, if we further digest the news of large CapEx budget cuts announced by the E&P companies in Alberta’s high cost oil sands, then we can reasonably assume that fleet sales (corporate sales) should be disproportionately negatively affected in a business slowdown relative to retail sales. Fleet sales are very low margin (typically less than 1% gross margins) and thus should have a miniscule effect on consolidated gross profits even if we assume large volume decreases in this category. Due to this favourable business mix-shift in the event of rapidly falling new corporate vehicle demand, I argue that the situation is less dire than what is perceived by the market.

2) I believe the bears (or panic sellers?) in general under-appreciate the resiliency of the franchised multi-dealership business model and especially AutoCanada’s track record of achieving best-in-class operational efficiency in their parts & services (P&S) segment. This segment is basically the bread-and-butter of every franchised car dealership should perform strongly even in an economic downturn.

3) Despite AutoCanada’s heavy Western Canadian exposure, the business is quickly diversifying in terms of acquiring new OEM partner brand dealerships outside of Alberta. The size of these acquisitions have been growing larger as the business scales its dealership base which should help mitigate the risk of declining profits in the event of any serious downturn in the Alberta economy.

4) I believe the market is pricing in the absolute worst case scenario where AutoCanada will do no more acquisitions or open up anymore dealerships (highly unrealistic) over the next several years. With a highly fragmented Canadian auto industry (~3,500 dealerships nationwide), acquisition targets remain plentiful and this predictable growth cannot be ignored. In short, management’s proven strategy of high-quality growth by acquisition remains intact, and should provide a long runway of multi-year growth compounding at high rates of return well into the end of this decade.

Debunking the Bear Case:
1) What’s really at risk?

Alberta, like many Canadian provinces, is quite big, and although is very reliant on the oil industry, there are more moving parts to consider. In fact, slightly more than a quarter of AutoCanada’s Alberta-based dealerships are located in Grand Prairie, which is an area that is more exposed to natural gas, forestry and the US housing industry than to oil. The rest of the company’s 22 Alberta dealerships are located in Calgary, Edmonton, Sherwood Park and Ponoka. Due to their employment demographics, these dealerships should be considered more exposed to a slowing local oil sands economy.

at risk dealerships

It’s all about the gross profit, not the sales.

I believe the slowdown in total new vehicle sales should disproportionately affect fleet sales (corporate sales) more than retail sales. As mentioned, fleet sales gross margins are very low and are typically less than one tenth of new retail vehicle gross margins. We can assume that the E&P companies will be cutting back on purchasing light pick-up trucks on the back of falling oil prices and budget cuts. In fact, if we look at the most recently reported quarterly results (see below), we’re already seeing same-store fleet sales volume decline considerably YoY on a 3 month and 9 month basis. I believe AutoCanada’s new fleet sales are more cyclical relative to new retail sales, especially given the company’s exposure to the Alberta’s oil-centric economy.

“Management cannot confirm, but believes that much of the increase in the overall Canadian new vehicle market can be attributed to increases in fleet sales from 2009.” – AutoCanada’s 2010 Annual Report

Looking at same-store-sales (SSS) in the latest reported quarter can give us a bit of a clue in what to expect in 2015 if we assume the cycle turns in Alberta.

sss

sss 2

As we can see, even with the sizable drop in new fleet volume and fleet SSS, same-store new vehicle gross profits still managed to grow 20.5% and 7.8% on a three and nine month’s basis, respectively; as long as we assume new retail vehicle ASPs remain stable or increase slightly (like they have been), small increases in new retail sales can offset larger fleet sales declines. In the event that even new retail sales volumes decline, I believe it’s reasonable to assume that AutoCanada’s used vehicle gross margins and gross profits will hold up strongly even in a severe downturn, supported by the fact that consumers and enterprises typically trade down to used vehicles to save costs during tougher economic times.

What’s interesting is that even if we look at the latest auto sales data that was released in January 15’, Dec 14’, Nov 14’, etc. there hasn’t been any real indication that there’s been any significant weakness in Alberta vehicle sales. Even if we assume there should be a slight lag in the industry data following oil price movements (oil starting crashing last July), November and December industry sales were both up 4.8 and 4.4 percent YoY, respectively, and nationwide industry sales have also been strong. The provincial data hasn’t been released in January 15’ yet, but overall industry sales are up and light truck sales have been outperforming. Given the recent data, it’s rather perplexing as to why retail sales haven’t been strongly affected in Alberta yet, and there’s even reason to believe that the lower oil prices have been incentivizing consumers to buy larger vehicles. My conversations with some of AutoCanada’s dealers largely confirm this thesis that new retail sales remain strong.

autocanada graph

Finally, the auto dealership model in general has quite a variable cost structure, helping reduce costs in a downturn. The vehicle sales and F&I segments that are most vulnerable to the cycle have the least operating leverage due to the highly variable nature of a car salesmen’s compensation structure.

2) The focus over the next several years should be on P&S, not new vehicle sales

I) I believe the franchise dealership business model is much more recession resilient than what the market gives it credit for. Despite the company’s cyclical exposure to new vehicle sales, parts & servicing (P&S) is where the real money is made, where gross margins are typically 50%+, are much more recession resilient, and recurring in nature. P&S is the most important segment for any auto retailer, and based on my research AutoCanada’s operating metrics are among the highest in the industry. If we look at AutoCanada’s operating history, the business has consistently achieved high “absorption rates” at near 90%, a metric which measures operational efficiency in the P&S segment. P&S is also a relatively counter-cyclical segment as consumers tend to keep their cars longer in downturns, and thus require ongoing vehicle maintenance and replacement parts.

II) As shown below in the excel sheet AutoCanada’s P&S segment is typically between 30-35% of their total gross profit in a mid-cycle year, and this percentage should experience outsized grow relative to vehicle sales when the cycle turns. Furthermore, there is a larger secular growth tailwind at play here as outsized growth in the stock of new vehicles aged between 1-5 years on the road today should boost same-store P&S gross profit growth at high-single to low-double digits (even higher EBIT growth due to operating leverage) well into the end of this decade; many consumers delayed purchasing new vehicles during the last downturn and there are now over 8 million cars over 10 years old on the road today. I believe this is one of the most overlooked key drivers by the market and the Street. AutoCanada’s P&S SSS has consistently grown at around high-single digits for the past couple of years, supporting this thesis. Many industry experts have always assumed this segment can only grew at mid-single digits longer-term; I believe this will prove to be a very conservative forecast, especially given recent strong growth in retail sales in Alberta

III) The P&S segment has the most operating leverage and highest incremental margins, and this is exactly the segment you want the most leverage as it is more predictable and recurring relative to new vehicle sales. I conservatively estimate that around 50% of P&S gross profits flows through SG&A. This segment also has good pricing power as vehicles repair and maintenance work becomes increasingly complex on newer vehicles and warranty contracts continue to lengthen. Light trucks which AutoCanada’s Alberta-based dealerships sell a lot of typically require more maintenance work on a more regular basis due to heavy usage compared to passenger cars.

IV) OEM franchised dealerships should continue to take servicing and repair market share from mom-and-pop repair shops that do not invest in the sophisticated equipment and software required to perform repairs and warranties on today’s increasingly complex vehicles. Each OEM requires specialized equipment for their own vehicle models which should freeze out mom-and-pops that under-invest in these areas.

AutoCanada’s Historical Segment and Margin Analysis:

autocanada margin

3) This time is really different, if there is a “this time”; 2009 is a poor precedent.

-Finance & Insurance (F&I) is a sizable portion in consolidated gross profits (90%+ gross margins). Decreased in FY2009 because of tight lending conditions – the company’s largest 3rd party financing partner, Chrysler Financial Canada, declared bankruptcy so they had to switch to GM Acceptance Corporation, which today is the newly re-organized, well-capitalized Ally Financial.
-Despite going through an extremely severe recession, having their largest OEM partner (Chrysler) go through a bankruptcy restructuring which affected the company’s access to floorplan financing to fund inventory purchases (I will touch upon floorplan financing later), AutoCanada’s same-store gross profits fell only 2.6% and 7.8% in 2008 and 2009, respectively; quite impressive for a cyclically exposed retailer
-Despite falling auto demand during the past recession, access to credit was a major issue. Around 85 and 60 percent of new auto and used auto sales today are financed with credit, respectively. Due to the continual low interest rate environment and a healthy credit market, credit should not be a problem this time around
-Not core to the thesis but industry analysts are still forecasting strong light vehicle growth in Canada (~1.8 million vehicles for 2015). The US numbers look strong as well. I believe despite the bear’s concerns about falling employment in Alberta, lower oil prices and the plunging Canadian dollar should help the company’s dealerships outside the province. Also keep in mind that this time the reason why oil took a hit was largely supply-driven. In 2008/2009, it was largely a demand-related shock. I think the recently reported industry data is already confirming that the sky is not falling and light vehicle sales across the country will remain strong.

4) Diversifying away from Western Canada
Despite having 22 out of its 48 dealerships in Alberta, we should really be focussed on new retail sales volume per dealership. Last year AutoCanada acquired a set of 2 powerhouse BMW/Mini dealerships in Quebec, which marks the first time they’ve expanded into the BMW/Mini OEM brand and into the French Canadian province. These dealerships are around 2.5x the size of an average AutoCanada Calgary-based dealership and combined they sold 3,860 and 1393 new vehicles and used vehicles, respectively, in 2013. These figures alone represent ~65% of all the vehicle sales volume of AutoCanada’s Calgary-based dealerships. AutoCanada’s new Montreal BMW/mini dealership alone volumes ~60-65% of all the BMW/mini cars sold in the city. What’s more important I think is BMW/Mini’s acceptance of AutoCanada’s public dealership model, which provides further diversification away from AutoCanada’s heavy D3 exposure. I believe the warranty and maintenance work for higher-end German vehicles is very attractive.
Finally, if we look at AutoCanada’s OEM brand mix, it’s heavily weighted towards the Detroit 3 and Japanese brands. I believe the luxury brands will be more at risk compared to these midline brands if we head into a slowdown. The company only has 1 Volkswagen dealership in Calgary purchased in 2014.

autocanada brand

dealership locations

Quick Industry Overview:
I believe the market currently under-appreciates AutoCanada’s long runway for growth driven by consolidating the fragmented Canadian auto franchise dealership industry. Based on my research, there are ~3,500 Canadian dealerships and more than 2,000 single owners. According to PwC, around 70% of auto dealership owners in Canada are either looking to retire or semi-retire, and selling their dealership is an attractive option. However, there are OEMs that restrict public ownership in Canada; Ford, Toyota and Honda are such brands and currently represent about 28% of all dealerships in the country. Even if we factor in these restricted brands, AutoCanada’s market share (by dealership number) is still less than 3% of all publicly-allowed dealerships in Canada. Due to the sheer number of acquisition targets for AutoCanada, these restrictions still do not derail the growth by acquisition thesis that should last well into the end of this decade and beyond. Also, it’s very possible that these restricted brands may eventually allow public ownership Canada, where it has already happened in the US. I this scenario as an additional free option to the growth thesis.
-Only a few privately-held dealerships of comparable size are competing for deals (Dilawri Group is the largest in Canada), and since they are private, they’ll most likely focus on acquiring non-restricted brands, so I believe given the sheer number of targets and the overall succession issue, average purchase multiples should remain reasonable (within 4x-6x EBITDA depending on the location and OEM brand).

Briefly looking upstream:
-Fiat-Chrysler has emerged post-bankruptcy as a strong, re-organized company with a good balance sheet that continues to take overall market share in Canada (only second to Ford). If we look at just light vehicle sales, Fiat-Chrysler actually has top market share at ~18%.
-OEMs were concerned about dealership group concentration in the past when the industry was much more competitive (some D3 franchised dealerships were closed down during the last recession and have emerged as independent used car dealerships), but now they are more focused on dealership profitability and supporting their P&S departments by including longer warranties and service plans on vehicle purchases.

Business Model:

This is a rather good retail business. They have good dealerships in good locations and generate a lot of free cash flow. Inventory risk is extremely low. The overall cost structure is quite variable for a cyclically exposed business. Where there is operating leverage it is where you want it to be (in P&S). This segment continues to take market share from independent garages and has good pricing power. There is virtually no internet disintermediation risk. The business generates high returns on invested and tangible capital; I estimate that AutoCanada generates around mid-20s on pre-tax returns on capital employed. I expect the return on invested capital to continue to improve as they ramp-up newly acquired dealerships and continue to leverage their fixed costs as they scale.
-The business is not capital-intensive (leases are quite low and are not inflationary) and capital intensity is shrinking as they have bought back some real estate; maintenance CapEx runs at ~1.5% of gross profits
-Barriers to entry for franchising an auto dealership are quite high; OEMs rarely allow new dealership openings, especially in areas where there are already enough distribution points, protecting the incumbent distributors. The total number of franchised OEM dealerships in Canada has roughly remained the same over the past decade, and may have even decreased slightly since the last recession due to D3 restructurings
-Competition on the new vehicle side is quite limited; franchised dealerships operate in de facto local monopolies or within a highly oligopolistic industry structure; eg. Only a few dealerships in any densely populated areas are granted franchises by OEMs

Management and Capital Allocation:
Anytime we have an extremely acquisitive company we need to make sure that management have considerable skin in the game, a strong track record of value creation, and incentives properly aligned with shareholders.

1) Ownership Structure:
Canada One Automotive Group (CAG) is a privately-held dealership group controlled by AutoCanada’s chairman and founder Mr. Priestner who has a ~87% equity stake in CAG. CAG owns one Ford, one Lexus, and one Toyota dealership (currently OEM brands that do not allow public ownership in Canada but will most likely be acquired by AutoCanada if this restriction is lifted) and has a nearly 10% stake in AutoCanada shares. If we do the math, the value of Mr. Priestner’s current equity stake in AutoCanada via CAG comes out to roughly $87 million.
-CAG recently sold several GM dealerships to AutoCanada with Mr. Priestner retaining a 15% ownership stake with voting control as owner-operator (a requirement by GM Canada). I believe having the seller retain partial ownership post-sale better aligns the economic incentives between the seller and acquirer when it comes to improving operations post-acquisition.
-The current President Tom Orysiuk was formerly AutoCanada’s CFO when he joined as the CFO of Liquor Stores Income Fund and based on his track record he understands good capital allocation.

2) Management’s Capital Allocation Track Record:
-Raised ~$200 million in equity financing when shares were near $78 last summer; this represents more than 20% of the entire market capitalization today! At $78 per share, essentially they were diluting the equity at ~32x 2014E earnings, ~26x 2015E earnings, and using the capital to purchase dealerships at 4-6x EBITDA. So issuing equity at a little over a 3% earnings yield to purchase assets at a more than 10% earnings yield. You can call this a “roll-up” if you want but I think it’s a pretty value accretive roll-up.
Furthermore, the company is buying real estate at attractive cap rates at 10% or greater; in fact I believe the 11 real estate related-party transactions that the company bought from CAG late in 2013 were purchased at close to a 10% cap rate. I would have much rather preferred it if management funded these purchases primarily with non-recourse debt. They could have funded these purchases primarily low cost mortgages at 4-5%, so essentially getting a high ROE with very low cost financing.
Some observers have pointed to CAG’s stake being continually diluted down over time via secondary offerings as a concern. For example, at the time of the large $200 million equity issuance last summer CAG exercised its over-allotment option and diluted its stake down to ~9.5% in AutoCanada today. I think we have to put the dilution and over-allotment in context. The stock price was basically trading at 32x earnings, not exactly a low multiple even for a high-growth company such as this one. If I were the largest shareholders I probably wouldn’t mind taking a bit of money off the table given the atmospheric rise of the stock price since the 2009 lows and especially given that the shares were likely overvalued. In retrospect, most of the cash raised at that high share price has been used to acquire additional dealerships at low multiples, so I believe it was a deal in the best interest for all shareholders. I think about it this way in terms of value creation: we’re basically getting a smaller piece of a much larger pie. One thing I should point out is that the over-allotment generated around $203 million in additional gross proceeds for the CAG shareholders. So the only thing that gives me pause or slightly concerns me is that I didn’t see any insider buying by Mr. Priestner when the stock tanked to the low 30’s. I don’t think this is a deal breaker to my thesis, but certainly a bit of a question mark.
-based on their past history, I haven’t seen them dilute the equity at a forward P/E multiple of less than 15x; remember, Mr. Priestner still has a large personal economic stake in the company
– They have a good, stable independent board with decent share ownership that has to approve related-party transactions
-I believe acquisitions remain the highest return on capital option and the best use of free cash flow

3) Alignment of Incentives:
AutoCanada’s management team have a terrific track record in acquiring well-run dealerships (at attractive 4-6x EBITDA multiples and no turnaround plays) at good locations and ramping up newly acquired mom-and-pop dealerships to their full potential after 2 years. 70% of AutoCanada’s “at-risk” dealerships were acquired in 2014, leaving lots of room for improving scale and operational efficiency. As mentioned they are starting to diversify their OEM brand mix and are definitely aware of the concentration of dealerships in Alberta
-President says they are buying dealerships at 5-6x pre-tax income; if they purchased the 2 BMW/Mini dealerships in Quebec within this valuation range it would be well below the range luxury brand dealerships typically sell for (closer to 6-7x EBITDA). They have a track record of improving operations from acquired mom and pop dealerships, leveraging best-in-class IT practices such as CRM, sharing inventory within a close proximity network etc.
-Based on the chairman’s industry contacts developed over 30 years in the business he has somehow managed to convince Chrysler to lift dealership number restriction rules and GM Canada to lift its public restriction
For 2014 the annual incentive plan was 40% weighted to adjusted free cash flow per share, 30% weighted to adjusted gross profit, and 30% was discretionary. In the prior year instead of adjusted gross profit the performance metric was adjusted return on capital. It’s not a deal breaker to me that they changed this metric but I will be seeing if they eventually put ROC back into their annual incentive package which properly measures an acquisitive company’s performance. They typically track this metric in their filings. Executive annual compensation remain a small % of the value of their holdings in the company.
In summary, I believe the AutoCanada’s management team are among the best auto retail operators in Canada. They have a long successful operating track record, and are allocating capital well. My only remaining concern is the absence of large insider share purchases at these current trading levels.

Valuation:
This is a retailer and it’s all about the same store metrics…
Since this is such an acquisitive company that closes deals almost every quarter it’s very difficult to project growth even on a run-rate basis, but I have basically modelled same-store metrics and applied them to the total number of company-owned dealerships on a forward basis. It’s a bit complicated but I believe it is a good, conservative rough estimation of intrinsic value.

Quick summary of Key Business Drivers:
Bear Case Scenario: I have modelled the key drivers for an overly pessimistic, unrealistic “bear case” scenario. I also sensitize the bear case intrinsic value with a “no acquisition” scenario that assigns 0 value to the incremental FCF that will be generated (basically assuming the cash just accumulates on the balance sheet) and an acquisition scenario with 6-8 deals (still below management’s annual guidance of 8-10 deals per year) closed in 2015. For all my key driver assumptions please see the appendix.

P&S Segment:
Based on my conversations with some of AutoCanada’s dealers, I believe ~50% of gross profits from P&S should flow through SG&A; (eg. if P&S gross profits grow by 5%, EBIT should grow by ~7.5%). I assume same-store P&S gross profits grows at low-to-mid single digits which I believe will prove very conservative.

New Vehicles Segment:
Fleet vs Retail Sales:
-Fleet is more cyclical, due to activities of major companies and being concentrated in Alberta which is a more cyclically exposed province due to oil industry exposure -> lower gross margins due to bulk wholesale pricing
-Fleet should decline more than retail sales; I assume company-wide new vehicle gross profits decline by high-single digits, driven largely by new fleet (largest decline) and retail sales (more muted) in Alberta, and even a single-digit decline in rest the rest of the country
Retail sales – on average, light trucks have higher ASPs (higher gross margins) vs passengers which are lower ASPs (lower gross margins); I assume a slight decline in average selling prices (ASPs) as consumers trade down to lower-priced cars even though the most recent data is showing that light trucks sales are growing faster than passenger vehicles

Used Vehicles Segment:
Management expects used vehicle ASPs and gross margins to continue to be pressured in the future. I assume a decline in same-store used vehicle sales, but more muted than new vehicle sales since consumers typically trade-down to used vehicles in downturns

Finance & Insurance Segment:
-Tied to new and used vehicle sales and their ASPs and to health of the credit markets
-I model a SSS decline in-line with same-store new vehicle sales; again this should prove very conservative since vehicle leasing and financing has been growing steadily due to the growing availability of credit

SG&A: I model this at 79.5% of gross profits, a nearly 200 bps increase from 2014E levels. I believe this is an extremely conservative assumption especially after the fact that the company purchased the real estate of 11 of its dealerships that it used to lease in late 2013; this should decrease their lease expense ~$10 million on an annual run-rate basis. Also they now have 48 dealerships which is ~50% more than in 2013 year end. Some cost savings and synergies on these additional dealerships acquired should be easily realized.

Capital Allocation and use of FCF:
I’ve layered in 6-8 acquisitions to my valuation with the deal assumptions shown below which conservatively leads to a few dollars of incremental value per share. I also have a scenario where the company closes no deals which is essentially assuming that the ~$65 million in incremental FCF that will be generated in 15’ piles on the balance sheet (highly unlikely for a management team that have consistently allocated capital at a high rate of return).

acquistions

Bear Case Summary and why this scenario is overly pessimistic:
Aside from the points I’ve already made in my thesis:

-We still have to take into account the typical 2-year ramp-up period and larger size of the most recent acquisitions outside of Alberta over the past year. Last year alone the company acquired/opened 16-17 dealerships which should boost FCF dramatically
-I arrive at a consolidated negative gross profit growth of 8.7%; just to put this figure in perspective it is a greater decline than in 2009 where same-store gross profits fell by less than 8%
-Most of the publicly-traded US auto dealer groups have been recently reporting high to single-low digit SSS growth in their P&S segments, which is supporting the young vehicle age growth thesis in North America
-Only a few good acquisitions are needed to fully offset any temporary weakness in organic growth, and the company certainly has the balance sheet to execute. Based on management’s track record this is almost a near certainty. I view further acquisitions as rather low risk since they are small in size, will have low valuations, and are not dependent on synergies for accretion

Unrealistic Worst Case Summary: Still upside in an Armageddon-like scenario

bear case

A Quick and Dirty way to sanity check my bear case valuation:
I took my bear case projected adjusted EBITDA figure and divided it the number of dealerships to get the average EBITDA per dealership. By this measure, the implied average EBITDA per dealership is ~$2 million. I simply believe this figure is far too low. If we look at the average deal size over the past 25 or so acquisitions that company has completed, and assume a 5x-6x purchase multiple range (mid-to-upper point range of management’s guidance) for these acquisitions, it implies that the most recently acquired dealerships should be generating on average at least $2.5 – $3 million in EBITDA. Also, remember that these dealerships haven’t fully gone through the 2-year ramp-up period, where better operational efficiency, and cost and revenue synergies can be easily realized. Therefore, I believe my bear case sanity check supports the case that this scenario is overly conservative.

bear case sanity

Base Case Valuation Summary:
$61-$65 target price by 2015 year end

base case

I believe AutoCanada should trade at a slight premium (1 – 2 turns) to Asbury Automotive Group, AutoNation and the other US publicly-traded auto dealership groups (which are arguably undervalued as a whole sector). These comparable companies are trading at around 15x-16x forward P/E multiples, and 10x-11x forward EBITDA multiples and should have lower growth prospects. On an absolute basis an 8% FCF yield is quite attractive for this business. Another way to look at the current valuation is that we’re essentially getting a lot of future growth for free.

valuation

The Bull Case is straight forward: I think this business could potentially be worth $100+ per share 3 years from now. This implies a valuation of 29x – 30x 2015 free cash flow per share of $3.30 – $3.45. The key drivers here are an acceleration in accretive deals as the business scales and P&S gross profits continue to grow at high single-digit rates. I don’t believe this scenario is too far out of reach.

Valuation and Target Return Profile:

irr

Why does this opportunity exist and what’s my edge?

1) The stock doesn’t screen well on an EV/EBITDA metric and appears over-leveraged given the large floorplan financing. EV/EBITDA should be adjusted for floorplan financing, which I treat not as debt but a use of working capital. AutoCanada’s floorplan financing has consistently been below inventory levels, indicating that the dealerships are turning over inventory efficiently within the 45-60 day interest-free period and that there is actually excess cash hidden in the floorplan.

2) This is very acquisitive company so the GAAP accounting is very messy. Obviously, the company has been making a lot of acquisitions, which obscure the true profitability of the business. Projecting forward earnings has to take into account both organic and inorganic growth which isn’t a simple task. The company also doesn’t break out the same-store figures from the growth from acquisitions.

3) Panic selling caused by retail investors and a short-term market overreaction to oil’s crash and its implications to AutoCanada’s intrinsic value

4) Small-capitalization company so more under the radar

What can go wrong?

-Similar to my DirecTV idea, I really don’t see anything that can “torpedo” my thesis. Even if we were to assume that Canada enters into a very deep recession, acquisition targets should remain plentiful and could likely increase due to owners worried about the cycle turning, and as mentioned AutoCanada’s cost structure is very variable. The only scenario I see that can cause permanent impairment of value at this price is management destroying shareholder value. Given the arguments I made above, I believe this is an unrealistic scenario.

-Oil continues to crash, causing further employment losses in Alberta; although I have argued that this is already largely priced in

-Interest rates spike up substantially. This is very unlikely. In fact the Bank of Canada just recently cut interest rates

-Auto credit bubble, Canadian housing bubble, record Canadian household debt-to-income levels all happening simultaneously stymieing demand for vehicles

Event Path and Catalysts:
These things are not important to my thesis since I believe that the shares are trading at such a discount to intrinsic value that 1 year from now I expect the stock to be trading much higher. I would also like to hold this business for the longer-term as long as it remains reasonably valued and provides a high IRR given the long runway for high-quality growth. Also as highlighted above, I think it’s a pretty good retail business that I would be happy to own longer-term.
1) WTI begins to sharply recover, and ACQ follows suit.

2) Announcement of large accretive deals; the company definitely has the balance sheet to execute.

3) This is a great example of how prices are much more volatile than underlying business values; prices can overshoot to the upside and to the downside; the core growth thesis remains intact and once the markets starts shaking off the oil plunge fears this stock can take off very quickly again and re-rate to a 20x multiple to properly reflect the growth prospects. This is a very likely scenario since this is a high-growth dividend-paying stock that should attract a lot of interest again especially as Bay Street will continue promote the stock. 

4) Monthly industry data continue to point to strong performance and less muted effect of lower oil on vehicle sales in Alberta.

5) Fiscal year 2014 year end results will be reported in March which will show strong inorganic and acquisitive-driven growth.

Summary:
1) This is a high-quality compounder with plenty of growth that has temporarily fallen out of favour – a classic “value investment”.

2) We have a fantastic management team focussed on driving shareholder value, are well aligned with shareholders, and are experienced in the industry with a suburb operational and capital allocation track record.

3) The bear case has no legs, and even if it does, there is virtually little to no downside at current trading levels. In fact there is plenty of upside since we are getting such a bargain price as until the market comes to its senses. I believe this situation exemplifies Monish Pabrai’s famous quote: Heads I win; tails I don’t lose much.

 

“In the short term the market is a voting machine, in the long-run it is a weighing machine” – Benjamin Graham
“Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1.” – Warren Buffett

 

 

Appendix:
1) Modelling Assumptions: Bear case and Base Case

modelling

Base Case: Average Dealership Financial Estimates:

sssss

Base Case same-store estimates (assuming no acquisitions):

ssssssssss

Base Case Unlevered FCF reconciliation:

reconcilation

Adjusting TEV by hidden excess cash in floorplan

Adjusting TEV by hidden excess cash in floorplan

14 Comments

    1. If you understand the moat and growth profile then you would most likely be coming up with a valuation range that shows that its very undervalued. Of course this is more of an art than science. I don’t think I’ve seen such a compelling opportunity in a very long while.

      Reply

      1. Richard thanks for this website. Great wrtieup on AutoCanada. Would you be willing to share your thesis on IBKR? Thanks and please keep up the good work. Thanks.

  1. I really want to like this idea because I love investing behind great capital allocators. I also think you have done great work on sizing up the opportunity from here. However, I have trouble with the related party transactions that you mention and potentially with the CEO incentive alignment argument given his net worth outside of ACQ CN.

    I have summarized the situation below as I see it. Would be curious to hear how you get comfort on the incentives?

    .• Canada One Auto Group owns 2.365M shares x $44 = $104M of value
    o CEO owns 87% of CAG = $90M of value in ACQ CN shares
    • Canada One also owns 3 dealerships let’s assume $3M of EBITDA each = $9M X 6 = $54M of value
    o CEO stake in dealerships worth $47M
    • CAG sold several GM dealerships to ACQ CN and retained 15% ownership
    o Any sense for how much cash CAG received?
    o Any sense for valuation?
    o How do you get comfort that the price was “good” for shareholders?
    • ACQ CN did a secondary at $78 in June 2014
    o Sold 2.564M primary shares raising $200M of cash
    o Sold 2.6M secondary shares including the shoe = $202M of cash (CAG shares)
    • Secondary reduced CAG holdings by >50%
    o CEO owns 87% of CAG so he pocketed $175M of cash (!!!)
    o I like the timing of the secondary to raise capital for deals but seeing the CEO sell his own stock to common shareholders just like me at $78 is concerning a bit (is this how he will always treat shareholders?)
    • Further, ACQ CN is buying real estate in related party transactions at 10% cap rates (11 transactions)
    o I assume this is the CEO selling real estate to the company?
    o Any sense for how much cash he pocketed in these sales?
    o How do you get comfort that the price was “good” for shareholders?
    • In summary, the CEO owns:
    o $90M of ACQ CN equity
    o $175M of cash from secondary
    o $47M in value of 3 dealerships
    o Cash he received for selling 85% of several dealerships to ACQ CN (I don’t know this amount)
    o Cash he received for selling real estate to ACQ CN (I don’t know this amount)
    o 15% of several dealerships that he sold to ACQ CN
    o This guys has at least $312M of assets and maybe likely $350M+ so ACQ CN is ~25% of his net worth maybe and he has more money outside of ACQ CN than he could even need?

    Reply

  2. Great write-up. I like the name and the industry. Their track record in building and growing the business is hard to argue with.

    However, I think one of the most important puzzle to figure out here is the related party exposure. The National Post ran a story on ACQ, not sure if you have had a chance to read it through but it is a good piece on the potential dangers. I know you have addressed some of these issues, but worthwhile to dig in deeper.

    http://www.theglobeandmail.com/globe-investor/investment-ideas/autocanada-real-estate-deal-raises-red-flags/article22644648/

    Reply

  3. Thank you for both your comments, Bin and Reddog. I want to correct a minor error in my write-up – CAG actually has 3 Toyota dealerships, not 1, so in total CAG currently owns at least 6 dealerships.

    Although it’s true that Mr. Priestner has a lot of cash on the sidelines, I don’t view that fact as a deal breaker to my thesis.

    1) Regarding their decision to cash out some of their shares at the top, I don’t blame them, and although I would have preferred it if they retained a larger stake in the company, selling overvalued shares shouldn’t been viewed as a negative … Yes, I know some company executives are extremely long-term oriented and would never part with their shares, but an opportunistic move with respect to their own private stake shouldn’t send a signal that they don’t care about shareholder value. The market overall is largely a zero sum game, and should transfer excess returns from the the smart money to the dumb money over the longer-term.

    2) Regarding the real estate transaction, the way I arrived at around a 10%+ cap-rate is based on the information they released in filings. If you do the math, the company paid a price that equated to their lease payment being ~15% of the transaction price. If you factor in operating expenses the transaction should be valued at about a 10% cap rate. Dealership real estate values are typically going for a 8-10% cap rate, which makes the transaction more or less in-line with the market. Also keep in mind that an independent board must approve every related-party transaction, and yes, they also have a sizable equity stake in the company. Finally, the second largest shareholders of ACQ recently acquired a position, and in my view they are the top fund in my country (I’ve personally met both the founders), and are likely keeping a watchful eye on the corporate governance. I would be much more worried if this was not the case.

    3) Also this is not a management team that are reliant on just their annual compensation to build wealth. They are owner-operators. If you look at their total compensation over the past several years it’s quite small relative to their total equity holdings. They’re also compensated on appropriate metrics, and although this can be further improved upon, it’s clear that they are focused on growing free cash flow per share over the long-term. This means that they aren’t chasing growth at any price, and have a clear eye towards return on capital as well.

    And finally, just look at their track record. They’ve undoubtedly created a lot of value for shareholders over the years. This is an extremely well managed company, and without Priestner’s industry connections, I don’t believe they would have been able to convince some of the OEMs like GM to accept the public ownership, or FCA to lift its dealership restriction. Priestner recently left his active CEO role and became the chairman. I believe this should also alleviate some of the concerns regarding where his focus is WRT operating multiple companies, and tells me that he will focus most of his time now on sourcing deals. The deal pipeline remains strong, and management have recently announced that they’re buying back a bit of stock at these prices. This again shows their opportunistic approach towards capital allocation (a skill largely absent in many corporate managers today). To assume that the incremental FCF that will be generated next year has 0 optionality value would be unrealistic in my view. I believe they are seeking more premium brands in the best locations, and are hoping that the current weakness and uncertainty in Western Canada would serve as additional leverage in their negotiations with nervous dealership owners.

    So although the alignment is not perfect, the positives definitely outweigh the slight negatives. Obviously I would also prefer it if they had 99% of their net worth invested along side shareholders. But up to this point what matters most is the actions they’ve taken to grow shareholder value. This company actually generates one of the highest returns on capital out of ALL of publicly-traded companies in Canada; it’s not a constellation software or a valeant pharma, but it’s a pretty good business. And as noted in my write-up I believe it is likely that incremental returns going forward will continue to improve, notwithstanding a huge turn in the cycle. The thesis remains intact, and despite the huge run-up in the shares over the past few weeks, more upside remains in my view, especially now that the market has shaken a bit of the oil plunge fears off.

    Reply

  4. The company announced they will be buying stock a week or so ago, to me this just looks like a ploy to stop the stock slide, or else why would they buy back stock at much higher multiples than what they can buy dealerships for, does not make sense to me from that perspective…..also Priestner not buying any shares despite big sale at $78 is a bit of a concern…I agree at $32 was overdone , not so much in the high $40s low $50s

    Reply

  5. Hello, thanks for your patience. I am working on the update post right now along with updating everything else I’ve looked at recently. I can tell you that my thesis on AutoCanada hasn’t changed, although I believe the IRR is now lower.

    Reply

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