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Auto Megadealers: Running Out Of Gas?


Like the smooth-talking salespeople on their showroom floors, the executives at publicly traded car-dealer chains made an enticing pitch to investors: Get a share of our big profits as we grow huge and use our size to lower the cost of selling cars and trucks. Investors responded, pouring billions into dealer groups such as AutoNation Inc. (AN) and United Auto Group Inc. (UAG) so the chains could buy up 1,250 independent dealerships since 1998. The torrid acquisition pace has duly fueled revenue growth of as high as 30% a year.

For much of the past year, investors haven't been disappointed, as they rushed to these stocks like bargain hunters to a 0% financing deal. AutoNation soared 45% in the past year, to $19 a share. United Auto and Asbury Automotive Group (ABG) saw their shares more than double, to $30 and $17 a share, respectively. Group 1 Automotive (GPI), Sonic Automotive (SAH), and Lithia Motors (LAD) each rose at least 50%.

But soon these companies may be forced to trade in their sports-car business models for something less racy. Already, their shares are starting to come down. Their biggest challenge? It's getting tougher to keep growing fast by making big acquisitions. At the same time, they haven't figured out how to perform any better than the mom-and-pop dealerships they bought. Indeed, most have lower net margins than the independents. And many make only a 5% to 6% return on assets, while paying between 6% and 10% on the money they borrowed to buy more dealerships. Says J.P. Morgan Chase & Co. (JPM) analyst Charles Grom: "They aren't creating value. They should slow down, cut costs, and reduce debt."

The one chain that has started to do just that is AutoNation, easily the most mature company of the six. Founded in 1996 by Florida billionaire H. Wayne Huizenga, AutoNation built a huge network with nearly $20 billion in annual revenue. (United Auto is next, with $9 billion in revenue.) Now it's buying far fewer dealerships. Last year it added new outlets with just $300 million in annual revenue, vs. $500 million in 2002. Says AutoNation Chairman and Chief Executive Michael J. (Mike) Jackson: "The low-hanging fruit is pretty much gone."

SLOWING GROWTH

Jackson has AutoNation acting more like an old-line industrial company than a hot-growth retailer. He has been wringing costs out of his dealerships and buying back stock to boost earnings per share. He is now resorting to such prosaic moves as buying mechanics' uniforms in bulk and holding down salaries. The cost-cutting added some $43 million to profits last year. In fact, AutoNation was able to boost its profit to $479 million last year from $382 million in 2002, though its revenue stayed roughly the same. Still, its stock has slipped 13% since September.

Like it or not, the rest of the chains might have to follow AutoNation's lead and slow their headlong expansion. There are still plenty of dealerships lining boulevards across the country, but they're getting expensive, even for chains that haven't been afraid to pay top dollar. And the chains are beholden to the big auto makers, which control the number of dealers nationwide -- roughly 22,000 -- and decide who gets to own them.

The auto makers don't want any one group owning too many dealers in one market because that would allow the chains to set prices and undercut the remaining independents. BMW is holding up Sonic's purchase of several dealers in Houston. Lexus limits dealers to owning six of its outlets nationally, and Honda's top-shelf Acura division caps an acquirer at five. Detroit also has various limits.

As a result, the chains appear to be downshifting their acquisition drive. The six listed chains acquired 95 dealerships in 2003, adding $2.5 billion to their top lines. But that was less than half the $5.2 billion in new revenue from acquisitions in 2002. Sonic bought enough dealerships in 2002 to add $2 billion to its revenue, but it came up with just $600 million in new-dealership revenue last year. It is aiming to add $800 million this year. Sonic President Theodore M. Wright says part of the reason is that the company needs to digest its previous acquisitions.

That would be good news for auto-maker execs, who say better-performing dealerships sell more vehicles and provide better service. Ford Motor Co. (F) vetoed Asbury's bid for a San Diego dealership last year, noting that the chain has lower profit margins and weaker customer-satisfaction ratings than other dealers. Asbury declined to comment. Ford says it is now scrutinizing other dealer-group purchases.

What Ford and other car companies see is that solidly performing independent dealers earn a net margin before taxes of roughly 2.6%, estimates dealer consulting firm NCM Associates Inc., while only AutoNation tops that. The chains save money by reducing advertising costs, consolidating their back-office work, and paying lower interest rates on inventory from the manufacturers. But the savings aren't enough to offset the cost of extra management layers or the regulatory expenses of being a public company.

HIGHLY LEVERAGED

But the biggest drag on margins, dealer-group execs say, is the $3.1 billion in debt the companies have piled up to fund their acquisitions. That's why they prefer to talk about operating earnings -- which don't count interest expenses -- instead of net income. "If you look at it on an operating basis, we're more profitable," says Sonic's Wright. "But we are more leveraged." And the chains pay high rates on this debt. Asbury forked over $40 million in interest payments last year, leaving it with just $15 million in net earnings. United Auto paid $43 million in interest last year and earned $83 million net. The more profitable chains -- AutoNation, Lithia, and Group 1 -- have less debt. But it is little wonder that Standard & Poor's (MHP) rates the bonds of every dealer group as junk, though AutoNation does have an investment-grade corporate line of credit.

Earnings per share also look rosier because of a quite legal and widespread accounting maneuver. Under generally accepted accounting principles, the chains are allowed to report an earnings-per-share figure that doesn't include the losses of poorly performing dealerships if the chains say these outlets are up for sale. Even if the chains still own them, they classify these dealerships as discontinued operations. By excluding such losses, Sonic was able to highlight earnings per share of $2.07 for last year, though it also reported net income of $1.69 per share. Dealer execs say the practice is perfectly acceptable.

As the dealer groups enter midlife, their task is clear: boost earnings by running good operations, not just by snapping up more car lots. The tougher challenge may be persuading investors that their new business models can be just as rewarding as the flashier ones they used to sell. By David Welch in Detroit, with David Henry in New York


Steve Ballmer, Power Forward
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