Markets & Finance

A Good Deal Auto Dealer


S&P likes Group 1 Automotive, owner of car dealerships and service centers, thanks to its mix of popular vehicle brands, and rates the shares strong buy

From Standard & Poor's Equity ResearchGroup 1 Automotive (GPI; $35) owns car dealerships and collision service centers that we expect will generate more than $7 billion in revenues in 2008. Our 5 STARS (strong buy) recommendation is based on several factors including our belief that the company offers a favorable and improving brand mix, that it has opportunities to enhance its margins, and that Group 1 stock has compelling appreciation potential.

We think Group 1's sales mix, composed of 75% import and luxury brands and 25% relatively underperforming domestic brands as of the 2007 second quarter, positions the company to outperform industry new-vehicle retail sales growth. Foreign brands have been steadily gaining market share in recent years, largely at the expense of domestic brands.

We see additional reductions in exposure to domestic brands in coming quarters as Group 1 primarily divests domestic dealerships and acquires those with foreign or luxury brands. The Toyota-owned (TM) brands—Toyota, Lexus, and Scion—account for more than one-third of Group 1's unit volume, while General Motors (GM), Ford (F), and Chrysler brands each represent between 6% and 13% of volume.

In addition to above-industry same-store sales volume growth, we expect the company to expand via acquisitions, mostly in non-U.S.-branded dealerships. We believe Group 1's internal cash flow generation plus its available credit facilities can support growth via acquisitions. However, we expect 2008 purchases to be below the company's yearly target of $500 million in acquired annualized revenues.

We think an expected 2008 slowdown in the pace of acquisitions should help Group 1 integrate past acquisitions and leverage its growing size. The company has been centralizing the organization for purchasing, back-office work, and other activities to improve operating efficiencies, and we expect these actions to benefit 2008 results.

Group 1 has targeted earnings per share growth of 15% over the next three to five years. We believe this objective is achievable and warrants a price-to-earnings multiple above the recent 8.3 times our 2008 EPS estimate of $4.20. By our analysis, industry and Group 1 price-to-earnings multiples should expand in anticipation of industry volume improvements that we expect for 2009 and beyond.

Company Background

Houston's Group 1 owns and operates 99 automotive dealerships, 136 franchises, and 28 collision centers in the U.S., as well as three dealerships, six franchises, and two collision centers in Britain, as of October, 2007. The company's dealerships offer 32 brands of automobiles. It markets and sells a range of automotive products and services, including new and used vehicles and related financing, vehicle maintenance and repair services, replacement parts, and warranty, insurance, and extended service contracts.

The company follows a strategy that focuses on decentralized management, new technology initiatives, and expansion of higher-margin businesses and customer service, and centralization of certain administrative functions.

Group 1 believes that by managing its dealerships on a decentralized basis, it can provide superior customer service and a focused, market-specific responsiveness to sales, service, marketing, and inventory control. It thinks that local presence and an in-depth knowledge of customer needs and preferences are important in generating market share growth. By coordinating operations on a platform basis, the company expects cost savings in areas such as advertising, vendor consolidation, data processing, and personnel utilization.

Group 1 is focusing on expanding its higher-margin businesses such as used vehicle retail sales, parts and service, and arranging vehicle service, finance, and insurance contracts. Although each platform operates independently, there is an integrated companywide strategy designed to promote growth in each of the higher-margin businesses, to enhance profitability and stimulate internal growth.

By consolidating the purchasing power of its dealerships on a centralized basis, the company believes it has benefited from significant cost savings. In addition, Group 1 says it has benefited from the consolidation of administrative functions such as risk management, employee benefits, and employee training.

Over time, Group 1 intends to expand into geographic markets where it does not currently operate, by acquiring large, profitable, and well-established mega-dealers that are leaders in their regional markets.

Company Outlook

We expect revenues to be up about 13% in 2007, with an additional 4% increase in 2008. Group 1's yearly goal is to acquire estimated annualized revenues of $500 million; however, we think that number will likely not be met in 2008, as the company integrates prior acquisitions. We see a challenge for Group 1 to increase comparable-store sales in 2007 and 2008, as we forecast U.S. light vehicle volume of just slightly above 16 million units, down from 2006's 16.56 million.

However, we think the company's sales gains should outpace those of the total market, as a result of the overweighting of import and luxury vehicles in its mix. We believe import and luxury brands will continue gaining market share in the U.S. In addition, the variable cost nature of the business, as well as countercyclical demand for used vehicles, can mitigate reductions in new vehicle volume, in our view.

We estimate 2007 EPS from continuing operations of $3.80, including costs for dispositions. We expect earnings to increase to $4.20 a share in 2008.

We project an effective tax rate of about 36.5% in 2007 and 38% in 2008, although the actual rate will depend on the geographic sales mix. The expected repurchase of up to $60 million of the company's common shares should be modestly accretive to EPS in 2007.

Long-term debt as a percentage of capitalization decreased from 30% in 2003 to 20.7% in 2004, and to 19.4% in 2005. However, after making acquisitions and issuing additional convertible bonds, the ratio rose to 38.1% in 2006. While our financial performance projection indicates a reduction in this ratio, increased acquisition activity or share repurchases could mitigate this trend.

Industry Background

The automotive retailing industry is the largest retail trade sector in the U.S. It generates approximately $1 trillion in annual sales, comprising roughly 10% of gross domestic product. The industry is highly fragmented, and we estimate that the 100 largest automotive retailers generate approximately 17% of industry revenues.

Consolidation is an important trend, as the number of franchised stores in the U.S. has declined in the past 20 years from approximately 24,725 in 1983 to 21,761 at the end of 2006. We think the large capital requirements necessary to operate and be competitive in today's retailing environment make it likely that consolidation will continue.

Valuation

The stock's valuation is at a discount to the peer average based on p/e, price-to-sales, and price-to-free cash flow ratios. We project net margins for Group 1 in the middle of the peer group range. Despite our favorable view of the company's higher mix of better-performing import and luxury brands relative to peers, we believe a peer valuation for Group 1 is warranted due to recent segment weakness. We consider Group 1's financial position to be strong, with long-term debt-to-capital ratios within its peer group range. We project free cash flow per share of $3.06 in 2007 and $3.42 in 2008.

Based on historical and peer price-to-earnings analyses, we think Group 1 shares are substantially undervalued. Applying a peer-average 10.8X multiple to our 2008 EPS estimate of $4.20, we arrive at our 12-month target price of $45, which implies upside potential of approximately 30%.

Corporate Governance

Our view of Group 1's corporate governance is generally favorable. The board of directors is controlled by a supermajority (more than two-thirds) of independent outsiders. In addition, the compensation and executive committees are comprised solely of independent outside directors.

However, an area of concern for us is that the board may amend the bylaws without shareholder approval. Generally, we would rather see shareholder input required for such actions.

Investment Risks

Risks to our recommendation and target price include decreases in multiples for automotive retailers. In addition, demand for import and luxury brand vehicles could be weaker than we expect, and overall industry volume could be lower than we anticipate.


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