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Auto Dealers

Auto Dealers -- Sonic Automotive (SAH) used as example
Long – June 2013
Note – this was a bunch of notes from March-May timeframe compiled in June. Stock prices aren’t all that different and
looking at 100-200% type upside from here over 2yrs. The only thing to mention on this latest quarter is you are starting to see
the P&S thesis below play out in the numbers (P&S SSS this last quarter accelerated for every dealer, this can be lumpy with
warranty work but it’s been a multi-quarter trend of consistent acceleration). Also very importantly, AutoNation is starting to
talk about this. They haven’t put real numbers around it yet and sell-side certainly isn’t modeling this upswing, but think
AutoNation will start educating people which should be good for the multiples. You should certainly listen to AN’s call and
you’ll notice the sell-side asking a lot of questions around this on all the other dealers’ calls for the first time.
I think the auto dealers are very attractive longs right now. There is enormous potential for profit growth on deceptively high
quality businesses that are local monopolies with high ROIC, big barriers to entry and generate lots of free cash flow. There is
modest upside on the front-end (car sales) part of the business with increased SAAR, but more importantly I think investors are
overlooking a huge multi-year ramp up coming in the parts and services business which is the real profit engine of a dealership
but not where investors/sell-side concentrate their analysis.
While P&S is only 12-15% of sales, it generates roughly half a dealer's gross profit. P&S is driven by the number of 0-5 year
old cars on the road (so right now depressed levels of SAAR during the downturn). Due to the lag on historical car sales, this
fleet has been steadily declining straight into early ’12. Starting in late ’13/early ’14, this headwind will turn around and
become a powerful source of growth as ’08, ’09 low SAAR years cycle out. Ultimately the 0-5yr fleet normalizes 35% higher
than it is today, a huge growth tailwind to P&S departments that should continue growing 3-5%/year in excess of the fleet.
This dynamic hasn’t been seen since the mid-80s, long before the dealerships went public. In the 1980s the fleet of 5-yr SAAR
grew 22% over the decade, industry-wide P&S grew at an 8.5% CAGR for the entire decade (with even higher same store sales
due to net dealership closures).
Industry wide
0-5y fleet gowth
P&S
1980s
1990s
2000-2007
2007-2012
2012-2020(2)

Public
Dealer's

CAGR(1) P&S SSS
total
CAGR
22.5%
2.3%
8.5%
weren't public yet
7.7%
0.8%
4.3%
weren't public yet
3.7%
0.5%
1.7%
3.8%
(25.3%) (3.2%) (0.3%)
0.5%
33.5%

3.7%

[?]

(1) Industry-wide P&S growth understates the SSS the public dealers due to ongoing net closures of subscale mom&pop dealers and ongoing
market share from scale dealers including the publics.
(2) back to normalized levels, SAAR ~17m based on 3 trilliion miles driven, car consumption, no catch up demand.

With big growth in the dealers core P&S profit engine, incremental EBIT/GP around 50% (vs. 20-30% starting point), and
redeployment of a ~10% FCF yield into accretive acquisitions and buybacks, earnings per share should grow 20-30% for the
next few years and in the mid-teens for many years thereafter. There is great visibility to this growth given P&S’ lag to SAAR
(i.e. analyzing history instead of the future), yet these stocks seem cheap at ~11-12x. I think SAH’s EPS can be 70% above
consensus FY15 estimates and multiples should expand as investors start to pay attention to what is happening in parts and
services and price in a growth trajectory that should last through the end of the decade well after SAAR stops growing.
I use SAH as an illustrative example whenever we’re talking specifics because it’s a very simple business. I think the best
places to play are SAH, ABG and GPI, for reasons discussed below.
There is a lot I want to include here, but want to keep it manageable. So Section 1 is a three page summary of the opportunity.
Since I have it already, I’m sharing a lot more detail in Appendices with charts/graphs that I think are useful. A lot of the charts
and tables don’t paste in VIC, best way to see it is here: [ [[ ]]]]. It’s jamming thoughts collected over a few months together,
so apologies if there is some repetition.
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5)
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Section 1 – Summary
Appendix 1– Overview of the business
Appendix 2 – P&S and the 5yr fleet historically – the key thing to understand
Appendix 3 – What’s normal SAAR?
Appendix 4 – Comparison of the dealers
Appendix 5 – CFPB – the key risk
Appendix 6 – Cyclical upside in dealers vs. OEs?

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Auto Dealers

SECTION 1 - SUMMARY
Easiest way to break down SAH is into 3 key levers – P&S growth, use of cash, multiples:
1. Parts & Service (P&S) upside -- consensus is missing a huge upswing coming in parts & service (P&S). Only young (05yr) cars are brought back to the dealer for service, so P&S is really driven by the service base - how many cars were sold
in the last 5 yrs (0-5yr fleet). P&S departments then consistently grow sales 3-5% in excess of fleet growth due to a
number of factors – increasing retention of service stream, more expensive repairs on more complex cars.
a. P&S generates half the gross profit of a dealership and incremental P&S gross profit falls through SG&A at ~5060% incremental EBIT/GP margins vs. existing 20% EBIT / GP margin (look at margins EBIT / GP b/c reselling
cars is a lot of pass-thru cost into revenue).
b. P&S is driven by three things:
i. How many 0-5yr cars are there to serve? - fleet
ii. How much of that service stream can the dealer capture (vs. losing to independent garages) - retention
iii. The amount of service per car – increases on price & increasing car complexity/ more components to
break, offset by better quality cars that lower rate of problems per car
c. Fleet (35% cyclical upside) -- Right now trailing 5yr SAAR consists of cars sold 2008-2012, the worst 5 year
period since 1979-1983, when the US had lots of problems and a population of ~220m
i. This 0-5yr fleet dynamic means P&S revenue lags SAAR
1. The decline is this fleet has been a big headwind for dealers, and was still a negative impact in
’12 even though SAAR had already been recovering off the bottom for 4 years.
a. Hist. 0-5yr fleet growth - 2008: (4%), 2009: (8%), 2010: (8%), 2011: (6%), 2012: (3%)
2. But late in 2013 it starts to turn positive as it begins rolling late 2008 SAAR and rolling on
current levels. It then becomes a huge tailwind in ’14 and beyond through the end of the
decade.
a. Forward 0-5yr fleet growth – 2013: +3%, 2014: +8%, 2015: +7%, 2016: +5%, then
+3% for multiple years.
3. In total 5yr SAAR fleet bottomed at 64m at end of ’12, it starts growing for the first time in the
back half ’13, and ultimately grows 35% to regain the 85m levels at normal SAAR
ii. This P&S lagging SAAR dynamic basically means today you can buy the dealers off the nadir of the
biggest SAAR downturn in 50 years, and with total visibility on the recovery. Buying in at 12m SAAR
going to 17m SAAR instead of buying OEMs at 15.5m SAAR going to 17m SAAR, and you’re getting
more operating leverage in the dealer model than the OEs.
d. Retention (ongoing secular shift) – On top of the growing 0-5yr fleet, dealers are increasing the % of that fleet’s
service stream they are capturing.
i. Dealers made a big push in downturn to keep customers in the service bay, everything from better CRM,
proactively contacting customers, offering new services (oil, tires, collision). These initiatives have
made big headway and should continue improving retention.
ii. There is a relatively recent trend towards OEM-included maintenance (standard on BMW, Volvo,
Toyotacare introduced 2yrs ago, GM just expanding its included maintenance program). This makes life
easy for dealers. Since the service/repairs are free to consumers at the dealer, the dealer retains 100% of
the service stream. Meanwhile OEMs pay dealer full rate by law in the vast majority of states, so this is
full profit work. Where OEMs don’t include free maintenance with the car, consumers are increasingly
buying 100% maintenance/repair plans with the car purchase (in this case a 3 rd party insurance co pays
the dealer for service instead of the OEM, again full rate).
iii. Increasing complexity of cars (particularly all the proprietary onboard computer systems), require
expensive OEM-specific tools and diagnostics, which is freezing the independent mechanics out of the
repair market on the newer models. I think a few years from now this could add a few percentage points
to P&S growth for a long time as this extends the period in which cars get serviced at the dealer.
iv. All of this is fully supported by the OEMs. They want service done at the dealer, which leads to higher
customer satisfaction and less brand churn at car replacement, higher residual values, more opportunity
to sell OE parts, etc. etc.
e. High incremental margins –
i. With the auto dealers focus on EBIT over Gross Profit margins instead of EBIT over sales margins (with
dealers reselling $30k cars, most of revenue is just buy/resell pass through, the starting point is really
gross profit).
1. I expect P&S gross profit moves in tandem with P&S sales, in other words P&S gross margins
will be flattish – COGS is almost entirely labor hours and cost of parts, so you won’t get any
gross margin leverage.
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Other – there are a few other possibilities that could create upside. All in all.5x your company average. Followed by another 3-4 years of ~15-20% EPS growth as growth in the 5yr fleet slows to ~3% and the new car market flattens out o This is very different than consensus expectations for ~10% EPS growth. I think they deserve at least a market multiple as investors start to understand the coming growth – If we’re in 2014 looking forward there is still a lot of growth ahead – on what I think are conservative assumptions (no growth on the front end. which I think is sustainable for a long period even once we’re past the peak in P&S ramp up. 2. it hits 50% of your gross profit and drops through EBIT with incremental margins 2-3. or ~30% of the market cap b. They make the most money on these younger cars. that’s a double for the stock in the next 18mo. What upside does this sketch out? I can’t share projections. MSD-HSD growth in P&S and use of cash). Credible bull case for SAAR (see appendix 3) – would be upside on front & back end b.  The front-end car sales side of the business drives 50% of gross profit. with incrementals on P&S higher than incrementals on the front end (more SG&A/commissions tied to a new car sale than to incremental service gross profit). when P&S grows. but just assume 50% in the analysis to be safe. so they had to grow P&S despite a stagnant fleet. Most of the buy-side doesn’t factor in a use of cash since its not clear how it will be used (except for AN which will buyback shares). certified pre-owneds etc. and lower 35% incrementals. that drives another ~5% EPS growth  All in all I think that leads to a few years of 25-30% EPS growth ahead while the P&S growth is highest. 4. used should grow more than new but if we just assume a ~7% growth in transactions (in line with SAAR). P&S generates over 50% of Sonic’s gross profit. Incremental EBIT / GP margins are ~40-50% in the dealer business as a whole. 5-yr fleet was flattish/shrinking slightly. Right now dealers can’t get enough high quality cars (very few 3yr leases entered in ’09). From discussions with dealers I think P&S has 60-70% incrementals. but I’m not personally convicted enough in either to underwrite them a. 3. a. EBIT is ~20% of total gross profit and 50% of incremental gross profit falls through to EBIT (dealers talk about 40-50% incrementals company wide. earn 20c for every $1 of gross profit generated). Consensus estimates are too low partly because they don’t utilize the cash. ~60-70% on P&S due to lower commissions. Stocks trade ~11x forward earnings right now. Not really a comparable situation for today. a market multiple of ~15x. at a 15x market multiple. v. Dealers are excited about this. P&S opportunity is not being followed closely. a. Sell-side just looks at historical multiples – for all of 2000s when these guys were public. These businesses generate a ton of cash which is put into high return investments -.  ~10% cash flow yield directed to buybacks/acquisitions provides another 10% EPS growth. car fleet was growing at about half the rate it grows going forward and the stocks that were public got 15-20x multiples. vs.g. but I just use 50% for P&S for now). I’m a bit more skeptical they’ll just compete it away somewhere between trade-in values offered and prices given to buyers. iv. o But I think it’s reasonable to expect multiple expansion as this P&S growth trajectory is better understood. If SAH maintains today’s 11x forward multiple. the stock is up 170%. Used car economics could get much better as used car supply loosens up. the stock would be up 130%. SAH’s starting EBIT over GP margin is 20% (e. despite being only 16% of sales. Turning on buybacks increases ’15 EPS 20%. or what the market seems to believe with these stocks trading 11-13x vs a 15x market multiple. so 1% P&S growth generates 1-2% EBIT growth on the whole business. For instance MS projects SAH building up $350m of cash over the next 4 yrs.  I think SAH could earn over $4 in FY15 (70% above consensus). and investors were constantly expecting SAAR to fall off. Use of cash.Auto Dealers ii. and its never happened before 07/30/13 6:55 PM Page 3 of 26 . or buy back shares. so will just sketch out Sonic’s sensitivities to these drivers:  P&S is 50% SAH’s gross profit. At 13x. more if you assume acquisitions instead. Multiple expansion. I think this is ~35% on front end due to high salesperson commissions. Why the opportunity exists: 1. trading at 7x multiples. iii.acquire at 4-5x EBITDA vs. you’re already in excess of 20% EPS growth. In late 90s.  This means ~10% P&S growth alone drives 10-15% EBIT growth for all of SAH. buy out underlying real estate at a 20-25% ROE.

They keep looking back and saying this space traded 10-12x in the 2000s. All the dealers are small caps. Interest rates. This is a crucial piece of profit for dealers and something that deserves a lot of attention. with the expectation other lenders will transition to the CFPB-blessed model. 2. 2. b. So 10-12x was a peak multiple reflecting the constant expectation of a fall off. Going forward. 3. I feel pretty comfortable there is limited risk to dealers’ profit due to the way CFPB implements changes. and this is certainly helping housing and autos right now.4m SAAR in 1999. Questions typically focus on front-end of the business. lobbyists etc. So lenders I’ve spoken to expect the flat fees will have to offer as good or better economics to the dealers. If rising interest rates offer less F&I profit per car. then SAAR bounced around between 16-18 for the following decade. but respond that they’ve never seen growth that high in P&S. In the late 90s the 0-5yr fleet was still growing and the dealers traded at 15-20x EPS (and ‘90s growth only a fraction of the growth it will see going forward). they all kinda agree what this should mean for P&S. well before these companies were rolled up and taken public in the late 90s/early 00s b. This situation deserves a different valuation. the P&S department was servicing a full fleet of 85m 05yr old cars which was more likely to fall than grow. you should expect that trend to reverse.Auto Dealers See Appendix 2 in back – the 0-5yr fleet hasn’t grown since the 1990s. CFPB watchers. c. Gross margin per car is a better starting point for revenue when you look at this industry. When you lay out the math. a.always a random smattering of retail / industrial folks taking a peek. a. Mgmt teams are also skeptical to commit to this growth. After talking to a lot of dealers. Could certainly squeeze out some F&I ancillary products.dealer interest rate markups will be changed to flat origination fees instead. But dealers still choose financing options based on where they make money. Its very different now in the first year of a huge cyclical P&S upswing that will last 8 years given the lag to SAAR. On the sell-side its mostly covered by auto analysts and is a sideshow to the OEMs & Tier 1s where all the market cap is. not financing. which is more relevant for their coverage universe. CFPB & auto finance. lenders will still compete for dealer referrals. but it does seem clear today’s SAAR levels are too low to replace car consumption unless US miles driven goes significantly lower 07/30/13 6:55 PM Page 4 of 26 . would need to see it before they commit to investors. SAAR is always a macro risk here. Sell-side targets pegged to historical multiples. CFPB is changing the way auto lenders compensate auto dealers for origination -. Very low margins – % margins on sales are very low. so doesn’t pop up on the radar a. when P&S grew at an 8. This change will be forced on the 4 biggest auto lenders first. Stocks screen weirdly. not auto manufacturing/supply. 4. lenders. . Rising rates make cars more expensive. Biggest is AutoNation at a whopping $5B. in joint meetings I hear a lot of intro type questions. maintaining a flat 0-5yr fleet. Leverage looks enormous due to floorplan financing b.5% CAGR for a decade! see Appendix 2). But have noticed more familiar hedge fund faces recently. or else the four first-movers will lose all their market share quickly. Biggest risks: 1. The good news – cars are consumed so they need to be bought. The dealers don’t really fit in any sector. but in reality these transactions have so many different facets its squeezing a balloon – as interest rates have fallen. Of course back then SAAR was flat and always expected to fall. so coverage/investor focus is weak – not retail. only half of which is free float. 3. presumably where their investment bankers did some deal way back when. with the profit driver of your business standing to benefit from a 35% cyclical recovery in the fleet on incremental margins 2. a. You need to look back to the mid-1980s to see the last period of such strong growth in this young fleet. I don’t see go-to-zero type risk like you could in existing home sales. Most bulge bracket firms only cover a random few of the dealer names. It’s a pretty unique business that sits on the fringe of any coverage universe.5x the group average. we’ve seen profit shift from the car margin to F&I b/c dealers can get more aggressive on the upfront car price when they know they’ve got a big bucket of F&I profit attached to it. Big durable good purchases benefit from low interest rates. Doesn’t fit buyside coverage either -. Free cash flow looks funky due to swings in inventory (funded by floorplan. We first hit 17. but kinda irrelevant when you’re reselling $30k cars. (they’ve never seen it because growth of this magnitude hasn’t happened since the 1980s. using this fee instead of markup – see Appendix 5 for more discussion. but not visibile in CFO-capex) c.

Dealer chains are earning special incentives to reward their investment in the dealerships and customer experience Deceptively good returns – adjusting out floorplan-financed inventory.3% GP  Car dealers earn a $$ profit per car on sales. that’s probably ~$1. Some customers may drive 50 miles to save a few hundred bucks on a new car. it’s all managed to a total $ per transaction metric) 07/30/13 6:55 PM Page 5 of 26 . there is an advantage to having a number of dealers near eachother as you can hook used cars into the same inventory system and sell much more off the lot (instead of wholesaling at zero profit) with significantly improved inventory turns. all new car sales (including fleet) have to go through the dealer network by law.5k for a luxury car. they are willing to be more aggressive on price. New Car Sales . ~$3. larger dealers. ROICs are in the high teens to 20% range Ample high return investment opportunities in acquisitions. Competitive market is shrinking (# of dealers down 20% in 5 years.1k per car. for SAH this is ~$2. after years of OEM fear of the public dealers (don’t want customer concentration). but vast majority of dealers are mom & pops with lower margins who often under-invest in their businesses and generally have a tougher time.  The public players combined only make up ~10% of the market. OEMs focused on improving dealer health. These per car margins are lower than historical norms (b/c F&I profit growing see later – if dealers know they can make more $$ on F&I when a car closes. floorplan interest etc). they now appear to be embracing and promoting them.Auto Dealers APPENDIX 1: BUSINESS OVERVIEW General overview Auto Dealer attractiveness  Franchise agreements with exclusive geographic areas create mini-monopolies or mini-oligopolies in densely populated areas. but generally similar across industry) Front-End Note: while front-end is contributing ~50% of gross profit. management systems. with better facilities and customer satisfaction . which is where the real value of a dealer lies. advertising. o Despite SAAR being only 12. new car sales per dealership were already higher than the’07 peak due to all the mom & pop closures (which are not coming back)     Scale advantages for public chains – purchasing. These attributes are largely found at the larger public market dealer groups.5k for a midline import. drive cost and efficiency advantages for the chains versus mom & pops. but they won’t drive 50 miles to get their car serviced. it’s EBIT contribution is substantially lower as the majority of SG&A can be attributed to front-end sales (new & used sales commissions. 21. down 33% over 30 yrs). which means revenue increases for dealers that are left standing that pick up the free P&S revenue and takeover the share of new/used sales. real estate and stock buybacks Segment overview / Business Model (using SAH’s splits as guidepost. Want fewer. There are a few private groups that operate at scale as well. advertising etc. In particular.53% of sales. CRM systems. And dealers aren’t incented to compete irrationally on new car sales outside their natural area since it won’t lead to recurring profit on the backend  No internet disintermediation threat.8m in 2011.

increasing volumes of certified pre-owned vehicles are leading to greater service retention (discussed later) and earning greater per car profit for franchised dealers than are possible through non-dealer channels. o Other – wholesale OEM part distribution. Gross margins are typically ~50-55% (half is service at ~70-80% margin. this is 0% revenue.)  F&I is realized on a lag. is the remaining ~5% of gross profit. 50. And new cars are delivered with interest credits worth 45-60 days that make them close to interest-free.4% sales. a Mercedes dealer bills $100120/hr for labor. 16. About 40% of F&I is financing spreads & flat fees paid to arrange the loan. which advantages scale networks (better inventory turns on larger breadth of inventory/customer pull). is ~85% of gross profit. I’m skeptical. about the same on loan or lease.  Quick turnover is crucial for used cars.  F&I has high SG&A dropthrough as the finance department gets less sales commissions than the car sales department. Arguably the inventory risk on new cars really lies with OEMs (as demonstrated in the downturn) who need the dealers to keep buying cars and will fund incentives if needed to get the dealer inventory off of lots so dealers will keep accepting new cars. 07/30/13 6:55 PM Page 6 of 26 . but provides a long tail of high retention service revenue (OEMs/issuing warranty company retains the liability to pay dealers as the service is performed. as service tech are essentially paid based on the work they perform (e. most states have laws specifying this service is done at full market rate. 12. the dealership is trying to manage for $x of profit in a transaction to make it worth their time. I’m not sure they have the discipline to make more money on this (certified pre-owned maybe being the one exception as that freezes out the rest of the used car market since CPO can only be done by the dealer. but lately hasn’t been possible as we lapped ‘08/’09 when almost no cars were leased so very little supply of used cars was available. revenue recognized in cars – so for most guys. do a lot of certified-pre-owned. However. Customer is the dealer itself. This has been a secular trend for a number of years. but can see why dealers expect this business to improve. o Best used car business for these guys is ~3yr old off-lease vehicles where they can make a lot of money.1% GP  Used cars are sold retail (~$1600 of profit per car) and wholesale (no profit). and typically released fully after 6mo. pays techs ~$25/billable hour). get higher F&I off higher purchase prices. Finance & Insurance (F&I) .28% sales. extended warranties. ~10-12% of gross profit (but Autonation & Sonic take revenue for the work out of used car sales and puts it into P&S.  Dealers I’ve spoken to are very excited about profit improving meaningfully in the used car business with the recovery in offlease availability.g. However the dealer’s holdback is only limited to the fees received. even responsible for their own core tools (though the dealer provides OEM-specialized tools and diagnostics that are increasingly complex and a complete barrier to entry to the service techs opening their own shops)  A few big pieces of business in here: o Warranty / customer pay work – this is the standard service department. oil service for life etc.  CFPB is a big question now and important enough to get its own section in Appendix 5 Back End Parts & Services (P&S) – 16. The fees earned can be given back if a customer immediately prepays a loan. 60% is stuff like gap insurance. o Gross margins are almost all variable – Parts COGS are of course variable. half is parts at ~35% margin). dealers seem to be convinced this will help them. Lithia puts the gross profit from refurb into the used car segment with the car sale). Anyway. but I have trouble believing dealers keep all this money – when a sale is closing.4% GP  This is the real profit center of a dealership. profit from this work recognized in P&S. this is financed 100% with floor plan programs.2. Service techs are closer to independent contractors than you would expect.Auto Dealers  Dealers hold ~2mo of new car inventory. so I think they can sustainably make more money there). Service COGS are surprisingly variable. maybe 90% of sales o Reconditioning / internal work – this is mostly refurbishing used cars before they’re sold. This should be a sizable step up in profit per car. collision work etc.2% GP  Dealers earn fees/spreads on car loans and leases. Used Car Sales . I’m less convinced. Dealers have a real advantage sourcing desirable supply at good prices through trade-ins and off lease vehicles. typically over 6mo from the purchase. used cars not sold after 30 days are dumped on the wholesale market for no profit  Used car inventory is also financed using floorplan programs  Within used car sales.6% sales. which have all been growing significantly o Strong growth in service plans are particularly important as a $1k service plan sale not only books upfront profit for the dealer.

but the number of cars affected has (line). so they should see a cyclical uplift in SAAR quicker (you can see this already in Lithia which has the worst brands which should be shorter cycle (maybe 3yr?) and grew P&S 8% last quarter). and warranty spend has come down (this is from sell-siders who mostly look from OEM side of busines) – this is true.  Elongating length of warranties. o Lower-end brands. finance programs.  More dealers (particularly the public guys) have pushed into collision work. which require dealer service (6-7 year leases now possible where before only 4 year leases offered. particularly larger chains who have invested in better CRM software solutions  Dealers have become more competitive on off-warranty work such as basic oil changes. the cost of the repairs retained increases. but have spoken to contacts where its not mandated and they charge out $120/hr to customer $110 to OEM. If you want to look at relative sizes of these pieces. The best arguments this P&S growth are: o Haven’t ever seen double digit P&S growth before (the caution I hear most from dealers and it makes me excited – because they shouldn’t have seen this type of growth since the mid-80s which was the last time you saw the fleet grow like it will in the coming years. ABG breaks out gross profit by these lines. Here’s a chart from Wards – the # of recalls (bar) hasn’t gone down at all. BMW unlimited service for 3 years.Auto Dealers >>>It’s the warranty/customer pay that will be driven by this fleet dynamic we’re looking at. This basically freezes out mom & pop service competition and should become a powerful driver of elongation when today’s computerized cars hit the age where they’d normally transition to independent garages o Strategic increases in dealer’s service share  Better CRM by dealers. Below the gross margin line it is mostly fixed costs – front office service managers. wiper changes. which was declining double digits. last year slowed to single digits. which usually don’t make sense for a typical garage that may only have 10% of its business in a given brand. real estate. this should argue for P&S organic growth touching double digits. o Normalized run-rate fleet size is ~35% higher than what’s currently being serviced  A number of factors are driving up the dealers capture of parts and service revenue. and that’s the vast majority of the P&S business. is now turning around and starts growing HSD going forward (see Appendix 2) o Given 3-5% P&S same store sales growth in a flat SAAR (as seen in the 2000s). was only BMW recently). Dealers I’ve spoken with estimated that out of the gate ~80% of new cars come back to the dealer for service (missing 20% voids warranties through laziness or otherwise). especially with cars under insurance and the legal right to choose your own repairer  This was a big push for the dealers in the downturn. I haven’t found anything too compelling. as this is the core of the thesis. revenue is tied directly to recent car sales. particularly the domestics have a shorter relevant range. Little advertising. dealer-mandated service)  Increased complexity/electronics of newer cars is shutting out mom & pop garages – requires bigger investments in specialized tools / software / lifts that are brand-specific. but when SAAR falls to 10m there are fewer cars so of course warranty dollars come down. equipment depreciation.  Main driver of parts and services is the young (0-5yrs) stock of cars on the road under warranty which are taken back to dealers for service. o Very few older cars on their 2 nd or 3rd owner are brought back to the dealer.  This is OEM/warranty-paid work gets the same rates and margins as customer pay (usually mandated by state law.  There should be a huge cyclical tailwind coming for P&S o Tied to 5yr SAAR. with GPI you can get a good idea from the earnings slides. which is largely a function of fewer cars on the road o 07/30/13 6:55 PM Page 7 of 26 . certified pre-owned programs giving a second round of warrantied. 35% at a Hyundai dealer. smaller sales commissions for the parts department etc. Volvo. ABG says they could double or triple their P&S work without having to add capacity What could be missing here? I’ve done a lot of work to try and tease out the counter-arguments. but as retention falls on older cars. above and beyond the cyclical impact of normalizing SAAR o Structural increases in dealer’s service share  Increasing service packages sold upfront with new cars – e.  P&S departments usually nowhere near capacity utilization. but that type of delta at worst). leases. VW. This makes a lot of sense for car-owners.g. GM just announced an extended service plan to be included. see Appendix 2) o Cars are being made better. similar programs at Mercedes. brake work etc. 3-4 years in that could have dropped to 60% at a BMW dealer. and staying in the high single digits for an extended period.  The incremental margins (EBIT / gross margin) appear to be huge in P&S judging from discussions with private dealerships. Toyotacare (this trend appears to be increasing.

computer systems. last longer. GPI says 50%. eliminating back office. some say they think its pretty much the same drop through across the business. but largely funded with non-recourse mortgage) 07/30/13 6:55 PM Page 8 of 26 . fund it 80% with non-recourse mortgages at 4-5% interest.  Buybacks – this is pretty high return at current share prices. The key line item below gross profit is SG&A. bringing better management / software etc. don’t need service for first 6-18mo. Japanese typically 5-6x. luxury 5.000.5-7.  o There is a valid point that cars are made better. and perhaps most importantly bringing the new dealer into an inventory network (expand on-hand selection in network while reducing inventory carrying costs). Number of Potentially Affected Vehicles for Model Years 1990 and Newer Number of Recall Campaigns Issued Total Number of Potentially Affected Vehicles (Model Years 1990+) Number of Potentially Affected Vehicles Auto Dealers Source: Edmunds. so the driver knows when something is wrong. reducing sharecount 37% over 5 years. There is also some multiple arbitrage on acquisitions. depending on what you buy (domestics can be purchased for 3-4x plus assets. Some of the public dealers agree P&S incrementals are higher. Inc. and the car directs the driver back to the dealer for service.  The dealers took out a lot of fixed cost in the downturn which should give them great leverage in a recovery Use of Cash EPS to cash conversion is high in this industry most of these companies generate ~8-10% FCF yield as they trade ~10-12x earnings. and adding all this content makes it more likely for things to break.000.250 40.com.5x). At end of lease life they have total leverage over landlord b/c they offer to buyout the property or they’ll move to a new location (and landlord stuck with a vacant dealership they can’t do anything with) o I’ll use ABG as an example because I have the data at my fingertips:  ABG owns roughly 60% it’s stores at this point. This would argue for more upside than envisioned. There are a lot of high-return ways to utilize the cash  Acquisitions – acquisitions can be very accretive with public co’s offering some synergy opportunities by bringing the smaller dealers into their purchasing network. But at the same time that’s more than offset by the huge increases in car complexity. big commissions to salespersons).  Current EBIT / GP margins are 20-30%  Across the industry the public companies are talking about ~50% incremental EBIT / GP margins over as they grow (ABG says 40-50%. achieved 70% last year. Autonation has been the most aggressive.000. that become more expensive to repair. you can change oil less frequently etc.000 200 32. SG&A Cost Structure People generally view gross profit as a revenue approximation here. While I typically wouldn’t be too excited about this. saying they see ~35% incremental margins which is probably a reflection of how much they over-invest)  Dealers I’ve spoken with think incremental margins are particularly high in P&S (potentially 70%?) and lower in car sales (pay small commissions to service managers. ABG & PAG have also bought back a log of shares.000. so I think of the SG&A to Gross Profit margin is similar to the way we’d think about an EBIT margin in a typical company. Another plus is all these computers now monitor the car. so maybe this really should be a 0-5yr fleet with 1yr lag which would mean this thesis happens but takes another year to really hit). Lag before new cars need service (this is true. sensors etc.com © Edmunds. Lithia says they’ll get total gross profit less SG&A margin from 30% to 40% which implies ridiculously high incrementals. I see the logic in choosing to buy in a lease at an 8-10% rate.000.000 0 0 19 90 19 91 19 92 19 93 19 94 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06 20 07 20 08 20 09 20 20 10 13 2 as 01 1 of 03 20 /0 12 4/ 20 13 Number of Recalls Yearly Number of Recalls vs.000 50 8. and has put ~$78m towards real estate purchases in the last two years (roughly half of FCF. and not adding any risk to your business with the non-recourse debt (no riskier than a lease) o The reason dealers can buy it in so cheaply at an 8-10% cap rate is because the real estate is purpose built.000 100 16. and SAH has recently started bigger buybacks. PAG is the only holdback.  Real Estate – the public dealers have been buying-in real estate at very accretive prices during the downturn. as dealers think about things on a $margin per car basis rather than a percent basis (not that helpful to look at sales when you’re reselling $35k cars).000 150 24. You’re essentially getting a 20-25% return on the 20% equity investment.

25B of real enterprise debt – I look at it this way to think about leverage / risk.Auto Dealers  ABG also has significant unencumbered real estate. You could view them as essentially debt free if they went back and retied more of their $435m debt to mortgages (which they are doing to get lower rates).75B non-floorplan debt at 12/31.5-2. o Also pay attention to companies where floorplan < inventory. For instance ABG had $1. b) real-estate linked debt (risk-neutral capital arbitrage discussed later with ~20% ROE). That’s just extra cash. dealers will not utilize all their flooplan b/c that’s at a higher rate than what you can earn in a bank account. It’s also helpful to look at EBITDAR and owned real estate. when you make those adjustments its actually $1. some of which it intends to mortgage to take advantage of low cost financing (and free up cash for acquisitions or buybacks). I estimate there is ~$527m of real estate vs. Instead of carrying a cash balance.9x).5x for the dealers (AN at 2. I like to look at EV/EBIT (after floorplan interest) and adjust for a) hidden cash in floorplan (if floorplan debt is less than inventory like it is at ABG & GPI. specifically ABG & GPI. but not as much to think about valuation. and EV (adjusted for floorplan debt) /EBITDA (after floorplan interest). that means they had excess cash and they stick it their b/c it’s a better rate than a checking account). lease). 07/30/13 6:55 PM Page 9 of 26 . Leverage  Take out the floorplan financing which is basically funded by the OEMs so dealers can hold cars. but some substantially less when you takeout mortgage debt on real estate they bought in (same economics as a lease its just own vs. OTHER INFO Valuation / How they trade  Metric – the key metric here is P/E.  Actual leverage is 1. and the hidden cash stored in undrawn floorplan. only $119m of mortgage financing at year end.

0% 17.5%) (6.38 12. In the downturn P&S grew well in excess of the fleet as dealers pursued a number of initiatives to improve retention.0%) 2.Auto Dealers APPENDIX 2: P&S AND THE 5 YEAR TRAILING FLEET Dealers make most of their money off of P&S.7% 5.00 0.81 2.9%) (2.8% 81.69 -0.20 8.32 3.0% 17.4% 73. and retention initiatives.4% 5.2%) 6. and this business has the highest incremental margins. If they were sold on a used car lot.30 4.4% 3.2% 2.2% 71.80 -17.83 6.4% (1.00 3.0% 67.0% 10.9% 17.8% 55.9% 6.00 0.85 -6.2% 74.5% 8. and are about to flip to a high single digit tailwind going forward. Toyota.8% 3.6% 15.3% 5.4% 85.50 1.7% 12.6% 65.5% 76.2% 6. Focused more on retaining a customer for the simple stuff – oil change.30 58.38 -7.5% 6.9% 70.7% 77.5% 6.2% 5.8% 14.3% 79. This is directly tied to the population of relatively recent new car sales.  Cars are increasingly being sold with all inclusive service plans.9% 86.90 -0. Volvo have followed. 07/30/13 6:55 PM Page 10 of 26 .1% 7.2% 75.1% 3.5% 13.05 -2. which still come back to the dealer for service.8% 6.75 -4.4% 6.53 -4.55 -11. These systems are all proprietary to the car brand and require specialized service. which should help dealers retain customer longer  Dealers (particularly the scale public guys) have gotten much better at retention in the downturn.1% 17.37 -5.Dealer estimated for me a Hyundai might be 35% retention out of the gate vs.1%) (6.2% 15.9% 15.00 0.49 -18.4% 3.3% 5.6% 6.2% 82.4% 5.9% 15.6% 65.1%) (5.4% 84.5% 85.5% (0.05 -8.2%) 2.0% 1.0% 10.3% 17.3% 0.3% 3.0% 17.8% 15.70 -18.1% 17.9% 68. Independent garages can’t afford to purchase this specialized equipment for all brands of cars.79 5.3% 3.8% 5.5% 9. that P&S stream would likely be gone.9% 5.45 -2.30 2.8% 10.12 4.2% 3.3% 2.6% 4.80 1.00 2. if sold in a CPO program with an OEM extended warranty you get service retention that is not too far off a new car sale.50 0.70 62.30 -2.83 2.0% 17. due to organic growth from price increases.8% 84.6% 16.80 1.9% 8. a BMW still has 60% retention year 5).6% 79. etc.3% 3Q12 1.68 3.6% 82.47 -1.8% 14.45 2.5% 4.0% 2.2% 5.12 -1.8% na 0.4% Trailing 5yr SAAR % growth P&S SSS gowth ABG LAD SAH GPI AN Average % better than 0-5yr car fleet growth Last time you saw this growth was mid-80s 4Q12 1Q13 1Q13 Adj.41 8.10 8.19 -6.54 19. email reminders for service.  Certified Pre-Owned programs are secularly growing.  More car complexity.8% 8.8% 69.3% 0.5% 3.1% 3.6% 4.9% 2. wiper change. warranty work.97 3.5% 3.50 4.4% 15.79 3.44 0.0% 72.4% 11.4% 4.50 1.2% 69.46 2.88 0.00 3.1% 6.but you’d have to stretch back to the 1980s to see the last time this dynamic played out and these dealer groups weren’t assembled until the late 90s.8% 63.2% 1. lowest on low-end cars --.4% 8. increasingly complex cars with more to repair.5%) (2.4% 1.1% 75.3% 69.4% 4. GM just announced an expanded free service program on new cars.0% 17. whereas a dealer with 100% of its business coming from one brand can buy them without a problem.9% 14.8% 12.86 -2.3% 16.45 2.04 6.0% 2.60 -21.1% 4.6% 1.8% 83.3% 2.1% 1.8% 3. Mercedes.5% 2.8% 17.2% 77.3% 5.8% 16. 10% growth in P&S alone equates to 10-15% EBIT growth on the entire businesses.77 11.70 3.1% 86.0% 14.5% 1.0% 6.5% 85.8% 70.0% 13.* 2.9% Last 4Qs 2Q12 (0.9% 16. OEMs will purposefully design things that require specialized tooling/software/diagnostic machines.32 -0.52 4. battery change – run promotions on that.6% 2. P&S revenue potential on a car grows as it ages.4% 4.79 13.2% 16. These cars elongate the service life a customer goes back to the dealer.69 -2.43 0.15 -4.04 10.46 -3.41 9. before factoring in growth in upfront business and the use of free cash flow generation.39 1.4% 4.1% 3.4%) (2.31 16.5% 14. Additional factors that should help dealers retain a larger % of service stream:  Warranties are lengthening – what used to be standard 3yrs is stretching to 4-5yrs.3% 61.1% (5.1% 3.5% na 2. SAAR was remarkably stable in the 90s and 00s throughout their operating history.4% 2.0% 7.48 17. BMW pioneered this as a freebie included. SAAR (Right Hand Scale) % growth 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013e 2014e 2015e 2016e 2017e 2018e 2019e 10. make sure customers are coming back to the dealer.8% 2.1% (3.0% 3.73 8.0%) 3. software etc is pushing more service back to the dealers.15 3.4%) 3.2% 2. which could set the stage for double digit organic P&S growth.2% 86.  What’s most interesting is the biggest concern the public dealers have about committing to this growth is that they’ve never seen it before --. Have installed CPM software to keep in touch with a customer. Dealers are also getting much better about selling unlimited work upfront into the car.3% 56.7% 3.2% 4.22 -0.5% 0.2% 15.7% 77.2%) (4.0% 17. Assuming 50% incremental margins over SG&A.  Fleet declines were a high single digit headwind in the downturn. but retention rates on those customers declines over time (retention rates highest and increasing most on luxury cars.5% 15. electronic systems.3% 13.04 -6.50 3.5% 3.3% 15.2%) (2.16 2.3% 4.4% 3.86 8.9% 4.6% * 3% headwind on 2 fewer working days y-o-y A couple of things to call out in the table above:  P&S consistently grew 3-5% in excess of the fleet size during the 2000s.8% 0.55 -4.14 -1.1% 0.1% 75.97 -1.

0%) 2.5% 85.1999 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 10. a lot of Chrysler.2% 2004 6.9% 8.8% 2.70 3.83 6.7% 77.0% 6.3% 0.8% 81.4%) 3.4%) (2.9% 15.1% 3.79 3.30 -2.0% 2.1% 3.2% 69.4% 8.41 9.2% 74.2% 4.0% 17.90 -0.00 3.10 8.3% 2.0% 17.81 2.46 -3.5% 13.0% 17.3% 5.6% 79.1% 75.69 -2.05 -8.5% 2011 0.4% 1.2% 1.0% 17.4% 5.5% 3.1% 75.0% 13.2% 77.5% 2008 (0.8% 14.7% 5.0% 17.1% 6.5%) (2.9% 4.1% 17.3% 5.30 4.3% 0.83 2.79 13.70 62.9% 86.4% 11.04 -6.16 2.9% 5.3% 56.4% 4.7% 12.9% 14.5% 2.5% 85.4% 5. really starts to get good in 2014.3% 79.2% 86. junkier cars and lower quality customers that are retained by the dealer for a shorter period of time.5% 3.39 1.6% 4.80 1.0%) 3.5% 6. 1 day leap year) which was a 3% impact as called out by AN.46 2.7% 77.2% SAAR (Right Hand Scale) % growth Trailing 5yr SAAR % growth 2000-2019  Can also see good momentum building in the recent P&S SSS growth results for the dealers.4% 2006 6.9% 17.0% 7.7% 3.97 3.15 3.8% 70.2% 5.8% 3.5% 6.22 -0.50 1.8% 5.86 8.45 2.73 8.48 17.1% 3.0% 72.3% 4.75 -4.49 -18.12 -1.4% 15.5% 4.60 -21.8% 55.0% 17.4% 4.0% 10.41 8.5% 76.52 4.5% 15.2% 2.4% 3.3% 69. so I’m planning on being patient and seeing how this looks towards the end of the year without putting too much weight on any given quarters between now and then 2000 P&S SSS gowth ABG LAD SAH GPI AN Average % better than 0-5yr car fleet growth 2001 2002 2003 5.8% 14.4% 4.8% na 0.9% 16.6% 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013e 2014e 2015e 2016e 2017e 2018e 2019e SAAR (Right Hand Scale) % growth 17.3% 15.1% 2009 (5.0% 1.9% 2.0% 14. and there’s volatility here on how many warranty recalls are made etc.1%) (5.0% 3.30 2.80 -17.5%) (6.15 -4.32 3.37 -5.45 -2.4% 3.0% 2.2% 2.32 -0.4% 4.9% Last 4Qs 2Q12 (0.8% 10.8% 12.4% 2.0% 10.47 -1.5% na 2.31 16.2%) (2.9% 68.54 19.88 0.2% 15.2% 3.38 12.5% 8.3% 5.3% 3. so think there will be a few quarters of ramp up.8% 6. 07/30/13 6:55 PM Page 11 of 26 .8% 16.8% 83.4% 3.6% 16.0% Trailing 5yr SAAR % growth 82.05 -2.6% 65.30 58.68 3.3% 2007 2.44 0.3% 61.19 -6.50 3.Auto Dealers That Chart above may not be readable it is so small. here it is in two pieces: 1980 .9% 15.6% 15.6% 2012 1.04 10.38 -7.9% 70.8% 69.1% 0.50 1.4% 85.8% 8.3% 17.1%) (6.86 -2.80 1.70 -18.1% 4.3% 16.1% 1.1% (3.00 0.3% 3Q12 1.6% 4.4% 84.3% 13. etc.97 -1.77 11.69 -0.8% 3.85 -6.2%) (4.9%) (2.00 3.4% (1.1% 86.45 2.79 5.12 4.2% 82. So you would expect this to hit Lithia first.5% 1. 1Q13 had 2 fewer days than prior year (1 day calendar shift.14 -1.2% 15.9% 6.55 -11.5% 3.2%) 2.1% 3.5% 14.00 0.50 0.04 6.4% 4Q12 1Q13 1Q13 Adj.4% 73.43 0.53 -4. With or without that impact the numbers are starting to look pretty good but there can be some volatility here and the fleet doesn’t go positive until back half.20 8.* 2.2% 16.50 4.2% 71. They do mostly D3.00 0.8% 84.2%) 6.6% 65.3% 3.8% 63.2% 75. which appears to the be the case.6% * 3% headwind on 2 fewer working days y-o-y  Also interesting to see Lithia’s growth has ramped further and faster than anyone else.1% 7.1% 67.5% 2005 9.55 -4.6% 2.8% 2010 0.8% 17.6% 6.8% 15.00 2.

even during boomtimes in the 00’s. car consumption.0% -5.5% in the 1980s). as seen in the red line below.7% 0. dealer industry P&S rev (NADA data) Same chart. sustained growth in industry P&S revs in the 80s because that fleet was growing. What is very interesting here is you saw big.5% 33.0% 1991 5.5% from 2012-2020 vs. Public Dealer's CAGR(1) P&S SSS total CAGR 22.0% 1985 10. P&S dept growth Industry wide 0-5y fleet gowth P&S 1985 1981 2019e 2017e 2015e 2011 2013e 2009 2007 2005 2003 2001 1999 1997 1995 0. industry P&S data to smooth out and see broader trend since the year to year has some volatility with recalls.0% 1989 5.5% 2.5% 1993 1991 1989 1987 Trailing 5yr SAAR Avg.3%) 0. P&S has a flat / negative tailwind for most of the 2000s.5% growth for the entire decade. But going forward there is huge growth in the 0-5yr fleet coming – this is much bigger than the modest fleet growth in the ‘90s.0% Trailing 5yr SAAR 1980s 1990s 2000-2007 2007-2012 2012-2020(2) 3. Industry P&S bounced around flat and went negative in downturn. inflation sub-3% from ’83 onwards). just before the professional lives of most of today’s investors / sell-siders I’m always thrilled to hear the pushback that no. Note industry P&S grows well in excess of 03yr fleet. P&S only grows mid single digits.5% 1. but it extends longer – total growth in 0–5yr fleet is 33. Car sales peaked in ‘99/’00 and were roughly flat/down a bit through the rest of the 2000s. (2) back to normalized levels.7% 0. and stayed around 10% for most of the decade (this is not inflation-driven. weather etc. P&S revs CAGR’s 8.7% 3. and well beyond the growth in the ‘80s to (growth doesn’t look as sharp in projections b/c I layout a gradual SAAR recovery. -5.3% weren't public yet 3.2%) (0.0% 1993 0.0% 1983 Trailing 5yr SAAR grow th & Industry P&S grow th 3-yr avg sm oothed (P&S per store grow s faster w ith mom & pop dealers closing) Trailing 5yr SAAR grow th & Industry P&S grow th (P&S per store grow s faster w ith mom & pop dealers closing) Page 12 of 26 . 0-5 yr fleet vs.0% 1981 15.8% (25. 07/30/13 6:55 PM 2019e 2017e 2015e 2013e 2011 2009 2007 2005 2003 2001 1999 1997 1995 Avg.0% -10. and an individual dealers’ P&S grows in excess of the industry as the industry continues net closing subscale mom & pop dealers and transferring market share to scale players including the public dealers. but with 3-yr avg.0% 1983 15.5% weren't public yet 7. The auto cycle is its own cycle. no catch up demand. P&S dept growth Chart on left lays out growth in 0-5yr fleet over periods and corresponding growth in P&S.0% 1987 10.7% [?] (1) Industry-wide P&S growth understates the SSS the public dealers due to ongoing net closures of subscale mom&pop dealers and ongoing market share from scale dealers including the publics.Auto Dealers Yes we’ve seen it before.3%) (3.0% -10. 22. As such. SAAR ~17m based on 3 trilliion miles driven.3% 8.8% 4.

07/30/13 6:55 PM Page 13 of 26 .Auto Dealers Finally. which should get people thinking about how dollars are driven as we roll through SAAR years. Lithia this past Q also included a chart that shows their gross profit earned on a car over time. I’m feeling better this dynamic will increasingly get broadcast by the dealers to investors. Think this should start getting talked about more as P&S trajectory really picks up. but dealers are afraid to get out in front of it. Auto Nation started showing a chart in February that shows some of this 0-5yr fleet. want to see the actual numbers coming through first.

000.000.67 Current Fleet Size average fleet age Mileage consumption (3 trillion miles) odometer at scrappage (average of 2yr old cars that are totalled.000.000 2.500. SAAR and miles driven vs. if SAAR stayed flat at today’s ~15. unemployed people have nowhere to drive. Consensus is for 16-17m type SAAR as a normalized level.000 20.000.000 6.000.000 250. think the stocks still can double. Population SAAR (right hand scale) Miles driven per employed person Page 14 of 26 .000 2.000 18.000.000 50.000.000 8.000.seems too high? Just getting rid of model year 1997 on average?) million cars 250 million cars 10. Also. an argument I think makes sense but isn’t sustainable growth so I’m not going to put a multiple on SAAR getting pushed towards 20m if it will fall right back.000.000.000. but the business itself is SAAR-intensive.000 16.S.000 16. perhaps to 3.000 200.500. Also interesting – I think most people are counting on construction to reduce unemployment. There is also a very convincing pent-up demand argument.000 - - 19 6 19 1 6 19 4 6 19 7 7 19 0 7 19 3 7 19 6 7 19 9 8 19 2 8 19 5 8 19 8 9 19 1 9 19 4 97 20 0 20 0 0 20 3 0 20 6 20 09 12 e 3.000."replacement demand" from chewing up existing cars Annual Miles Driven (in mm) Miles before avg car scrapped Implied average life @ scrappage Normalized Replacement demand 3.000. requiring a lot of light trucks in particular.000.3m units.000 15 16. There are some real SAAR bulls out there pointing to higher numbers -.000 1. For now I think its easy enough to justify 16-17m as the right normalized range.000 150.000.000.000 Miles / avg car / year Does 16.000.8 years 12. the fleet is very old at this point and needs a refreshing etc.000.000 300. Population vs.000 10.000 180.000.000.000 2. Back of the envelope SAAR -.000 8. Does “replacement SAAR” need to be 16.000 500.000 1.000. People look at normalized SAAR a bunch of different ways – graph trends.500. This is a particularly bullish for SAAR as not only will re-employed workers buy personal cars.000.000. the recent flattening in miles driven has a lot to do with unemployment the slowdown in miles driven makes more sense on a per employee vs.000. then the US is chewing through 16.5-17m of replacement demand seems to directionally make sense when you look at population vs.000 4.000 14.5-17m make sense in historical terms? 16.there has been population growth.000 - 3.000.000 4. SAAR 20. replacement demand plus population growth.000 10. So if employment picked back up it would seem miles driven should increase.5m. back where it was for all of 2000s.5-17m?? 3 trillion miles driven / 250m cars in the fleet equates to 12k miles put on every car in the fleet ever year. SAAR Miles Driven vs. the need to scrap and replace an unusually high number of cars.000.000 19 61 19 64 19 67 19 70 19 73 19 76 19 79 19 82 19 85 19 88 19 91 19 94 19 97 20 00 20 03 20 06 20 0 20 9 12 e 0 Miles SAAR (right hand scale) Miles Driven per person 07/30/13 6:55 PM 350. before any pent up demand.000 18. per pop basis.3m on a recovered economy which would put replacement SAAR at 18.7m cars per year. anything above that will just be a nice surprise.000 2.000.000 12.000.000 100. If cars are retired on average with ~180k miles on the odometer and ~15 years old. 25yr old workhorses) years -.000.000 6.000 U. just on replacement demand.000 12. SAAR. probably a little higher when employment (and miles driven) pick up.000.000. Employment of course helps. But the base case for the dealers doesn’t require SAAR upside.000 14.Auto Dealers APPENDIX 3: WHAT’S NORMALIZED SAAR? This is included because I think it is really interesting and is incrementally bullish for the dealers long term.

0 6.no growth 7.Auto Dealers What could catch up demand be? The fleet has aged a lot in the downturn.0 How much SAAR to reduce avg.5 7.8 Median and average age of the US Fleet 11. we’d need to scrap that same 16. fleet age . then maybe the average age of a car should be 7. Other Charts that I thought were interesting to look at (mostly from BofA) 07/30/13 6:55 PM Page 15 of 26 . life of catch up new cars (spread 6 years) Avg life of retired cars Catch up cars to normalize Resultant average life 3 16 63 Still seems too high 7.0 Median Age 9. When you start thinking hypothetically – if the average car should get scrapped after 180k miles (15 yrs). car to half the 15 year useful life? Normalized avg.2 10.0 Average Age 9.0 Seems too high Alternative method -. In fact it should be younger if the fleet is growing with time.0 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012e 2013e 2014e 2015e 2016e 2017e 2018e 5.7m cars and replace them with 0 year old cars just to keep the average age of a car flat at these elevated levels.8 yrs.8 yrs to 10. SAAR dropped off in ’08.5yrs. If we’re replacing 15yr old cars with new ones. we’d need to sell an extra 8. in either case with medium term overshoots on pent up demand.5-17m. since pent up demand would be unsustainable I’m not taking it into account in the models.5m cars. this is nice upside to have. However this yields ridiculous numbers like 50m+ units of pent up demand (per below).0 7.0 If you thought about it a different way – How high would SAAR need to be just to keep average age flat? Well let’s assume that 250m carpark all ages one year. over 18m if the economy recovers.5 So median car has ~100k miles Catch up cars to normalize? 55.car replacement Avg. But again. Aging of US car fleet Implied catch up SAAR? 10. >>>Takeaway – looks to me like replacement demand might be 16.1 8. after which the average age of a car moved from 9. To reduce the average age by 6mo.

Auto Dealers 07/30/13 6:55 PM Page 16 of 26 .

Each has their own wrinkle. Capital allocation is important. At the back of this section there’s some good charts on the different businesses that can help you compare them from afar. The following chart lays out brand exposure by dealer. You can run a dealership better than the next guy. It seems the big potential here is for the OEMs to get more aggressive on sales and invest in more content in the cars now that the yen is weakening. better margins. BMW X1. o In private market transactions. I think good mgmt (AN. but they can’t choose the menu.  Japanese / import brands had a hiccup in ’11 after the tsunami and didn’t fully recover market share in FY12. yet the luxury-heavy public dealers seem to receive no premium in the public market. and with SAH at a lower margin starting point that will lead to more profit growth (and they could always get their act together and improve the business a lot). These are all factors which will be driven more by macro and how good BMW is at designing and advertising desirable cars and gaining market share. they could have the most cyclical upside as they are the most depressed and there are some large fleet refreshes coming up. can’t choose the price. its just more on the margin in this industry. Mini). They’ve got quality assets heavily weighted to luxury brands which are the most valuable and best secular growth. think its worth pointing that value in this industry is more driven by the assets (which brands & what locations). and c) how many BMW’s are already on the road for the P&S department. see no more upside for D3 cars than J3 cars from here even though the D3 brands are further from peak. So while I’m normally willing to pay a premium for great mgmt. market share has shifted so their sales are where they are. but it’s a relatively small premium. The P&S trend we’re looking at will hit all these businesses no matter what. I focus on the secular. and continue to steal share away at the high end from the mass market brands as they roll out more affordable ‘entry-luxury’ cars (e. efficient operation is important. And they’ve got reasonable valuations.g. and really happy to own Sonic even though it’s a family business that has some operational issues and difficulty filing their financials on time (but they own a ton of great luxury locations benefitting from secular growth). in this case not willing to pay anywhere near the premium AN trades at. The Europeans (BMW/Mercedes/Audi) have great brands that were more resilient in the downturn. b) BMW’s market share in Atlanta. luxury brand dealerships trade for twice the multiple of mass market brands. In addition to the richer service stream. A dealer franchise with BMW in Atlanta will be heavily impacted by a) total demand for cars in Atlanta. They own the McDonalds location and can run it efficiently. Note: secular measures ’04-’07 units vs ’00-’03 units when 2% fewer cars were sold in total. I think they will secularly continue to lose market share going forward. than the great mgmt teams. On the negative side. or people who want a Mercedes. Luxury brands are also making the most progress in packages that increase dealer retention of service work such as service-included new car sales. No BMW dealer is going to be good at selling cars to people who aren’t in the market to buy a car. ABG) deserves a premium here. Sonic probably has the most to gain as incremental margins should be the same as everyone else. so all “secular” trajectories have a ~2% understatement. what was the growth pre-downturn as a proxy for secular trends.Auto Dealers APPENDIX 4: COMPARISON OF THE DEALER GROUPS There are some choices to be made. much moreso than your typical industry. Second. On the positive side. These are franchises. o Luxury brands have the richest service stream as customers are more likely to take cars to dealer (BMW ~80% retention through warranty while field calls suggest Hyundai only ~30%).5m last year. GPI & ABG. more efficient service. and make more money on used cars due to higher penetration of leases / young trade-ins. certified pre-owned used car sales. and have been slow to shutdown an overbuilt dealer network meant to handle 1970s market share). On the right are two things I thought were interesting – first. see much better rates of repeat customers. leading to free incremental sales for the dealers left standing (though this is mainly due to the fact the domestic brands have lost half their market share in the past 3 decades. I think the most interesting ways to play this are SAH. Generally. luxury brands spend less to attract customers. and there is room for mgmt to drive better topline than competitors. I think all producers were at SAAR of 14. where was FY12 sales relative to average ’04 / ’06 as a proxy for how far off the peak it is. The cyclical column I think is a red-herring – of course D3 is down more b/c it always loses share and the markets were down. can’t run the main advertising campaigns. get better P&S retention. Domestic brands (particularly Chrysler) closed the most dealerships by far. 07/30/13 6:55 PM Page 17 of 26 . but you can only do so much better. PAG. Talk about Brands / Geography Brands  Luxury brands are the most stable and have the best secular growth. Before diving in.  Domestic brands have been losing share for decades. Luxury not as far off peak b/c it keeps gaining share and pushing further down into historically mid-range customers.

5% 11% 15% 21% 7% 6% 11.6% 2. but I don’t subscribe to that.Automotive Group.4% Lexus Acura Infinity Porsche Audi Other Premium Lux Luxury Share Est.5%) (27.so what looks like a more cyclical compressed market may really just be an ongoing secular shift.8% 19.0% 102.0% 100.5%) (32.1% 6.0% 2.2%) 1% 2% 2% 1% 4% 2.0%) 17.0% 101.Auto Dealers Car Dealer Brand Exposure Growth Position Cyclical Secular FY12 / avg '04-'07/ avg '04-'06 avg '00-'03 Brand Toyota Honda Nissan J3 Share (7.8%) (23.7% 3% 47% 4% 37% 37% 15% 8% 12% 8% 2% 10% 6% 6% 16% 20% 10% 4% 20% 33% 55% 1% 3% 2% 2% 4% 4% 4% 6% 8% 4% 2% 100.8% 3.7% 66. Florida.0% -7.9% 11% 70% 17.1% (23. I’d rather be in growing areas like Texas.2% 0% 22% 2% 28% 0% 45% 3% 40% 6% 3% 1% 10% 30% 12. I put more focus on brand than geography since that is a more dynamic driver.5% 21.0% 4% 2% 22. incl Lexus/Acura Ford GM Cadillac Chrysler D3 Share 0.5% 33. Automotive Group.7%) 36.2% 13.8% 32. Automotive Asbury Inc.1% 0% 6.7% 99.4%) (14. Florida etc.  Argument could be made you’d want LAD’s more rural exposure because it is cyclically depressed.3%) (40. Sunbelt.6% 8.1%) (22.6% 5. bigger cities.0% 2. 1 Automotive Inc. 07/30/13 6:55 PM Page 18 of 26 .8% 8% 102.2% 25.1%) (7. o Long term.9% 38.0% 18.8% 11% 26% 12% 9% 22% 4% 7% 9% 8% 15% 4% 10% (19.8% (12.6% 44.4% Mercedes BMW Audi 27. South. SonicInc.4% 39.4% 12.8% 2% 2% 4% 6. than rural areas that are still further off peak.7% 2.8%) (2.0%) Volvo VW Other Imports Other Domestic Other Other Share Total Market Cyclical Secular AutoNationPenske Inc. California.5% 66. cars are transportable.5% 10% 10% 11% 21% 12% 11.7%) (12.2% 17.8% 58.4% 31.0% 17. Lithia Motors Inc. California.2% (4. ex Lexus/Acura 72. on geography. o On top of this if you’re dealing with secular population decline on a business with lots of operating leverage I just don’t think rural areas area good place to be long term  So overall.2% 4% 2% 5% 1% 1% 7% 5% 5% 6% 3% 1% 7. GroupInc.0% 12% 19% -1% 15% -2% 21% 0% 18% -9% 7% Geography  Generally I want to be in desirable areas that are seeing net population growth.5% 10.1% 4. AN PAG SAH ABG GPI LAD 20.4%) 34.1% Subaru Hyundai Kia Other Asian Total Asian Est.0% 101.3%) 1. The expensive part of car consumption is those first 3 years of life.0% 43.2% 1% 1% 13% 9% 2% 43.2% 22% 26% 45% 37% 20% (13. No reason poor rural areas should buy many if any new cars in my humble opinion – middle of nowhere Georgia with $30k median income should just be buying used cars as they come out of Atlanta --.4%) (35.

and SAH is getting a lower multiple on those earnings. so don’t see downside to the stock price from here on this strategy. AN SAH ABG GPI LAD California New Mexico Nevada Arizona Florida "Boom-bust states?" N Dakota Oklahoma Texas Oil & Gas? Washington Idaho Oregon Montana Colorado Alaska Western Maryland Virginia New Jersey Massachussets New Hampshire New York Mid-Atlantic / NE 17% 28% 5% 6% 26% 54% 2% 7% 37% 16% 16% 3% 28% 31% 16% 10% 4% 29% 29% 1% 17% 7% 7% 8% 39% 47% 15% 2% 6% 10% 6% 20% 8% 8% 2% 14% 2% 2% 1% 3% 25% 27% 9% 53% 1% 6% 5% 2% 6% 7% 5% 10% 3% 4% 22% Mid-Atlantic Illinois Iowa Kansas Missouri Michigan Ohio Middle Country 2% 5% 1% 10% 2% 2% 4% 3% 3% 12% 1% 5% Alabama/Tennessee Mississipi Arkansas Louisiana Alabama Georgia South Carolina North Carolina Tennessee South 6% 10% 1% 5% 3% 9% 11% 10% 12% 7% 11% 21% 45% 2% 3% 1% 4% 2% Georgia & Carolinas 12% I think the best ways to play are: Sonic (SAH) Great assets – luxury focus and sunbelt exposure. but at the very least its significant expense that can roll off if its not successful. the cheapest valuation and biggest upside potential. I don’t think much irreversible damage can be done to the business beyond running expenses too high for a while. lower starting F&I production. attractive valuation. this all could be read as more potential. just more upside potential. this is my favorite way to play this now that some of the others stocks have gone up. hard to tell for now. Biggest concern is SAH management– 2nd generation family business.Auto Dealers Below is a chart showing geographic exposure. by reputation is not as professionally managed as the rest. Sonic AutomotiveAsbury Inc. They are spending a lot of capital on an “ipad” strategy right now. Automotive Group Group. But the expense is already reflected in lower earnings. Lithia Inc.  Positives 07/30/13 6:55 PM Page 19 of 26 . Name Ticker Geography AutoNation Inc. and in the meantime. market is skeptical it will work. But lower starting margins. 1 Automotive Inc. These guys will get all the same tailwind benefit coming and it should be a disproportionately large driver for them (same incremental margins on a lower starting margin base etc). Motors Inc. With high luxury brand concentration second only to PAG. with franchise assets. Recent late filing of 10-K (2nd time in 4 years) a good indication.

Group One (GPI) Good brand & geographic mix at a very reasonable price. o Cheaper than it looks – stuffs a lot of excess cash into its floorplan facility just as a place to store it until it is deployed. rather than money to return to shareholders. not Chrysler. though the UK sounds structurally attractive from initial conversations.Auto Dealers Good valuation on great assets. o Main issue is the valuation has gotten a little richer lately.  Negatives o Brazil acquisition. but think ABG still is a top pick. The D3 they do have is to Ford & GM. So this is a hidden value here. which maybe is a bad tradeoff). how to drive service growth. This will revererse and start to work in their favor when rates rise. I would pay no premium for the entrepreneurial distractions -. where to put money. o Excellent FCF generation. Really impressive management team. o Has been buying back a lot of stock. key concern is the Brazil acquisition. Roger Penske has a Steve Jobs reputation in the auto world. This could be distraction. Mercedes.I don’t want them wasting time and money testing out rental car franchises and building a distribution network for the SMART car that never arrived. they get ROIC. Stock gets a premium (known as the “Roger premium”). really like their assets and certainly some of the smartest guys in the business.  Positives o Baseline consensus projections seem particularly weak o Excellent FCF generation o Hidden cash in the floorplan facility o Interest rate hedging – EPS weighed down by an extra 30c (7%) b/c they’ve been aggressive hedging out rates. which could be dilutive to the US recovery story. o Unnecessary complexity with convert (but uneconomic to unwind). o All that said. due to a continued plan to overinvest (but think a lot of this will actually just shake out as they achieve better than they tell people). it’s more about having the right brand franchises in the right areas. For my purposes. o Highest mix of luxury of any dealer (BMW. Lexus). substantial J3 exposure. small UK presence – together ~12% of the company outside US. o Excellent mix of assets with high luxury. o Been spending a lot on internal software systems. o Good geographic footprint o Buys back more stock than anyone aside from AutoNation (who does no acquisitions. but it has run a bit more recently. 07/30/13 6:55 PM Page 20 of 26 . now have $144m total they could do (11% of market cap) Negatives o Management questions – 2nd generation family business o Historical FCF conversion not as good as the rest. 35% of biz is in UK which dilutes the real US thesis I’m focused on. which are dragging down marginsthe spend won’t roll off until later in ‘14 o  Asbury (ABG) – This is my favorite company. High luxury and J3 exposure. Penske invests heavily in its dealerships (too heavily?) and are way ahead of any standards the OEMs will set. will GPI pour more money into investments that are a distraction to the US thesis we want to own them for. whole team is impressive when you meet them. Increased rep authorization $100m at end of ’12. which SAH has. o PAG has ~35% international exposure (mostly UK). stock gets a premium for playing with all these entrepreneurial new business options I’d prefer they not get involved with in the first place Great management team – really like these guys. o Point to only 30-35% incremental EBIT/GP margins. Concerned that more profit here is viewed as more money for Roger to invest in goldplating dealerships & new ventures. took out convert dilution etc. from here forward any acquisitions will be funded with Brazilian generated cash. interest rate swaps Penske (PAG) >>I usually just pass on this one. o 2nd largest dealer behind AutoNation. though says no further cash going into Brazil. Businesses that are “asset centric” while execution is key. CEO is former Autonation CFO and a very smart guy. Reputationally one of the better management teams. lowest of anyone I’ve spoken too.

Lithia (LAD) These guys are mostly D3.  Negative – o Premium valuation with more upside cooked into consensus already.5x EBITDA (trading at 8x). Also more liquidity here. If this were the only option to play the space it’d still be a top position for me. low quality cars. Problem is that’s more than priced in b/c people like this as a “housing derivative” (high truck exposure. o Also a 2nd generation family run business 07/30/13 6:55 PM Page 21 of 26 . best thing about them is they just return all cash to shareholders (37% reduction in share count over 5 ys). brand alignments hemorrhage market share. but like everyone else it will get to bounce off the bottom. Great company. in particular Chrysler. which rebounds with housing). the rolling impact of the 0-5yr fleet is really more like a 0-4yr fleet or 0-3yr fleet for Lithia. adding 10-15% revenue per year o 60% truck exposure – part of SAAR that should rebound most dramatically (tied to construction etc) o P&S thesis takes hold here first because the bad brands have very short service retention lives – 8% P&S growth in 4Q. Problem is it consistently trades at a 4-5x premium to the rest. facing the same SAAR etc. So it’s now trading at a big premium instead of a big discount to the group. but doing it at ~3. just no way to justify paying up for it since they’re all asset based business operating in the same country. So it hits Lithia first. In fact because it is such a low quality relationship with the customer and they don’t retain service on cars for long. o Still don’t think D3 is good long term exposure. Low quality customers. The lowest value dealerships out there (can buy Chrysler at 3x in private market while BMW costs 8x). and it’s already showing up in their HSD P&S department numbers. Eddie Lampert & Cascade have big positions. Fundamentally it’s worth the price – think AN will blow away expectations as this plays out. but why pay 16x cash flow when there are so many ways to make the same bet at 11-12x cash flow.Auto Dealers Autonation (AN) Biggest and the best. think it is cheap on the real earnings it will achieve. o Most accretive acquisitions (b/c the lowest quality assets bought and LAD now has a big valuation) – buying tougher businesses.

which I understand is unusually weak language for the CFPB) o But none of this matters. auto lenders. lifetime oil change plans. b) cars that are leased.2k F&I per car. with the goal of having the rest of the industry follow (a model they’ve followed many times before). but its certainly important enough to watch very closely. which means it must offer competitive economics to the dealer: 07/30/13 6:55 PM Page 22 of 26 . neutral for economics? o Key thing to understand – dealers will still be the originators who choose which lenders get the financing business. Wells Fargo. the CFPB issued a bulletin saying auto lending practices could potentially be discriminatory. I think you can get a pretty good picture of how this plays out: With certainty – this model will change. just that’s there is no possibility of discrimination. (In practice there are lots of variations. would win the court case saying CFPB has no jurisdiction (because its true). argue CFPB doesn’t have authority or mechanism to force a change in how fees are paid or how much fees can be (also true). To make this work. not discretionary (e. (or that people of different races will get different rates on loans). o The CFPB plans to push this change through four of the largest auto lenders. They are too practical to fight a matter of principle. Here’s how the lending system currently works: o Dealers have databases of loans available at wholesale rates and terms – they choose the ones that pay the best economics to the dealer. o If Joe Smith’s credit rating says he can get a 2. dealer not allowed to markup rate (most likely outcome)  Dealer markups become automatic. sometimes a flat fee and a markup. etc) o This markup arrangement doesn’t apply to a) cars that are not financed. possibly 30-40% -. but roughly $400/car from rate markups. saying they think this opens the door to disproportionate impact.g.Auto Dealers APPENDIX 5: THE CFPB RISK     In late March. Chase. They don’t care what the rate is. c) financing with promotional low interest rates by the OEM’s captive finance arms. etc. just a flat fee. CFPB watchers and lobbyists. o $400/car is an average across all cars sold. d) some offers that are just a flat fee payment to dealer already.5%. So this is a big portion of earnings that’s been discussed. Speaking with a number of dealers.could pencil out 10-20% worst case scenario if all rate markups moved to the lowest flat fees dealers receive from captive companies. they haven’t shared any data and used language citing “experience suggests possibility for abuse” instead of actual data results. the new model has to succeed. This is exactly how the CFPB has successfully pursued a number of issues. think it is unlikely you see any earnings impact at all the way this action and this industry is structured. but then the headlines read something to the effect of “Wells Fargo & Chase suing CFPB so they can keep making racist loans”. Like it or not. the dealer will say “Mr. Lenders are hungry for auto loans and will still compete to get their loans originated.5%) In practice pretty similar to a fee. and some $700s o This F&I income drops down at high ~70% incremental margins (low F&I manager sales commissions & dealership mgmt level incentive commissions). I don’t think there is very limited risk of the 10-20% hit case. or back end kickers like if you originate $x for us this month we’ll pay you extra [ ]%. net positive. CFPB will effect this change by intimidation.75% rate to finance this vehicle”. In practice this means:  Lenders’ offered rates come with a flat fee for dealer origination. half of which goes to the lender (those $$ to the lender are a crucial part of the lender’s profit model). then rate to buyer is always 4. argue CFPB doesn’t have any actual data showing discrimination (possibly true.75% 5 yr amortizing loan collateralized by the car. So question is – is the change net negative. extended warranties. How does it change? o CFPB just wants to remove the discretion to charge rate markups at the dealer. etc.75% rate is capitalized into a $ amount. roughly half of which goes to the dealer. However. o The difference between the 2. So just a portion of car sales have this interest rate markup (called “dealer reserve” in the industry) How big is the $ amount in question? o Varies a bit by dealer. o People are arguing all these reasons why CFPB doesn’t have authority to do anything: CFPB has no jurisdiction over dealers (it doesn’t – dealers have a powerful lobby and were explicitly excluded from CFPB oversight in the CFPB creation document).75% and 4. Dealers get a total of $1-1. if a lender’s wholesale rate is 2. They don’t like how dealers can markup interest rates. Smith I got great news – I was able to find you a 4. included service plans. arguing captive lenders. small finance co’s are outside of CFPB oversight (also true). so in reality there are some zeros (no financing). with the remainder being products like gap insurance.

This solution works for everyone  If instead Chase’s offer is a 3. So if the new rate structure establishes a system that is breakeven economics for the dealers industry-wide. But I’m watching this like a hawk as it’s a big chunk of profit. The lenders will lose market share and this will be a tough for others to follow.I’ve spent a lot of time speaking with people in the industry and this seems to be the consensus I hear amongst lenders & CFPB/industry watchers. but I don’t think they will be needed) o Dealers make money 3 ways in a front-end transaction – gross profit $ on the car sale. On the whole the public dealers are much less aggressive than the typical dealer on rates. Secondary question– any backup defenses? (nice to haves. if a bank’s old offer was 2. o Dealers have one of the strongest lobbying groups around.75% rate (so its economics are safe) and a $200 fee (worse for the dealers). I ended up having to pay an extra $300 to get the car without financing – I was thrilled to later learn he was amongst the 789 dealers who had their franchises cancelled by Chrysler in bankruptcy (OEMs can’t do this outside of bankruptcy). which could be a drawn out fight (for certain CFPB explicitly can’t touch the dealers themselves. This would be a face-saving way of dropping it (the DOJ wouldn’t do anything b/c they’d require evidence of wrongdoing of which I understand there is none. meaning he couldn’t make a few hundred bucks on the origination. F&I income. They’ve already gotten the Congressional Black Caucus to request CFPB produce information to backup their claims (following demands by Minority Dealers Association for the same – its widely believed there is no actual data that discrimination is happening). it could actually be an economics step up for public dealers who are leaning on the rate markups less today. the dealers would flock to this new CFPB-approved model. Think this is more potential upside than downside.  If the new model isn’t competitive for dealers. Update  >>>More recently been feeling less certain this will change at all. it will be very hard for the CFPB to succeed here -.the piece-of-S Chrysler dealer actually reneged on our agreed price when he found out I was just paying cash instead of financing. dealers will quickly shift Chase’s market share to the better options out there. won’t use CFPB’s questionable legal theories). valuation given on the trade-in. the extra rate gives room to pay fixed fees that approximate the capitalized markup that used to be paid to dealers. Everyone makes more money. which the lender expects dealers to mark up by 2% so lender nets 3. that will just get factored into the car purchase price the same way the dealer can give you a better price on the car today if he knows you’re financing with him and buying an extra warranty plan etc. big chunks of auto financing also appear to be outside CFPB’s authority) I think the upshot is this shift should be neutral or positive for dealer economics. Dealers seem confident they’re economics are safe (though you’ll see as you talk to dealers there is a wide variety of competency in this industry so that doesn’t always make me feel better).a decent portion of the industry will stick to old practices & immediately gain a lot of market share. The public guys have monitoring systems to make sure F&I departments are abiding by policies. o Public dealers already cap the rate spread they allow their dealerships to charge. and if it is not. If you push on one side of the transaction the profit just moves elsewhere –  I learned this when I bought a Jeep 5 yrs ago -. but will sleep better when the new system is set – hopefully very soon. sounds like it would be because the CFPB is on super shaky 07/30/13 6:55 PM Page 23 of 26 .  A model that works is the lenders could offer a 4% interest rate and a $600 fee. But I think this is very low probability b/c the new financing model should be neutral to dealers. CFPB will then have to find the authority to enforce against financing channels it doesn’t have any authority over. Wholesale interest rates will rise across the board and probably end up at the same levels customers pay now after the dealer markup. Supposedly after a lot of congressional pressure the CFPB could be considering handing this over to the DOJ. A worst case where all the rate markups go to a $200 flat fee type of scenario puts ~15% of earnings at risk. >>>>>If others out there have done work on this I’d be very interested to hear what you’ve learned on this --.75% wholesale rate.Auto Dealers  o  For example. and so the rest of the auto lending industry follows. CFPB doesn’t have time to chase everyone or authority to enforce over large portions of the auto financing space. Even plain vanilla lenders the CFPB can threaten will certainly have time to adjust their models to follow the first 4. If this happens.75% and pays the dealer $500 for its 1% rate share.

have gotten very comfortable the change will happen and dealers will make just as much money. PNC is a small player in the market.html So as the CFPB if you have to choose your battles and weigh your future. Paul to withdraw the case: http://online. so would almost prefer that outcome so this could all be in the rearview mirror.wsj. last time it was there was it looked like court would rule against it so Obama administration essentially bribed the city of St. “disparate impact” which is a ridiculous and hypothetical legal theory that allows CFPB to allege discrimination without even looking for evidence of discrimination is going back to the supreme court again. this may not be the best fight given its had more political blowback than the typical action against payday lenders or deceptive credit insurance fees >>>I don’t know if this is a negative or a positive.Auto Dealers   ground as it stands and they are getting more political pushback on this than on their typical action b/c the dealer lobby is strong. 07/30/13 6:55 PM Page 24 of 26 . instead of a kick the can down the road and “drop it without officially dropping it” solution >>>The very latest is now that PNC bank has switched to 2% fixed markups on loans – this could be a model offer the CFPB could accept. (CFPB at risk on a variety of fronts– recess appointments case (NLRB) looks like it could go to the supreme court and would put everything CFPB has done at risk of being unwound. If it switches to the 2% flat fee model it’s a non-event for dealers’ profitability. so would have to see others switch over.com/article/SB10001424127887324281004578356581889324790.

I view it differently. these stocks are getting richer multiples on more recovered earnings OEMs GM Ford Tier 1s Delphi 07/30/13 6:55 PM TRW Page 25 of 26 . It also shows how the stock prices have moved. better to focus on OEMs/Tier 1s. but no one pays attention. With OEMs/suppliers. you’re buying a SAAR recovery with SAAR already at 15. so even though we’re now much deeper in SAAR recovery than was expected. But on the real profit driver.. I think this is a reflexive reaction from guys who have been in the industry a long time that view the dealers as the low-beta players due to the stable P&S business.Auto Dealers APPENDIX 6: WHY DOES EVERYONE TELL ME TO FORGET ABOUT DEALERS AND FOCUS ON OEMS/TIER1S? I’ve found it interesting that over and over again people tell me dealers are the wrong way to play a recovery. Tier 1s and Dealers as the SAAR recovery has taken hold over the last few years. This was true for their entire public history when 0-5yr fleet was flat and P&S just grew slowly and steadily. while Dealers are skyrocketing (showing which business model has better operational leverage – though to be fair OEMs/Tier1s also have non-US exposure). given the unanimity of the advice I’ve gotten from sell-siders/buysiders I thought the charts below were interesting – lays out how FY13 EPS estimates have moved over time for OEMs. right now you’re buying that at the absolute SAAR trough (equiv to ~12m/year) going to 17m SAAR with the highest incremental margins relative to existing margins in the auto space. due to the SAAR lag. OEMs/Tier1s stocks are up while EPS estimates are down. dealers are defensive stocks. You get that same exposure with just as high incrementals on the front-end part of the dealers. Seems like a better way to play this. The argument is always that we’re in a SAAR recovery. It’s not the case today. P&S. OEMs/Tier 1s estimates have been falling. you only want to own them when SAAR is at peak. Anyway.3m hoping it goes to 17m (plus whatever happens for better or worse in Europe & China).

only looks starker with F/GM stocks running up further and earnings estimates not moving. And with the OEMs you’re still buying largely fixed cost capacity utilization businesses where capacity is being added. but not as fast. Dealer stocks have risen. Dealers Autonation Asbury Group One Sonic Lithia 07/30/13 6:55 PM Page 26 of 26 . Production is slightly more flexible than pre-bankruptcies. today they get the same multiple on FY13 earnings as they got in ’10 when it was a 3yr forward multiple). so their EPS seems to be significantly increasing with the SAAR recovery (due to high operating leverage on the front end business too.Auto Dealers Dealers on the other hand have seen FY13 estimates climb meaningfully. whereas dealers stocks have increased less than earnings ests…. seems the biggest risk for OEMs is a price war if demand is softer than production schedules. Note: these charts are 3 months dated now but I didn’t want to re-run them all. compressing multiples (e. but still rigid. you get the idea. and P&S has still been a headwind this whole period just flipping to tailwind in ’13). Dealers don’t carry that risk and actually do very well in that scenario. estimates up 20-50% in last 18mo.g.