Analysis

This auto retailer’s credit is being priced like it’s in the middle of the Great Recession, not this very unique recessionary environment

September 23, 2020

The Great Recession was devastating for the automotive industry. Demand collapsed and with it, millions of jobs were lost as large corporations were forced to declare bankruptcy. However, the pandemic-driven recession has been different and much of the declines in vehicle sales have already reversed.

Today’s company is a car retailer with a presence across the United States. The company’s credit profile is being treated as an elevated credit risk because of memory of past recessions, despite its strong liquidity position and industry growth trends.

Below, we show how Uniform Accounting restates financials for a clear credit profile. We also provide the equity tearsheet showing Uniform Accounting-based Performance and Valuation analysis of the company.

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The At-Home Revolution has been great for people who commute and lease cars. Many commute times have been reduced to zero, as companies embrace working from home. For those who lease a car, they no longer have to worry about overshooting the 8,000, 10,000 or 12,000 mileage limits they are capped at annually.

This change in consumer behavior has led to near-term pressures in the new vehicle market. New vehicle sales plummeted 18% year-over-year in July. Consumers are tightening their spending and may be pushing car-buying decisions to the future considering the lack of driving currently.

That being said, this pandemic-driven recession has been different from its predecessors. We have talked previously about how the typical playbook during recessions has been thrown out the window. Generally, auto companies are crushed during downturns.

In the 2008 recession, many auto producers were forced into bankruptcy, including giants like General Motors (GM) and Chrysler (FCAU). New vehicle sales fell by 40%, and nearly 45% of employees within the motor vehicle industry were out of work. It was not until 2014 that vehicle sales reached the previous 2007 peak.

Comparatively, this recession looks nothing like past downturns that have crushed the auto industry. New vehicle sales have only seen half of previous recessions’ declines and the top auto companies remain solvent.

There may also be a faster recovery in the auto markets considering the unique nature of the current economic situation. It is unlikely it will take 7 years to reach the previous vehicle sales peak, as it did in 2008. Auto sales have already begun to bounce back, with each month seeing sharp increases since the low in April. August auto sales were only down 11% year-over-year, highlighting the strength of the recovery.

These factors bode well for companies like AutoNation (AN). AutoNation sells both new and pre-owned vehicles in more than 360 retail locations across the country.

Despite the rebound in car demand, credit markets are treating AutoNation as a high credit risk. We can see why this is misguided by looking at the company’s Credit Cash Flow Prime (CCFP).

AutoNation should have no problem meeting all of its obligations using just its cash flows. As demand snaps back at a much faster rate than previous recessions, AutoNation is well-positioned from a cash flow perspective. This is on top of AutoNation’s significant cash build, as well as revolver availability that can be tapped if necessary.

Despite its strong liquidity position, AutoNation’s credit default swaps (CDS) are being priced at 418bps. This would imply the firm is a high credit risk and may struggle to meet obligations due to decreased car demand.

Our intrinsic CDS (iCDS) sits at just 158bps, pointing out that it is a much safer credit risk than CDS markets perceive. AutoNation has a strong liquidity position and this unique recession means demand shouldn’t be as challenged in the recovery as it normally is.

Considering the lack of any risk in meeting obligations, AutoNation’s CDS of over 400bps appears overly pessimistic. After looking at the company’s CCFP, it is clear AutoNation is well-capitalized to meet any obligations.

While investors may be panicked about past recessions, this just creates an opportunity for those who can see through the noise.

Only when looking at Uniform numbers can we understand just how good of a position AutoNation is in.

A Tightening of CDS Spreads is Likely Given AN’s Strong Cash Flows and Healthy Liquidity

CDS markets are grossly overstating credit risk with a CDS of 418bps, relative to an Intrinsic CDS of 158bps, while cash bond markets are accurately stating credit risk with a YTW of 2.055%, relative to an Intrinsic YTW of 1.845%. Meanwhile, Moody’s is accurately stating AN’s fundamental credit risk, with its Baa3 rating one notch lower than Valens’ IG4 (Baa2) rating.

Fundamental analysis highlights that AN’s cash flows alone should comfortably exceed all operating obligations in each year going forward. In addition, following its recent debt issuance, the combination of the firm’s cash flows and expected cash build should be sufficient to cover all obligations, including debt maturities through 2026.

However, its neutral 75% recovery rate and moderate market capitalization may prohibit the firm from accessing credit markets on an ongoing basis. Should cash flows remain suppressed for a longer period of time, this could prove problematic.

Incentives Dictate Behavior™ analysis highlights mostly positive signals for credit holders. Management’s compensation framework should drive them to focus on all three value drivers: top-line growth, margin expansion, and asset efficiency, which should lead to Uniform ROA expansion and increased cash flows available to service debt.

Moreover, management members have low change-in-control compensation, indicating they are not incentivized to pursue a sale or accept a takeover of the firm, limiting event risk. However, management members are not material owners of AN equity relative to their annual compensation, indicating they may not be well-aligned with shareholders for long-term value creation.

Earnings Call Forensics™ of the firm’s Q2 2020 earnings call (7/23) highlights that management may be downplaying quarterly revenue declines, disruptions to new car production and the wholesale market, and their decision to use their PPP loans to bring back 7,000 furloughed employees.

Moreover, they may be exaggerating their ability to be disciplined with costs and capital, the strength of their liquidity position, and the extent to which customers have returned to their service lanes. Finally, management may be concerned about the impact of coronavirus on non cash charges and with rent and other expenses.

Strong cash flows and healthy liquidity levels suggest CDS markets are grossly overstating AN’s fundamental credit risk. As a result, a tightening of CDS spreads is likely going forward.

SUMMARY and AutoNation, Inc. Tearsheet

As the Uniform Accounting tearsheet for AutoNation, Inc. (AN:USA) highlights, the company trades at a 18.5x Uniform P/E, which is below global corporate average valuation levels, but around historical average valuations.

Low P/Es require low EPS growth to sustain them. In the case of AutoNation, the company has recently shown Uniform EPS improvement of 26%.

Wall Street analysts provide stock and valuation recommendations that in general provide very poor guidance or insight. However, Wall Street analysts’ near-term earnings forecasts tend to have relevant information.

We take Wall Street forecasts for GAAP earnings and convert them to Uniform earnings forecasts. When we do this, AutoNation’s Wall Street analyst-driven forecast projects a 3% and 33% EPS growth in 2020 and 2021, respectively.

Based on current stock market valuations, we can use earnings growth valuation metrics to back into the required growth rate to justify AutoNation’s $53.36 stock price. These are often referred to as market embedded expectations.

The company’s current price is justified, with immaterial UAFRS earnings growth expectations needed each year over the next three years to satisfy market expectations. What Wall Street analysts expect for AutoNation’s earnings growth is below what the current stock market valuation requires.

Furthermore, total obligations—including debt maturities, maintenance capex, and dividends —are above total cash flows, but intrinsic credit risk is 158bps above the risk-free rate, signaling only average credit risk to its operations.

To conclude, AutoNation’s Uniform earnings growth is above peer averages but the company is trading well below average peer valuations.

Best regards,

Joel Litman & Rob Spivey

Chief Investment Strategist &
Director of Research
at Valens Research