Low Debt, Ample Liquidity, and Pent Up New Vehicle Demand Are All Favorable for Penske

Sector Strategist

David Whiston

Penske Automotive Group receives over 90% of its light-vehicle dealer revenue from import and luxury brands. This percentage is significantly higher than many dealers and helps mitigate the cyclical nature of auto sales; these brands have more-affluent customers who will not limit their discretionary spending during a downturn. Despite this wealthy customer, the firm's operating margin tends to be on the lower end of the publicly traded dealers. Penske gets less of its gross profit from higher-margin finance and insurance commissions than its peers, and selling, general, and administrative expenses (including rent expense) as a percentage of gross profit are higher than the other public dealers. Penske cannot get as much finance business--a 100% gross margin business--as its peers because more of its customers lease vehicles or pay cash. When excluding rent, Penske's SG&A ratio is competitive.

Penske has heavy-truck distribution in Australia and New Zealand, 44 truck dealers in the U.S. and Canada, and 20 CarShop used-vehicle stores in the U.S. and U.K. The National Automobile Dealers Association reports that as of 2022, the number of U.S. new-car dealerships was 16,773, down from 25,025 in 1987. This highly fragmented industry is always consolidating because smaller players cannot compete with the scale of the public franchise dealers, and it's very difficult for a small operator to be awarded an open point by an automaker for a new store.

Parts and service was only 10% of 2022 retail automotive revenue but made up 35% of gross profit. This significant contribution to profitability is less volatile than new- and used-vehicle sales and will continue to mitigate the cyclical risk of the auto industry. Large dealers are enjoying a growing competitive advantage for repair work because the increasingly advanced technology of cars presents an obstacle for smaller repair shops that are less able to afford the equipment and training needed to provide competent service. Consumers incur search costs (most notably time) to get many service estimates, which we think makes it more likely that they will keep going to the dealer.

Business Strategy & Outlook

We are maintaining our narrow moat rating, as Penske's size continues to generate economies of scale and working capital efficiencies while the service segment's warranty work gives the company an intangible advantage over garages. A large dealer such as Penske can move inventory around to different stores where it will be in most demand, something a small dealer with just one or two stores in that same market cannot do. We think the dealer sector is the best business in the automotive supply chain. The public dealers can centralize back-office operations and generate far more volume than a small dealer, which brings scale. Dealers have no burdensome retiree expenses, and the large public dealers are not dependent on the health of one brand. The dealers enjoy mid- to high-single-digit gross margins on new vehicles and 100% gross margins on financing and insurance. We think the best source of competitive advantage is the parts and service operations. Many customers bring their vehicle to the dealer for servicing because either the vehicle is under warranty or the dealer is close to home and has the factory parts and expertise to service the vehicle. Once vehicle owners know a dealer, we think they are likely to keep going back to the dealer for service. The dealer knows the vehicle, and comparison-shopping for repair work is very time-consuming since the customer has to bring the vehicle to each shop to get a quote. These cost advantages and intangible advantages from service give dealers a moat.

These logistics create inelasticity of demand, which creates pricing power for the dealer and is a source of excellent profit in good times and bad. In fact, during a downturn in new-vehicle sales, dealers generally report higher gross margins due to a favorable mix shift to parts, but then report lower operating margins due to SG&A deleveraging. Excluding large impairment and restructuring charges, dealers can still report positive EBIT even in a severe recession. Although most dealerships are good businesses, we think the large publicly traded dealers are best positioned for growth since they can be the most flexible in changing brand mix. Many small-business owners are choosing to exit or sell because they cannot get the scale on a variety of expenses compared with large dealer groups.

Narrow

Economic Moat

Penske Automotive Group

Penske Automotive Group, Inc. operates as an international transportation services company. Which engages in the distribution of commercial vehicles, diesel engines, gas engines, power systems and related parts & services. It operates through the following segments: Retail Automotive, Retail Commercial Truck, Non-Automotive Investments, and Other. The Retail Automotive segment consists of retail automotive dealership operations. The Retail Commercial Truck segment is the dealership operations of commercial trucks in the U.S. and Canada. The Other segment comprises commercial vehicle and power systems distribution operation and other non-automotive consolidated operations. The Non-Automotive Investments segment is the equity method investments in non-automotive operations. The company was founded in October 1992 and is headquartered in Bloomfield Hills, MI.

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Penske Automotive Group, Inc. is an international transportation services company, which engages in the distribution of commercial vehicles, diesel engines, gas engines, power systems, and related parts and services. It operates through the following segments: Retail Automotive, Retail Commercial Truck, Non-Automotive Investments, and Other. The Retail Automotive segment includes retail automotive dealership operations. The Retail Commercial Truck segment includes the dealership operations of commercial trucks in the U.S. and Canada. The Other segment focuses on the commercial vehicle and power systems distribution operation, and other non-automotive consolidated operations. The Non-Automotive Investments segment includes equity method investments in non-automotive operations. The company was founded in October 1992 and is headquartered in Bloomfield Hills, MI.

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Penske Automotive Group, Inc. (NYSE:PAG ) Q2 2023 Earnings Conference Call July 26, 2023 2:00 PM ET Company Participants Anthony Pordon - EVP of IR and Corporate Development Roger Penske - Chairman and CEO Shelley Hulgrave - EVP and CFO Richard Shearing - North American Operations Randall Seymore - International Operations Conference Call Participants John Murphy - Bank of America Rajat Gupta - JPMorgan Daniel Imbro - Stephens David Whiston - Morningstar Operator Ladies and gentlemen, good afternoon. Thank you for standing by, and welcome to the Penske Automotive Group Second Quarter 2023 Earnings Conference Call.

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