AutoCanada Inc.

AutoCanada Inc.

Revenue per share (the red line) had increased strongly and steadily from 2009 to 2015 but declined in 2016 but increased modestly in  2017. Adjusted earnings per share were increasing very rapidly until a decline in 2015 and a further decline in 2016 due to the recession conditions in Alberta where many of the dealerships are located. Adjusted earnings per share were flat in Q2 2017 and grew strongly in Q3 2017, grew modestly in Q4 but declined very significantly in Q1 2018.

AutoCanada Inc.
RESEARCH SUMMARY  
Report Author(s): InvestorsFriend Inc. Analyst(s)
Author(s)’ disclosure of share ownership:  The Author(s) hold shares
Based on financials from: Dec ’17 Y.E. +Q1 ’18
Last updated: 08-May-18
Share Price At Date of Last Update:  $                             17.34
Currency: $ Canadian
Generic Rating (This rating does not consider the circumstances of any individual investor and is therefore not specific advice for any individual): Buy rated at $17.34
SUMMARY AND RATING:  The graph of revenues per share (red line) shows  that revenues per share has recently slowed and adjusted earnings per share declined somewhat. Book value per share (the green line) had previously increased sharply but that was in part due to share issues at well above book value and the growth flattened in 2015 and declined in 2016 mostly due to a write-off of goodwill and intangibles. Book value per share has risen since the start of 2017 partly due to accounting gains upon the sale of interests in four dealerships. The Value ratios would indicate a Buy  rating. Management is relatively new and so the quality of management remains to be seen. The insider trading signal is neutral as there have been no recent trades. Executive compensation is reasonable. The outlook appears to be positive unless the factors that caused sharply lower adjusted profits in Q1 2018 continue. The company has scale advantages over individually owned dealerships. Overall we would rate this as a  Buy. Essentially this investment allows share owners to ride the coattails of a successful consolidator of car dealers and do so at a share price which seems reasonable.
LON TERM VALUE CREATION: AutoCanada as of now, has not created much value in the long term given that its book equity value is almost exactly equally to the share owner capital entrusted to it (with basically no accumulated retained earnings). Based on GAAP the only value creation has been the dividend which was attractive until it was cut in 2016. The market is currently valuing the equity at only 93% of the GAAP level.
DESCRIPTION OF BUSINESS: (Updated from 2018 Q1 report) AutoCanada  owns 54 automobile dealerships and has a total of 4,200 employees. Brands include the various Chrysler Brands (Chrysler, Dodge, Jeep, Ram), FIAT, the various General Motors brands (GMC, Chevrolet, Cadillac , Buick), Infinity, Nissan, Hyundai, Subaru, Mitsubishi, Audi, Volkswagen, Kia, BMW and MINI, Toyota and Lincoln. Revenue categories include new car sales, used car sales, finance and insurance and parts/service.  45% of revenue is from dealerships  in Alberta with a further 20% in B.C. They lease about half of their locations and own the others. These figures exclude the Q2 2018 acquisition of 8 dealerships in the Chicago metro area plus a large autoplex also in Illinois.
ECONOMICS OF THE BUSINESS: In the four quarters ending March 31, 2018, the adjusted net profit was only 1.2% of revenue. This was leveraged up to 2.3% of ending assets as revenues were 85% larger than the assets. The return was further leveraged up to about 7% of ending equity as share owner equity is only 31% of assets. In 2017 gross profits on new vehicle sales to retail customers  was 8.3%, while on new fleet sales it was only 1.9%, For used vehicle sales to retail customers the gross profit was 8.1 and for wholesale used vehicle sales the gross profit was 3.0%. The gross profit on finance and insurance was 91%  and on parts and service was 52%.  Finance and insurance is likely highly profitable on a net income basis. Parts and service may also be quite profitable but it would have substantial costs and assets below the cost of sales line item. Overall the economics of the business are currently somewhat mediocre but this may be to the lingering effects of the energy recession in Alberta. And, the return on tangible equity (after deducting goodwill and equivalent) is 28% indicating that the underlying business is strong and that AutoCanada’s lower ROE is driven by the premium price it paid to acquire dealers. Auto dealers everywhere generally appear to be prosperous businesses and do not appear to be reluctant to spend on facilities which arguably indicates that it is fundamentally good business.
RISKS: See annual report for additional risks. The main risk is likely a risk of lower car sales in recession conditions. Also car manufacturers could decline to allow further consolidation of dealers in groups like AutoCanada.
INSIDER TRADING / INSIDER HOLDING: Based on the period from August 1, 2017 to May 6, 2018 there have been no insider transactions. This may have been due to restrictions on trading as the company is very often involved in activities that might constitute material  insider information. There is no insider trading signal at this time. In terms of insider ownership, CEO Steven Landry owns 25,000 shares  Michael Ross (director) owns 17,000 shares. Gordon Barefoot (director)  owns 9000 shares. Dennis Desrosiers (director) owns 4500 shares and Barry James (director) owns 3267 shares. A few other insiders also own shares. The insider ownership is a positive indicator although most insiders have not increased their share positions in the past few years.
WARREN BUFFETT’s CRITERIA: Buffett indicates that all investments must pass four key tests: the business is  simple to understand and predict (pass), has favorable long-term economics due to cost advantages or superior brand power (marginal pass due to scale advantage and the limited number of dealership locations allowed by manufacturers), apparently able and trustworthy management (pass based on track record), a sensible price – below its intrinsic value (pass), Other criteria that have been attributed to Buffett include: a low  debt ratio (marginal pass), good recent profit history (marginal pass) little chance of permanent loss of the investors capital (pass) a low level of maintenance type capital spending required to maintain existing operations excluding growth (marginal pass at best as dealerships have to be refreshed periodically)
MOST RECENT EARNINGS AND SALES TREND: The growth in adjusted earnings per share in the past four quarters, starting with the most recent, Q1, 2018 was negative 86%, positive 8%, positive 28%, and minus 1%. The “growth” in revenue per share in the same past four quarters was negative 3%, positive 16%, positive 11%, and positive 6. Q1 2018 was very weak in terms of adjusted earnings partly due to some recent dealer divestitures but also due to lower margins on used vehicles and service work in Q1.  While new car sales had declined during the energy recession in Alberta there was little indication of discounting as gross margins on new cars declined only marginally in 2015 versus 2014 and then remained flat in 2016 and increased marginally in 2017 but declined marginally in Q1 2018. Overall, the trend has turned quite negative in the latest quarter after having turned strongly positive in Q3 2017..
COMPARABLE STORE SALES: Comparable store revenue in the most recent four quarters beginning with the most recent (Q1, 2018) were positive 4.6%, positive 11.1%, positive 2.9%, and positive 0.1%. Comparable store total revenue growth is reasonably strong.
Earnings Growth Scenario and Justifiable P/E: The recent P/E of 15.8 could be justified with modest growth.
VALUE RATIOS:  Analysed at a price of $17.34. The price to book ratio is 0.93 which, on its face, seems reasonably attractive, however note that a very large portion of the assets are intangible indicating that the company has already paid a large premium above hard asset value to acquire the dealerships. The dividend yield is modest at 2.3% but represents a payout ratio of only 29% of trailing adjusted earnings. The trailing P/E ratio, based on adjusted earnings, is attractive at 12.6. The adjusted earnings ROE is somewhat unattractively low at 7.9%.  Revenues per share have increased at a compounded 17% annually  in the five years but declined 11% in 2016 and then rose 7% in 2017. Adjusted earnings per share had grown strongly until 2014 but have declined since then despite growing 11% in 2017. Intrinsic value is a less reliable calculation when earnings are volatile but we calculate $24 per share if adjusted earnings growth averages 10% per year and the P/E is 14 in five years or $36 per share if earnings growth averages 15% per year and the P/E is 17 in five years. Both estimates use a required return of 7.0%. Overall, these value ratios would support a rating of Buy.
SUPPORTING RESEARCH AND ANALYSIS  
Symbol and Exchange: ACQ, Toronto
Currency: $ Canadian
Contact: ir@autocan.ca
Web-site: www.autocan.ca
INCOME AND PRICE / EARNINGS RATIO ANALYSIS  
Latest four quarters annual sales $ millions: $3,083.0
Latest four quarters annual earnings $ millions: $59.0
P/E ratio based on latest four quarters earnings: 8.1
Latest four quarters annual earnings, adjusted, $ millions: $37.7
BASIS OR SOURCE OF ADJUSTED EARNINGS: We used the adjustments provided by management involving balance sheet revaluation of liabilities but also deducted any gains on asset sales.
Quality of Earnings Measurement and Persistence: Earnings measurement appears to be reliable given that there are relatively few estimated items. The persistence of earnings deteriorated to a decline in 2015 and 2016 but recovered to an increase in 2017 but then declined significantly in Q1 2018.
P/E ratio based on latest four quarters earnings, adjusted 12.6
Latest fiscal year annual earnings: $57.8
P/E ratio based on latest fiscal year earnings: 8.2
Fiscal earnings adjusted: $41.5
P/E ratio for fiscal earnings adjusted: 11.5
Latest four quarters profit as percent of sales 1.2%
Dividend Yield: 2.3%
Price / Sales Ratio 0.15
BALANCE SHEET ITEMS  
Price to (diluted) book value ratio:                                         0.93
Balance Sheet: (last updated for Q1, 2018) Assets consist of 5% cash, 42% vehicle and parts inventories, 9% accounts receivable (including other current assets)  21% property and equipment (largely dealership land and buildings although in most cases they lease land and buildings) and 23% goodwill and equivalent. These assets are supported on the liability and equity side of the balance sheet as follows: 41% floor plan debt (which approximately equals the inventory), 19% general debt, 5% accounts payable, 2% deferred income taxes, 1% current redemption liability, 31% common equity, 1% minority equity, and other small items.  Overall this appears to be a reasonably strong balance sheet although that depends on the goodwill and equivalent maintaining its value.
Quality of Net Assets (Book Equity Value) Measurement:  This business, like most, is valued for its earnings. The book value of equity is not that much larger than goodwill and equivalent to goodwill (the value of franchise agreements) therefore the tangible equity is quite small.
Number of Diluted common shares in millions:                                  27.5
Controlling Shareholder: The circular to the annual meeting does not clearly disclose this figure and it appears that there is no controlling share holder.
Market Equity Capitalization (Value) $ millions: $476.4
Percentage of assets supported by common equity: (remainder is debt or other liabilities) 30.8%
Interest-bearing debt as a percentage of common equity 60%
Current assets / current liabilities: 1.1
Liquidity and capital structure:  Excluding the debt used to finance inventory (on which it has a negative interest cost due to manufacturer allowances) the debt is 79% as large as equity which does not seem excessive. It appears that the company relies heavily on a very large line of credit as well as long-term debt notes. Overall, the liquidity seems only fair to good.
RETURN ON EQUITY AND ON MARKET VALUE  
Latest four quarters adjusted (if applicable) net income return on average equity: 7.9%
Latest fiscal year adjusted (if applicable) net income return on average equity: 8.9%
Adjusted (if applicable) latest four quarters return on market capitalization: 7.9%
GROWTH RATIOS, OUTLOOK and CALCULATED INTRINSIC VALUE PER SHARE  
5 years compounded growth in sales/share 15.2%
Volatility of sales growth per share:  steady
5 Years compounded growth in earnings/share 11.5%
5 years compounded growth in adjusted earnings per share 4.5%
Volatility of earnings growth:  Somewhat volatile
Projected current year earnings $millions: not available
Management projected price to earnings ratio: not available
Over the last ten years, has this been a truly excellent company exhibiting strong and steady growth in revenues per share and in earnings per share? No
Expected growth in EPS based on adjusted fiscal Return on equity times percent of earnings retained: 6.3%
More conservative estimate of compounded growth in earnings per share over the forecast period: 10.0%
More optimistic estimate of compounded growth in earnings per share over the forecast period: 15.0%
OUTLOOK FOR BUSINESS: The outlook is for continued growth in profitability due to acquisitions and a stronger economy in Alberta. However, Q1 2018 was very weak in terms of bottom line adjusted profit and it is not clear if the factors that caused that will continue in 2018 particularly considering that the recent U.S. acquisitions should more than replace the profits lost in the dealer divestitures made at the start of 2018. In Q! 2018 the cost of financing the floor plan inventory significantly exceeded the manufacturer finance credits whereas previously the credits were larger than the cost. This could indicate that higher interest rates will be a drag on earnings unless manufacturer credits will also increase with interest rates.
LONG TERM PREDICTABILITY: Car dealerships should be reasonably predictable although there is some possibility for eventual  industry disruption such as increased direct sales from manufacturers to customers as well as from the reduced service needs of electric vehicles.
Estimated present value per share: This calculation is subject to great uncertainty because earnings per share are still being affected by the recession in Alberta. However, we calculate  $26 if adjusted earnings per share grow for 5 years at the more conservative rate of 10% and the shares can then be sold at a P/E of 15 and $38 if adjusted earnings per share grow at the more optimistic rate of 15% for 5 years and the shares can then be sold at a P/E of 18. This assumes a robust recovery from the Alberta recession well within the five years and/or rapid expansion outside of Alberta and therefore may be optimistic. Both estimates use a 7.0% required rate of return.
ADDITIONAL COMMENTS  
INDUSTRY ATTRACTIVENESS: (These comments reflect the industry (car dealers in this case)  and the company’s particular incumbent position within that industry segment. Michael Porter of Harvard argues that an attractive industry is one where firms are somewhat protected from competition based on the following four tests. Barriers to entry (pass, since the manufacturers control the number of dealers). No issues with powerful suppliers (fail, because dealers are heavily dependent on the manufactures). No issues with dependence on powerful customers (pass), No potential for substitute products (pass) No tendency to compete ruinously on price (fail because dealers appear to compete aggressively with each other on price). Overall this industry appears to be unattractive as least as far as new car sales.
COMPETITIVE ADVANTAGE: AutoCanada benefits from its scale in a highly fragmented industry.
COMPETITIVE POSITION: The Canadian auto dealer industry has traditionally been highly fragmented and has not included publicly traded entities.  AutoCanada is Canada’s only publicly-traded dealer group.
RECENT EVENTS: In April 2018 the company completed a $1080 million credit agreement with four banks which presumably shows confidence on the part of the banks.  In April 2018 AutoCanada purchased eight dealerships in Metro Chicago plus six brands in an automall (This is considered one large dealership) also in Illinois. The total price was $135 million and did not include land and buildings except in one case. For comparison at March 31 the company owned 54 dealerships and had assets of $1,670 million. The acquisition is expected to increase annual revenues by about 17%. At the very beginning of 2018 the company did transactions with its founder and former CEO who is no longer associated with the company. This involved selling its majority interest in four dealerships for $41.0 million booking a $4.8 million gain as well as a $20.8 million increase to book value and purchasing the 20% minority interest in five others for $18.7 million booking a $2.7 million loss to book value.  On a consolidated basis this reduced the dealership count from 58 to 54 and led to lower revenues and sales in Q1. In the net this was equivalent to the sale of approximately two dealerships. We had understood that they had commenced construction of a new relocated Nissan dealership in Ottawa and this was to open in late 2017 – but the nothing further seems to have been said about this after Q2 2017. An Audi dealership was relocated and expanded recently. A large Mercedes- Benz dealership in Montreal as well as a large Mazda dealership were purchased in May 2017. The long-serving President (not the CEO) retired abruptly in March 2017. This may indicate dissention in the ranks. They opened a new Volkswagen dealership in Sherwood Park Alberta in February 2017. There was a $54.1 million write-off of intangibles and goodwill in Q3, 2016. The founder stepped down as CEO in 2016 and exited the Board in May 2017. A new CEO from outside the company with extensive experience was appointed in April 2016.
ACCOUNTING AND DISCLOSURE ISSUES: The disclosure is good and quite detailed. They give a lot of detail regarding the volume of sales and gross profit on the four categories of their earnings. It is interesting that the adjusted earnings were often lower than the actual earnings. It is rare to see a company adjust earnings lower to remove unusual gains. The company adjusts for the revaluation of the redemption liability to minority owners and we agree with that adjustment as well as their adjustment to remove the portion of stock compensation expense that relates to share price movements. However, it appears that they failed to adjust for or properly discuss the impact of a gain on a sale of a dealership in Q1 2016 but they partially corrected this by adding more line items to adjusted earnings in 2017. But they failed to adjust for a gain on sale of dealerships in Q1 2018. They may have an aggressive view of free cash flow since they treat all dealer relocation and major improvements as growth capital spending.
COMMON SHARE STRUCTURE USED: Normal, one vote per share.
MANAGEMENT QUALITY: Management quality appears to be fairly strong. However, there has been considerable changes in the executive ranks. A new CEO with extensive industry experience was appointed in April 2016. The Chief operating officer announced his retirement at that time as of October 2016 and therefore apparently on good terms. A long-time and very senior executive “retired” abruptly in March 2017. The founder and previous CEO, who previously owned substantial shares  (and may or may not still own) stayed on for one year but retired from the Board in May 2017 (which seems very unusual and may have been something of a red flag). He had interests in other auto dealers and this may have created a conflict of interest concern.
Capital Allocation Skills: It’s not year clear if AutoCanada has shown strong capital allocation skills. The Q3 2016 write-off of goodwill suggests they may have over-paid for some dealerships based on today’s economic conditions. Their decision to issue shares in 2014 appears to have been very astute given the high price received for the shares. Capital allocation skills are paramount for this growth-by-acquisition company. The company spends heavily on dealership relocations and improvements. The early 2016 decision to reduce the dividend to preserve capital for acquisitions was an intelligent move in our opinion.
EXECUTIVE COMPENSATION: In 2017 the compensation of the five named officers ranged from $352,000 to $1.773 million. The executive compensation appears to be reasonable and is not a concern. Compensation for the CEO was considerably higher in 2016 which included a signing bonus and a large award of stock options.
BOARD OF DIRECTORS: Warren Buffett has suggested that ideal Board members be owner-oriented, business-savvy, interested and financially independent. That may describe most of the eight members here. Probably a reasonably  good Board. However there does not appear to be any representation from larger share owners.
Basis and Limitations of Analysis: The following applies to all the companies rated. Conclusions are based largely on achieved earnings, balance sheet strength, achieved earnings per share growth trend and industry attractiveness. We undertake a relatively detailed  analysis of the published financial statements including growth per share trends and our general view of the industry attractiveness and the company’s growth prospects. Despite this diligence our analysis is subject to limitations including the following examples. We have not met with management or discussed the long term earnings growth prospects with management. We have not reviewed all press releases. We typically have no special expertise or knowledge of the industry.
DISCLAIMER: All stock ratings presented are “generic” in nature and do not take into account the unique circumstances and risk tolerance and risk capacity of any individual. The information presented is not a recommendation for any individual to buy or sell any security. The authors are not registered investment advisors and the information presented is not to be considered investment advice to any individual. The reader should consult a registered investment advisor or registered dealer prior to making any investment decision. For ease of writing style the newsletter and articles are often written in the first person. But, legally speaking, all information and opinions are provided by InvestorsFriend Inc. and not by the authors as individuals. The author(s) of this report may have a position, as disclosed in each report. The authors’ positions may subsequently change without notice.
© Copyright:  InvestorsFriend Inc. 1999 – 2018  All rights to format and content are reserved.