Recently, rising interest rates have put a lot of pressure on the already struggling automotive sector.

Last month, rate hikes pushed the interest on auto loans to 8.95%, a significant increase from the 5.66% recorded a year prior. This has made it more expensive to buy a new car, especially as prices have already been relatively high.

Buyers now face an average monthly interest expense of $784, compared to $177 at the onset of the pandemic.

Consequently, the souring of customer sentiment towards new cars has negatively affected the automotive market, leading to a negative credit outlook from rating agencies.

Lithia Motors (LAD) is one of the victims of this trend. It is the third largest new vehicle automotive dealership group in the United States.

In addition to being in an economically sensitive industry, the company also has a somewhat risky growth strategy.

Lithia Motors engages in roll-up acquisitions to grow its scale. In other words, the company acquires a large number of small players within its industry to consolidate the automotive dealership market.

Especially since the start of the pandemic, Lithia Motors has been aggressively buying low-performing dealerships at bargain prices.

These dealerships are typically struggling financially and are selling for less than their market value. The company then rehabilitates these dealerships to improve their profitability, by making changes to operations, staffing, and inventory.

The company acquired seven businesses year-to-date, worth nearly $3.6 billion more than all of last year’s activities.

While rating agencies generally dislike highly acquisitive companies, Lithia Motors has a disciplined strategy and seems to be benefiting from it.

The US dealership network is fragmented, with many small and independent dealerships. This makes it difficult to become a dominant player in the first place.

Nevertheless, Lithia Motors has aggressively expanded its business by acquiring these smaller dealerships and leveraging its scale. These dealerships were generally placed in key locations, such as near major population centers.

Over the last four years, the company has acquired businesses that generate an average of $3.7 billion in revenue each year.

On top of that, the management claims a remarkable 98% success rate in their acquisitions, defining success as achieving a post-tax return of at least 15%.

Rating agencies, however, seem to ignore the company’s growing revenue and market dominance and instead only view it as a risky acquirer in a struggling industry.

That’s why, S&P gives Lithia Motors a “BB+” rating. This rating suggests a risk of default around 11% over the next five years. It also places the company in the risky high-yield basket.

Given its successful acquisition strategy and current financial health, we believe it deserves a significantly safer credit grade.

We can figure out if there is a real risk for this company by leveraging the Credit Cash Flow Prime (“CCFP”) to understand how the company’s obligations match against its cash and cash flows.

In the chart below, the stacked bars represent the firm’s obligations each year for the next five years. These obligations are then compared to the firm’s cash flow (blue line) as well as the cash on hand available at the beginning of each period (blue dots) and available cash and undrawn revolver (blue triangles).

The CCFP chart shows that Lithia Motors’ cash flows are more than enough to serve all its obligations going forward.

The chart suggests that the company has a strong financial footing and should be able to meet its obligations without difficulty going forward.

It only has two debt maturities in 2026 and 2027 which doesn’t seem concerning when taking into account its massive cash flows.

Moreover, the company may further increase its earnings through newly acquired companies.

Therefore, in contrast to the rating agencies’ judgment, we believe Lithia Motors does not pose a major default risk.

Thus, we are giving an “IG3-” rating to the company. This rating ensures it is in the safer investment-grade basket and implies a risk of default of around just 1%.

It is our goal to bring forward the real creditworthiness of companies, built on the back of better Uniform Accounting.

To see Credit Cash Flow Prime ratings for thousands of companies, click here to learn more about the various subscription options now available for the full Valens Database.

SUMMARY and Lithia Motors (LAD:USA) Tearsheet

As the Uniform Accounting tearsheet for Lithia Motors (LAD:USA) highlights, the Uniform P/E trades at 14.4x, which is below the global corporate average of 18.4x but above its historical P/E of 11.6x.

Low P/Es require low EPS growth to sustain them. In the case of Lithia Motors, the company has recently shown a 19% Uniform EPS growth.

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, Lithia Motors’ Wall Street analyst-driven forecast is for a 18% and a 1% EPS shrinkage in 2023 and 2024, respectively.

Based on the current stock market valuations, we can use earnings growth valuation metrics to back into the required growth rate to justify Lithia Motors’ $298 stock price. These are often referred to as market-embedded expectations.

Furthermore, the company’s earning power in 2022 was 2x the long-run corporate average. Moreover, cash flows and cash on hand are 3x its total obligations—including debt maturities and capex maintenance. The company also has an intrinsic credit risk that is 160bps above the risk-free rate.

Overall, this signals a moderate credit risk and a low dividend risk.

Lastly, Lithia Motors’ Uniform earnings growth is in line with its peer averages and is trading in line with its average peer valuations.

Best regards,

Joel Litman & Rob Spivey

Chief Investment Strategist &
Director of Research
at Valens Research

This analysis of Lithia Motor’s (LAD) credit outlook is the same type of analysis that powers our macro research detailed in the member-exclusive FA Alpha Pulse.