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Morningstar | AutoNation Has SG&A Headwinds From New Vehicles and Branding Investments in 3Q

AutoNation's third-quarter revenue miss probably explains the stock falling nearly 10% the morning of Oct. 30. We think the stock is cheap and we are not changing our fair value estimate. Revenue fell 1.5% year over year to $5.35 billion, slightly missing consensus of $5.56 billion. Diluted EPS from continuing operations of $1.24 grew 24% and set a third-quarter record while matching consensus. Same-store revenue declined only 0.6% while new-vehicle same-store revenue fell 4.4%. New vehicle was the only core area with a revenue decline. The segment appears to be hit hard by fierce competition, with total company new-vehicle unit sales down 8.1% and new-vehicle gross profit per unit down 5.8% to $1,583. The other areas of variable operations, used and finance, posted increases in GPU of 2.3% and 6.7%, respectively, which suggests to us the problems lie in new. Data on new-vehicle unit mix by brand shows Ford to be the problem area. Ford and Lincoln made up 12.4% of new-vehicle unit volume in the quarter, down from 14.2% in the third quarter of 2017. Ford's lineup is old, but that will change next year with new generations of popular models such as the Escape and Explorer crossovers and Ranger pickup.

The company has long recognized the rising difficulties in new-vehicle profitability for all dealers, which is why in the past few years it rebranded stores under the AutoNation name, opened five stand-alone used-vehicle stores under a new brand, AutoNation USA, and invested in AutoNation branded parts. It expanded this investment this quarter with the launch of a private-label credit card in association with Synchrony. We like these moves a lot because as the largest U.S. dealer, AutoNation can leverage its brand in ways like this that smaller dealers can't. Its SG&A leverage has suffered for these investments, but with most spending behind it, we are optimistic that AutoNation will resume its place as one of the best SG&A dealers in the space next year.

Also noteworthy is that AutoNation announced a $50 million investment for about a 7% stake in used-vehicle online retailer Vroom. CEO Mike Jackson did not want to discuss reasons for the move in detail but did say discussions will take place to see what else the firms can do together. He spoke highly of Vroom's leadership team, which includes former Priceline.com CEO and CMO of Booking.com Paul Hennessy. This investment is a key reason, in our view, that AutoNation did not repurchase any stock in the third quarter. We hope management becomes aggressive in repurchases soon, as it has been in the past, because the stock trades well below our fair value estimate.

The Vroom investment happened about the same time that Lithia Motors, another dealer we cover, announced a similar investment in online used-vehicle retailer Shift. We think both AutoNation and Lithia will try to learn from their partner's artificial intelligence capabilities while gaining another portal to one day sell and procure more used vehicles. This opportunity, along with spending on branding discussed earlier, probably explains AutoNation's management saying on the call that the USA store count will stay at five in 2019. We are not terribly bothered by freezing the store count because AutoNation can afford to be cautious as it enhances its playbook for stand-alone used stores. The USA stores are not profitable but deducted less than $0.02 from EPS for the quarter.