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Morningstar | Group 1 Closes 2018 With a Tough Comparable From Hurricane Harvey Recovery

Group 1's fourth-quarter results gave us no reason to change our fair value estimate. Adjusted diluted EPS of $2.31 slightly beat consensus and increased 9.5% year over year. Same-store revenue fell 3% but declined by 1.9% on a constant currency basis. Total company revenue increased 0.8% adjusting for foreign exchange, while GAAP revenue fell 0.4% and slightly missed consensus. An 8% increase in total used vehicle gross profit, along with a robust 8.1% rise in financing gross profit, offset a 9.2% fall in new vehicle gross profit and enabled a 1.5% rise in gross profit. Despite this growth the company could not offset a 4% rise in SG&A spending and adjusted operating margin before floorplan interest fell 30 basis points to 3.2%. It's important to note, though, that Group 1 had a tough comparable in the U.S. for the quarter due to fourth-quarter 2017 being very strong in Houston following Hurricane Harvey. For example, due to strong demand to replace damaged vehicles, advertising in fourth-quarter 2017 was pulled back significantly, whereas the firm resumed more typical spending during the fourth quarter of 2018.

Management sounded more upbeat on Texas than it has recently, which may be due to good financial results lately from big oil companies. Texas, by far Group 1's biggest market, constituted 36.4% of new vehicle unit volume in 2018. The U.S. has upside potential for Group 1 this year in our opinion because the extra service headcount added at 57 stores in 2018 to give technicians a four-day work week has doubled customer pay growth at these stores versus stores that don't have it. Service is a very profitable business with gross margins over 50%. The other reason we are optimistic on U.S. results in 2019 is the digital pilot is complete and will be rolled out to all U.S. stores before the end of June, which should make customer satisfaction better and give Group 1 an advantage over smaller stores that don't have the capability to invest in IT as much.

Brazil made money for the quarter and constituted 3.4% of total gross profit. Management sounds upbeat on Brazil in 2019 due to double-digit growth in new vehicle industry volumes in 2018 likely to repeat in 2019 and the new president being good for business. The U.K. in the fourth quarter continued to suffer from lack of inventory due to non-compliance from German automakers with the new WLTP emission standards. Audi is about 30% of Group 1's U.K. new vehicle unit mix and the brand for the U.K. industry in the fourth quarter declined by 46%. CEO Earl Hesterberg sounded upbeat on Audi for the first quarter because January industry sales only fell by 14% for retail sales, but we note that even as inventory recovers the U.K. economy continues to face massive uncertainty over Brexit implementation. The U.K. made up 15% of fourth-quarter gross profit. We asked management about the profit impact should an exit plan not be finalized by the March 29 deadline, but it would not provide numbers. Group 1's plan would be similar to the last recession where headcount on the front end (sales) and back office would be reduced while more emphasis would be given to used vehicle and service sales efforts to compensate for a fall in new vehicle demand.