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Morningstar | Group 1's 2Q Is Robust and We Like Management's Renewed Focus on Capital Allocation. See Updated Analyst Note from 29 Jul 2018

Group 1 reported good second-quarter results and we are raising our fair value estimate to $65 from $61 to reflect double-digit used vehicle revenue growth that we had not been previously modeling. We forecast revenue to increase 3.6% on a five-year compound annual basis instead of 2.7% previously. Adjusted diluted EPS grew 31% year over year to $2.45, easily beating consensus of $2.14. Revenue increased 10.2% (9.2% excluding foreign exchange) to match consensus of $2.9 billion. Same-store revenue increased 2.2% (up 1.5% on a constant currency basis) with same store used vehicle revenue up 9.8%. All three geographic divisions (U.S., U.K., and Brazil) grew same-store revenue on a constant currency basis, but Brazil's metric including currency impact declined by 5.8% due to a weaker real against the dollar.

We liked what we heard this quarter from management on a new focus on divesting underperforming stores and enthusiasm about returning cash to shareholders often. The latter will mostly be buybacks. Through July 25, Group 1 has repurchased 5.5% of its float during 2018 and $73.4 million of buyback authorization remains. CEO Earl Hesterberg guided for there to be more divestitures than acquisitions for the time being. There is also an interesting opportunity for a strong rebound in oil patch cities such as Houston and San Antonio. Hesterberg said Group 1 stores in these cities still saw negative growth for the quarter despite a soft prior-year comparable quarter. This weakness is occurring because the oil jobs in these cities are more on the support and corporate side, as opposed to drilling, and these corporate jobs have not seen hiring pickup yet. Group 1's stores in West Texas, near the drilling locations, grew slightly. Given that Texas is 35% of new vehicle unit volume globally for Group 1, we think that whenever hiring in Houston accelerates the firm will likely have a positive earnings surprise for that quarter.

Also encouraging is that Group 1's recently announced used vehicle strategy, Val-U-Line (see our March 19 note), enabled the company to retail 2,000 used vehicles in the quarter that it normally would have instead auctioned for little to no profit. Used vehicle revenue increased 20% year over year while used vehicle gross profit rose 14%, compared with only a 2.2% rise for new vehicle gross profit. Val-U-Line was 10% of second-quarter U.S. used vehicle volume and generated an incremental $1.1 million of finance and insurance gross profit, which all flows to operating income because F&I is a 100% gross margin business driven on commissions from third party service providers. Total company F&I gross profit increased by 8.1%.