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Morningstar | Lithia Rightfully Takes Long-Term View in 2Q Results

We are not changing our fair value estimate for Lithia Motors despite the company's second-quarter adjusted diluted earnings per share of $2.52 missing consensus of $2.94. The company saw a big selling, general, and administrative expense headwind in the quarter with adjusted SG&A as a percentage of gross profit rising 430 basis points year over year to 71.3%. Higher labor costs, especially in sales associates, seems to be to blame, but it also sounds like Lithia's large acquisition pace over the years caused some growing pains in the quarter. CEO Bryan DeBoer pointed out that about two thirds of the nearly 200 stores have been with Lithia only three or four years. We believe this shows that although results may disappoint from time to time, the long-term earnings growth story at Lithia is very attractive. Lithia's best stores have SG&A to gross profit ratios in the mid-50s while newer ones have ratios in the mid-80s.

Management prefers to buy underperforming stores that it can turn around; it is a value investor, so to speak. This strategy means that sometimes profits hit bumps, but the long-term road looks interesting to us because the company is investing for future profits. To keep investors focused on the long term, the company announced that starting in 2019, it will no longer provide annual earnings guidance.

These growing pains, along with higher interest rates increasing floor-plan interest more than management expected, led to Lithia lowering its 2018 full-year adjusted EPS guidance to $9.50 from $10.60. The change seems to be more due to expense issues than revenue, but top-line guidance also fell to $11.75 billion-$12.25 billion from $12.0 billion-$12.5 billion. This guidance does not account for future acquisitions, and we expect Lithia to remain highly acquisitive.

Lithia is looking nationally at both rural and metro areas and has plenty of opportunities in the United States. It is not present in the Southeast, which may take some time as management believes there are not many underperforming stores there and asking prices have been high, but we think the company will be there eventually. Expansion outside the U.S. to Canada and the United Kingdom is also probably on management's radar.