Lithia Motors, Inc. (NYSE:LAD) - Navigating Normalization with Resilience and Diversification

Published on September 24, 2024 | Ticker: LAD

Lithia Motors, Inc. (NYSE:LAD) is one of the largest global automotive retailers, providing a comprehensive array of products and services throughout the vehicle ownership lifecycle. The company has demonstrated remarkable resilience and adaptability as it navigates the normalization of industry conditions, leveraging its diversified business model and strategic initiatives to drive consistent profitability.

In the fiscal year 2023, Lithia Motors reported annual revenue of $31,042.3 million and net income of $1,000.8 million. However, the company's performance in the first quarter of 2024 reflects the ongoing industry dynamics, with revenue increasing by 22.8% year-over-year to $8,561.8 million, while net income declined by 28% to $162.6 million.

Business Overview

Lithia Motors operates in two reportable segments: Vehicle Operations and Financing Operations. The Vehicle Operations segment encompasses all aspects of the company's auto merchandising and service operations, excluding financing provided by the Financing Operations segment. The Financing Operations segment, primarily driven by the company's captive finance division Driveway Finance Corporation (DFC), continues to grow and diversify Lithia's business model.

Lithia's comprehensive network of 482 locations across three countries, representing 51 brands, allows the company to provide seamless, blended online and physical retail experiences to its customers. The company's diversification strategy, which includes its Driveway and GreenCars brands, complements its in-store offerings and enables Lithia to deliver differentiated, proprietary digital experiences.

Operational Performance

In the first quarter of 2024, Lithia's total revenues increased by 22.8% year-over-year, driven by growth across all business segments. New vehicle retail revenue increased by 22.4%, while used vehicle retail revenue grew by 25.7%. The company's finance and insurance (F&I) income also increased by 7.0%, and service, body, and parts revenue rose by 24.0%.

However, the company's profitability was impacted by the normalization of gross profit margins. New vehicle retail gross profit margins declined by 280 basis points to 7.4%, and used vehicle retail gross profit margins decreased by 90 basis points to 6.5%. This normalization was partially offset by a 140-basis-point increase in service, body, and parts gross profit margins to 55.0%.

Lithia's same-store performance reflects the ongoing industry dynamics. Same-store new vehicle retail revenue increased by 2.3%, while used vehicle retail revenue declined by 5.0%. Same-store finance and insurance revenue decreased by 4.8%, and service, body, and parts revenue grew by 3.2%.

Financing Operations

Lithia's Financing Operations segment, which includes the company's captive finance division DFC, continues to be a key driver of diversification and profitability. In the first quarter of 2024, the Financing Operations segment reported a loss of $1.7 million, a significant improvement from the $20.8 million loss in the same period of the previous year.

DFC's penetration rate in the United States increased to 11.7% in the first quarter of 2024, up from 10% in the previous quarter. The weighted average APR on loans originated by DFC was 10.2%, up 124 basis points from the prior-year period, while maintaining consistent credit quality. The company remains confident in DFC's ability to achieve profitability in the latter half of 2024 and contribute to Lithia's long-term earnings growth.

Acquisitions and Network Optimization

Lithia's growth strategy is centered around strategic acquisitions and network optimization. In the first three months of 2024, the company completed the acquisition of Pendragon PLC's Fleet Management and UK Motor Divisions, establishing a partnership with Pinewood Technologies and adding a profitable fleet management business to its portfolio. Additionally, Lithia expanded its U.S. footprint in the North Central region with the acquisition of the Carousel Group.

Lithia's disciplined approach to acquisitions targets after-tax returns of more than 15%, with an average return of over 25% by the third year of ownership. The company's acquisition strategy aims to drive network growth, improve customer service, and leverage national branding and advertising.

In response to the current market environment of elevated acquisition pricing, Lithia has adjusted its capital allocation strategy, targeting 50% to 60% of free cash flow towards acquisitions, 25% towards internal investments, and 15% to 25% towards shareholder return in the form of dividends and share repurchases.

Liquidity

Lithia maintains a strong financial position, with available liquidity of approximately $1.3 billion as of March 31, 2024, comprising $264.4 million in unrestricted cash, $49.9 million in marketable securities, and $969.8 million in available credit on its credit facilities. The company's unfinanced real estate could provide an additional $300 million in liquidity.

During the first quarter of 2024, Lithia generated free cash flow of $218 million. The company defines free cash flow as EBITDA, adding back stock-based compensation, less interest, income taxes, capital expenditures, and dividends paid in cash.

Lithia's balance sheet remains well-capitalized, with net leverage of approximately 2.25x as of March 31, 2024, comfortably below the company's target of 3x and its banking covenant requirement of 5.7x.

Outlook

Lithia's management team remains focused on executing its long-term strategy, which aims to achieve an earnings-per-share (EPS) to revenue ratio of over 2:1. Key elements of this strategy include:

1. Driving operational excellence, innovation, and diversification: Lithia is committed to enhancing the customer experience, leveraging data science to improve market share and profitability, and exploring transformative adjacencies, such as its captive finance division DFC.

2. Growth through acquisition and network optimization: Lithia continues to pursue accretive acquisitions that diversify its brand and geographic mix, while also optimizing its existing network through strategic divestitures.

3. Thoughtful capital allocation: Lithia manages its liquidity and available cash to support growth initiatives, including acquisitions and investments in its existing business, technology, and adjacencies, while also returning capital to shareholders through dividends and share repurchases.

Despite the ongoing industry challenges, Lithia's diversified business model, strategic initiatives, and experienced management team position the company to navigate the normalization of industry conditions and continue delivering value to its shareholders.

Conclusion

Lithia Motors, Inc. has demonstrated its ability to adapt and thrive in a dynamic automotive retail environment. The company's comprehensive network, diversified business model, and strategic focus on operational excellence, acquisitions, and capital allocation have enabled it to navigate the normalization of industry conditions while positioning itself for long-term success. As Lithia continues to execute on its strategic initiatives, investors can expect the company to leverage its unique strengths and deliver consistent, profitable growth.

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