Lithia Motors Is a Used-Car Dealer Stock That Could Rise 65%. That’s a Good Reason to Buy It.

Text size

Good luck finding a bargain on a used car—but you can get one in the stock of used-car dealer

Lithia Motors
.

This year has been a bad one for auto stocks—and auto retailer Lithia (ticker: LAD) is no exception. Low production has driven up prices for new and used vehicles but also limited sales, because there have been too few cars to sell. Now, the worry is that car prices have peaked along with profit margins for car dealers, while a potential economic slowdown could mean car sales won’t be bouncing back—even when there is enough supply.

Throw in concerns about competition from the likes of

Vroom

(VRM) and

Carvana

(CVNA) and other online retailers, and shares of Lithia, which owns about 280 dealerships nationwide and has a market capitalization of $8.2 billion, have slumped 27% over the past 12 months.

Those worries seem overblown. Lithia, based in Medford, Ore., is growing fast, while margins, which shot higher because of shortages, might be more resilient than the market is giving it credit for. At the same time, Lithia is taking steps to compete with the online used-car sellers. With a single-digit valuation, Lithia looks like a value stock, but it has growth-stock potential.

It’s certainly growing like a growth stock. Sales have increased at an average annual rate of roughly 20% over the past five years, while operating income has grown at about 38% a year over the same span, not too far behind

Amazon.com

(AMZN), which has increased sales by 28% and operating income by 43% over the same period. And Lithia, which is expected to generate about $29 billion in sales in 2022, plans to generate $50 billion in sales by 2025, to go with earnings per share between $55 and $60.

But with the stock trading at just six times 12-month forward earnings, the market doesn’t seem to believe those targets are attainable. One of the reasons is its profit margins. Lithia’s gross profit per unit hit $6,825 in the first quarter of 2022, up from prepandemic margins of about $3,600. Investors are worried that margins will regress to the historical average.

That doesn’t have to happen all at once, says Wells Fargo Securities analyst Colin Langan, who expects margins to remain high for longer than expected thanks in part to Lithia’s Driveway online business, which has grown to 2,000 transactions this past January from 550 in June, though Carvana sold an average of about 35,000 vehicles a month in the first quarter of 2022. “[Lithia’s] omnichannel strategy is compelling in our view as it leverages its existing operations to better serve online customers, possibly giving them an edge on online retailers,” Langan says.

Investors have also worried about the shift to electric vehicles from gasoline-powered ones because it could mean fewer parts to service. That’s a potential problem for Lithia, which generated about a quarter of its gross profit from its parts-and-services business in 2021. But Chief Financial Officer Tina Miller isn’t worried, telling Barron’s that though Lithia does see reduced shop visits with EVs, it also sees higher customer retention. She also expects there to be an opportunity to service EV batteries as they age. Lithia has also leaned into the electrification trend in a big way through its GreenCars initiative, an electric-vehicle learning resource, EV marketplace, and complimentary EV charging network all rolled into one.

Lithia has other growth levers that should make hitting its goals possible. It’s investing in its base business, buying about 30 existing dealerships over the past three years, paying for acquisitions mainly out of cash flow from existing operations. In addition, Lithia’s auto-loan business, known as Driveway Finance, could grow to 15% of cars sold, from about 4% today. It’s “a margin expansion play for us…[and] expands our profitability,” adds Miller.

If everything clicks, Lithia could earn $57 a share by 2025, according to Morningstar analyst David Whiston, which is right in the middle of the company’s guidance. He values Lithia at $467 a share, or 10 times 2022 estimated earnings of about $46.60, up from just six times today. (That might seem extreme, but it’s roughly Lithia’s five-year average.) Whiston’s price would represent a gain of 65% from Friday’s close of $283.13. Even eight times estimated earnings would put the stock at about $375.

“Lithia isn’t just growing really well through acquisitions done in a responsible way—no excessive debt or mass dilution—it’s also [growing] organically,” says Whiston. “Same-store gross profit dollars rose 32% in the first quarter on a 12% revenue increase, for example.”

The trick now is getting investors to believe that 2025 can look that good. Based on Lithia’s history, that seems like a reasonable bet.

Write to Al Root at [email protected]