One Corporate Center Rye, NY 10580-1422 Tel (914) 921-8336 www.gabelli.com Penske Automotive Group (PAG - $28.67 - NYSE) -Please Refer To Important Disclosures On The Last Page Of This Report- June 24, 2013 Gabelli & Company New Top Pick - Buy Year EPS P/E PMV 2015P $ 3.15 9.1 x $ 47 Dividend: $ 0.60 Current Return: 2.1% 2014P 2.85 10.0 x 42 Shares O/S: 90 million 2013E 2.55 11.2 36 52 Week Range: $ 34.34 - $ 20.26 2012A 2.28 12.6 31 COMPANY OVERVIEW Penske Automotive Group, headquartered in Bloomfield Hills, MI, is the second-largest automotive retailer in the United States. Penske has 174 franchises in seventeen states and Puerto Rico and 168 franchises outside the United States, primarily premium/luxury dealerships in the United Kingdom. The company generates just under $10 billion in annual revenue from premium auto brands, with roughly $3 billion generated from volume import brands and $1 billion per year from Detroit 3 brands. We estimate the company will earn $2.55 on sales of $14.4 billion and generate $455 million of EBITDA in 2013. Reason for Comment Penske shares have not participated in the broader market rally in 2013, with the stock down over 4% to $28.67. Investor concerns about margin contraction as well as growth in the company s European operations that have weighed on shares are, in our view, overblown. Penske shares trade at a meaningful margin of safety to our 2014 PMV of $47 per share and we now consider the stock our top pick in the automotive space. - Premium operator with strong growth profile and solid cash flow generation. PAG is a leading automotive retailer with an attractive and diverse brand portfolio in attractive locales both in the U.S. and in the UK. Strong cash flow generation has helped fund a series of acquisitions that should fuel sales growth in excess of underlying market demand in both 2013 and 2014 and position the company well for more deals in the future. Additionally, PAG should benefit from increasing luxury penetration via new launches and a steady refresh schedule. - Stock has underperformed for all the wrong reasons. Investor hesitance regarding PAG shares has centered on the company s European exposure, which we consider misunderstood. Penske generates roughly $5.3 billion of its $14.4 billion in estimated 2013 revenue its European dealership groups, of which roughly $4.6 billion will be generated in the resilient UK market, which has shown registration growth over the last two years as well as continued share gains by luxury OEMs. - Repopulation of core Parts and Service population. PAG has generated positive same store sales comparisons within its profitable parts and service business despite what we estimate is the trough in its addressable P&S auto population. We expect an inflection point for PAG s core P&S market to be reached in 2014, driving the company s two to six-year old population from 800,000 in units to 2014 to just under 900,000 by 2016 and repopulating the set of on-warranty cars that help drive 58% gross margins for PAG s P&S segment. - Balance sheet and cash flow supportive of acquisitions and buyback. PAG leverage at March 31 was 1.9x net debt to EBITDA despite $482 million of net acquisitions completed over the past two years. We estimate the company will generate ~$1.5 billion in FCF after dividends over the next five years which can be utilized to buy dealerships approximating $7.5 billion in revenue or $1.44 in EPS. Investment Case PAG shares trade at a meaningful discount to Private Market Value. Shares currently trade at over a 30% discount to our Private Market Value of $42, corresponding to 8x 2014E EBITDA of $495 million. Table 1 Penske Auto Group Earnings Summary, 2012A-17P in millions, except per share amounts CAGR FYE 12/31 2012A 2013E 2014P 2015P 2016P 2017P '12-'17 Net Sales $ 13,170 $ 14,430 $ 15,220 $ 16,110 $ 16,980 $ 17,640 6.0% % Growth 13.9% 9.6% 5.4% 5.9% 5.4% 3.9% EBITDA 410 455 495 535 590 640 9.3% % Margin 3.1% 3.2% 3.3% 3.3% 3.5% 3.6% EPS $ 2.28 $ 2.55 $ 2.85 $ 3.15 $ 3.55 $ 3.90 11.3% % Growth 26.9% 11.8% 11.8% 10.5% 12.7% 9.9% Capital Expenditures $ 120 $ 110 $ 120 $ 130 $ 130 $ 140 Source: Company reports, Gabelli & Company estimates
THE STRONG GET STRONGER: PREMIUM OPERATOR WITH STRONG CASH FLOW CHARACTERISTICS We regard Penske as a strong operator with excellent free cash flow characteristics run by an entrepreneurial management group with a defined vision for profitable growth over the next several years. As the second-largest automotive retailer in the United States and largest in the UK, Penske enjoys scale advantages that we believe will help the company defend its own market position and steadily grow its footprint via selective acquisitions. We have long held the thesis that the Strong will Get Stronger within the automotive dealership community over the foreseeable future, as larger groups continue to take share from more poorly capitalized competitors. The U.S. auto dealer market remains highly fragmented, with the top-ten dealer groups owning less than 7% of the 17,900 dealerships. We expect the slow motion roll-up of independently owned dealerships by larger, well capitalized dealership groups to continue over the next several years, particularly given large number of older owner-operators without heirs or widely evident succession plans (an accelerating trend in dealer purchases). Exhibit 1 U.S. Auto Dealer Population Source: Automotive News Data Center REPOPULATION OF PARTS AND SERVICE VEHICLES We find it likely that increasing supply, a weaker Yen, and a consumer base with greater access to information will all factor into gross margin headwinds on new vehicles going forward. Therefore, it is critical for dealer health that its Parts and Service arm be supplied with a steady stream of two- to six-year old vehicles that provide a recurring, highly profitable revenue stream. Penske, by virtue of its exposure to Premium brands, enjoys a highly captive customer base that overwhelmingly chooses to have its vehicles serviced at the dealer as opposed to independent service shops. This loyalty to dealer service is a driving factor behind the company s leading 58% P&S gross margin. The population of profitable four and five-year old vehicles has been declining for the past two years as the low new vehicle sales years of 2009 and 2010 cycle through the car parc. We view 2014 as the inflection point for the critical 2-6 year old vehicle demographic (very little breaks on 0-1 year old cars). The dynamic is similar for the 4-5 year old vehicle subset, which we regard as most critical for dealers given ~50,000 miles of wear and tear coupled with the last two years for those vehicles being under factory warranty. For Penske, we estimate the population of core parts and service vehicles will bottom at some point in 2014 before beginning a multi-year ramp. This is particularly true in 2016 when the core 2-6 year old market jumps 8%, with four and five year vehicles (still on warranty) increasing 9.3%. Exhibit 2 PAG 4-5 year old vehicle population Exhibit 3 PAG 2-6 year old vehicle population Source: Company filings, Gabelli & Company estimates -2-
While this inflection point should provide a tailwind for the entire dealer population, PAG is likely to see outsized benefits as P&S initiatives (oil changes, tires, customer retention programs) over the last three years have proven successful. Penske parts and service same store sales have comped positive for ten consecutive quarters despite the decline in its addressable warranty market, positioning the company well for outperformance as the market turns. Ex. 4 PAG P&S Same Store Sales Source: Company filings, Gabelli & Company estimates Regarding our model, we conservatively estimate PAG can grow same store comps by 2% per quarter through the end of 2014 at which time comps begin to accelerate to the 4% range (with our bias to the upside). Given its present footprint (which is likely to expand), every 1% increase in P&S same store comps adds roughly $13 million in annual revenue, equating to $4.9 million in net income or ~$0.05 per share. NEW VEHICLE MARGIN CONTRACTION LESS IMPORTANT THAN INCREASING NEW UNIT VOLUME PAG gross profit per new unit retailed declined $104 YoY in Q1, partially due to a difficult comp vs. elevated margins on Japanese vehicles sold early in 2012 given long term inventory constraints due to the March 2011 Tsunami. Nevertheless, the decline in unit profitability lent credence to those believing that lower new vehicle margins would structurally diminish dealer profitability. We find this theory misleading in a rising sales environment. While dealers do not strive to lose money by dropping prices on new cars, the fact remains that a $100 loss on a new vehicle now will likely be repaid many times over in Parts & Service gross profit in the following years. Oregon-based Lithia Motors, the 9 th -largest auto group, provides a good representation for the order of magnitude of gross profit a sold vehicle makes for a dealership in the years following the sale. In years zero and one, revenue is minimal as wear and tear on a new car has yet to snowball. Thereafter, however, revenue (and profit) soars. All told, Lithia generates $550 of service gross profit over five years for each car that it sells. Applying the $550 amount to Penske (which we believe is low given mix differences), margin compression of $100 per unit on a new vehicle will be more than made up by the service opportunities on the back end. Exhibit 5 Lithia Motors Cumulative Gross Profit by Model Year Source: Company filings, Gabelli & Company estimates -3-
UK MARKET RESILIENCY One of the largest pushbacks we get from investors regards Penske s European exposure. Penske is the largest dealership group in the United Kingdom, an area that has largely avoided the broader declines that have beset the balance of the Europe. United Kingdom automotive sales have grown for thirteen consecutive quarters. Finally, market share in the UK for premium brands has steadily crept higher over the past several years, owing both to relatively weaker sales for volume brands (particularly at the low end) as well as efforts made by German automakers to move down-market and capture customers with entry-level luxury vehicles with price tags comparable to heavily contented volume brands (Audi A3, BMW 1 series, Mercedes A-Class etc.). Exhibit 6 Premium Luxury Brand share of UK Market Penske s European exposure is almost exclusively (95%) with premium/luxury brands, meaning the company s customers do not consist of marginal buyers that will more than likely choose the deferral of an automotive purchase given personal economic uncertainty. Penske s UK customers (both retail and corporate) are typically better capitalized, with upwards of 50% of UK buyers purchasing vehicles for cash. We further view the drop in the top UK marginal tax rate to 45% from 50% as particularly helpful in maintaining steady premium demand among upper income buyers. EARNINGS RAMP CLEAR AND PREDICTABLE We model PAG new unit same store sales growth to mirror SAAR in the US over the next four years, while keeping company sales in the UK flat, giving the company no credit for potential (and likely) future acquisitions. Additionally, we model 10bps of gross margin pressure on new units through 2014, while used unit margin contracts 10 bps annually to 2016. We keep service and parts gross margin flat at 58.6%. Regarding SG&A, we see 50bps in annual improvements in the company s SG&A to Gross Profit ratio, approximating ~60bps of SG&A margin improvements over a 5 year period. Finally, we view floorplan expense (the dealer cost of carrying inventory) as an operating expense and include it in our EBITDA calculation. With these inputs, we conservatively see a clear ramp for the company to drive earnings growth at a 12.5% CAGR for the next five years from $2.55 per share in 2013 to upwards of $3.90 per share by 2017, with EBITDA rising 10% annually over the same time frame. Table 2 Source: Company filings Penske Auto Group Earnings Summary 2012A-17P in millions, except per share amounts CAGR FYE 12/31 2012A 2013E 2014P 2015P 2016P 2017P '12-'17 New Vehicle Sales $ 6,780 $ 7,660 $ 8,050 $ 8,500 $ 8,870 $ 9,050 Used Vehicle Sales 3,745 4,050 4,380 4,735 5,120 5,535 Finance & Insurance 325 355 370 395 420 440 Service & Parts 1,445 1,540 1,570 1,615 1,680 1,715 Fleet & Wholesale 865 830 845 860 880 895 Total Sales 13,160 14,440 15,220 16,110 16,970 17,640 6.0% Gross Profit 2,013 2,191 2,294 2,406 2,523 2,610 EBITDA (incl. Floorplan) $ 410 $ 455 $ 495 $ 535 $ 590 $ 640 9.3% EBIT (incl. Floorplan) 325 365 395 425 465 500 Adjusted Net Income 206 231 257 283 318 351 Shares Outstanding 90 90 90 90 90 90 Adjusted EPS $ 2.30 $ 2.55 $ 2.85 $ 3.15 $ 3.55 $ 3.90 11.1% Source: Company reports, Gabelli & Company estimates -4-
FREE CASH FLOW AND BALANCE SHEET SUPPORT FURTHER ACQUISITIONS Penske has been the most aggressive acquirer among the publicly traded dealership groups over the past three years, having acquired dealerships representing approximately $750 million in annualized revenue in 2012 alone. However, the increased purchase activity has not resulted in excess balance sheet leverage, a testament to the strong cash flow produced by the dealer model. In fact, PAG spent $482 million in 2011 and 2012 on dealership acquisitions, while keeping net debt/capital flat at 42% and reducing net debt/ebitda from 2.7x in 2010 to 2.3x in 2012 in the process (currently 1.9x NTM). We estimate PAG will generate over $1.5 billion in free cash before dividends over the next five years (just under $1.0 billion including dividends) for which it can continue to either be selectively acquisitive or strategically buy back shares. Using the company s acquisition of its Ontario BMW/Mini franchise as a proxy for future company acquisition multiples (roughly 20% of sales), PAG will be able to acquire over $7.5 billion in dealer revenue over the next five years, equating to an additional $1.40 in earnings per share by 2017. Table 3 Potentially Acquirable Revenue and Earnings with Free Cash Cumulative Free Cash, 2013-2017 $ 1,530 Acq. Dealer Revs @ 20% of Revs 7,649 Net Income @ 1.7% after tax margin 130 PAG Shares outstanding 90.4 Potentially acquirable EPS $ 1.44 Assuming the highly unlikely scenario in which the company makes no acquisitions, PAG would be debt free by the end of 2016. Table 4 in millions, except per share amounts 2012A 2013E 2014P 2015P 2016P 2017P Net Income 187 232 258 284 319 352 + Depreciation 54 61 69 78 87 96 Non-Floorplan Interest 47 51 45 38 30 20 Income Taxes 94 112 125 138 154 171 Disc Ops/One Time Items (2) (2) (2) (2) (2) (2) Adjusted EBITDA 380 455 495 535 588 637 Less: Working Capital Inc. (60) (60) (60) (60) (60) (60) Less: Capex (115) (113) (119) (126) (132) (138) Less: Dividends (44) (46) (48) (50) (53) (56) Free Cash Flow 162 236 268 299 342 384 Net Debt/(Cash) @ Year End $ 894 $ 820 $ 720 $ 596 $ 437 $ 243 Source: Company reports, Gabelli & Company estimates Penske Free Cash Flow 2012A-17P We expect PAG to continue to expand its international operations, where it currently sees more attractive dealership multiples. According to the company, acquisition multiples in the US remain higher than the company is willing to pay. We also see the non-recurrence of major capital improvement projected required by dealers. The company has spent over $2.3 billion in capital expenditures over the last decade on continuing improvement projects, primarily for now-completed programs for Audi and Mercedes. Penske notes some requirements for BMW dealerships, particularly in the UK, but expects capital expenditures to remain in the $110-115 million range for the foreseeable future given its current footprint. Entrepreneurial management not afraid to think outside the box Roger Penske s entrepreneurial spirit is evident within the organization, which has shown a willingness to expand outside the company s core operations to drive shareholder returns. While not all have been successful (Smart), the company has maintained discipline regarding investment and has generally avoided major missteps (Saturn distribution). More recently, Penske completed the acquisition of the Hertz rental car franchise for the Indiana market, and now operates fifty on and off-airport locations in Memphis and throughout Indiana. The rental car business, while small, can provide critical sourcing of high-content, low mileage used vehicles that the company can retail as used units without having to engage in potentially high cost third party auctions. -5-
VALUATION IS ATTRACTIVE FROM BOTH A PMV AND MULTIPLE PERSPECTIVE PAG shares currently trade at a greater than 30% discount to our 2014 Private Market Value estimate of $42 per share. While we view the chances of a strategic purchase of PAG near zero, margin of safety at less than 7x 2014E EBITDA and ~10x 2014E EPS is more than sufficient for our Buy Recommendation. Our model assumes PAG will pay down debt with its excess free cash- a tactic we find least likely (particularly given PAG s current valuation). We do not model any new acquisitions by PAG. Table 5 Penske Automotive Group Private Market Value Analysis 2012A-2017P in millions, except per share amounts FYE 12/31 2012A 2013E 2014P 2015P 2016P 2017P Revenue $ 13,170 $ 14,430 $ 15,220 $ 16,110 $ 16,980 $ 17,640 EBITDA (incl. PTL) 410 455 495 535 590 640 Valuation Multiple 9x 9x 9x 9x 9x 9x Total Private Market Value $ 3,690 $ 4,095 $ 4,455 $ 4,815 $ 5,310 $ 5,760 Less: Net Debt (894) (820) (720) (596) (437) (243) Less: Option Payments (a) (3) (4) (5) (5) (6) (7) Equity Private Market Value $ 2,793 $ 3,271 $ 3,730 $ 4,214 $ 4,866 $ 5,509 Shares Outstanding 90 90 90 90 90 90 PMV per Share $ 31 $ 36 $ 42 $ 47 $ 54 $ 61 Market discount to PMV 7% 21% 31% 39% 47% 53% Source: Company reports, Gabelli & C o m pany estimates (a) After-tax payments to buy out options holders at Private Market Value Other Companies Mentioned: BMW AG (BMW GR) Hertz Global Holdings (HTZ NYSE) Lithia Motors, Inc. (LAD ) Penske Automotive Group - Price Performance Source: Public data. As of June 24, 2010 PAG was rated HOLD and changed to BUY on July 30, 2010. I, Brian Sponheimer, the Research Analyst who prepared this report, hereby certify that the views expressed in this report accurately reflect the analyst s personal views about the subject companies and their securities. The Research Analyst has not been, is not and will not be receiving direct or indirect compensation for expressing the specific recommendation or view in this report. Brian Sponheimer (914) 921-8336 Gabelli & Company 2013 Important Disclosures ONE CORPORATE CENTER RYE, NY 10580 GABELLI & COMPANY TEL (914) 921-3700 FAX (914) 921-5098 Gabelli & Company ("we" or "us") attempts to provide timely, value-added insights into companies or industry dynamics for institutional investors. Our research reports generally contain a recommendation of "buy," "hold," "sell" or "non-rated. We do not undertake to "upgrade" or "downgrade" ratings after publishing a report. We currently have reports on 662 companies, of which 43%, 40%, 3% and 14% have a recommendation of buy, hold, sell or non-rated, respectively. The percentage of companies so rated for which we provided investment banking services within the past 12 months is 0%, 0%, 0% and less than 1%. Ratings Analysts ratings are largely (but not always) determined by our private market value, or PMV methodology. Our basic goal is to understand in absolute terms what a rational, strategic buyer would pay for an asset in an open, arms-length transaction. At the same time, analysts also look for underlying catalysts that could encourage those private market values to surface. A Buy rated stock is one that in our view is trading at a meaningful discount to our estimated PMV. We could expect a more modest private market value to increase at an accelerated pace, the discount of the public stock price to PMV to narrow through the emergence of a catalyst, or some combination of the two to occur. A Hold is a stock that may be trading at or near our estimated private market value. We may not anticipate a large increase in the PMV, or see some other factors at work. A Sell is a stock that may be trading at or above our estimated PMV. There may be little upside to the value, or limited opportunity to realize the value. Economic or sector risk could also be increasing. We prepared this report as a matter of general information. We do not intend for this report to be a complete description of any security or company and it is not an offer or solicitation to buy or sell any security. All facts and statistics are from sources we believe to be reliable, but we do not guarantee their accuracy. We do not undertake to advise you of changes in our opinion or information. Unless otherwise noted, all stock prices reflect the closing price on the business day immediately prior to the date of this report. We do not use "price targets" predicting future stock performance. We do refer to "private market value" or PMV, which is the price that we believe an informed buyer would pay to acquire 100% of a company. There is no assurance that there are any willing buyers of a company at this price and we do not intend to suggest that any acquisition is likely. Additional information is available on request. As of May 31, 2013 our affiliates beneficially own on behalf of their investment advisory clients or otherwise approximately less than 1% of Penske Automotive Group, BMW and Hertz. Because the portfolio managers at our affiliates make individual investment decisions with respect to the client accounts they manage, these accounts may have transactions inconsistent with the recommendations in this report. These portfolio managers may know the substance of our research reports prior to their publication as a result of joint participation in research meetings or otherwise. The analyst who wrote this report may receive commissions from our customers' transactions in the securities mentioned in this report. Our affiliates may receive compensation from the companies referred to in this report for non-investment banking securities-related services, or may be soliciting these companies as clients for non-investment banking securities-related services. The analyst who wrote this report, or members of his household, owns no shares of the above-mentioned companies. -6-