Penske Stock: Secular Decline Ahead (NYSE:PAG)

Investment thesis

Penské (New York Stock Exchange: PAG) was extraordinarily well positioned during the pandemic and subsequent semiconductor shortage, driving record earnings and stock prices. However, as the supply of new cars inevitably returns to pre-pandemic levels and consumer demand for the second-hand market is starting to dry up, Penske’s valuation leaves plenty of room for downside risk. Additionally, the increased adoption of electric vehicles could prove disastrous for Penske’s business model. Therefore, given that the global car dealership model may soon be entering a secular decline, I argue that the divestiture and sale Penske’s stock at this high valuation is the best course of action for current owners.

Comprised of 88% of total revenue and approximately 89% of the company’s gross profit, automotive retailing is certainly the main driver of the company’s growth. The shortage of semiconductors caused by the pandemic has strengthened this segment on several fronts. Clearly, the lack of new cars has driven buyers to Penske’s used offerings, which are traditionally far more profitable. According to the National Car Dealerships Association, a dealership can expect to make $2,000 in profit on an average used car sale, compared to just $1,200 on a new car sale.

Additionally, the customer lifetime value of a used car customer is often higher because older cars, on average, will require more ongoing service and maintenance than a new car. While the recent mass adoption of used cars will likely provide years of revenue growth in Penske’s service and parts segment, their sales future is far less certain. In recent months, used car listing prices have begun to decline, illustrating a slowdown in demand as new car production increases and consumer confidence continues to deteriorate.

As the chart above shows, consumer confidence is heading dangerously towards 2020 levels, a time when Penske’s revenues have fallen and new and used car sales volumes have fallen significantly. This can be seen in the graph below.

While many argue that Penske’s business is somewhat insulated from these macro trends due to the inelastic nature of its highly profitable parts and service segment, future developments in the electric vehicle market could begin to change that reputation.

As mentioned earlier, many analysts describe car dealership service operations as the lifeblood of the business, as they are significantly more profitable than car sales, provide ongoing recurring revenue from “sticker” customers, and are sheltered from economic downturns. For example, in 2019, Penske’s service and parts business accounted for 11% of automotive retail revenue, but more than 40% of its gross profit.

While the automotive service and repair industry has remained largely unchanged over the past few decades, the large-scale deployment of electric vehicles could bring about sweeping changes.

In recent years, sales of electric vehicles have exploded worldwide, with an impressive double-digit CAGR. While Penske is involved in the sale of some electric vehicle offerings from traditional automakers, like Mercedes EQS, they are not involved at all with many new electric vehicle companies, like Tesla (TSLA), which has adopted a new DTC model, bypassing intermediaries like Penske. While that alone is worrisome for Penske’s car sales business, the impact EVs would have on their core service and repair business could be even more dramatic. This is because electric vehicles have very few moving parts compared to traditional gasoline-powered cars and, therefore, do not require as much ongoing maintenance.

According to a Consumer Reports study, the lifetime repair and maintenance cost of an EV is half that of a traditional ICE (internal combustion engine) vehicle ($4,600 vs. $9,200). Since parts and service make up such a large portion of Penske’s gross profit, any decline in this segment could significantly reduce the company’s overall profitability.

Evaluation

As Penske’s recent financial reports show, the company is currently in a strong financial position. Revenue grew 22% in FY21 and its EBITDA reached a new high of $1.8 billion, an increase of more than 100% from pre-pandemic levels. However, as I have explained throughout the investment thesis, I believe that the favorable market conditions that allowed Penske to achieve such impressive financial heights may change in the near future. Based on the introduction of electric vehicles and softening demand for used cars among other talking points mentioned in the investment thesis, the revenue model below represents what I believe to be a possible outcome for Penske.

As can be seen above, an increase in new vehicle sales as global supply increases will lead to lower prices and demand for used vehicles, which will slow and eventually plummet vehicle revenues. used from Penske. Importantly, fewer used vehicles on the road, combined with increased adoption of electric vehicles, will reduce revenue from Penske’s highest-margin segment, parts and service. Although this decline may be gradual and delayed as it is a lagging indicator of macroeconomic changes at play (many recently sold used cars will still be on the road and in need of maintenance for several years) , I think it’s inevitable at some point down the road.

Using these revenue projections in a DCF model (7% WACC, 6.2x exit EV/EBITDA, 2% perpetuity growth rate) illustrates the downside potential for Penske stock.

The average DCF price target here is $86.71, which represents 28% downside potential for the stock. Additionally, the sensitivity charts above show how the downside/upside changes with different WACCs, exit multiples, and infinity growth rates.

Conclusion

Penske has certainly emerged from the pandemic as a financially stronger company. There is little the company can do, however, except a complete shift in corporate strategy, in the face of macro uncertainty and disruptors in the form of electric vehicles. On the bright side for Penske, EV adoption is still in the single digits, and right now the used car market is still much stronger than it was before the pandemic. Therefore, the company can still have several years of growth and management has plenty of time to pivot its business model to one more suited to the future economy. However, at Penske’s current valuation, the somewhat substantial long-term risks outweigh the potential upside – hence my sell view on the stock.