Extension and protection opportunity in AutoNation

admin | August 23, 2019

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

A steep curve coupled with coupon step language that provides for an interest rate adjustment should ratings lose their investment grade status, provides for an attractive extension opportunity in the AutoNation Inc. (AN – Baa3/BBB-/BBB-) curve.  AN’s 5-year to 8-year curve is steep relative to other BBB peers at +50 bp g-spread, with names such as Dollar Tree (DLTR – Baa3/BBB-/BBB-) and AutoZone Inc. (Baa1/BBB/BBB) trading closer to +30 bp g-spread (Exhibit 1). A swap out of AN 4.5% 2025 into AN 3.8% 2027 bonds enables investors to take out nearly five points in premium, pick +20 bp in g-spread while moving into a bond that provides ratings protection.

Exhibit 1: Low BBB – retail curve

Source: Bloomberg

Coupon step language

Both the AN 3.5% 2024 and the AN 3.8% 2027 bonds are the only bonds in AN’s capital structure that contain coupon step language. The language provides for the interest rate to adjust up 25 bp per downgrade notch, per agency (Moody’s and S&P) should the ratings fall below investment grade, absent a change of control (COC).  The maximum adjustment is 200 bp, or four notches by Moody’s and four notches by S&P. Should the ratings fall below B1 at Moody’s and B+ by S&P, the coupon would not step up any further.  The coupon step language is not to be confused with the COC put language that gives the holder the ability to put the bonds back to AN at $101, should a COC occur causing the ratings to fall below investment grade.

Resilient business model

 While demand for new vehicles is cyclical in nature, AN demonstrates a relatively resilient business model with a diverse vehicle product offering (domestic, import, premium luxury) coupled with services businesses. AN’s diversified business model provides for some margin insulation in economic downturns and profit/cash flow stability. Aside from vehicle sales, AN participates in the higher margin and recurring in nature parts & services and finance & insurance businesses.  While parts/service and finance/insurance combined only represent roughly 21% of revenues, they make up the majority of gross profit. Parts/service generated nearly 46% of gross profit in fiscal 2018, while finance/insurance accounted for roughly 29% of gross profit.

AN’s recent shift in focus to used vehicles has also helped to improve margins. Used car volume SSS were up 7.6% in the quarter, the strongest growth in used cars in the past four quarters. This is important as used vehicle sales carry a much higher gross profit margin per vehicle retailed than new vehicle sales. In 2Q19, AN’s gross profit per used vehicle was 69.3%, 24 percentage points higher than the gross margin per new vehicle. That said, while total SSS were flat year-over-year in 2Q, gross margin was up 5% in the quarter reflecting the used vehicle sales growth and subsequent growth in customer financial services. Additionally, while AN’s annual EBITDA margin has been maintained in the 4.4%-4.8% range since FYE09, the company posted a 4.8% margin on a LTM basis ended 6/30/19.

Conservative financial profile

 AN has historically maintained a conservative financial policy and has reiterated its commitment to investment grade ratings.  As such, management strives to keep leverage below 3.0x.  AN ended 2Q19 with leverage, as defined by the credit agreement, at 2.84x.  We note that this is down from 3.06x at year end 2018. Management has in the past suspended its share repurchase program to direct free cash flow to debt reduction during times of EBITDA contraction and after acquisitions.

Liquidity remains solid

Liquidity is solid as AN maintains a $1.8 billion revolver (maturing 10/19/22) that acts as a backstop to its commercial paper (CP) program. As of 6/30/19, AN had $41.7 million of letters of credit outstanding and $470 million of CP outstanding, leaving $1.29 billion of availability. Liquidity also benefits from good free cash flow which totaled $325 million on an LTM basis.  Additionally, AN’s debt maturity profile is very manageable with no debt walls and nothing maturing until 2/1/20 when $350 million comes due.  AN only has five issues outstanding with no issue larger than $450 million.