Group 1 Automotive

Group 1's stock fell over 16% in intraday July 30 trading after reporting second-quarter adjusted diluted EPS of $9.61 that missed the $10.81 LSEG consensus. The company also announced that by year-end it is closing on the acquisition of 10-store Hennessy Automotive in Atlanta for $1.3 billion.

Why it matters: Low used-vehicle supply following the pandemic and chip shortage remains a headwind for the auto industry, and it caught up with Group 1 this quarter. The firm said it had low used inventory and chose not to replenish via expensive auction sourcing. Management said it will be more aggressive on offers to consumers to buy their vehicles, as this is cheaper than auction procurement. Used unit volume fell 11.2% in the quarter year-over-year, which, along with declines in all other segments, led to total gross profit down 8%. The Hennessy deal will be funded via debt and selling weaker existing Group 1 stores. Hennessy brings annualized revenue of about $1.7 billion and will be immediately earnings accretive. The deal is part of Group 1's cluster strategy of many stores in growing markets with premium brands.

The bottom line: We maintain our narrow moat for Group 1, but we are lowering our fair value estimate to $432 from $461, reflecting a higher share count (share repurchases are likely complete for 2026) and to factor in the consideration for Hennessy. We like the Hennessy deal due to its brand mix including Cadillac, Honda, Lexus, Porsche, and Jaguar Land Rover. Along with two other Atlanta acquisitions (Honda and Toyota), Hennessy will bring Group 1's Atlanta store count to 15 and make Atlanta the firm's second-largest revenue market. Group 1 will use a bridge loan facility to buy Hennessy and then replace that facility with new bond debt. The firm's rent-adjusted leverage ratio will increase to nearly 4 times at close but is expected to fall back to target levels closer to 3 times by mid-to-late 2027.

We are lowering our Group 1 per share fair value estimate to $432 from $461. The change is due to a higher share count (share repurchases are likely done for 2026) and for factoring in the consideration for the Hennessy acquisition announced on July 30. Our weighted average cost of capital is 8.1%. We expect no more buybacks in 2026 based on management saying they are likely done for 2026 until after Hennessy closes.

We expect better overhead cost leverage long term due to benefits from the company’s AcceleRide omnichannel platform and the chance of lower inventories than prepandemic levels after the semiconductor shortage ends could enable better pricing power long term. We expect Group 1’s SG&A leverage to improve significantly over time, driven by the AcceleRide omnichannel platform, greater size and scale from the Prime acquisition, and permanent SG&A cuts in staffing and advertising. Covid, for dealers, in our view, accelerated digital changes and related expense reductions that would have taken several years into just a few months in 2020. We think Group 1 has made good moves to improve itself in recent years by adding service technicians to increase lucrative service work and from the Val-U-Line used-vehicle strategy, which should result in more profits over time from retailing more used vehicles versus wholesaling them. Our midcycle operating margin, including floorplan interest, is about 4% and reflects a range of operating margin between below 3% in bad times and 5% or better in good times.

Our average operating margin including floorplan interest during our five-year explicit forecast period is about 4%. In recent years, Group 1 has continued to generate better economies of scale than in prerecession years, thus upside potential to our valuation exists should the company keep improving operating margin or SG&A expenses. Our midcycle common-size SG&A expense figure is slightly over 10%, and there is upside potential to our valuation if the company ever consistently keeps its SG&A below that level.

We forecast revenue to increase by nearly 5% on a five-year compound annual basis including the Hennessy acquisition. We model US industry light-vehicle sales growth throughout our forecast period other than for 2026. We assume annual acquired revenue from acquisitions for 2027-30 of $1 billion each year, purchased at a price/sales ratio of 0.25. We model capital expenditures to average 1% of sales.

We are maintaining our narrow moat rating for Group 1, as its size continues to generate economies of scale and working capital efficiencies and the service segment and its warranty work give the company an intangible advantage over garages. We think the dealer sector is the best business in the automotive supply chain. The public dealers can centralize back-office operations and generate far higher volume than a small dealer, which brings scale as does a national brand to help leverage advertising costs. Dealers have no burdensome retiree expenses, and the large public dealers are not dependent on the health of one brand. The dealers enjoy mid- to high-single-digit gross margins on new vehicles and 100% gross margin on financing and insurance. We think that the best source of competitive advantage is the parts and service operations. Many customers bring their vehicle to the dealer for servicing because the vehicle is either under warranty or because the dealer is close to home and has the factory parts and expertise to best service the vehicle. Once vehicle owners know a dealer, especially while the vehicle is under warranty, we think they are likely to keep going back to the dealer for service. The dealer knows the vehicle, and comparison-shopping for repair work is very time-consuming since the customer has to bring the vehicle to each shop to get a quote.

These logistics create inelasticity of demand, which creates pricing power for the dealer and is a source of excellent profit in good times and bad. In fact, during a downturn in new vehicle sales, dealers generally report higher gross margins due to a favorable mix shift, but then report lower operating margins due to SG&A deleveraging. Excluding large impairment and restructuring charges, dealers can still report positive EBIT even in a severe recession. Although most dealerships are good businesses, we think the large publicly traded dealers are best positioned for growth going forward since these firms can be the most flexible in changing brand mix. Many small owners are choosing to exit or sell because they cannot get the scale on a variety of expenses compared with large dealer groups, so public dealers can keep growing via acquisition and open point awards from automakers easier than small dealers. Group 1 is one of the largest dealers in the US, yet has just under 1% new-vehicle market share, a threshold we expect it to surpass in the next few years. About 91% of dealer owners own between one and five stores per the National Automobile Dealers Association, so we see a long growth runway for consolidators such as Group 1.

The firm is also following what other large dealers such as AutoNation have done and is rebranding stores under the Group 1 name. This move complements management's so-called cluster strategy where it seeks many stores in one growing metro area with mostly premium brands. The Hennessy deal announced in July adds Atlanta to the cluster strategy, Group 1's ninth US cluster market. Other cluster cities include Houston and Boston.

Auto dealerships are profitable businesses with a diversified stream of earnings beyond selling new vehicles.

Parts and service revenue should continue to be lucrative over time because most manufacturers require warranty work to be done at the dealership, and large dealers can more easily afford the technology and training needed to service increasingly complex vehicles. Parts and service provide a large portion of gross profit, despite being a small part of overall revenue.

AcceleRide and Val-U-Line could prove good future sources of profit.

Because publicly traded dealers command greater share in some markets, manufacturers may refuse to approve transfers of franchise rights at some dealerships, potentially limiting acquisition-based growth.

As category killer CarMax and online-only used-vehicle retailers grow, they have potential to take away some of the highly profitable used-car business.

The company has had prior goodwill and fixed-asset impairment problems, and overpaying for acquisitions could pressure results in the future.