Living in 2024 is such a gift.
Modern medicine, technology, global travel, etc.
Human beings have never had it better.
Also, investors have never had it better.
Trades are usually free, platforms are incredibly robust, and rich data on businesses from all over the world is instantly accessible.
The Dividend Champions, Contenders, and Challengers list is a prime example of that last point.
This list is full of data on hundreds of US-listed stocks that have raised dividends each year for at least the last five consecutive years.
A rising dividend determines whether or not an investment qualifies under the dividend growth investing strategy – a long-term investment strategy that advocates buying and holding shares in high-quality businesses that pay safe, growing dividends to shareholders.
It’s an approachable strategy that tends to funnel investors right into some of the best possible long-term investments out there, as it requires greatness from a business to be able to routinely generate the ever-larger profit necessary to sustain ever-bigger dividend payments.
I’ve been using this strategy for more than a decade, allowing it to guide me as I’ve gone about building the FIRE Fund.
That’s my real-money portfolio, and it produces enough five-figure passive dividend income for me to live off of.
I’ve actually been in the extremely fortunate position of being able to live off of dividends since I retired in my early 30s.
My Early Retirement Blueprint explains how I was able to do such a thing.
Now, successful long-term investing isn’t just about selecting great businesses for investment.
Whereas price is what you pay, it’s value that you get.
An undervalued dividend growth stock should provide a higher yield, greater long-term total return potential, and reduced risk.
This is relative to what the same stock might otherwise provide if it were fairly valued or overvalued.
Price and yield are inversely correlated. All else equal, a lower price will result in a higher yield.
That higher yield correlates to greater long-term total return potential.
This is because total return is simply the total income earned from an investment – capital gain plus investment income – over a period of time.
Prospective investment income is boosted by the higher yield.
But capital gain is also given a possible boost via the “upside” between a lower price paid and higher estimated intrinsic value.
And that’s on top of whatever capital gain would ordinarily come about as a quality company naturally becomes worth more over time.
Undervaluation introduces a margin of safety.
This is a “buffer” that protects the investor against unforeseen issues that could detrimentally lessen a company’s fair value.
It’s protection against the possible downside.
If you can slowly assemble a portfolio of high-quality dividend growth stocks at attractive valuations, you’re making life – something already great in 2024 – even better.
Circling back around to my earlier point on how much data is now easily accessible, Lesson 11: Valuation is another perfect example of this.
Written by fellow contributor Dave Van Knapp, it helps anyone unfamiliar with the valuation process and succinctly lays out how to go about estimating the fair value of almost any dividend growth stock out there.
With all of this in mind, let’s take a look at a high-quality dividend growth stock that appears to be undervalued right now…
Lithia & Driveway (LAD) is an American automotive dealership group.
Founded in 1946, Lithia & Driveway is now an $8 billion (by market cap) car dealership retailer that employs more than 25,000 people.
Lithia & Driveway operates over 300 dealerships across 25 US states representing 40 different OEM car brands (such as Honda and Toyota).
The company also started an international expansion in earnest recently by entering Canada and the UK, but the majority of operations are in the US.
The company reports results across five categories: New Vehicle Sales, 49% of FY 2023 revenue; Used Vehicle Sales, 36%; Service, Body & Parts, 10%; Finance & Insurance, 4%; and Fleet & Other, 1%.
By vehicle type, its sales mix for FY 2023 was: Import, 44%; Domestic, 30%; and Luxury, 26%.
Because higher margins can be found in servicing and providing parts for vehicles (relative to selling vehicles), the company’s Service, Body & Parts category accounted for about 1/3 of FY 2023 gross profit (despite representing just 10% of revenue).
Lithia & Driveway has used the serial acquirer method to slowly assemble a small empire of automotive dealerships.
An individual car dealership can be a terrific business.
An army of them is even better.
What’s so great abut the car dealership business model is the built-in, self-perpetuating ecosystem.
When a consumer buys a new (or even gently used) vehicle from a dealership, they’re basically “locked” into this ecosystem.
Only OEM-authorized dealerships are able to sell new cars, and there tends to be a strict limit on the number of OEM franchise rights per geographic area, providing a localized monopoly.
Moreover, most consumers coming back for their second (and third, and fourth…) new car naturally end up trading in their current used vehicle, providing the dealership with a steady, easy, cost-advantaged supply of used fleets.
There are also the lease returns, which leads to more new leases (and used vehicles to later sell).
It’s this virtuous cycle of repeat business.
And that’s just on the sales side.
There’s also the service side – a real money maker for a dealership.
Far higher margins can be found in servicing and providing parts for vehicles (relative to selling vehicles).
Indeed, the Service, Body & Parts category accounted for about 1/3 of FY 2023 gross profit (despite representing just 10% of revenue).
Once again, only these same OEM-authorized dealerships are authorized to carry out warranty repairs/maintenance on vehicles.
This work cannot be performed by independent shops under factory warranty.
Furthermore, because of how complex these modern vehicles are (which often require specialized machines, trained technicians, and OEM support), it’s extremely challenging (and sometimes even impossible) for independent shops to handle non-warranty maintenance and repairs on these vehicles.
Perhaps best of all, this self-reinforcing ecosystem is further reinforced by the fact that a personal vehicle is, arguably, an essential component of American life (due to the dearth of public transportation in most areas) – making consumers beholden to the dealerships.
What you end up with are consumers that are practically beholden to these local monopolies, making the dealership model extremely lucrative and attractive.
And this is why Lithia & Driveway is nearly a lock for revenue, profit, and dividend growth over the long run.
Dividend Growth, Growth Rate, Payout Ratio and Yield
The company has increased its dividend for 15 consecutive years already.
The 10-year dividend growth rate of 14.6% shows what a stalwart Lithia & Driveway has been.
Of course, with the stock yielding only 0.7%, you really do need that kind of dividend growth in order to make sense of the stock from the perspective of total return and the eventuality of satisfying income.
By the way, this stock never really offers a meaningful yield, but it is currently 10 basis points higher than its own five-year average.
Seeing as how the stock has returned more than 300% (on a total return basis) over the last decade (easily beating the S&P 500 over that time frame), it’s getting its job done.
And while it’s certainly not an income play in the current sense, those dividend raises can and do add up over time.
Indeed, the quarterly dividend is nearly four times higher than it was a decade ago, so those with patience can see a once-modest level of income rise pretty significantly over time.
With a payout ratio of only 6.8% – one of the lowest I’ve ever seen – Lithia & Driveway has plenty of room for very generous dividend raises over the years ahead (almost regardless of how fast the underlying business grows).
For younger dividend growth investors who have time to let compounding do its magic, Lithia & Driveway has proven itself to be a compounding machine.
Revenue and Earnings Growth
As much as that may be true, though, some of these numbers are looking backward.
However, investors must always have their eye on the future, as today’s capital gets put on the line for tomorrow’s rewards.
Thus, I’ll now build out a forward-looking growth trajectory for the business, which will come in handy when later estimating intrinsic value.
I’ll first show you what the business has done over the last decade in terms of its top-line and bottom-line growth.
I’ll then reveal a professional prognostication for near-term profit growth.
Blending the proven past with a future forecast in this way should give us enough information to made an educated call on where the business might be going from here.
Lithia & Driveway advanced its revenue from $5.4 billion in FY 2014 to $31 billion in FY 2023.
That’s a compound annual growth rate of 21.4%.
Extremely strong top-line growth here.
However, as I noted earlier, Lithia & Driveway is a serial acquirer.
The blueprint is to consistently and methodically acquire smaller dealerships in bolt-on deals that open up new markets and drive additional growth beyond what is organically possible.
This is one of the best industries in which to apply the serial acquirer model, as it is highly fragmented and ripe for consolidation.
A perfect example of this playing out is the company’s recent acquisition of Pendragon’s UK motor and fleet management divisions through a strategic partnership for a cash consideration of approximately $350 million, further expanding Lithia & Driveway’s geographic footprint.
With this caveat regarding top-line growth out of the way, let’s dig into how that’s translated into the bottom line.
Earnings per share increased from $5.26 to $36.29 over this period, which is a CAGR of 23.9%.
Even better bottom-line growth, showing that management has made the best of their acquisitions and squeezed out synergies and accretion.
The acquisitions have created, not destroyed, value.
Very, very impressive.
This is tech-like growth out of a car dealership chain!
It’s quite remarkable.
Looking forward, CFRA is forecasting a -8% CAGR for Lithia & Driveway’s EPS over the next three years.
Expecting a negative growth rate out of a business that’s been compounding at north of 20% annually is quite the comedown.
This is really a pandemic story.
Vehicle sales and prices temporarily went through the roof for a couple of years after the pandemic hit, a trend that was driven by a number of unique factors that drove up demand (e.g., consumer liquidity from stimulus, as well as a flight to less dense suburban environments) and drove down supply (e.g., pandemic-related manufacturing problems).
To CFRA’s point, FY 2023 EPS was nearly 18% lower compared to FY 2022.
A normalization is playing out.
That said, even with FY 2023 EPS dropping so much on a YOY basis, that 10-year EPS CAGR was still almost 24%.
Pretty incredible.
Furthermore, if we back up to before the pandemic, the five-year CAGR for Lithia & Driveway’s EPS from FY 2015 to FY 2019 was 13.8%.
That’s close to the 10-year dividend growth rate.
I think a mid-teens type of number is a reasonable expectation for Lithia & Driveway’s longer-term growth trajectory, lining up well with both EPS and dividend growth.
That said, since the last few years have been so extraordinary, leading to a burst in growth to well over the long-term norm, a short-term negative growth rate in order to normalize things out and create a new base to grow from isn’t surprising.
On the other hand, for an investor with many years ahead of them to let compounding work, I don’t think the long-term story has been negatively impacted at all.
CFRA indicates as much: “We believe [Lithia & Driveway] has one of the industry’s best management teams. The automotive retail industry is large and fragmented, which offers the potential for growth via acquisition. [Lithia & Driveway] has proven adept at growing EPS through accretive acquisitions and buybacks over time.”
Speaking further on that management point, it should be noted this is a family-led business.
The DeBoer family founded and still owns more than 1% of the company.
The family also controls key management positions.
Bryan DeBoer is CEO.
Sidney DeBoer (the son of the original founder) is the Chairman.
The DeBoer family is clearly incentivized to continue executing and creating value for shareholders.
I acknowledge the next couple of years could be tough going as everything right-sizes itself, but I don’t see anything to clearly convince me of the long-term growth trajectory being greatly different from where it mostly has been.
That implies mid-teens bottom-line and dividend growth over the long run.
And for those more interested in total return than current income, that seems to set up the business for more market-beating performance.
Financial Position
Moving over to the balance sheet, Lithia & Driveway has a somewhat weak financial position.
The long-term debt/equity ratio is 1.1, while the interest coverage ratio is at about 3.7.
That latter number is especially concerning.
I’m typically uncomfortable with an interest coverage ratio below 5.
Now, I admire and support the programmatic acquisitions.
In fact, I have a number of serial acquirers in my own portfolio, but most of these businesses are funding acquisitions with cash flow (not debt).
However, Lithia & Driveway’s aggressiveness has relied much more on debt and has stressed the balance sheet.
The company finished FY 2023 with more than ~$7 billion in long-term debt, which is approaching the company’s entire market cap of ~$8 billion.
This balance sheet is really the only thing I don’t like about the business.
Profitability, on the other hand, is quite good.
Return on equity has averaged 23.2% over the last five years, while net margin has averaged 3.6%.
Returns on capital are consistently high.
And the only reason margins aren’t higher is because selling cars is a thin-margin proposition.
What saves the entire business model is the higher-margin opportunities across other areas of the business (such as service and finance).
Overall, there’s a lot to like about this high-growth, high-performance business.
And with scale in a fragmented industry, localized franchise monopolies, OEM-backed inventory, and OEM-authorized warranty servicing that protects the dealership flywheel, the company does benefit from durable competitive advantages.
Of course, there are risks to consider.
Regulation, litigation, and competition are omnipresent risks in every industry.
While the auto industry is extremely competitive at a high level, each individual dealership is insulated and protected by local franchise control.
Vehicle prices continue to fall from unsustainable heights, and that’s negatively impacting near-term profitability.
The company’s balance sheet is stretched, which may start to limit its ability to continue doing bolt-on acquisitions.
Cars are high-ticket purchases, and any kind of broad economic weakness would likely reduce demand for auto sales (although this may serve to raise demand for service and parts on an older fleet).
The serial acquirer model requires the consistent application of sound capital allocation, introduces execution risk, and adds integration risk.
Interest rates are high (but coming down), which hurts both auto loan demand and the company’s balance sheet.
Insurance rates have risen significantly in recent years, which could stretch consumers’ ability to afford newer cars.
There are definitely some risks for this business (as is true for any business).
But the low valuation seems to be pricing in more risk (and less growth) than what I see…
Valuation
The stock is trading hands for a P/E ratio of 10.
This is an earnings multiple that is less than half that of the broader market’s earnings multiple, and that’s on a stock that has routinely outperformed that same broader market.
It’s a below-average multiple on an above-average name.
The P/S ratio of 0.3 is also extremely undemanding, and it’s right in line with its own five-year average.
And the yield, as noted earlier, is basically in line with its own recent historical average.
So the stock looks cheap when looking at basic valuation metrics. But how cheap might it be? What would a rational estimate of intrinsic value look like?
I valued shares using a two-stage dividend discount model analysis.
I factored in a 10% discount rate, a 20-year dividend growth rate of 15%, and a long-term dividend growth rate of 8%.
This is, arguably, an aggressive valuation model.
Then again, I’m not so sure.
The payout ratio is below 10%.
Also, as I showed earlier, this business is clearly growing its bottom line and dividend at a mid-teens rate over a longer period of time.
So I’m purely assuming more of that mid-teens dividend growth over the years to come, which (again, due to that payout ratio being so low) could materialize even without the same kind of EPS growth.
In fact, Lithia & Driveway could grow the business at a high-single-digit rate (which would be below potential) and still grow the dividend at a mid-teens rate.
That would be a sustainable action for many years.
However, since Lithia & Driveway is still ripe for so much growth (based on both the existing business and the acquisitions to come), I don’t think the payout ratio will need to rise all that much over the coming years.
But just knowing it could gives so much flexibility to this dividend.
While there will likely be ups and downs along the way, averaging things out, it’s hard to see a scenario in which the dividend can’t or won’t grow at this kind of rate over the long run.
The DDM analysis gives me a fair value of $348.37.
The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide.
The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.
It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today.
I find it to be a fairly accurate way to value dividend growth stocks.
This stock looks at least modestly undervalued to me.
But we’ll now compare that valuation with where two professional stock analysis firms have come out at.
This adds balance, depth, and perspective to our conclusion.
Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system.
1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.
Morningstar rates LAD as a 4-star stock, with a fair value estimate of $424.00.
CFRA is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line.
They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.
CFRA rates LAD as a 4-star “BUY”, with a 12-month target price of $325.00.
I’m somewhere in the middle here. Averaging the three numbers out gives us a final valuation of $365.79, which would indicate the stock is possibly 15% undervalued.
-Jason Fieber
P.S. If you’d like access to my entire six-figure dividend growth stock portfolio, as well as stock trades I make with my own money, I’ve made all of that available exclusively through Patreon.
Note from D&I: How safe is LAD’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 60. Dividend Safety Scores range from 0 to 100. A score of 50 is average, 75 or higher is excellent, and 25 or lower is weak. With this in mind, LAD’s dividend appears Borderline Safe with a moderate risk of being cut. Learn more about Dividend Safety Scores here.
Disclosure: I have no position in LAD.