Undervalued Dividend Growth Stock of the Week: Penske Automotive Group, Inc. (PAG)

The S&P 500 just broke through another all-time high recently.

With this in mind, it can be difficult to find stocks that are attractively valued.

Especially high-quality stocks.

And that’s really the rub a lot of the time.

I invest my personal capital into high-quality dividend growth stocks like those you’ll find on David Fish’s Dividend Champions, Contenders, and Challengers list.

I invest this way because these stocks often represent the “best of the best” – companies that are so routinely increasingly profitable that they are in a great position to share the wealth with shareholders in the form of growing dividends.

And these dividends can add up quickly.

The six-figure portfolio that I’ve spent the last six years building is on pace to send me more than $10,500 in dividend income this next year, which covers a very substantial portion of my core personal expenses.

Better yet, this income should only grow in time, further bolstering my dividend income and the opportunities that income provides.

But because of these inherent attributes, it’s sometimes difficult to find these stocks at attractive valuations.

That is, it can be hard to find high-quality dividend growth stocks that are undervalued, especially in this market.

The reasons one would want to buy a dividend growth stock when it’s undervalued (as opposed to overvalued) are very simple.

An undervalued dividend growth stock will almost always offer a higher yield, better long-term total return prospects, and less risk.

That is, of course, compared to what the same stock would offer if it were overvalued.

The logic is quite easy to follow.

Price and yield are inversely correlated; as a stock’s price falls, its yield will rise. All else equal, a lower price equals a higher yield.

This higher yield helps boost the long-term total return prospects, which is on top of any upside that exists between the stock’s price at an undervalued level and its price at a fair valuation or higher.

Of course, this also lessens one’s risk, too.

It’s obvious that you’re going to risk less absolute cash if you’re going to spend $30 per share rather than, say, $50. That’s $20 less per share that you’re risking.

In addition, you create a margin of safety when you buy a high-quality stock when it’s undervalued. This safety margin helps cushion any material drops in the underlying value of the stock while simultaneously increasing upside if everything goes well.

This is why I aim to not only load my portfolio up with high-quality dividend growth stocks but do so when they’re undervalued.

The good news is that it’s not all that difficult to value a dividend growth stock before buying it, thus allowing one to determine whether or not it appears to be undervalued right from the start.

One such system that’s designed to help facilitate this is fellow contributor Dave Van Knapp’s valuation lesson, which is part of an overarching series of lessons on the dividend growth investing strategy.

Using some of the aspects that can be found within this lesson along with a few valuation tools of my own, I recently happened upon a high-quality dividend growth stock (which can be found on Mr. Fish’s list) that appears to be undervalued right now…

Penske Automotive Group, Inc. (PAG) owns and operates car dealerships that sell new and used cars. These dealerships also provide parts, service, and collision support. They also offer certain financing and insurance products.

The network of dealerships that Penske Automotive Group owns and operates reaches far and wide – a total of 335 franchises, as of December 31, 2015, with about half in Europe (most of which are in the UK) and the other half located in the US and Puerto Rico.

Most of these dealerships offer luxury/import vehicles. Think Audi, Ferrari, Bentley, and Porsche, among other high-end brands. The company offers 40 brands in all.

This kind of brand alignment mitigates, to a degree, the company’s exposure to the cyclical nature of the automotive industry since the customers that are going to be buying a Ferrari or a Lexus are less likely to avoid a car purchase in case of an economic downturn compared to customers that are more middle or lower class.

Moreover, this business model is in a great position due to the fact that customers cannot purchase one of these cars new outside of a franchise. One cannot just purchase a new car directly from a car manufacturer or a competing dealership that doesn’t have the appropriate franchise.

In addition to having a captive customer, the dealership model presents many other ways to earn more money.

Providing parts and service is typically very profitable, offering higher margins than what can typically be had on selling new cars. And since warranty work can only be performed by a franchise dealership that provides factory-supported (OEM) parts and service, the customer is somewhat captive once more.

And then there’s the opportunity to sell used cars, provide financing, and offer accessories.

All in all, there’s just a lot more to this business model than selling new cars. And many of these additional avenues for profit boost the company’s bottom line.

But what good is any of that if the company isn’t sharing the wealth with shareholders?

CaptureWell, Penske Automotive Group is sharing plenty.

They’ve paid an increasing dividend for six consecutive years.

And over the last three years, the dividend has grown at a compound annual rate of 26.9%.

So they’re definitely sharing… and then some.

The only knock against the dividend here is that the company eliminated the dividend during the height of the financial crisis. So this is a risk to consider before investing in the company.

That said, the payout ratio right now stands at 29.6%, meaning there’s a pretty big cushion there for the safety of the dividend in case earnings take a hit from a cyclical downturn.

On top of that, the stock offers a pretty attractive yield of 2.71%.

That’s certainly higher than what the broader market offers. And it’s more than 100 basis points higher than what the stock has averaged over the last five years, giving that aforementioned boost to income and potential long-term total return.

A lot to like here with the dividend. You’re looking at a fairly high yield (in this low-rate environment), a low payout ratio, and a commitment to returning cash to shareholders.

In fact, the company is so committed to making up for past issues that they’ve been increasing their dividend quarterly since re-intiating the dividend in 2011.

We’re talking 22 quarters in a row!

But whether or not this kind of activity continues on in the future depends on what kind of growth the company is generating.

So we’ll take a look at that next, first taking a peek at what kind of top-line and bottom-line growth that’s occurred over the last decade before going over a forecast for future earnings growth.

The company has grown its revenue from $11.242 billion to $19.285 billion from fiscal years 2006 to 2015. That’s a compound annual growth rate of 6.18%.

Meanwhile, earnings per share is up from $1.32 to $3.63 over this same stretch, which is a CAGR of 11.90%.

There was certainly a big hit to earnings (and the dividend) during the Great Recession, but the long-term picture is actually really solid here. We see some excess bottom-line growth there, largely explained by improving profitability across the board.

Looking forward, S&P Capital IQ is calling for the company to compound its EPS at an annual rate of 8% over the next three years. Notably, Penske Automotive Group is heavily exposed to the UK, which is in a state of turmoil due to Brexit. As such, I think it’s difficult to forecast growth over the near term. However, quarterly earnings were just reported and no measurable impact from Brexit showed up. Either way, the business should be just fine over the long run.

The rest of the fundamentals look pretty strong, although the company does carry some debt. Not uncommon for the industry, as it can be somewhat capital-intensive to build these networks out (especially high-end dealerships), but it is something to be aware of.

The long-term debt/equity ratio for the company is 0.70. And the interest coverage ratio is a little over 5.

This is competitive stuff in relative terms. I don’t see anything here to be concerned about when looking at the industry as a whole. However, there is still a good amount of leverage at play here.

Profitability is also suitable for the industry, though it’s here that Penske Automotive Group does lag some of the competition a bit.

Over the last five years, the company has averaged net margin of 1.64% and return on equity of 17.19%.

These are good numbers, but there’s some room for improvement. The company knows this and has been making strides across the board, with numbers moving in the right direction over the last decade.

However, I think the company is at somewhat of a disadvantage here relative to some of their competitors due to the very clientele they cater to. Affluent customers can often afford to buy a car in cash, which limits some opportunities for high-margin financing product sales.

This strikes me as a pretty strong idea in today’s market. With the broader market breaking through to a new all-time high and many stocks priced near their respective all-time highs, PAG is down more than 25% over the last year.

There doesn’t appear to be any rational reason for that drop. The business model appears to be strong from top to bottom.

I do see some potential long-term risks if the Tesla Motors Inc. (TSLA) model of selling direct becomes more widespread. And self-driving cars could mean that cars themselves become more homogeneous. However, there’s no indication the direct-sales model will catch on. And self-driving cars are many years away from being widespread.

I last highlighted this as an undervalued dividend growth stock back in May, and it’s up more than 11% since then. Plus, the company reported great results has increased its dividend in the interim.

Yet it still looks to be quite cheap…

The P/E ratio is sitting at 10.89. That’s less than half the broader market. That’s also substantially lower than the stock’s five-year average P/E ratio of 14.4. Furthermore, all other basic valuation metrics I look at are well below their respective recent historical averages. Add in that divergence in yield and you have a pretty compelling idea here.

So it does look to still be really cheap. But how cheap? What’s a good estimate of the stock’s intrinsic value?

I valued shares using a dividend discount model analysis. I assumed a 10% discount rate and a long-term dividend growth rate of 7%. With the current practice of increasing the quarterly dividend by one penny per share every quarter, this growth rate is very conservative. However, I’m factoring in the cyclical nature of the business over the long run. The DDM analysis gives me a fair value of $39.95.

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.

So my analysis seems to indicate the stock is almost exactly fairly valued, although I am admittedly being pretty conservative here. For additional perspective, we’ll take a look at what some professional analysts think of this stock and its valuation.

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 PAG as a 3-star stock, with a fair value estimate of $42.00.

S&P Capital IQ 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.

S&P Capital IQ rates PAG as a 4-star “BUY”, with a fair value calculation of $51.10.

I came in the most conservative here, but I like to blend these three different perspectives together. That concentrates these valuations into one number, which should ultimately improve accuracy. That final valuation is $44.35, which indicates the stock is 7% undervalued right now.

scBottom line: Penske Automotive Group, Inc. (PAG) operates a high-quality business with exposure to some of the biggest and most popular markets and brands in the world. They continue to increase their dividend quarterly, and the stock offers a yield that’s much higher than its recent historical average. Add in the potential for 7% upside, even after a recent run, and I think there’s a lot to like for long-term dividend growth investors here.

— Jason Fieber

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