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

Work hard, play hard.

It’s an adage we’ve all heard plenty of times.

But what if we could put ourselves in a situation where it’s possible to play hard without working hard? 

Well, I believe financial independence is a life situation that can allow for this.

While some people might think financial independence is some kind of lifestyle reserved only for a lucky few in this world, that’s just not true at all.

Indeed, I reached financial independence at 33 years old, with the real-life and real-money portfolio I spent a handful of years building generating the five-figure passive dividend income I need to cover my basic expenses in life.

And I did this on a very regular, middle-class salary.

How?

This happened in part because I was willing to work harder than most for a few years of my life so that I could play harder than most for the rest of my life.

I spent a six-year period of my life living extremely frugally and working around the clock to earn and save as much as possible.

This allowed me a lot of excess capital, which I intelligently and regularly deployed into high-quality dividend growth stocks like those you’ll find on David Fish’s Dividend Champions, Contenders, and Challengers list.

Mr. Fish has compiled invaluable data on more than 800 US-listed stocks, all of which have paid their shareholders increasing dividends for at least the last five consecutive years.

These stocks tend to be some of the best in the world precisely because it takes a special kind of business to be able to generate the kind of consistently-growing profit necessary to fund ever-larger dividends.

And if you’re looking to become financially independent, you’re going to need a source of passive income that can cover your bills.

Growing dividend income from a great and diverse collection of high-quality dividend growth stocks is arguably the best source of passive income available. 

That’s because the dividend income is truly passive – one doesn’t need to do anything (other than continue to hold their stock) in order to collect a company’s dividend.

A dividend just shows up in your account when it’s supposed to. It couldn’t be easier.

Moreover, this passive income is likely going to grow faster than inflation, increasing one’s purchasing power.

This is important because financial independence doesn’t mean much if you’re forced to get a job five years down the road after your expenses rise faster than your passive income, canceling out your financial freedom.

You need to make sure your passive income can at least keep up with inflation, but it’s far better if the passive income is growing faster than inflation.

This all said, dividend growth investing isn’t a completely foolproof investing strategy whereby one can just buy random dividend growth stocks whenever they want.

One should make sure they’re buying high-quality businesses that meet certain quantitative and qualitative standards. 

You want to see satisfactory top-line and bottom-line growth, good profitability, a solid balance sheet, durable competitive advantages, and a reasonable number of business risks.

Perhaps just as important, you want to make sure you pay the right price for the right business. 

Even a great business can be a subpar investment, especially over the short term, if the price paid is too far above intrinsic value.

See, price is what you pay for something.

But value is what something is actually worth.

Knowing price means almost nothing, while having a pretty good idea of value means almost everything.

And when looking at high-quality dividend growth stocks, it’s incredibly beneficial if one is able to buy a high-quality dividend growth stock when it’s undervalued (when its price is below its intrinsic value).

That’s because an undervalued dividend growth stock should provide a higher yield, greater long-term total return potential, and less risk. 

This is all relative to what the same stock might otherwise offer if it were fairly valued (price and value roughly equal) or overvalued (price above value).

Price and yield are inversely correlated.

All else equal, a lower price will result in a higher yield.

This higher yield obviously positively impacts one’s expected income, both over the near term and long term.

But it also positively impacts total return, because total return is comprised of income (dividends or distributions) and capital gain.

The income portion is boosted via the higher yield, which has a fairly immediate effect on total return.

But the capital gain portion is also given a potential boost via the “upside” that exists between the lower price paid and the higher intrinsic value of the stock.

While the stock market isn’t necessarily very good at appropriately pricing stocks over the short term, price and value tend to more roughly mirror one another over the very long term.

If you can take advantage of mispricing in the short term, though, this can provide for a nice potential boost if/when the market more correctly reprices a stock (meaning price rises to meet fair value).

And this all has a way of reducing risk, too.

That’s because one introduces a margin of safety when one buys an undervalued stock.

If there’s a large and favorable gap between price and value, this means one has a nice “buffer” in case some unfavorable change were to occur to a business, reducing its fair value in the process.

After all, you don’t want to pay $50 or more for a stock worth $50, because any kind of unexpected and unfavorable change to fair value could quickly put your investment underwater (meaning it’s worth less than you paid).

With these benefits in mind, it should be pretty clear why buying a high-quality dividend growth stock when it’s undervalued can be such a powerful creator of wealth and passive income for the long-term investor. 

Fortunately, the process of valuing a dividend growth stock isn’t all that difficult, as estimating the intrinsic value of just about any dividend growth stock can be a fairly straightforward and streamlined process.

Fellow contributor Dave Van Knapp has actually designed a system that can do just that, with his valuation lesson on dividend growth investing educating dividend growth investors of all backgrounds on how he goes about estimating the intrinsic value of dividend growth stocks.

But I won’t leave you investors and readers there.

I’m going to now highlight a high-quality dividend growth stock that potentially 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.

Penske Automotive Group has a massive network of car dealerships, with 335 franchises spread out across the US, Puerto Rico, and Europe. The network is such that approximately half are located in the US and approximately half are located in the UK.

While the dealership business is cyclical – as auto sales are cyclical – Penske Automotive has insulated itself somewhat through the very design of its business model.

Primarily, the company focuses on higher-end luxury and import brands (like Audi, Bentley, and BMW), which cater to a more affluent customer that is less likely to be overly impacted by economic downturns.

In addition, a significant chunk of the company’s gross profit (42% for FY 2016) comes from the parts and service side of the business, which is also less affected by economic downturns. That’s because a vehicle’s repair can’t often be delayed or outright avoided like the purchase of a new(er) car can be.

The parts and service side of the business (which is far more profitable than the vehicle sales side) also provides numerous competitive advantages.

For instance, warranty work can only be performed at a dealership that is supported by the OEM (original equipment manufacturer). Smaller, independent repair shops are cut right out of this work.

Plus, vehicles have become incredibly advanced and technical, making it difficult for those independent shops to keep up with the training, tooling, and overall expenses necessary to competently perform repairs.

This should keep customers returning back to the dealership, providing Penske Automotive Group a captive customer for both recurring parts/service and new-vehicle purchases.

This dynamic is also favorable for a dividend growth investor, as it allows for the kind of business growth that keeps the increasing dividends flowing, limiting the cyclical impacts that could force a dividend cut/elimination.

Looking at the existing track record in this regard, Penske Automotive Group has increased its dividend for seven consecutive years.

The major blemish here is the fact that the dividend was eliminated during the financial crisis; however, the company didn’t really have the kind of consistent dividend growth they’ve been demonstrating since 2011.

And that consistency is pretty incredible – the company has increased its dividend every quarter since reinstituting its dividend in 2011: that’s 27 quarters in a row!

The five-year dividend growth rate is phenomenal, standing at 35.6%.

Of course, much of that growth is possible because the dividend was just revving up again five years ago.

That said, the dividend increases just keep on coming… every quarter.

And with a payout ratio of just 30.9%, there appears to be no slowing down in sight.

A major economic downturn (which would have to occur in the US and the UK simultaneously, due to the company’s footprint) could cause that payout ratio to rise substantially (due to falling EPS), but the numbers are conservative as they sit right now.

And it’s not just dividend growth we’re talking here.

The stock also offers a relatively attractive yield of 2.73%.

That’s better far better than the industry average, and it’s well in excess of the broader market.

Furthermore, that’s almost 100 basis points higher than the stock’s own five-year average yield.

But we do have to keep in mind that the dividend was aggressively growing off of a rather small base five years ago.

So there’s a lot to like about the dividend here.

We’re looking at a market-beating, well-covered dividend that’s growing every quarter.

But we don’t invest in where a dividend and business has been; we invest in where a dividend and business is going.

As such, it’s important to set some baseline expectations for a company’s growth going forward.

This will help us not only determine what kind of dividend growth to expect, but it will also help us value the business as a whole.

While we don’t invest in where a company’s been, though, using a company’s demonstrated long-term business growth (assuming 10 years as a proxy) is a great foundation upon which to build forward-looking expectations. Of course, one then wants to compare that to where the company appears to be going currently.

So we’ll first look at what Penske Automotive Group has done over the last decade in terms of top-line and bottom-line growth, and we’ll then look at a near-term profit growth expectation from a professional analysis firm.

The company has increased its revenue from $12.792 billion to $20.119 billion from fiscal years 2007 to 2016. That’s a compound annual growth rate of 5.16%.

That’s right in line with what I’d expect from a fairly mature dealership network.

There’s still plenty of growth opportunities, however, as the markets in which Penske Automotive Group competes in are heavily fragmented and ripe for consolidation.

The bottom-line growth fared better, thanks to share buybacks and margin expansion.

Penske Automotive Group grew its earnings per share from $1.35 to $3.99 over this period, which is a CAGR of 12.80%.

Looking forward, CFRA expects Penske Automotive Group to compound its EPS at an annual rate of 8% over the next three years.

That would be a drop from what we see transpired over the last decade, but it would still be a very good result.

Moreover, it would allow for like dividend growth. The payout ratio is still conservative enough to where EPS and dividend growth could match each other without a problem.

With a cyclical business model that will likely rely on more M&A activity, maintaining a balance sheet that isn’t too heavily leveraged is important.

The long-term debt/equity ratio is 1.04, while the interest coverage ratio is just under 5.

This is probably the biggest weakness of the business, in my view.

And it’s the area of the company I’d like to see improved the most.

That said, the company isn’t in dire straits here. The leverage isn’t critical. It’s just that the balance sheet could be cleaned up.

Profitability, meanwhile, has seen a steady and impressive uptick recently.

Over the last five years, the company has averaged net margin of 1.63% and return on equity of 17.81%.

While these numbers are better than they were a few years ago, they still lag the industry.

That’s largely because of the very clientele Penske Automotive Group caters to. Since affluent customers are more likely to be able to afford to buy cars in cash, this limits some of the profit the company can earn from high-margin financing products, making recurring car sales and repeat business on the parts and service side that much more important.

Overall, this is a solid business in the industry.

In fact, from many angles, it’s my favorite play in the dealership space.

But there are some risks to consider.

Besides current risks (such as competition and the cyclical nature of the business model), new risks are emerging.

The direct-sales model that Tesla Motors Inc. (TSLA) is popularizing could threaten to upend the dealership model.

And self-driving cars could make vehicles more homogeneous, limiting the popularity of high-end brands. It could also make dealerships less necessary.

But this stock offers a compelling (and improving) story.

From a dividend growth investor’s perspective, you’ve got a big dividend that’s growing every quarter, with more room to spare. And the company’s growth profile is pretty stellar.

But no stock is worth paying any price for. Is this stock’s valuation attractive right now? 

The stock is trading hands for a P/E ratio of 11.32. That’s less than half the broader market. It’s well below the industry average. And it’s significantly less than the stock’s own five-year average P/E ratio (13.8).

Investors are also paying less for the company’s cash flow, relative to its three-year average.

And the current yield, as noted earlier, is well above its own five-year average.

So the stock does look cheap at first glance, but how cheap might it be? What is a fair estimate of the intrinsic value here? 

I valued shares using a dividend discount model analysis.

I factored in a 10% discount rate and a long-term dividend growth rate of 7%.

That DGR seems quite reasonable when considering the recent dividend growth, the long-term business growth, the near-term forecast for EPS growth, and the modest payout ratio.

Even though it’s a cyclical business model, dividend growth that averages out to 7% over the long run doesn’t seem to be at all unrealistic here (although it could be bumpy along the way).

The DDM analysis gives me a fair value of $47.08.

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.

My analysis shows a stock that’s trading pretty close to its estimated intrinsic value, although I was purposely being a bit conservative on my DDM analysis (due to the cyclical nature of the business model and how that could impact the dividend). But professional analysts have also taken a look at the business and have valued its stock. Let’s see how my viewpoint stacks up.

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.

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 PAG as a 3-star “HOLD”, with a fair value calculation of $67.51.

So the latter firm is obviously quite sanguine, but the former firm is arguably too bearish on the valuation. Averaging the three numbers out gives us a final valuation of $52.20, which would indicate the stock is potentially 8% undervalued right now.

Bottom line: Penske Automotive Group, Inc. (PAG) is a high-quality firm that has hundreds of dealerships, spread out across markets and brands. Its industry is heavily fragmented, favoring a larger player like this company. The clientele it caters to, as well as the way in which it earns its profit, should insulate it somewhat from business cycles. Meanwhile, dividend growth investors are looking at a market-beating and industry-beating dividend that’s growing quarterly, on top of the potential that shares are 8% undervalued. If you’re looking for exposure to this industry, this could be your best bet.

— Jason Fieber

Note from DTA: How safe is Penske Automotive Group‘s (PAG) dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 8. 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, Penske Automotive Group’s dividend appears extremely unsafe with a high risk of being cut. Learn more about Dividend Safety Scores here.

[ad#agora]