Penske Automotive is an automobile dealer with the bulk of their operations in the US and UK. Penske sells new and used vehicles and offers maintenance and repair services. The stock has outperformed the S&P 500 by nearly 20% this year, based on a very strong first quarter earnings report. The stock has come back down a bit over the last few weeks but remains elevated. Penske managed well through the pandemic and has been able to offset falling volumes with price increases. However, I expect that strong run to come to an end in the face of inflation, a slowing economy, and higher interest rates.
Penske is a solid company that has consistently generated strong cash flows for many years. The management team in place has a good track record of conservative growth and working capital management. During the pandemic, the company took advantage of a tight car market and was able to increase margins and cash flow. The additional capital these price changes generated was then allocated conservatively and used to pay down debt. Total debt has decreased by over $2.3 billion since year end 2019. Most of this decrease is from a fall in floor plan notes payable, which is debt used to fund inventories. As inventories have fallen by over $1.1 billion, the need for financing has also decreased dramatically. The company has also paid down nearly $900 million in unsecured debt as well. As of March 31, total debt was a hair over $4 billion, with $1.5 billion of that unsecured.
The current environment has become too challenging for the strong trends in the business to continue. Vehicle sales have been trending down in general. Car sales in May were roughly 1MM units lower than the previous year. In addition, used car prices have come down off their highs from early in the year. While still up nearly 9% YoY, the Manheim US Used Vehicle Index is down over 5% year-to-date. It is likely that these trends continue in June and going forward. Interest rates and gas prices have continued to spike, which will continue to be a drag on demand for cars. It is possible that these issues don't show up materially in revenue numbers for another quarter, spring is a good time of year for selling cars and I'm skeptical of the "seasonally adjusted" car sales data above. I am confident that the economic headwinds will hit Penske's revenue within the next two quarters.
In addition to the economic headwinds, Penske also has a very light inventory position of new cars that will need to be rebuilt. On the first quarter earnings call, Shelley Hulgrave, the CFO, said that the company had a 16-day supply of new vehicles. The used car supply is in a bit better shape with a 41-day supply. A fluctuating inventory can be very difficult to manage in a time period with rapid price changes. If prices are decreasing, loading up on inventory can lead to tight or even negative margins. Building inventory back up is also a huge drain on cash flows. This will mean Penske has to add back debt as interest rates are increasing.
Finally, the strong US Dollar will be a major headwind for a company that generated roughly 30% of its sales in the UK last year. The GBP has decreased by about 9% against the dollar (using average prices) this quarter. This alone can lead to an over 2% drop in revenue from the first quarter.
Despite all of these challenges to the business, Penske is on of very few stocks that has performed well this year. Including dividends, the stock has returned -1.67% this year through June 30. This compares to a drop of 19.99% for the S&P 500. A cyclical big-ticket industry with a soaring stock price in the middle of a weakening economy and rapidly increasing interest rates is a recipe for disaster. If you are hesitant to put on an all-out short position, a pairs trade with the SPY could be an interesting alternative. However, looking at the November option expiration, a synthetic short position looks to be the most attractive option. Using the November options allows for the next two earnings reports to come out before expiration. The reports should be late July and late October. A synthetic short using the $105 strike allows us to take out a short position with only ~$60 outlay per 100 shares. This gives us a breakeven price of approximately $104.40 with the stock currently trading at $105.62. The risk of this position is unlimited with the short call position, one should carefully consider all factors including your own objectives and risk tolerance before executing any trades, especially trade ideas you find from some stranger on the internet.