Just as important as buying good stocks at a good price is knowing when to sell stocks that have run their race at this point, especially in these merciless markets, writes Paul Larson of Morningstar StockInvestor.
The following two companies are leaders in their industries, but sport stock valuations that make little sense to me. For instance, why should I buy AutoNation (AN) at 19 times forward earnings when I can buy longtime favorite (and faster growing) CarMax (KMX) at just 13 times?
Meanwhile, Public Storage (PSA) trades at roughly 30 times forward earnings and with a yield just north of 3%, a relatively paltry amount for a REIT.
As always, caveat emptor!
AutoNation’s heavy concentration of sales in California and Florida may slow revenue growth for the next several years. Despite this headwind, we believe the company’s massive size and resulting scale advantages will allow it to deliver operating margins over 4% over the long run.
New vehicles make up about 54% of AutoNation’s sales, but only 21% of gross profit. About 47% of this revenue comes from California and Florida, which is far higher than the 20% industry average for these states.
Such dependence on two large economies exacerbates the already cyclical nature of auto sales and will hurt the company for the next few years if consumers there cannot recover from a decline in housing prices. In the long term, however, these two states are going to keep contributing a large portion of US auto sales, and AutoNation’s profits should benefit from remaining in these large markets.
The company mitigates these risks with its sheer size and resulting economy-of-scale benefits. Selling, general, and administrative expenses are about 72% of gross profit, and AutoNation is always much better than the industry average. This superior cost structure allows the company to post above-average operating margins even in weaker economic times.
Also noteworthy is the company’s sizable dealer network within its large markets, which enables AutoNation to quickly reallocate inventory among its dealers to better meet demand. Investments in information technology have also contributed to increasing efficiency.
Parts and servicing was only 18% of 2010 revenue, but made up 45% of gross profit. This significant contribution to profitability is less volatile than new- and used-vehicle sales and will continue to mitigate the cyclical risk of the auto industry.
Large dealers like AutoNation are enjoying an increasing competitive advantage for repair work, because most automakers require warranty work to be done at a dealer rather than an independent repair shop. Also, the increasingly advanced technology of cars presents an obstacle for smaller repair shops because they are less able to afford the equipment and training needed to provide competent service.
Our fair-value estimate is $27. We believe the company’s current cost-cutting will enhance its scale benefits once vehicle sales improve. Thus, we are modeling strong margin improvement relative to the recession years as vehicle sales rebound.
We forecast revenue to grow just over 9% on a five-year compound annual growth rate basis during our five-year forecast period. We expect the operating margin to average 4.4% instead of 4.3%, and capital expenditures to be 0.8% of sales. Over time, the operating margin should expand due to economies of scale. Our weighted average cost of capital is 8.5%.
NEXT: Public Storage
|pagebreak|Public Storage is the largest player in the fragmented and highly competitive self-storage sector. The competitive dynamics in the space aren’t conducive to an economic moat, but Public Storage is nonetheless best of breed, due to its geographic diversification and excellent operations, which exploit its decent economies of scale.
Replete with a conservative capital structure, we suggest a moderate discount to our fair-value estimate prior to investing.
While the company has interests in European self-storage and commercial spaces, via its equity stakes in Shurgard Europe and PS Business Parks, its US self-storage operations are its bread and butter, comprising over 80% of its operating earnings. The company’s 2,050 US storage facilities encompass about 130 million square feet across 38 states.
This geographic diversification shields it from being overly reliant on any single region’s economic prospects. More important, this scale is unmatched in the industry—Public Storage is the size of the next four largest operators combined.
However, the self-storage pie is enormous; collectively, the five largest operators own just about 10% of the aggregate rentable square footage. In addition to this fragmentation, the self-storage space is characterized by short-term leases, little product differentiation, and cheap building and maintenance costs, which lead to low bargaining power over customers and low barriers to entry.
Though a recovery in sentiment and a firming of economic fundamentals has led to near-term improvement in occupancy and rate, intense competition will likely curb outsized growth.
While it doesn’t have an economic moat, Public Storage’s scale enables it to drive down its cost structure. Most of the firm’s maintenance, administrative, and marketing processes are centralized.
Moreover, Public Storage has the resources to buy up considerably more high-profile print, television, and Internet advertising than its competitors. With these efforts spread out over a much wider base of properties, Public Storage is able to consistently garner high net operating income margins.
This operational efficiency is complemented by Public Storage’s fortresslike balance sheet. The firm finances nearly all of its acquisitions and operations via preferred equity or retained earnings instead of debt. With negligible debt obligations, Public Storage has the flexibility to seize attractive acquisition opportunities as distress arises.
Our fair-value estimate is $85 per share. This implies a 6.4% capitalization rate on our 2010 net operating income forecast (after adjusting for certain balance sheet items), and a 4.5% annualized, recurring dividend yield.
Excluding 2010 acquisitions, we project property revenues to grow 2.7%, on average, during the next ten years, slightly above our expectations of inflation. Including 2010 acquisitions, our ten-year average revenue growth rate bumps up to 2.9%.
We think the firm’s occupancy rate will range between 90% and 92% throughout our forecast, with the lower and upper bounds respectively suggesting recovering and expansionary economic environments. Public Storage’s low-cost operating structure should lead to net operating income margins of roughly 67% throughout our forecast period.
About $7 of our fair value estimate is derived from the firm’s joint venture holdings, which mostly consist of its 41% common equity interest in PS Business Parks and its 49% common equity interest in Shurgard Europe.
Altogether we think Public Storage can garner a return on income generating real estate assets of 10.5%, on average, during the next ten years, a premium to our 9.4% weighted average cost of capital estimate.
However, this is not indicative of an economic moat, as Public Storage can’t readily affect the considerable buyer bargaining power and low barriers to entry that are endemic to this property sector.
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