Gabelli & Company, Inc.

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1 One Corporate Center Rye, NY Tel (914) Fax (914) March 1, 2004 Gabelli & Company, Inc. AutoNation (AN - $ NYSE) Earnings Dynamics FYE PMV EPS P/E 2006P $28 $ Dividend: None Current Return: N/A 2005P Shares O/S: 283 million f/d 2004E Week Range: $ $ A SUMMARY & RECOMMENDATION AutoNation reported full year earnings on February 4, 2004 of $1.32 vs. $1.19 a year ago, in line with our estimate of $1.30 per share. In 2004, we estimate earnings of $1.50 per share. AutoNation faces some headwinds in 2004, such as potentially higher interest rates that reduce floorplan income; shrinking new vehicle gross margins; and media focus on industry finance practices that could limit the profit AutoNation generates per vehicle. However, we believe these potential negatives should be more than offset by modestly higher industry new car sales, improved mix, and a 150 basis point reduction in SGA as a percentage of gross profit, due to continued focus on corporate expenses and back office redundancy at the company s 300 locations. Additionally, AutoNation projects outlays of $400 million for share buybacks and dealership acquisitions. More importantly, our model envisions almost 11% growth in earnings over the next five years. At an attractive multiple of 11X this year s earnings, we continue to recommend purchase of the stock. EARNINGS In Table 1 below we lay out our five-year earnings model. Table 1 Earnings Model 2003A-2008P CAGR 2003A 2004E 2005P 2006P 2007P 2008P 2003A-2008P Revenue By Product New Vehicles $11,791 $12,417 $13,009 $13,593 $14,195 $14, % Used Vehicle Retail 3,706 3,837 3,969 4,104 4,241 4, % Parts & Service 2,457 2,556 2,657 2,761 2,866 2, % Used Vehicle W holesale % Finance & Insurance % O ther % TOTAL REVENUE $19,381 $20,296 $21,156 $22,013 $22,890 $23, % Cost of Goods Sold 16,490 17,270 18,005 18,731 19,489 20,265 Gross Profit $2,891 $3,025 $3,152 $3,282 $3,401 $3, % SG & A $2,158 $2,212 $2,285 $2,366 $2,438 $2,522 D & A Operating Income % Loan/Lease (Income) (6) O ther (G ains) / Losses 26 IRS Payable Interest Exp Interest Expense O ther incom e / (expense) 17 Pre-Tax Income $591 $670 $721 $760 $802 $840 Income Tax Expense Net Income $379 $409 $440 $464 $490 $512 Shares Outstanding Earnings Per Share $1.32 $1.50 $1.65 $1.85 $1.99 $ % Source: Company filings, Gabelli & Company Inc. estimates. -Please refer to important disclosures at the end of this report-

2 FIRST, THE HEADWINDS Gabelli & Company, Inc. Inventory. U.S. new car dealers had 3.9 million vehicles in inventory on December 31, 2003, or 280,000 more than they had a year earlier. This equates to 68 days supply, above the day range considered optimal. AutoNation, which accounts for 2.5% of the U.S. market, had 71 days. While the number is not catastrophic or unmanageable, it does present short-term challenges for the company: Gross Margin Contraction. Reducing inventory often leads to lower gross margins, as dealers are willing to accept lower prices in order to make the sale. However, there is already a secular erosion of dealer gross margins taking place that goes above and beyond reducing inventory. AutoNation s new vehicle gross margin, excluding floor plan subsidies from vehicle OEMs, has declined from 6.9% in 2000 to 6.2% in Over the same period, industry sales have dropped from a record 17.4 million in 2000 to a still robust 16.6 million in This is in spite of increasing incentives from vehicle manufacturers, which have risen from $1,600 to $2,600 per vehicle the past five years. OEMs have been reluctant to cut production in spite of declining sales, which forces dealers to even further discount the vehicles in order to move the metal and save on inventory carrying costs. This additional discount shows up as lower dealer gross margin. Less Floorplan Credit. Dealers are offered wholesale financing by subsidiaries of vehicle manufacturers (e.g. GMAC, Ford Motor Credit). Shortly after a dealer takes delivery of a vehicle, they receive a cash payment to cover the interest on the wholesale loan for the first sixty days the vehicle is on the dealer lot. Each day the vehicle is in inventory, the dealer is charged interest, which is paid back to the same finance company shortly after the vehicle is sold. Consequently, the longer a dealer holds inventory, the less profit they make. In Table 2, in which we plot AutoNation s average new vehicle inventory versus net floorplan credit. Table 2 Quarterly Floorplan Credit (Expense) Vs. New Vehicle Inventory Avg. Days Sales Outstanding Floorplan Income (in $ millions) Days Outstanding Floorplan Income Sources: Company Filings. In addition, there is an inverse relationship between interest rates and floorplan interest. In general, for every 100 basis point increase in interest rates, AutoNation loses $0.03 per share due to lower floorplan. Dealer Finance Reserve. In 2003, AutoNation earned $601 million pre-tax from a combination of arranging vehicle financing for its customers as well the sale of extended warranties and security systems (considered insurance products). That equates to $911 per vehicle retailed, new or used, of F & I. Of the $911, $ is finance related. This breaks down further to $375-$400 based on a fixed percentage of loan value, with the remaining $ being volume incentives from captive finance companies. Assuming a $2,000 average down payment (roughly AutoNation s average), this works out to 1.4% of loan value, well within the caps imposed by finance companies of, generally, 2.5-3% of loan value. The cap is the maximum spread allowed by a finance company between what the interest rate a dealer is charged and what the consumer sees. For example: should GMAC deem a particular customer qualified for a 5% interest rate loan, AutoNation can charge the consumer as much as 7.5% and keep the difference as a fee for arranging the loan.

3 There have been lawsuits filed in several states alleging that some dealers actually charge rates that far exceed the caps and overcharge consumers. Some of these lawsuits seek to impose a flat fee that a dealer can earn per loan, regardless of the quoted rate or credit quality of the customer. Such a flat fee would reduce AutoNation s earnings per share. In Table 3 below, we depict AutoNation s earnings per share sensitivity to different levels of flat fees. Note that $375 is roughly what AutoNation earns now. Table Pre-Tax & EPS Sensitivity To Finance Flat Fees Per Vehicle Current Flat Fee $100 $150 $200 $250 $300 $375 Pre-Tax Profit Negative Impact (193.0) (157.9) (122.8) (87.7) (52.6) EPS Impact $ (0.43) $ (0.35) $ (0.27) $ (0.19) $ (0.12) $ - Source: Gabelli & Company Inc. estimates. Used Car Prices. AutoNation s used vehicle gross margins hit their peak of 11.6% in Since then, used car prices have dropped 10% on average. AutoNation s revenue per used car retailed has remained flat at $15,100, reflecting a richer mix and smart procurement. In general, though, lower-priced vehicles carry a higher margin as a percent of sales. AutoNation in recent quarters has more aggressively pursued lower-priced vehicles, and in 2003 actually recorded a higher gross margin than the prior year, 10.8% vs. 10.6%. Weak used car prices are generally a net negative for the industry, as they result in lower trade in values (less equity to buy a new car) and often mandate higher incentives for new vehicles. AutoNation has managed to stabilize used car margins in a down pricing market, a testament to the disciplined purchase practices instituted across the company s nearly 300 dealerships. THE BULL CASE Higher Sales, Better Mix. Light vehicle sales in the U.S. are expected to match or slightly exceed the 2003 level of 16.6 million units. In general, every 1 million shift in industry sales equates to $0.10 per share for AutoNation. Thus, due to the resiliency of AutoNation s business model, a dip in new vehicle sales does not necessarily mean a dip in earnings. In addition, the company s domestic mix as a percent of sales has been declining (53.9% in 2003 vs. 60.7% in 1999) and is below the industry average of 62.4%. Foreign brand inventory stood at 70 days on December 31, versus 62 days for domestics, implying that less dealer discounting will be necessary to sell the vehicles, which already carry a generally higher gross margin than domestic nameplates. In Table 4 below we present AutoNation s new vehicle mix versus the industry as well as respective growth rates. Table 4 New Vehicle Revenue vs. Total U.S. Industry Sales 2003 vs % of AN % of US AN YOY US YOY Revenue Unit Sales % Chg. % Chg. Ford 24.3 % 18.0 % (7.9) % (4.6) % General Motors (0.3) Premium Luxury (a) (4.5) Toyota Chrysler (5.2) (3.5) Honda Nissan Other Imports (b) (2.7) Source:, Ward s Automotive Reports (a) Includes Mercedes, BMW, Jaguar, Lexus, and Rolls Royce (b) Includes Acura, Audi, Infiniti, Land Rover, Mazda, Mitsubishi, Volvo, Volkswagen, Subaru, Hyundai, Kia, Isuzu, and Suzuki

4 While the comparison of revenue and units is not a perfect one, broadly speaking, AutoNation s declining dependence on the Big Three for new vehicle sales should be viewed positively, given those brands decline in market share. Judging by recent acquisitions, it appears management will continue to lessen Big Three share. Of the last six publicly disclosed transactions, non-big Three franchises accounted for about $500 million of the $600 million in acquired revenue. Expense Control. AutoNation s revenue is down $1.2 billion since 2000, but EBITDA is actually up $88 million. Mix has had a lot to do with it: gross profit from parts, service, finance, and floorplan assistance more than offset the decline in profit from retailing new and used vehicles. Controlling SG & A explains the rest, and this is where the company s performance has been most impressive. Below we chart the company s SG & A as a percent of gross profit, the industry standard in measuring store performance. Dealer gross profit is strongest in the second and third quarters, thus we ve smoothed out seasonal fluctuations by using a trailing twelve months number. Chart 1 Trailing Twelve Months SGA % of Gross Profit % 77.5% 77.0% 76.5% 76.0% 75.5% 75.0% 74.5% Source: Company Filings. Going forward, we believe the company will reduce the SGA to gross ratio by another 150 basis points in 2004 and plateau in the high 72s over the next five years. Higher Fixed Coverage. The strength of AutoNation s business model is its diverse streams of income, which make earnings less susceptible to the ebbs and flows of the new vehicle cycle. One way this diversity can be measured is by fixed coverage: the extent to which parts and service gross profit covers fixed costs. In 2001, fixed coverage approximated 82%. In 2002, it rose to 88%, and in 2003, 93%. We depict fixed costs graphically in Chart 2. Chart 2 Parts & Service Gross vs. Fixed Costs (In $ Millions) P & S Gross Fixed Costs Source: Company data

5 We project that fixed coverage will approach 100% within the next two years, essentially allowing AutoNation to break even before a single new or used vehicle is sold. The high fixed ratio gives us additional confidence that the company s earnings and free cash flow will still grow even in the event of a significant decline in new vehicle sales. Free Cash Flow. In Table 5 below we lay out our free cash flow model through Table 5 Free Cash Flow 2004E-2008P (in $ millions) 2004E 2005P 2006P 2007P 2008P Net Income $409 $440 $464 $490 $512 IRS Payments (40) (40) (43) 0 0 D&A Working Capital (25) (25) (25) (25) (25) CAPEX & Lease Buyouts (230) (130) (130) (130) (130) FREE CASH FLOW $186 $323 $349 $422 $448 Property Divestiture Proceeds 30 Divesitures / (Acquisitions) (178) (178) (178) (178) (178) Net Stock Buyback (204) (220) (222) (222) (222) AVAILABLE FREE CASH FLOW ($166) ($75) ($51) $22 $48 Source: Company filings, Gabelli & Company Inc. estimates. AutoNation s free cash flow will dip in 2004 due to lease buyouts at several dealerships. Through February $70 million of cash had been used for this purpose and we re projecting $100 million for the full year on top of $130 million in ongoing capex. The company has some remaining properties for sale worth about $30 million as well as about $40 million in annual payments to the IRS related to accelerated health-care deductions taken in About $400 million will be used for stock buybacks and acquisitions: - Acquisition multiples are generally in the 0.2X sales range; we project AutoNation will acquire dealerships generating about $900 million in annual revenue. - Debt covenants limit stock buybacks to 50% of annual net income Sometime in the time frame, we project AutoNation will generate cash beyond its requirements for share buybacks and acquisitions, testament to the enormous cash-generating characteristics of their business. CONCLUSION Since exiting the ANC rental car business and disbanding its used car megastore concept at the end of 1999, AutoNation has grown earnings per share from $0.84 to $1.32, a 16% annual growth rate. Share buybacks have helped, but even adjusting for this, EPS has grown at a 7.5% rate. We expect the same factors that drove EPS growth in non-vehicle retail related businesses, SGA control, quick inventory turns, and prudent acquisitions to continue the next several years. With continued share buybacks, this should lead to annual EPS growth of 10.5% through 2008, at which time EPS should approximate $2.20. At this rate, the company should generate cumulative free cash flow of $1.8 billion. AutoNation s long-term earnings and free cash flow growth make it an attractive investment at this price and our recommendation is BUY

Table 6 Private Market Value 2003A-2008P (in $ millions except per share) 2003 2004P 2005P 2006P 2007P 2008P Revenues $ 19,381.0 $ 20,295.8 $ 21,156.4 $ 22,012.8 $ 22,890.0 $ 23,788.

6 Table 6 Private Market Value 2003A-2008P (in $ millions except per share) P 2005P 2006P 2007P 2008P Revenues $ 19,381.0 $ 20,295.8 $ 21,156.4 $ 22,012.8 $ 22,890.0 $ 23,788.6 EBITDA (after floorplan) ,001.8 Valuation Multiple Total Private Market Value 6, , , , , ,016.5 Less: Net Debt (653.6) (818.1) (888.2) (929.0) (890.1) (810.9) Less: IRS Tax Payable (122.8) (82.8) (42.8) Less: Option Payments (a) (231.0) (322.6) (405.7) (491.8) (584.5) (675.2) Equity Private Market Value 6, , , ,530.4 Shares Outstanding PMV per share $19 $22 $25 $27 $30 $32 Disc. To PMV 15.4% 25.4% 32.7% 38.9% 44.4% 48.9% Source: Company filings, Gabelli & Company Inc. estimates. (a) After tax payments to options holders at PMV. Company Reports: The Lampert Effect May 23, 2003 One May 23, 2003, we recommended to BUY AN at a price of $13.60 per share. On December 19, 2003, we reiterated a BUY recommendation at $17.50 per share. The Research Analyst who prepared this report hereby certifies that the views expressed in this report accurately reflect the analyst s personal views about the subject companies and their securities. The Research Analyst has not been, is not and will not be receiving direct or indirect compensation for expressing the specific recommendation or view in this report. David J. Siino (914) Gabelli & Company, Inc ONE CORPORATE CENTER RYE, NY GABELLI & COMPANY, INC. TEL (914) FAX (914) Gabelli & Company, Inc. ( we or us ) attempts to provide timely, value-added insights into companies or industry dynamics for institutional investors. We do not have any formal ratings system for our research reports, and we do not undertake to upgrade or downgrade ratings after publishing a report. We generally write reports on securities that we believe to be undervalued and do not issue any sell ratings. Thus, virtually all of our reports containing recommendations would be considered buy ratings. We prepared this report as a matter of general information. We do not intend for this report to be a complete description of any security or company and it is not an offer or solicitation to buy or sell any security. All facts and statistics are from sources we believe to be reliable, but we do not guarantee their accuracy. We do not undertake to advise you of changes in our opinion or information. Unless otherwise noted, all stock prices reflect the closing price on the business day immediately prior to the date of this report. We do not use price targets predicting future stock performance. We do refer to private market value or PMV, which is the price that we believe an informed buyer would pay to acquire 100% of a company. There is no assurance that there are any willing buyers of a company at this price and we do not intend to suggest that any acquisition is likely. Additional information is available on request. In the last 12 months we have provided investment banking services as a syndicate or selling group member of underwritten offering to approximately 0% of the companies that were the subjects of our research reports (all of which would be considered buy ratings). Our affiliates beneficially own on behalf of their investment advisory clients or otherwise approximately 1.4% of common stock of AutoNation. Because the portfolio managers at our affiliates make individual investment decisions with respect to the client accounts they manage, these accounts may have transactions inconsistent with the recommendations in this report. These portfolio managers may know the substance of our research reports prior to their publication as a result of joint participation in research meetings or otherwise. The analyst who wrote this report may receive commissions from customers transactions in the securities mentioned in this report

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