What a fantastic six months it’s been for Lithia. Shares of the company have skyrocketed 43.6%, hitting $387. This was partly thanks to its solid quarterly results, and the run-up might have investors contemplating their next move.

Despite the momentum, we're sitting this one out for now. Here are three reasons why LAD doesn't excite us and a stock we'd rather own.

Why Is Lithia Not Exciting?

With a strong presence in the Western US, Lithia Motors (NYSE:LAD) sells a wide range of vehicles, including new and used cars, trucks, SUVs, and luxury vehicles from various manufacturers.

1. Shrinking Same-Store Sales Indicate Waning Demand

Same-store sales is an industry measure of whether revenue is growing at existing stores, and it is driven by customer visits (often called traffic) and the average spending per customer (ticket).

Lithia’s demand has been shrinking over the last two years as its same-store sales have averaged 3.1% annual declines.

2. Low Gross Margin Reveals Weak Structural Profitability

Gross profit margins are an important measure of a retailer’s pricing power, product differentiation, and negotiating leverage.

Lithia has poor unit economics for a retailer, signaling it operates in a competitive market and lacks pricing power because its inventory is sold in many places. As you can see below, it averaged a 16.3% gross margin over the last two years. That means Lithia paid its suppliers a lot of money ($83.74 for every $100 in revenue) to run its business.

3. Short Runway Exposes Shareholders to Potential Dilution

As long-term investors, the risk we care about most is the permanent loss of capital, which can happen when a company goes bankrupt or raises money from a disadvantaged position. This is separate from short-term stock price volatility, something we are much less bothered by.

Lithia burned through $270.3 million of cash over the last year, and its $11.64 billion of debt exceeds the $359.5 million of cash on its balance sheet. This is a deal breaker for us because indebted loss-making companies spell trouble.

Unless the Lithia’s fundamentals change quickly, it might find itself in a position where it must raise capital from investors to continue operating. Whether that would be favorable is unclear because dilution is a headwind for shareholder returns.

We remain cautious of Lithia until it generates consistent free cash flow or any of its announced financing plans materialize on its balance sheet.

Final Judgment

Lithia isn’t a terrible business, but it isn’t one of our picks. After the recent rally, the stock trades at 12x forward price-to-earnings (or $387 per share). Investors with a higher risk tolerance might like the company, but we think the potential downside is too great. We're pretty confident there are superior stocks to buy right now. We’d suggest looking at Cloudflare, one of our top software picks that could be a home run with edge computing.

Stocks We Would Buy Instead of Lithia

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