Over the past six months, Lithia’s shares (currently trading at $299.91) have posted a disappointing 7.9% loss, well below the S&P 500’s 16.4% gain. This may have investors wondering how to approach the situation.

Is now the time to buy Lithia, or should you be careful about including it in your portfolio? Get the full stock story straight from our expert analysts, it’s free for active Edge members.

Why Is Lithia Not Exciting?

Despite the more favorable entry price, we're cautious about Lithia. Here are three reasons we avoid LAD and a stock we'd rather own.

1. Flat Same-Store Sales Indicate Weak Demand

Same-store sales show the change in sales for a retailer's e-commerce platform and brick-and-mortar shops that have existed for at least a year. This is a key performance indicator because it measures organic growth.

Lithia’s demand within its existing locations has barely increased over the last two years as its same-store sales were flat.

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 bad 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 15.6% gross margin over the last two years. Said differently, Lithia had to pay a chunky $84.39 to its suppliers for every $100 in revenue.

3. High Debt Levels Increase Risk

Debt is a tool that can boost company returns but presents risks if used irresponsibly. As long-term investors, we aim to avoid companies taking excessive advantage of this instrument because it could lead to insolvency.

Lithia’s $14.72 billion of debt exceeds the $417.1 million of cash on its balance sheet. Furthermore, its 7× net-debt-to-EBITDA ratio (based on its EBITDA of $1.92 billion over the last 12 months) shows the company is overleveraged.

At this level of debt, incremental borrowing becomes increasingly expensive and credit agencies could downgrade the company’s rating if profitability falls. Lithia could also be backed into a corner if the market turns unexpectedly – a situation we seek to avoid as investors in high-quality companies.

We hope Lithia can improve its balance sheet and remain cautious until it increases its profitability or pays down its debt.

Final Judgment

Lithia isn’t a terrible business, but it isn’t one of our picks. After the recent drawdown, the stock trades at 8× forward P/E (or $299.91 per share). This valuation is reasonable, but the company’s shakier fundamentals present too much downside risk. We're pretty confident there are superior stocks to buy right now. We’d suggest looking at a fast-growing restaurant franchise with an A+ ranch dressing sauce.

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