'Mind your eye' it's a Value Trap

Thursday, 26th October 2017 09:03 - by David Harbage

Based on the glitzy ‘For Sale’ banners, there are bargains to be had on the motor forecourt and the share prices of the UK’s motor car dealers have also tumbled. But are either new or used motor cars - or the distributors’ stock prices - good value, or are they likely to fall further?

Recent updates from the motor trade have confirmed what some have suspected for some time: that the manufacturers have been indiscriminately supplying (taking little account of actual demand) or ‘dumping’ new stock at lower prices and forcing their assigned dealers to take a cut in profit margins. Essentially, ‘pricing power’ between manufacturer and retailer comes to the fore again – something which we saw in October 2016 when Unilever and Tesco fell out over the pricing of leading branded products (including Comfort and Marmite). Certainly the retail consumer and the UK corporate fleet purchaser has benefitted from seeing price reductions, if not bargains – in the premium, as well as the volume, end of this high end ticket product.

Earlier this week, one of the country’s biggest motor retailers, Pendragon, came out with an unexpected interim management statement (IMS) and strategy update. The group, best known for its Evans Halshaw garages, has 300 dealerships which have extended beyond a bias towards premium marques - like BMW, Ferrari, Jaguar and Porsche - to represent over 20 brands with Ford, and then Vauxhall, having the largest representation. This statement, covering the 16 week period from the 1 July to 20 October 2017, revealed that the group’s trading had showed a marked deterioration from the first half of the year. Perhaps counter-intuitively, this business is not driven (if you’ll excuse the pun) by new car registrations - which had been hitting regular impressive new records, until this year – but rather the aftersales activities surrounding the sale of used cars, servicing, repairs etc.  

In the third quarter of this year total new UK registrations fell by 8.9% and, when considering that the decline in the first nine months of 2017 was just 3.9%, the steepness of the most recent fall is alarming. The operationally geared nature of selling motor cars is shown by the hit to Pendragon’s profitability, as its gross profit on new cars fell by 20.7% in the period under review on a like-for-like (taking no account of acquisitions and new garages) basis, whereas 10.2% represented the comparable year to date decline. There was a significant knock-on effect in used car prices, and profit margins took a significant ‘hit’: despite like-for-like used car revenue rising 18.1%, gross profit fell 20.3% in the monitored period.  

Beyond the ‘dark clouds’ of the UK sales performance, there are some ‘silver linings’: while aftersales servicing gross profits held up reasonably well in a competitive domestic market (fell 3% in the period, but rose 3% in the year to date), the US business and Leasing performed strongly. Overall, Pendragon management expect full year profits to fall from £73m to £60m, with trading remaining tough for the next 6-9 months, before recovering in the second half of calendar 2018.  The balance sheet strengthened, as net debt fell £34.5m from £175.7m - despite adding 6 used car garages to their national network in the UK and spending £17.7m on a Chevrolet dealership in California – as compared to the £350m market capitalisation of the equity.       

The prime reasons for the slowdown in new sales are probably dominated by two issues. One is uncertainty surrounding the future of fuel and the relationship with European motor manufacturers post Brexit, the other  consumers’ lack of confidence to make a big purchase (or at least, in these days of leased or otherwise financed purchases) a lengthy commitment. There has been much in the media in praise of, and alluding to the future dominance of, electric cars and almost as much written about the environmental shortcomings of diesel as a source of fuel. The author won’t extend this article by discussing the future of the British motor industry post Brexit; suffice it to say that the future is far from clear, inhibiting corporate buyers. With wages struggling to keep pace with inflation, consumers will be feeling less well-off and the inevitable slowdown in the proceeds of PPI claims (as a bumper source of deposits on high ticket items) may also have contributed to sentiment and purchasing intentions.

Management were caught out by the collapse in demand and will now hope that stability in car prices and profit margins (notably in used, taken in part exchange, motors where they have greater control in determining profitability) arrives by the turn of the year. Some influential fund managers have suggested that the firm’s strategic update represents a patch on, rather than a solution to, its problems. Actions feature calling a halt to the expansion of its US network (in California), accelerating the use of intelligent software (in managing its stock and servicing capabilities), focusing on the used car market (plan to double 2016’s turnover by 2021) and aftersales part of the business, and finally (impacting new cars) reviewing their relationships with the motor manufacturers.

The broking community remain sceptical and Pendragon shares have fallen from 29p to 22p this week, putting the stock on an apparently cheap rating – a price-to-earnings multiple of 6.8 times the £60m profit forecast by management. This significant discount to the wider market reflects investors’ concern that the quality of earnings is poor (unreliable) and that the UK motor industry has peaked - with only the magnitude, and speed, of its cyclical fall in question.   

Yesterday the newly appointed chairman, Chris Chambers bought 510,000 Pendragon shares at 23p (taking his holding to 2m shares or 0.14% of total equity) and  CEO Trevor Finn bought 2m shares at 22.25p  (taking his stake up to 16.7m shares, 1.17% of the group). This might support sentiment in the very short term, but astute investors will be aware that this stock could be a ‘Value Trap’ – meaning that an apparently cheap valuation (based on the PE ratio) should not hide the prospect of further downgrades in profit forecasts if domestic demand for motor cars remains soft.

The ‘bottom line’ is that the shares of Pendragon, along with peers like Lookers and Vertu Motors represent critical plays on the outlook for the UK consumer – for better or worse. News that the most recent domestic economic growth had been a little stronger than expected (+0.4% in the third quarter of 2017, relative to 0.3% in each of the first two quarters of the year) could be viewed in one of two ways. Optimists will be cheered by this ‘forecast beating’ growth, while pessimists will say that such growth underlines the need for a rise in interest rates (which could dampen consumers’ appetite to spend). Investors will also be mindful that there could be measures in next month’s Budget to affect the motor industry, one way or another.   

Perhaps the UK motor distributors should be viewed primarily as an attractive, well covered dividend stock: Pendragon shares currently yield 5.9% (covered 2.7 times by earnings). Elsewhere in this segment of the retail sector, prospective investors will take a look at another similar sized business: Lookers a £403m market cap nationwide dealer whose shares are comparably valued on a PE multiple of 6.9 times forecast earnings for calendar 2018. The dividend pay-out is less than generous, but covered 3.8x, with the stock yielding 3.6% on next year’s anticipated distribution. The other notable domestic-focused listed motor dealer is Vertu Motors, a £184m equity capitalised business on an earnings multiple of 6.7 times broker forecasts for their accounting year ending February 2019; covered 4 times by profits, the dividend yield is 3.4%.

Finally, beyond those three – which have a total equity worth of approximately £1bn – a much bigger motor retailer resides in the FTSE250 index: the £3.3bn market capitalised Inchcape Group. Unlike the others, this is a truly international business and represents a play on the global economy, perceived as offering growth (notably via significant exposure to the world’s emerging markets) and is valued very differently by the London stock market. The shares have held up much better than Pendragon, and currently stand on a much higher rating of 11.8x estimated earnings for the year to December 2018 offering a prospective dividend worth 3.4%, covered 2.4 times.     

The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.