Investing in a car dealership like a leveraged bet for a speculative investor. You can either make big profits or lose a lot of money, depending on their business cycle. Also, the sector to open to various car dealerships meaning it is super competitive.
This is a background post in understanding the fundamentals of car dealerships.
Today, I will look at two car dealers, one is Lookers and the other is Vertu Motors.
A super competitive sector
A super competitive sector often attracts too many competition and result in low margins. So, if you see a car dealership selling for over two times their net assets value, it is best to cash your investment out when times are good.
Margins are barely above 2%.
Graph 1: Vertu Cash Margin
Graph 2: Lookers Cash Margin
As you can see, a 1% drop in margin can cause a sudden drop in cash earnings.
Take Vertu’s net cash flow in 2017 of £49m, which is equivalent to 1.77% cash margin. A 1% drop means a loss of £28m in cash earnings, taking net cash earnings down to £21m.
Therefore, you must pay attention to the economy because any recession will trickle down and affect the car retail industry (due to their high price tag). Also, look at high unemployment, declining wages and tightening of credit to have a big impact in this sector. The last time that happened their share price collapsed by 90%!
Keep an eye on stock levels
We all know that cars value drop rather rapidly. In fact, they drop by 15%-30% in value per year, this depends on the brand. That’s why you need to keep an eye on car inventories.
Graph 3: Vertu and Lookers car inventories
The levels of stock, as % of sales, are steady for both companies at 18%-21%.
Beware of Capital Employed
Given the razor thin margins and high revenue, investors should always pay close attention to the utilisation of capital.
Because sometimes a company requires lots of capital to increase earnings.
Graph 4: Capital Turnover
Vertu Motors has an advantage over Lookers because of higher capital turnover meaning management has efficiently optimised capital generate more in per capita “sales”.
However, high sales don’t mean high-profit margins.
This is down to how management controls internal costs without wrecking their business model.
Graph 5: Lookers ROCE
Graph 6: Vertu’s ROCE
Comparing the two graphs together, you see Lookers have the advantage of achieving higher returns on capital employed because of their superior operating margins. Meanwhile, Vertu Motors have razor-thin margins of barely 1%!
But, one way to achieving higher operating profits is to lower the depreciation rate (in Lookers case, amortisation rate).
Graph 7: Lookers Amortisation Rate
Despite the rising cost of intangible assets, the annual amortisation charge didn’t keep pace, therefore it lowers the rate charged.
Now, at 1.4%, which is below their 4%-5% average. That helps to boost operating profits by £4m-£5m per year, but not enough to dent their operating margins.
But, there are different ways to grow earnings.
A look for External Financing
If you can’t improve margins “per car” than the other way is to sell more cars to grow profits.
As mentioned earlier, that requires a lot of capital and sometimes it leads to reliance on debt and equity.
Graph 8: Net Real Debt
On the debt department, Lookers has been loading up on too much debt, as net debt (including pension deficits) rose to £152m, while Vertu has a net cash position of £21m.
Does that make Vertu a safer investment than Lookers? According to the market, it doesn’t because both are trading at P/E ratios of 7 times earnings. It could be Vertu low EBIT Margin.
Or, it could be that Vertu is using equity to fund their expansion.
Graph 9: Proceeds from Equity
Vertu raised a total of £161.9m, while Lookers took on £83.1m.
Adding net equity and debt raised
Putting this together, Vertu saw net debt position improved from £16.92 in 2008 to £21m in net cash, a positive swing of £38m. Minus the £161.9m of equity raised, this means Vertu rely on £123.9m in external financing, since 2008.
For Lookers, their net debt position rose from £90.7m in 2005 to £152.5m in 2016, an increase of £61.8m. Meanwhile, it took on £83.1m in equity, giving it a reliance on external financing of £144.9m, since 2005. Remember, Lookers has recently sold their parts distribution for £120m in cash, and that saw a reduction in net debt of £65m. Therefore, without the disposal than external financing is over £200m.
A Question about Free Cash Flow
With all the expansion and reliance on external funding, the question of sustainability is often questioned. Can car dealers ever generate free cash flow?
Table 1: Lookers
Table 2: Vertu
The funny thing about comparing these two tables is the more post-tax normalised earnings are earned, the more negative free cash flow gets generated. I don’t know if this applies to all car dealers, given the level of competition, but I hope not!
For instance, Lookers generated cumulated normalised post-tax earnings of £546m, since 2005, but manage to produce cumulative negative free cash flow of £539m.
Meanwhile, Vertu generated cumulated normalised post-tax earnings of £92m, since 2008, but manage to produce cumulative negative free cash flow of £100m.
A bit like: “An eye for an eye!”
However, the culprit is down to high capital expenses due to expansion. But, if both these businesses were to expand at a slower pace (equivalent to 1.5 times to 2 times of depreciation), then positive free cash flow is likely.
Don’t neglect Land and Property
Holding land and properties gives any business enormous advantage in raising cash. And both businesses have it in abundance. But, how does the market view properties holdings?
Graph 10: Property, as % of Enterprise Value
The market under appreciates Vertu’s properties despite net book value registering 91% of costs, compared with 93% from Lookers.
Vertu’s properties value is one and a half times greater than their enterprise value, a level last seen in 2011.
And, speaking of valuation
Valuation: How do they compare?
Both companies have P/E numbers of 6 or 7 meaning investors are expecting zero growth and negative growth in the future.
But, have investors went over pessimistic on the whole sector?
Graph 11: EV/EBIT
Record low multiples are recorded in both companies. So, does this represent value for investment or a value trap?
For cylindrical businesses, low multiples mean something else. A low multiple can mean growth has slowed as earnings reach their peak. Therefore, earnings could collapse causing multiples to rise.
Why is this the case?
Because businesses make “excess” profits during good times and “excess” losses during bad times.
As of right now, management is showing no signs that both companies are experiencing operational distress.
P.S. It needs more in-depth analysis.
Graph 12: Buffett’s PE*PB Equation
For those who don’t know, this equation “P/E*P/B < 22.5” is an equation devised by Buffett to represent fair value.
Both companies, especially Vertu is signalling a buy signal, and again more analysis is required.
Below is a reminder of the following things you need to keep your eye on:
-If you hear the car dealership sector is facing rising costs or there is a drop in car sales, be alarmed because a small movement in margin affects levels of profits.
-Watch the level of stock holding because means cars aren’t getting sold fast enough to maximise selling price value.
-Always check for too much debt build-up or proceeds from shares. Operations aren’t funded by internal sources.
-Low valuation multiples don’t signal a buy until earnings experience a trough period. That is because earnings can make a full recovery.
There are more posts to come on Vertu Motor and Lookers, so stay tuned!!!
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