After falling 40%, do Vertu and Lookers signal a buy, or are something amidst that we haven’t discover?
Before you take a dive into these car dealership stocks, how about we look into the sector as a whole? Explore where the car dealership market is trending. Understand what is driving (financing) the car demand in the UK.
After that, you can decide if these stocks or the sector as a whole is worthy of investment.
Afterwards, we will explore the scenarios for both Vertu and Lookers by making assumptions on their future earnings. This will help us to avoid “value traps” set by the market.
Start with the car dealership sector in the UK
A Macro Perspective
Here is a chart showing the level of new car registration in the UK:
One reason for achieving five years of unbroken growth is thanks to low oil prices.
Notice the rise in oil price, typically signal slow growth or bring about a decline in new car registration. But, that isn’t all. The way car financing has changed over the past decade has helped to boost demand.
PCP Financing, what’s all about?
With rents and mortgages rising and wages stagnating, how are people able to pay for cars up front?
The solution PCP financing.
PCP stands for personal contract purchase and is a loan to help you get a car.
Here how it works:
You typically pay a 10% deposit on the value of the car. The amount you borrow depends on how much value is lost over 24 or 36 months. This means you don’t pay the full value of the car. Typical APRs are 4%-7%.
Let’s imagine you sign up for a PCP over three years to buy a car with a ticket price of £18,000. You put down a deposit of £2,000 and the finance company calculates that the car will be worth at least £8,000 after three years. Here’s how that would look…
To ‘borrow’ the car you pay…
Loan: £8,000 (£10,000-£2,000) plus interest
Total: £10,000 plus interest
To buy the car you pay…
Loan: £8,000 (£10,000-£2,000) plus interest
Balloon payment: £8,000
Total: £18,000 plus interest
(P.S. The above is a typical example from Money Saving Expert.)
You can own the car outright by paying off the balloon interest of £8,000. Or, get the car “revalued”, and if it’s over £8,000, (let’s say £9,250), then use the difference (£1,250) as part of the deposit for your next PCP deal. That means you won’t have to drive the same car for more than two to three years.
Is the economics of PCP financing sustainable?
According to the Society of Motor Manufacturers and Traders, about 80 per cent of new cars in the UK are sold on PCP.
And it has benefitted everyone. The reason is the increase in the “churn” factor. Previously, a carmaker would sell two cars to a typical owner. Now they can sell three cars. This helps to deal with overcapacity in the manufacturing side of the equation.
However, the problem lies when used car prices start declining. For instance, if the revalued car is £7,500, instead of the £9,250, then the owner would have to pay the deposit up front! Sometimes, customers won’t have the money upfront, which leads to a loss of some customers.
And that leads to lower demand, which means smaller car financing as car dealers make less money from interest.
What PCP has done is to shift the oversupply from the manufacturing to the retailer side. The car dealers will soon face a glut of two to three years old car building in their inventory.
Already, we are seeing cars like the Toyota Aygo or Volkswagen Up! rose by 80 per cent in 2016. But, for now, car demands remain strong, but weaknesses are creeping into the market.
The Society of Motor Manufacturers and Traders Warning
Here is what the SMMT thinks about UK car sales in the next two years:
“The SMMT is forecasting a 5 per cent decline this year and 3 per cent in 2018.”
That means car prices will come under pressure.
If the forecast is accurate, then car sales will drop by 10% in two years.
Mainly the car dealers because they rely on volume to drive business growth and profits. So, a fall in demand means lower sales, add in a fall in prices, this will exacerbate the problem. For us investors, we need to know how big this problem is!
Preparing for the worst-case scenario
In this section, I will focus more on Lookers rather than Vertu because it is the older and larger car dealer.
I will be using the earnings power value because it links the share price and fundamentals together. This valuation method will help forecast both Lookers and Vertu Motor share price by making assumptions on earnings.
During the financial crisis, new car sales fell by 15% to 2m and tighter credit led to lower prices. However, the car market was saved by a government programme called “cars for clunkers”, where the government and automakers give a £2,000 subsidy to car buyers to upgrade their old cars for new cars. It helped to stop the rot on falling demand.
However, it came too late for the car dealers when profits turned into losses, and their share price was collapsing.
For Lookers, it saw net income fell from £9.1m in 2007 to a net loss of £8.82m in 2008 and back to a small profit of £2.79m in 2009.
Net cash flow took a big tumble from £43.6m in 2007 to £1.6m in 2008.
Meanwhile, the share price decline by 90% during this period.
As the SMMT forecast a 5% decline in new car sales for 2017, will this affect Lookers operation financially?
Their interim result (released a few days ago), showed net profit stable at £36m, but the biggest surprise is the net cash flow falling to £44.5m from £90.3m.
These results are somewhat obscured by Lookers attempt to boost adjusted earnings and comparing it to “continuing operations”while ignoring the fact that more acquisitions helped to stabilise profits!
Another problem when facing falling car demand is a build-up in inventories. And Lookers has seen its inventories level rose by 8% from a year ago, to £857.1m, but sales manage a 4% increase.
Have earnings peaked?
Analysts on Lookers see stagnant growth on earnings but gave a rosy share price forecast of between £1.55 to £1.90 in the next 12 months.
Before I give my share price prediction, let’s do some projections.
Looker’s Earning Power Value
The correlation between Looker’s share price and EPV per share is startlingly positive meaning a rise in the EPV per share is often followed by the share price.
The required rate of interest used is 11% because of the company’s thin margin and external financing requirements. Also, their market capitalisation is below £1bn, add-in the fact it is a cylindrical business.
Now, how will Earnings Power Value, or EPV per share react to falling earnings.
Assuming a 30% fall in 2017, culminating to a 50% in 2018
For the sake of prudence, let’s say adjusted earnings fall by 30% at the end of 2017, which cumulates to a 50% in 2018, how will this affect Looker’s share price going forward?
As you can see, if Lookers maintain a £56m after-tax profits, then EPV per share falls to 93 pence, slightly below current share price. But, if earnings were to half to £40m by 2018, then EPV per share drops to 56 pence.
The fall in new car sales will likely drag profit margin down, therefore investors should expect earnings to drop leading to the share price falling.
On the other hand, Revenue won’t change much, as Lookers is willing to acquire more franchises to make up for any sales shortfall. That strategy will expense a bit of capital.
Vertu Motors is a newly-formed business. Here is the historical Earnings Power Value data on a chart:
Using the same assumptions as Lookers.
For Vertu Motor, the collapse in earnings has been mostly factored in because 2017’s EPV per share is 50 pence (above current share price) and 2018’s EPV per share is 32 pence.
So, an investment in Vertu Motors won’t be disastrous meaning you won’t see the shares fall more than 30% unless car market crashes!
My Share Price Prediction for Vertu and Lookers
Okay, my share price prediction for Lookers is it will trade around 80 pence in the next 12 months and for Vertu Motors it’s 35 pence.
My reasoning is the reversal of earnings as car demand peaked in the UK. This will increase supply for those selling cars rather than the car manufacturers because of the PCP financing model.
A model where car owners no longer own a car for more than two to three years, before changing for a newer model. (Car average economic life is 14 years.) With excess supply and falling demand, this will lower the price of cars. (read the macro section above, if you haven’t)
Another important concern is the car dealerships shouldn’t experience a decline in full-year earnings. Until this happens, we won’t how bad the decline will become.
My personal advice is to avoid car dealerships for the next 12 months.
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The opinions expressed by the writer is for entertainment and research purposes. It does not constitute professional investment advice. Data is correct on available information at the time.
Finally, the writer does not own the company’s stock, unless stated otherwise.