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IBV Capital on Automotive Retailers & Vertu Motors

C4K Monthly Manager Insight – IBV Capital: Finding Value In Vertu Motors PLC, March 2017

  • Automotive retailers exhibit numerous qualities that are consistent with a business model that compounds capital at above average rates
    • Cost of building or purchasing a physical dealership is quite low and dealers don’t pay for their new car inventory upfront – instead, usually financed by manufacturers at very low interest rates, only to be further subsidized through floorplan interest credits received when a car is sold
    • While not obvious, high barriers to entry also exist: market dynamics show that auto retailers compete locally, not nationally; market share is further protected by dealership agreements that prohibit competing dealerships from being built near existing facilities
    • Another misnomer is the degree of cyclicality: revenues are cyclical but profits are typically quite stable because dealership performs three main services – 1) selling new and used cars; 2) performing aftermarket services; 3) selling financing, insurance, and warranty packages
      • New and used vehicle sales are impacted by macro health and consumer confidence – making it cyclical; while they make up the lion’s share of a dealer’s revenue, contributes only a small portion of gross profits
      • Aftermarket services isn’t nearly as dependent on economic environment; high margins and upwards of 40% of total gross profits
      • F&I makes up only few % of revenues but margins are so high that nearly all of this revenue falls to the bottom line; in the UK, retailers don’t break out F&I for fear of increased regulatory scrutiny – therefore, underlying impact of this segment remains hidden
        Gross Profit Mix
    • Before investing in Vertu, spent a few years following the North American auto retailer space; began with Canada and its only publicly traded retailer – AutoCanada
      • AutoCanada focused its growth in Western Canada and subjected to economies that are disproportionately underpinned by oil and gas industries and a sizzling hot real estate market
      • Another structural challenge is their inability to own specific manufacturer brands – symptom of them being public and ultimately disproportionate influence manufacturers have on auto retailers
      • Passed on the name as a result of these reasons and elevated valuation from all-time high new car sales
    • Retailing environment is much better in the US
      • Retailers have more influence over the manufacturers
        • In part due to legislation that forbids manufacturers from owning their own dealerships as well as strong dealership contracts that make agreement terminations by manufacturers very difficult
      • Most of the industry’s top retailers had competent management teams, sound operations, and good financial results
      • However, accompanied by premium valuations that were unattractive
    • Attention turned to UK and its many publicly traded auto retailers – each of which are trading at valuations that are a fraction of North American peers
    • Vertu:
      • Robert Forrester, Vertu’s CEO, founded the company as a cash shell in 2006
      • Over the next 10 years, Vertu would buy dozens of dealerships: buy underperforming dealerships and turn them around or buy performing ones and bolt them onto their existing dealership platform
      • Today, generates £2.5 billion in sales, making it 6th largest retailer
      • Analyzing an acquisitive company’s earnings power is challenging and it is especially more difficult due to their focus on underperforming dealerships
      • Ongoing success with its acquisition strategy can be attributed to management focusing intensely on executing their four-year turnaround plan; plan usually starts with replacing existing management, executing better processes
      • With so many acquisitions having been made in the last few years, financial impact of these turnarounds haven’t fully taken hold – relative to their peer group, operating margins are depressed
      • Closer look at their financial disclosures uncovers stabilized dealerships having materially better financial performance than their more recently acquired dealerships
        • Vertu’s operating profit would increase by over 60% if they achieved margins that matched their mature UK peer group
      • Strong balance sheet – with private valuations contracting due to BREXIT, Vertu is in a prime position to continue to expand their dealership count; net cash position provides heightened level of comfort to invest during these uncertain times
        long term debt
      • While Vertu previously made acquisitions by issuing stocks, plans to make acquisitions with both debt and existing cash flow going forward
        • Past stock issuances provided them with the scale and financial strength to be successful but negatively impacted their historical per share compounded annual growth rates
      • Average North American firm has long-term debt/cap of 48% relative to the UK’s 21%
        • Suspect the difference between North American and UK capital allocation practices explain some of the divergence in their valuations
        • This makes Vertu’s intentions to optimize its balance sheet a meaningful catalyst that may narrow the valuation gap
      • Brexit has cast a shadow over the future of the UK and this uncertainty helped create this investment opportunity
        • Discussions with management and industry experts revealed that the impact of Brexit would be isolated to potentially adverse macroeconomic conditions
        • UK automotive retailer business model will remain intact
        • Precise impact of Brexit is unknown but comforted by the underpinnings of new car demand
      • Attractive business with dynamics that make it an excellent compounder of wealth
      • Trades at discounted levels to historical norms and North American past and present values
        • Encouraged by their organic growth opportunities and future acquisitions that will be more accretive to earnings as they will be financed with debt and cash flows
        • With an intrinsic value that exceeds 67 GBp (currently price of 46 GBp), pleased with the potential for continued share price appreciation

IBV Capital is a Toronto based boutique investment management firm. IBV Capital emerged from a well-established multi-family office in 2012. J. Talbot Babineau serves as President and CIO.

Image Source: Vertu Motors
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