Description

Aston Martin Lagonda (“Aston Martin”) is a British car manufacturer with a checkered past. The company has gone bankrupt 7 times throughout its history and loss-making up until very recently. On the surface, it seems like Aston Martin has experienced a rejuvenation since the ex-Nissan executive Andy Palmer took over the reins in 2014.

I think there is more than meets the eye however. While Aston Martin newly released vehicles look stunning and may indeed accelerate the top-line growth of the company, underlying profitability remains poor. It seems that he recent turnaround is more due to aggressive accounting maneuvers than any fundamental change to the business.

Controlling shareholders Industrialinvest and Adeem Investment offloaded part of their shares into the IPO and they will most likely be selling after lock-up expiry on 1 April. This sets minority shareholders up for a bumpy ride as existing shareholders will probably try to exit before more conservative accounting policies are put in place.

The motive

Aston Martin was founded in London in 1913 and remained independent until Ford’s purchase of the company in 1987. It has featured in many Bond movies and remains a well-recognized brand in the UK and elsewhere. In 2007, Ford sold its shares to a consortium of Kuwaiti investors for £470m. Since then Italian private equity company Industrialinvest and Daimler have also acquired significant stakes and helped appoint Andy Palmer as the company's CEO.

One year after Palmer became CEO, the company unveiled a plan to turn around the company. The gist of the plan was to introduce one mass-market vehicle per year until 2022. The first vehicle launched under the new plan was the DB11 in 2017, followed by DBS Superleggera in 2018 and the soon-to-be-released DBX SUV.

Aston Martin DB11

Aston Martin DBS Superleggera

Aston Martin DBX SUV

The company went public on 3 October 2018 at a price of £19/share. The first question mark in my mind was that despite a significant amount of debt, the company didn’t raise any new cash for the company, instead shares sold in the IPO came from existing investors. This suggests that they didn't consider the shares to be undervalued at the IPO price. The Kuwaitis had done very well on their investment, making 10x their money in just over a decade.

The luxury auto industry has experienced significant tailwinds over the past ten years as a wave of quantitative easing and Chinese credit growth has pushed up asset prices, borrowing and demand for high-end goods. Second-hand prices for classic Aston Martin vehicles have gone up by a multiple of 3x over the past decade. This massive increase in prices may also have elicited speculative demand. There have even been reports of speculators crowd-funding the purchase of Aston Martin Valkyrie vehicles for those that cannot afford buying an entire vehicles themselves.

Aston Martin classic vehicle price index Source: Historic Automobile Group International

Prior to the IPO, the board was represented half-half by the Kuwaiti investors and Italy’s Industrialinvest, on top of a board seat for CEO Andy Palmer. The board set all the company’s accounting an remuneration policies. And those policies were probably set to maximize the return on their investment rather in the best interest of minority shareholders. The remuneration policy was and is still based on the following metrics: volumes, ROIC, revenue, adjusted EBITDA and adjusted net debt/EBITDA. The CEO's annual bonus is based 40% on Adjusted EBITDA, 40% on net leverage (which itself is a function of Adjusted EBITDA) and 20% from a strategic scorecard. And the long-term incentive plan is based 40% on EPS, 40% on ROIC (operating profit / capital employed) and 20% on share price performance. And it's probably not a surprise that the accounting has been stretched to maximize the company's performance based on those particular metrics.

The crime

Aston Martin is not really a growth company. I can't rule out that future model releases might lead to a rejuvenation of the brand. The new SUV and the Lagonda EV could potentially attract a new set of buyers. But so far, search query data seems to suggest that customer interest in the brand remains flat to down.

Website traffic has improved somewhat. Youtube viewership of the company’s main “Aston Martin” remained sluggish throughout 2017 and 2018, but spiked heavily just after the IPO - probably due to a marketing campaign rather than organic growth in buyer interest.

In the run-up to the IPO, the company set up a wholesale finance facility with Standard Chartered Bank to provide extra liquidity to dealers who wish to purchase inventory. Before this, dealers were required to pay for their inventory within 10 days of delivery. What seems to have happened here is that Aston Martin pulled forward demand through generous customer financing, and recognized much of that revenue in 2018.

Some anecdotal evidence suggests easy financing terms for the purchase of new Aston Martin vehicles. Aston Martin dealers in Dallas offer customers $0 down payment and the first 2-3 payments paid for by the dealership. In California, a 36-month lease with 7500 miles per year and a 57% residual had an APR of just 1.15%. Customers report of dealers being willing to knock off $10k the price without even haggling. This conditions seem unusual for cars at this price point and during this part of the business cycle.

The company’s accounting has become increasingly aggressive:

• Almost all research & development costs are capitalized. Aston Martin spent £214m on R&D in 2018, but only £11.5m was recognized as an expense (5%). At Ferrari, 62% of R&D was expensed in 2018. Many other auto companies expense all their R&D.

• Aston Martin’s receivable days rose from 48 to 80 days in 2018. The total receivables balance rose +109% YoY vs top-line growth of only +25% YoY for. Are dealers experiencing difficulties paying? Unlikely, as receivables overdue fell from 25% to just 8% in 2018. The most likely explanation for the spike in receivables seems to be a change in revenue recognition. The table below shows how revenue recognition policies changed in the run-up to the IPO. Up until 2017, for vehicles sold via the Standard Chartered financing arrangement and with sales dates more than one year in the future, vehicle deposits were capitalized in anticipation of future revenue recognition. In 2018, such capitalization stopped. The overall effect seems to have been to exaggerate 2018 revenues.

• In the first half of 2018, the company enjoyed “consultancy income” of £20m from the sale of certain legacy intellectual property. According to management, this income is not expected to repeat in 2019.

• In 2017, there was a one-off gain from changing the pension benefit policy, reducing future pension obligations. This increased 2017 earnings by £24.3m.

• The discount rate used to test the value of goodwill and other intangibles with indefinite lives (brand names, etc) fell from 12.3% in 2017 to 8.8% in 2018. This would have had the effect of lowering the likelihood of impairment of intangibles.

• The company paid taxes of £7.9m in 2018, suggesting that at a 19% statutory tax rate, taxable income should have been around £42m.

As mentioned earlier, the main metrics management is judged against are 1) “adjusted EBITDA” and 2) metrics derived from this adjusted EBITDA (such as EPS, ROIC and adjusted operating profit. The below charts show how adjusted EBITDA and related metrics improved dramatically in 2017.

I believe that the major contributing factors to this higher profitability came from the dealership financing facility as well as the capitalization of R&D. The following chart should make it clear that the increase in Adjusted EBITDA was almost entirely due to more aggressive capitalization of R&D. Even though total R&D expenditures almost doubled in 2017, the sum of R&D expenses and amortization of intangibles actually fell by £40m. Amortization of intangibles is supposed to start when “an asset is available for use”. Maybe an accountant can tell me why the release of the DB11 and DBS Superleggera did not qualify as those assets being available for use.

If one were to expense 60% of R&D in line with Ferrari’s accounting policies and also deduct the revenues that came about from an increase in receivable days, Adjusted EBITDA would instead end up being closer to this numbers:

Using the 4-year average “adjusted adjusted EBITDA”, Aston Martin's leverage ratio would rise to 16.4x EBITDA. This is a highly indebted company.

The question is when all of this will start to matter.

The punishment

The first part of the unravelling in my view was the poor 2018 results and the lower-than-expected 2019 volume guidance. Probably priced-in at this point.

The second catalyst is the lock-up expiry on 1 April 2019 for the selling shareholders (Industrialinvest and the Kuwaitis) and their representative directors. The second lock-up expiry (for all other shareholders and directors) will happen on 3 October 2019. Given how the IPO was structured, my best guess is that the controlling shareholders will be looking to sell their shares at the earliest possible date. They still own over 47% of the company.

The third catalyst might come from the appointment of Ernst & Young as a new auditor. KPMG resigned from its role as an auditor on 6 March and Ernst & Young was appointed instead. Note that KPMG was paid only £115,000 in audit fees during 2017 vs £665,000 for “other services”. This raises questions about KPMG’s independence and objectivity. The big question is now whether Ernst & Young will push Aston Martin to adopt more conservative accounting policies, most importantly the capitalization of R&D.

The fourth potential milestone would be a failure of a new car release, which would lead to an impairment of development costs. I am not predicting this will happen, just that such an event has a non-zero probability. An impairment test is carried out annually, and would be announced with the release of the 2019 annual report in early 2020.

I like the look of the Vantage (despite its Mazda Miata-like headlights), the DB11 and the curiously-named DBS Superleggera. But Aston Martin is not Ferrari - not even close. The company’s brand recognition is probably closer to Maserati, another company that was barely profitable in 2018. Development of new vehicles is costly and as a niche car manufacturer it’s hard to reach the volumes needed to bring down the development cost per vehicle. Developing the Lagonda EV model seems even riskier, given that practically no OEM has been able to make consistently selling EVs. The phase-outo of Federal subsidies in the US and Chinese subsidies will be another headwind. While Aston Martin’s vehicles are decent, the company hasn’t shown an ability to substantially improve its unit economics. Good cars, but not a good business. My guess is that we’ll see more of the same - decent sales of the new vehicles but poor profitability. And eventually the company will have to revise its accounting to reflect the underlying poor profitability.

How much is the stock worth? With “adjusted adjusted EBITDA” of £80m in 2017 and a generous 12x multiple to account for the growth potential of vehicles already in development, an EV much above £1 billion doesn’t seem reasonable to me. Deduct £560 million in net debt and you’ll end up with a value of equity below £500 million, or below £2/share. A £1 billion EV would represent a valuation multiple of 1x sales - very close to the 0.93x multiple that the Kuwaiti investors paid for Aston Martin in 2006.

There seems to be an underlying assumption that since Aston Martin vehicles are similar in nature to Ferraris, the company should be trading at a similar EV/Sales multiple. But Ferrari’s operating margins are 24% whereas Aston Martin’s – properly adjusted – are probably closer to zero. Every car enthusiast I have spoken to agrees that Ferrari is on a completely different level in terms of brand recognition and customer engagement. Second-hand prices for Ferraris hold up very well as supply is tightly managed to avoid speculation and oversupply. The average price per Ferrari is over twice the price of an Aston Martin. Ferrari makes $80,000 on each vehicle, whereas most other car manufacturers (including Aston Martin) probably make closer to $10,000 for each additional vehicle. Aston Martin is closer to the rest of the industry than it is to Ferrari.

While I concede that this write-up is a bit late to the party, I believe the risk-reward is still skewed towards the downside - especially with lock-up expiries just around the corner. The likelihood of intangible impairments seems to be high. Eventuall, the company will be forced to expense a greater portion of its R&D. Once they do, Bloomberg estimates for £450 million of EBITDA in 2020 for example will have to be downgraded - by a lot. I’m betting that Aston Martin will eventually return to the poor profitability of its recent past and that the shares end up at multiples much closer to the industry averages.

Catalyst

• Lock-up expiries on 1 April 2019 and 3 October 2019
• Accounting restatements and impairments
• Potential for new model release failures
• April 2022 maturity of the senior secured notes