Description

CDK Global Inc. (CDK)

The dealer management system (DMS) product is ripe for modernization and being transformed. CDK has been a dominant force in the industry for decades, but is not resting on their laurels and is progressing their technology in order to provide customers with advanced software and integration. Their high market share should allow CDK to bring these new products efficiently to customers while giving them confidence that they will not lose any information during an upgrade.  

Nearly all large franchise dealers use a CDK, Cox Automotive or Reynolds & Reynolds (R&R) DMS. Customers have been frustrated with some of these companies in the past, leading to anti-competitive lawsuits. Reynolds & Reynolds has seemingly been slower to adapt and has potentially been losing market share. However, R&R recently hired a new CEO, after their previous CEO was accused of federal tax fraud, who is evaluating changes to the business. CDK has a head start on improving their technologies after hiring Brian Krzanich in late 2018, who has been advancing the business into the new technological age.

I see Reynolds & Reynolds continuing to be the primary market share donor in the coming years as contracts expire. Changes in market share can be slow as customers are often required to sign 5 plus year contracts. Also, since the DMS is the backbone of the business, customers will need to see significant value elsewhere before they undertake the arduous and complex process of switching systems.

However, this opportunity is not all about the DMS system. If CDK can hold their market share in DMS and capitalize on the growing application market, and continue to add services to other parts of their business. CDK can continue to monetize their customer base and grow revenue per customer/site. Applications have become increasingly important, particularly when it comes to online store platforms, and payment systems. CDK provides dealers with an online store API and continues to grow their partnerships with payment processors.

Despite new entrants bringing DMS products to market, CDK’s management will be able to effectively compete with their own products. CDK has increased their R&D spending to at least 3-5% of sales in recent years in order to increase the speed in which they are advancing their products. CDK also provides unique products such as the first DMS integrated CRM system for the heavy equipment industry. Their diversification and high market share will provide stability while they focus on disrupting themselves to drive their next decade of growth. 

Background

• Development of the business began in 1972. They became their own company through a spin off from ADP in October of 2014.

• Market cap of $6.2 B, with some analyst coverage, weighted more toward the credit side.

• Hired Brian Krzanich, former CEO of Intel, in late 2018.

• Executive incentive compensation is based on revenue and EPS growth targets. The stock-based incentive compensation makes up a maximum of 84% of total compensation. 

How do they make money?

• CDK provides software-based management systems and applications primarily to auto dealerships, but also to commercial vehicle, boat and other recreational vehicle dealers. They recently sold their international segment to focus solely on the North American business (North America was 84% of revenue prior to the sale).

• They are paid for software subscriptions, on-site installation, and receive transaction-based revenue based on system usage (credit checks, vehicle registrations processed, etc.)

• Customers sign multi-year contracts in order to use CDK’s software.

• Their primary product is a dealer management system (DMS) which facilitates the sale of new and used vehicles, customer financing, repair and maintenance services, and parts and inventory management. 

• Additionally, they provide layered software applications and services on top of their DMS platform, but these applications can also be used by customers who do not currently use their DMS.

• Applications include an online store, CRM System, and many others.They provide connected store software to enable dealers to sell vehicles online. 

Their North American business has 40-50% market share for franchise auto sites, less than 1% share of independent auto sites and 15% share for value-added applications. The number of US franchise dealerships has been fairly steady at ~18,000, so gaining market share typically comes from winning customers from another DMS provider. CDK has been able to slowly grow their customer numbers and maintain their revenue per customer in recent years. 

Customers

CDK is helping their customers adapt to changes in technology and customer preferences. 7 of the 10 largest automotive retailer groups are CDK customers, but no single customer has represented more than 10% of revenue or accounts receivable in recent years. Their DMS software tends to be sticky leading to an average client retention rate of 20 years.

Their customers are capital intensive vehicle dealers, which leads to customers typically having less optimal balance sheets. However, the necessity of CDKs products led to their revenue being less cyclical during the financial crisis and there have been no major write-offs due to customer deterioration issues since mid-2010 (mid-2010 is the beginning of independent financial data). ; will look to confirm A/R write-offs with IR).

Acquisitions and Divestments

Divestments

Over the past 5 years, CDK has made two major divestments. The digital marketing business divestment completed in April 2020 and plans were announced to divest their international operations on November 30, 2020 which closed March 1st, 2021.is expected to close in mid-2021.

Their international segment did not have much overlap or synergies with their North American operations and is expected to generate $1.3 B in proceeds, which will allow them to accelerate their deleveraging objective. This business was sold at 15x LTM adjusted EBITDA, whereas CDK currently sells at a multiple near 8x adjusted EBITDA.

Acquisitions

CDK has made one major acquisition in the last 5 years. ELEAD was acquired in September of 2018 for $513 M or 8% of CKD’s market cap. ELEAD is a provider of customer relationship management software and call center solutions, which added a service on top of the core DMS platform that is integral to the dealer ecosystem. Customers pay a subscription cost for this service.

Growth Plans

Growth is expected to come through increased retention and upgrades of their core DMS platform, the sale of value-added applications that add functionality beyond a DMS platform, and adoption of the Fortellis platform.

CDK recently launched their cloud enabled Drive and Driveflex DMS platforms. These upgrades to the platform focus on improving retention and potentially increasing market share growth of independent dealers where they have much lower market share relative to large multi-dealership customers.

Despite having about 40% market share for DMS, management estimates that only 15% of their DMS customers are using CDK apps. Dealers spend 2-3x more on apps than they do the DMS platform. These apps include services such as a connected store that is integrated with the DMS system.

Fortellis is an open data platform which allows application developers access to programming interfaces to collaborate and add services to an “app store”. These apps would have access to interfaces that are structured for the automotive industry. CDK will look to release their own applications through the Fortellis platform, along with apps developed by others. For example, CDK announced a partnership with Global Payments (GPN) who will offer a payment processing API through the platform. The Fortellis platform will replace the “partner program”, which will be phased out over time. Revenue from this platform will depend on the application, but will primarily be generated through a small fee per transaction/entry.  This program will replace the “partner program” which will be phased out over time. Revenue from this platform will depend on the application, but will primarily be generated through a small fee per transaction/entry.  

Financial Strength

Management had begun the process of deleveraging after the acquisition of ELEAD in late 2018 with a long-term objective of 2.5-3x debt to EBITDA. The divestment of their international segment during the last quarter will allow them to reach their objective. Pro forma, including $1.7 B of sale proceeds, net debt to EBITDA should be around 2x. Management has commented that proceeds of the divestment will be used to strengthen the balance sheet prior to review of capital deployment strategies. It seems they are more focused on organic growth as of now.  

• Cash: $1,981 M (includes divestment proceeds of $1,700 M)

• They maintain an $750 M line of credit of which $730 M is currently available.

• Debt: $2,665 M (ex-leases)

• Leases are $13 M

• Debt is made up of two term loans and a number of public corporate bonds.

• Covenant: amended the covenants in May 2020 due to COVID to give them additional headroom

• Maximum Debt to EBITDA of 4.75x, scaling down to 3.75x over time.

• Current: 4.1x (pro forma net 2.0x)

• Minimum EBITDA to Interest Expense of 3x.

• Current: 4.6x

• Credit rating: BB+ by both S&P and Moody’s

Moody’s recent comments (9/4 & 12/5): Positive: The sale of international is positive as North American business has higher margins and will help to accelerate deleveraging. CDK is a market leader with stable revenue due to recurring subscriptions with strong margins and consistent cash flow generation. Negative: The company is small compared to peers in its rating class. Leverage is high due to the ELEAD acquisition and debt repayment is expected to reduce leverage within the targeted range. They operate in a cyclical end market.

Competition

Large competitors include Cox Enterprises, through DealerTrack which was acquired in 2015, and Reynolds and & Reynolds. Combined with CDK these companies make up at least 50% of the DMS market. There are a number of small competitors that also operate in this market along with new entrants. All major competitors are private companies.  

Auto manufacturers certify DMS systems prior to allowing their franchise dealers to use it. This process can take over a year due to complexity of new systems and specific regulations in certain states (you have to accept barter as payment in Iowa), which creates some barrier to entry. Once the product is certified however, the OEMs do not require and have no say in which DMS system is used by the dealerships, but they can offer incentives for dealers to use particular DMS systems.

This industry has begun to attract new entrants for the DMS vertical. Tekion, for example, is a newer dealer management software company led by Tesla’s former chief information officer and backed by GM, which just completed a funding round which valued the company at $1.1 B.

Per CDK’s investor relations, Tekion software is similar to what they are developing with driveflex. Tekion is still a small player without significant market share, and does not have as robust of an offering as CDK. Tekion’s software lacks certain features like a CRM system. Both Tekion’s and CDK’s drive flex DMS’ are in the process of growing their number of OEM certifications.     

Anti-Competitive Lawsuits

Multiple lawsuits were filed in 2017-2018 against CDK alleging anticompetitive behavior beginning around 2015. Their lawsuits were centered around agreements between CDK and Reynolds and Reynolds relating to control and integrations of data within their DMS.

The majority of these lawsuits have been settled with the most recent agreement completed in October of 2020. CDK had already set aside a litigation liability provision of $90 M in mid-2019, but including the most recent settlement the litigation liability stands at $69 M (increased $12 M in the most recent quarter). 

Risks

• End markets are cyclical and customers often have poor balance sheets.

• Increased competition from the settlement of lawsuits and new entrants. Also, competition for customers from new online competitors like Carvana.

• Saturation in the DMS market and lack of ability to penetrate the applications market.

• Decline in the partner program could impact margins. The partner program generated $125 M of revenue in 2018, and $105 M in 2019. Revenue is expected to continue to decline. Margins are higher than the company average and may not be replaced immediately by Fortellis. 

Valuation

Since all competitors are private companies, doing a comparable valuation analysis is tough. However, looking at other software companies, CDK’s current EV/EBITDA of ~15x seems rather reasonable, albeit with CDK having lower growth than some. Their 5 year average EV/EBITDA has been 16.5.

Looking at a FY2021 EBITDA estimate of $660 and a reasonable multiple of 10x, this would produce an IV of $55.

Using a similar 2 stage DCF with 4% growth in the first 5 years and 3% to perpetuity along with a 9% discount rate I arrive at an IV of $56.  

If CDK can prove they can continue to grow and capitalize on monetizing their customer base by increasing revenue per site in the face of new competition, they could rerate higher giving upside to my estimates above. This business has produced ROICs in excess of 10% consistently; out earning their cost of capital. They should be given a premium for this, which is not reflected in the current stock price. 

Catalyst

Improved balance sheet due to the sale of the international segment, and progress on growing revenue per site.