Value Investors Club / Cambria Automobiles (CAMB)

Description

Cambria Automobiles is a United Kingdom based auto dealership group that was founded by

current CEO Mark Lavery in 2006 to pursue a dealership roll-up strategy. Lavery owns 40% of

the outstanding shares and from a starting capital base of only £10.8m has built Cambria into a

business with a market cap of £58m along with operating earnings of £11.8m in 2017. This

impressive performance over the past 11 years has been achieved during a period that has

included two recessions in the UK.

Auto dealers are high quality businesses and Cambria has averaged an ROE in the high teens. In

2017, Cambria earned an ROE of 20%. 40% of Cambria’s gross profits are generated by

aftermarket (parts and service) which is not cyclical and will benefit from multiple tailwinds over

time. Used car sales make up another 30% of gross profits and this portion of the business is

consistent and growing.

Cambria is trading for just 6.3 times earnings. Earnings are being depressed by two temporary

factors that I will discuss in further detail in the valuation section. Going forward, Cambria’s

business has multiple tailwinds that will benefit earnings in the long run. 1) High margin

aftermarket parts and service revenue is consistently growing. 2) Many of their acquired

dealerships have not reached their full operational potential. 3) There are six capital projects

under way that will contribute to earnings once complete. 4) Cambria’s management team has

demonstrated intelligent capital allocation decisions over time and I expect them to continue to

deploy existing cash flows into intelligent acquisitions.

Cambria trades at a large discount to peers in the United States and historical acquisition

multiples in the UK. In the next 5-7 years, I believe Cambria will reach £1 billion in sales and

earn a 2% pre-tax margin. If this is achieved and Cambria trades in line with US peers and

historical buyout multiples, Cambria is likely worth 4 times the current price.

Business

Cambria is comprised of 31 dealerships representing 46 franchises and 16 brands. Brands consist

of Abarth, Alfa Romeo, Aston Martin, Dacia, Ford, Fiat, Honda, Jaguar, Jeep, Land Rover,

Mazda, Nissan, Renault, Seat, Vauxhall, Volvo, Triumph, and they will soon add ultra-luxury

brands Bentley and McLaren.

Cambria has a unique strategy. They purchase sub-scale and underperforming dealerships and

implement extensive processes and systems to improve operations. A typical seller is an

entrepreneur that is either retiring or looking to sell out. There are over 5,000 individual auto

dealers in the UK and ownership is very fragmented, with most operators owning just one or two

dealerships. Oftentimes these dealerships are inefficiently run and sub-scale without the ability to

purchase expensive software and other processes to optimize their business. Scale matters in the

auto dealership business and Cambria has been very successful implementing a buy and build

strategy over the past 11 years.

Let’s examine an actual acquisition. The most recent acquisition was in July of 2016. Cambria

acquired a Jaguar and Land Rover dealership in North London from Pendragon for £2.1m. This

particular dealership was purchased at a bargain price, less than 3 times 2015 pre-tax earnings

and was earning a pre-tax margin of 1.6% at the time. This is before Cambria works to improve

both earnings and revenue by implementing their model to improve operations at this dealership.

Acquisitions such as this one create a lot of value for shareholders and I expect Lavery to deploy

ongoing cash flows to continue acquiring dealerships. After studying management’s past

acquisitions, it is clear Lavery and team have demonstrated intelligent capital allocation

decisions over time.

I appreciate that the management team is patient and opportunistic when making acquisitions. In

fact, they have not made an acquisition in 18 months because they feel deal prices aren’t

compelling enough. Cambria’s small size, and the fragmented ownership in the UK auto

dealership market, will give them substantial opportunities to purchase underperforming dealers

when prices are more attractive.

Quality of the business

There are three components to an auto dealer’s business: new car sales, used car sales and

aftermarket (parts and service). A dealership is a mini monopoly for a specific brand over an

exclusive geographic area and they compete locally. For both UK and US auto dealers, ROIC is

in the high teens to 20% range. This is a good business and I don’t see anything on the horizon to

disrupt it.

Aftermarket

Let’s peel back the covers and dissect the business model. Of the three portions of an auto

dealer’s business, aftermarket has the best economics and is the largest contributor to earnings,

making up 40% of gross profits in a typical year. Aftermarket is also the highest margin portion

of the business with gross margins in the 40% range. Furthermore, aftermarket revenue is not

cyclical. The main driver of aftermarket parts and service revenue is the 0-5 year old car parc.

After selling a car, franchise dealers retain approximately 80% of the aftermarket business during

this period. After 5 years, the retention rate for parts and service on vehicles sold tends to decline

as consumers turn to cheaper independent mechanics.

I am very bullish on the aftermarket business going forward. There are a number of tailwinds to

support continued growth in aftermarket revenue.

1) Although automobile sales have stagnated in the UK, the 0-5 year car parc is growing and this

is a tailwind for aftermarket sales. The 0-5 year old car parc in the UK is still about 20% below

what it averaged in the mid 2000s. UK auto dealer Pendragon (which references the 0-6 year old

car parc) estimates it will continue growing through 2020.

2) It takes 4-5 years for a newly opened or acquired dealership to reach full potential on

aftermarket. A newly opened dealership typically doesn’t have a customer list and this take years

to develop. This is what drives aftermarket revenue.

3) The increasing complexity of newer cars requires expensive and sophisticated brand specific

diagnostic and repair equipment. Independent mechanics have a tough time justifying this large

investment in specific equipment for each individual brand. As a result, the barriers to entry for

independent mechanics is growing and auto manufacturers favor the franchise dealers.

Independent mechanics are being frozen out and the number of independent mechanics in the

UK is steadily falling. Going forward, I believe franchise dealers will continue to retain an

increasing share of service revenue.

4) Connected vehicles have the ability to connect back to the franchise dealers and notify

customers before a part goes out. This will increase retention of aftermarket revenue.

5) The increasing use of leases and finance contracts also contributes to higher retention of parts

and service for dealers as they require vehicles to get serviced at the dealership or the warranty is

voided.

6) Management has noted in recent releases that they are working on initiatives to further

improve the service retention on vehicles sold.

Overall, aftermarket is high margin and stable. I am bullish about this portion of the business

growing regardless of overall auto sales.

Used car sales

Used car sales are the second largest contributor to gross profits and make up about 30% of gross

profits in an average year. Used car sales are also quite resilient through the cycle. Cambria

excels at selling used cars with an industry leading ROI in their used car division.

New car sales

New car sales are the smallest contributor to gross profits and in a typical year make up slightly

less than 30% of gross profits. The market is concerned about falling new car sales in the UK

and I believe this is a major reason Cambria is undervalued. However, I will illustrate why this

should not worry a long-term investor, later in the report.

Cambria’s business model is resilient and is underpinned by non-cyclical aftermarket parts and

service revenue. Management not only successfully navigated two recessions in the past 11

years, they prudently took advantage of these adverse conditions to opportunistically make

acquisitions at distressed prices. Cambria has plenty of capacity to make acquisitions if the price

is attractive.

I believe Cambria’s business is more resilient today than it has been in the past for the following

reasons: 1) Cambria has shifted its focus from mass market brands to premium and luxury, which

are more stable during a downturn. 2) Lavery believes industry new car sales will be less volatile

going forward due to the growing popularity of personal contract purchase (PCP) contracts. In

2012, 40% of UK new car purchases were financed and today that number exceeds 80%.

Financing terms are generally 36 months and create a natural replacement cycle because

consumers upgrade their vehicles at the end of the term. 3) Cambria’s business is more mature

today with a greater portion of higher quality aftermarket and used car revenue.

Management

I’ve studied the track record of the management team and it is impressive. Lavery has turned a

total invested capital base of £10.8m into a business that produced £11.8m in underlying

operating earnings in 2017. Growth has been self-funded with minimal leverage. Lavery’s

incentives are aligned with shareholders, he owns 40% of the shares outstanding purchased on

his own rather than through options grants.

Lavery acts counter cyclically and his track record of buying dealerships and turning them

around has a demonstrated history of success. I’ve studied Lavery and Chairman Philip

Swatman’s letters to shareholders over the past 7 years and they are the type of managers I like

to invest alongside. Management’s overarching goal is to maintain a superior and consistent

return on equity. This focus is rare. They highlight this focus throughout every shareholder letter

in the annual report. For example, in their 2017 letter to shareholders they say, “For compelling

acquisition targets, like the JLR acquisitions, where a premium may need to be paid, we will still

focus on ensuring that the Group delivers strong and consistent returns on equity.”

Management’s acquisition discipline is also impressive. In the 2017 letter to shareholders Lavery

says, “We maintain a pipeline of prospects, but we will only acquire a business if we believe that

it is capable of generating a superior return against capital required and will respond to the

operational changes and discipline the team brings.” It is clear in the letters that this management

team is shareholder focused and honest in their assessments. In the 2016 shareholder letter,

Lavery mentions, “The board remains confident that Cambria’s resilient business model is well

positioned to take advantage of any opportunities that the current economic uncertainty could

provide.”

Tailwinds

Cambria will benefit from multiple positive tailwinds going forward:

1) Many of their acquisitions have not yet reached full operational potential. It takes 4-5 years

for an acquired dealership to fully benefit from the initiatives that management implements to

improve operations. This provides a natural earnings tailwind over time.

2) Further growth in aftermarket as discussed above.

3) There are a number of capital projects under way that will contribute to earnings once

complete:

Barnet Jaguar Land Rover launched in July 2017. This is a redevelopment of an existing

site that began in February 2016 and cost £7m. Management noted there has been a

significant amount of disruption to the Barnet business while its been under construction

over the past year. It will take a number of years for this dealership to reach its full

potential.

The Swindon Jaguar Land Rover redevelopment commenced in May 2017 and will open

in July 2018. This will replace the existing dealership on the site. The cost of this project

is £6m.

Cambria is also in the process of acquiring land in the Welwyn Garden City territory to

relocate their existing Jaguar Land Rover and Aston Martin dealership in Welwyn. The

new facility will also house a new McLaren franchise. They have agreed to terms on a 4.3

acre piece of land in Hatfield. The total cost for the land and development is estimated to

be £17m. They plan to begin this project in January 2018 and complete it by the end of

2018.

They also secured a new development site in Solihull for an Aston Martin dealership to

replace a temporary facility that opened in May 2016. The total cost for the Solihul site is

estimated to be £5m. They plan to complete this project by the end of Q1 2019.

Cambria will add two Bentley franchises to existing locations. They are in the process of

refurbishing existing freehold premises at a cost of £1m. These two franchises will be

operational by January 2018.

These projects have been incurring costs during development and have yet to contribute to

earnings. Acquisitions in the past 3 years have marked a shift from volume brands to premium

and luxury brands. Although Cambria is paying higher multiples for premium and luxury

dealerships, they are more resilient through the cycle and have higher margins. Premium and

luxury brands warrant a higher multiple for Cambria if it is ever acquired.

4) Cambria’s owner operator management team has a demonstrated history of intelligent capital

allocation decisions over time. I expect ongoing cash flows will be deployed into further

acquisitions of sub-scale dealers at intelligent prices. There are over 5,000 dealerships in the UK

and ownership is fragmented with most operators owning just one or two locations. Cambria’s

strategy is scalable.

Valuation

Any way you slice it, Cambria is undervalued. Cambria trades for just 6.3 times TTM earnings.

This is despite two temporary factors negatively affecting earnings in 2017: 1) The construction

at the Barnet dealership has had a significant impact on profitability at this dealership. 2) A fire

that took place in October of 2016 at the Jaguar and Aston Martin dealership in Welwyn

significantly hurt the profitability of that site. The Barnet project was finished in July 2017 and

the Welwyn site was back in operation in June 2017.

Cambria trades at a large discount to peers in the US. Damodaran has US automotive retail

trading at an average EV/EBIT of 18.44 compared to 4.6 for Cambria. US peers (AN, KMX,

CPRT, KAR, GPI, LAD, PAG, SAH) trade at an average forward EV/ EBITDA of 12.8, compared

to 3.7 for Cambria. Those peers also trade for 15.4 forward earnings compared to 7.7

for Cambria. There is no reason for this discount, as the business models are the same.

Cambria trades at a discount to historical buyout multiples. Reg Vardy was purchased in 2005 by

Pendragon for £500m at just over 18x TTM earnings, 2.43 times book value and an EV to sales

of .28. By comparison, Cambria currently trades for 6.3 times earnings, 1.15 times book value

and an EV to sales of .08. Cambria trades at less than one third of the valuation of the Reg

Vardy acquisition. This is a good comparison to Cambria. Lavery was the operations director at

Reg Vardy at the time of its sale. Additionally, Reg Vardy’s dealerships were made up of a

similar group of brands to what Cambria has today. At the time of sale, Reg Vardy’s 2005

operating margin was 2.33% which highlights the margin improvement potential at Cambria.

Management’s goal is to grow the business to £1 billion in sales and earn a 2% pre-tax margin.

In 2017, sales were £644m and pre-tax margins were 1.8%. Results thus far suggest this is an

obtainable goal. I believe the revenue goal is likely to be achieved from organic growth alone. I

also believe 2% pre-tax margins are quite likely to be achieved. Many of their dealerships are not

yet at full margin potential. At Reg Vardy, the same management team achieved pre-tax margins

of 2.33%. I believe they are more likely to exceed both the revenue and margin goal within 5

years.

This would result in £20m in pre-tax income and £16.5m in after-tax income. If these results are

achieved, the stock is selling for less than 4 times future after-tax earnings.

I believe this goal is achievable. I also believe Cambria should trade more in line with US peers.

If Cambria achieves after-tax net income of £16.5m at a multiple of 15.4 times earnings (in line

with US peers), the business is worth £254m, or 4 times the current price.

The auto dealers are quite popular with value investors in the US. The same business model

exists in the UK at half the valuation. There is no reason for this discount to exist. Warren

Buffett purchased the largest privately held US dealership chain, the Van Tuyl Group, in 2014.

Balance sheet

Throughout Cambria’s history, management has financed the business conservatively. Cambria

has a net debt balance of just £3.4m at August 31st 2017 (including dealer floorplan financing).

In November 2017, Cambria refinanced their revolving credit facility for another 5-year term and

added an additional £23m in availability. Cambria has plenty of capital available to make

prudent acquisitions if the opportunity arises. I appreciate management’s conservative mentality.

This is a “sleep well at night” investment.

Auto dealers rely on dealer floorplan financing from their automotive partners to finance their

vehicle stock. This shows up in the payables line and I regard this as additional debt. When

evaluating the capital structure of auto dealers, I incorporate this financing and net it against the

value of the vehicle stock. Typically, dealers have significantly less in inventory than they do in

floorplan financing. Aggressive management teams use this to increase leverage and typical

metrics miss this fact.

When this adjustment is made, it becomes clear that Cambria is far less levered than their peers.

Cambria’s adjusted debt to equity is 7%, Pendragon is at 62% and Marshall Motor Works is at

123%. Cambria has one of the most conservative capital structures in the industry and at the

same time has the highest ROE of any dealership group in the UK. Their conservative balance

sheet will allow them to make more acquisitions in a downturn when some of their competitors

may be forced sellers.

Why is this cheap?

The market is worried about declining UK new car sales and I believe this is the reason the

sector is cheap. A long-term investor should not worry about this. In fact, in will end up

benefitting a long-term and patient investor.

Cambria has successfully operated through two recessions and I believe their business is even

more resilient today than it was during the prior two downturns. Cambria’s success to date is due

in large part to the acquisitions made during the past two downturns. Cambria is conservatively

financed and has ample capacity to make distressed acquisitions if the opportunity presents itself.

Long-term shareholders should do well regardless of market conditions.

Let’s explore what happened during the double dip recession in the UK in the back half of 2011

and first half of 2012. During this period, Cambria’s earnings fell 37%. However, they acquired

a few dealerships that were losing money at the time. When you take out the effect of those

acquired dealerships, earnings fell by 28%. New car sales made up the entire decline with both

used car sales and aftermarket remaining stable during this period. Cambria’s ROE bottomed out

at 13.5% that year. If Cambria witnesses a similar earnings decline today, it would be trading at

9.3 times earnings, a multiple I believe is still significantly undervalued for this high quality

business model.

Cambria’s business is becoming more resilient over time. The greater portion of revenue coming

from luxury brands provides more stability during a downturn. Going forward, management is

focused on continuing to move away from mass market brands and expanding in premium and

luxury, which will add to the consistency of earnings. Additionally, management believes the

natural replacement cycle created by the growth in financing contracts will smooth out the cycle.

Finally, as the existing dealerships mature, the portion of profits being generated by aftermarket

increases as a percent of a dealerships profits and the non-cyclical nature of this portion of the

business will lead to more consistent earnings overall. This business is less cyclical than people

think and investors are more than compensated for the risk of a downturn.

Disclosure:

This has been prepared solely for informational purposes. Information herein is not intended to

be complete, and such information is qualified in its entirety. This is not an offering or the

solicitation of an offer to purchase an interest in any fund, and it is not an offer to buy or sell or a

solicitation of an offer to buy or sell any security. Nothing herein should be construed as

investment advice, an opinion regarding the appropriateness or suitability of any investment, on

an investment recommendation. No representation is made that the objectives or goals of any

investment or strategy will be met or that an investment or strategy will be profitable or will not

incur losses. Past performance is no guarantee of future results. Reliable methods were used to

obtain information for this presentation but the information herein cannot be guaranteed for

accuracy or reliability; the information in this presentation may be out of date or inaccurate. The

information contained in this summary is and may not be distributed without permission.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

1) Valuation converges with historical multiples and peers in the US. 2) Many of their dealerships have not reached their full operational potential providing latent growth in earnings. 3) The six capital projects underway have yet to contribute to earnings and will be complete within the next few years. 4) Continued investment of excess cash flows at high returns. 5) Eventual sale to a larger dealership group.

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			2018	2019
Price:	0.58	EPS	0.075	0.079
Shares Out. (in M):	100	P/E	7.7	7.3
Market Cap (in $M):	58	P/FCF	0	0
Net Debt (in $M):	-6	EBIT	10	11
TEV (in $M):	52	TEV/EBIT	5	4.8