Description

The virtually unanimous consensus is that Turkey is a bankrupt autocracy in a permanent state of economic crisis. However, Turkey’s real GDP growth last year was 1.8%, and this year is likely to come at around 7%-8%, making Turkey the fastest growing large economy in the world over the pandemic period, ahead of China. And all this despite no QE, minimal fiscal support to the populace, and benchmark interest rates that have more than doubled over the past twelve months. Being a low-cost, vast, populous and demographically growing (84m people expected to grow to 107m by 2060), young country (only 15% of the population over 60 and 53% under 34), effectively already part of the EU common market, a manufacturer and exporter of ever more sophisticated goods not commodities (much like China and unlike Brazil, Russia, and South Africa), with broadly business-friendly economic policies – the secular growth drivers are as self-evident as they are overlooked by investors, clouded mostly by politics and by the Turkish government admittedly awful and erratic investor communication. True, Turkey’s official CPI inflation is 19%, and real inflation probably in excess of 25%. As a result, the lira has depreciated by nearly 30% vs the dollar since end-2019. However, for companies with a good product that have pricing power, inflation can be a boon.  

Dogus Otomotiv (Bloomberg DOAS:TI, CMP TRY 27.1, market cap USD 714m), the exclusive distributor of all Volkswagen group cars into Turkey with a network of over 400 dealerships and a multi-decade mutually beneficial relationship with VW (the distribution agreement has recently been renewed into perpetuity) earned over TRY 8.5 EPS over the last twelve months (to June 2021) and TRY 4.4 EPS in H1 2021 alone, on revenues and net profits soaring 137% and 286% y/y respectively, admittedly from a low base due to the pandemic, yet not ultra-low because after all last year car sales in Turkey were in line with the prior 10-year average. For the full year 2021 we expect Dogus to earn anywhere between TRY 6 and 8 EPS, depending on the availability of cars in H2 (when incidentally y/y comps get harder), as the shortage of chips and other components is expected to bite harder in Turkey in H2 vs H1. Since this is a Turkish stock, Turkey being arguably the cheapest, most under-weighted and under-researched decently sized stock market in the world, plus a small cap grossly misunderstood even by local investors in our view, despite the stellar business performance the stock this year has barely moved, and on our estimates it sits on only about 3.5x to 4.5x FY 2021 p/e. However, having generated some USD 3.5bn revenues and USD220m net earnings over the past twelve months (to June 2021), this is not such a small company after all; it’s the valuation that is too low.

Is the stock so cheap because maybe these are peak-cycle earnings? Not at all, in our view. This year light vehicle sales in Turkey are expected to come pretty much in line with last year and with the past 10-year average, at around 800k units (>400k already sold in H1), and would have probably recovered the historic peak of 1 million if supply had not been so severely constrained, demand clearly outstripping supply according to virtually anyone we spoke with in the industry. In addition, we believe that over the long run car demand in Turkey can only grow, and substantially so. Car affordability in Turkey is the worst among all major economies (a middle class car costing ~650% of the average yearly salary vs ~50% in Australia), due to a combination of a severely undervalued currency (Turkey’s GDP in PPP being over 3x larger than at current FX according to the World Bank, and cars being of course a dollarized global commodity), plus 20%+ interest rates and ultra-conservative (mandated by law) tenures/loan-to-value limits of max 36-60 months/50% making car loans largely unviable (indeed some 80% of Dogus customers are cash buyers), plus (last but not least) the highest taxes in the world on new car purchases. This year the Turkish government is expected to collect over US$10k in special consumption taxes for each new vehicle sold, and this penalizes Dogus the most, because the tax is steeply progressive on the engine and class, and Dogus/VW is effectively the only large premium player in the Turkish market, mainly competing against the likes of Fiat, PSA, Renault, and Ford which mostly sell small/mass-market vehicles (Dogus-VW, PSA, Tofas-Fiat, Ford Otosan, and Oyak-Renault each hold a light vehicle market share which fluctuates between 10% and 20%, but in H1 Dogus reclaimed No 1  spot – or No 2 behind Stellantis, but the dealer network of Fiat and PSA have not yet been integrated under the same umbrella in Turkey – with 19.3% market share, up 3% vs H1 ’20).

All the aforementioned seemingly insane policies to severely discourage car ownership in Turkey have been put in place in various steps over the past decade to actually discourage imports (6 out of 10 cars bought in Turkey are imported, and the ones produced locally are mostly cheap vehicles) hence reduce the current account deficit, a perennial problem for Turkey, outright import duties being not allowed under EU common market rules. The result is a fictitiously depressed car market with only 15% PV penetration, vs typically 60% to 80% in developed countries and 20% to 40% in middle income countries like Turkey, and a ratio of second-hand car sales to new car sales of approximately 8 to 1 in H1 this year (vs typically less than 1 for developing fast growing economies like Turkey).

The catch though is that the level of pent-up demand accumulated over the past decade is tremendous, in our view. Any improvement in Turkey’s current account, potentially resulting in more rational policies for car ownership, may help releasing that enormous latent demand. And here, we believe, there are reasons to be optimistic. Despite tourism receipts (around 10% of GDP pre pandemic) still sitting well below pre pandemic levels, thanks to the weak currency demand for Turkey’s exports of goods (some 30% of GDP) has boomed lately, up by some 40% y/y in H1 this year to an all-time high of USD 105bn. As a result, the current account deficit is expected to reduce to 3%-4% of GDP this year vs 5% last year. Looking longer term, even if the pandemic were to become endemic, hence tourism never fully recover, Turkey should be arguably one of the biggest beneficiaries (perhaps along with Mexico) from the relocation of manufacturing out of China and the shortening of supply chains, a secular trend which is likely to accelerate in our view in light of the recent extreme supply bottlenecks experienced by businesses across the world (skyrocketing container freights etc), so severe to likely leave a vivid memory even after they will have been fully resolved.

Add to the above that:

·        Dogus is not a manufacturer but a retailer, with a relatively stable gross margin (historically ranging 8% to 12% for new car sales and ~30% for spare parts and repairs) but OPEX virtually all fixed or discretionary (hence significant operating leverage there, which of course cuts both ways, but as mentioned we are very positive on the secular demand outlook)

·        Dogus is the only pure listed play on the Turkish domestic car market. The other two listed Turkish auto stocks, Tofas and Ford Otosan, are mainly manufacturers producing mainly low-end cars which are part sold domestically but the majority is exported to Europe, a region with a secularly stagnating demand profile

·        Among the three, Dogus is not just the only retailer/domestic play, but also the ‘premium’ player, the VW Passat in Turkey being basically equivalent to the BMW 5-series in most other countries due to the much higher retail prices (but Dogus also sells Audis, Porsches, and Lamborghinis, in surprisingly high numbers especially in Istanbul, despite their ultra-high retail prices, multiple times higher than in the west, because Turkey’s Special Consumption Tax escalates to 220% for vehicles with engines exceeding 2000cm3). In most car markets, it is the well-run premium car dealers that traditionally seize most of the retail profits in the industry. China is a vivid example, considering for example the rich profit margins of the likes of Zhongsheng and Meidong, both listed.

Given the above, it seems to us that among the three listed Turkish auto stocks Dogus is by far the highest quality business with the brightest long term growth outlook. However, since it’s a very different animal compared to the other two, local brokers in Turkey don’t know model it properly in our view, perhaps modelling the top line in liras rather than hard currency and OPEX as variable rather than fixed/discretionary, hence usually failing to capture operating leverage (despite disclosure being exceptionally good in our view and by the way all available in English: https://www.dogusotomotiv.com.tr/en/investor-relations/investor-relations/investor-relations-home). Not having much visibility on future earnings (during the quarterly results calls analysts keep asking for guidance on the operating margin, which of course the company cannot reliably provide, being mostly a function of sales volumes and the lira), local investors also always invariably prefer Tofas and Ford Otosan (trading on 8x – 11x P/E on FY 2021 consensus vs 5.5x for Dogus) due to their higher earnings predictability, stemming from the fact that Tofas and Otosan are basically tolling operations of Stellantis and Ford which clearly allow the benefit of the weak lira and operating leverage to be reaped only partially and temporarily before renegotiating terms downward. Being a dealer instead of a manufacturing tolling operation without IP, Dogus is a different animal altogether, having a broadly fixed pre-discounts gross margin per vehicle, but reaping all the benefits in a growing market (via better mix, lower discounts, and OPEX leverage), even in a merely nominally growing market on the back of lira devaluation.

However, eventually reality catches up. Bearish local brokers started off 2021 projecting FY EPS of around TRY 2, and the company generated over TRY 4.4 EPS in H1 only. Current consensus of around TRY 5 remains basically in denial, ultra-conservatively implying sequential de-growth of some 90% in H2 over H1, something that we calculate would happen only if H2 car sales at Dogus came at about half the level of H1. In reality, even our FY 2021 forecast range of TRY 6 to 8 (assuming H2 car sales down 1/3 to nil sequentially) may prove to be conservative if there’s any let up in the chips shortage and the availability of vehicles improves. As mentioned, LTM actual EPS is over TRY 8.5 (all real earnings, no significant net exceptionals/one-offs), implying 3.2x LTM P/E at Dogus current share price of TRY 27.1.

Putting all the pieces of the mosaic together, we believe new car sales in Turkey may very realistically double over the next 5 years, reaching a level ~40% (vs. current ~20%) that of Germany that has a similarly sized population, and (thanks to operating leverage) net profits at Dogus may very realistically triple from here, resulting, at current market price, in a valuation of about 1x P/E and 50% to 60% dividend yield. Dogus is a high quality company in our view which earns over 50% ROE, is not highly leveraged (net debt to EBITDA below 1x), has good governance standards, exceptionally good disclosure for a Turkish small cap, and historically has paid some 60% of profits in dividends (plus bought back 10% of its shares, the legal limit in Turkey), something that is expected to continue because the parent Dogus Holding (one of Turkey’s largest family conglomerates, which holds 75% stake in Dogus Oto, 10% being treasury shares, and only 15% free float, yet very actively traded providing surprisingly decent liquidity) is highly leveraged (no recourse to Dogus Oto), which also focuses Dogus Oto’s management’ minds on cost control, which in fact in our view has always been very good. 

Even if the Turkish car market never grows from here, what you have on current earnings is a static 3.5x to 4.5x P/E and 11% to 17% dividend yield to be paid next year, with 2021 consensus likely to increase by 20% to 60% (depending on how the chips shortage plays out) in our view over the next few months, providing a short-term catalyst too.

Catalyst

earnings growth, analysts' forecasts upgrades