Description

We recommend buying shares of Inchcape plc (INCH:LON), a leading automotive distributor.

Inchcape recently closed on the sale of its automotive retail business, clearing a path for investors to fully appreciate its distribution business. The "new" Inchcape has higher margins, high free cash flow conversion, less leverage and more favorable capital allocation. While current trading at more than a 10% free cash flow yield, we are optimistic Inchcape shares can almost double over the coming few years.

Inchcape is an automotive distribution business that partners with automotive OEMs (original equipment manufacturers) to distribute and sell vehicles across many countries globally. Inchcape is the largest 3^rd party distributor in the world and works with most of the best OEMs to cover markets where the OEM does not have a direct, first-party distribution strategy. Most OEMs derive ~80% of their revenue from their top 20 countries, where OEMs often have direct strategies. OEMs leverage companies like Inchcape to cover the remaining 20% of their revenue.

Inchcape primarily focuses on developing markets where GDP per capita grows at faster rates and where automotive adoption per capita is considerably lower, but growing quickly, when compared to more developed countries. Inchcape has longstanding relationships with its OEM customers, with 5 relationships spanning longer than 50 years and many longer than 25 years. Inchcape has never lost a distribution contract outside of Toyota’s decision to sell directly into the UK many years ago. As a distribution business, Inchcape has low margins; and given the complexity of the operation, it does not make economic sense for OEMs to go direct in a first-party distribution approach in the countries that Inchcape cover.

In addition to vehicle distribution (85% of revenue), Inchcape distributes parts (15% of revenue) for repairs and service as vehicles age or are damaged. While vehicle distribution earns 10-15% gross margins, parts distribution earns 40-45%. We do not suspect the mix of parts revenue will dramatically change over time, but it should grow at or slightly above the vehicle revenue over time, providing a stable mix of margins. The parts business is an attractive and recurring one in many cases. Being the parts distributor further deepens relationships with the OEMs. Overall, we expect Inchcape to grow revenues organically in the mid single digits.

Inchcape possesses formidable competitive advantages given the complexity of logistics, product planning, channel management, branding and marketing, and retail networks across many countries. Doing business in developing countries with different regulation, customs, consumer habits, currencies, etc. requires specialized knowledge and expertise. Further, establishing retail network partners in various counties is a time consuming and difficult task.

Inchcape also possesses significant scale advantages given its position as the largest global 3^rd party distributor. This is a low margin business that depends on certain degrees of market share capture in specific countries to earn suitable earnings, as distributors must leverage shared logistics and other infrastructure to spread the fixed costs to more revenue opportunities. This makes it harder for smaller distributors to compete in the long term.

Further, the barriers to entry are considerable. The upstart costs are significant, but landing contracts, establishing distribution networks, securing logistics partners, building a dependable track record, and other factors are far more daunting. Therefore, there are no new entrants looking to consume Inchcape’s market share.  

On August 1st, the company closed on the sale of its retail business to Group 1 Automotive for £346m. The deal price, well above sell-side estimates, will bring leverage to about .3x, well below the company self imposed ceiling of 1.0x (which we believe is entirely too low). More importantly, the sale removes a lower margin, yet higher capex business and concludes a multi year process to become a pure play distribution business.

It's clear management is focused on the distribution business. In the past two years the company has signed 18 new distribution contracts, compared with just 8 contracts over the prior 3 years. Importantly, these contracts are initially a drag on profitability and only tend to be accretive after year 3. We believe this dynamic will lead to an acceleration of revenue and earnings growth beginning in 2026.

Below, we highlight some key financial metrics. These metrics are prior to any further capital allocation, which includes a recently announced (and upsized) £150m buyback and potential acquisitions. With only ~ £250m of net debt (company defined), we expect management will look to M&A to continue growing its ~3% market share in a very fragmented market. In early 2023, the company completed the acqusition of Derco for £1.3b, a Latin America distributor. We believe this was an excellent acquisition, in good markets with good brands, adding scale and margin expansion to the core Inchcape business. We suspect future deals may be smaller, but  there are many opporunities for inorganic growth.

So, despite all the progress made by this management team, Inchcape is trading for historically low multiples: roughly 5X forward EV/Adj EBITDA and a 10% FCF yield when you account for lease expenses. Without any improvement in the multiple, the equity returns inclusive of cumulative dividends approaches 50% upside in 3 years. With modest improvement in the multiple, both as investors give the company credit for the divestiture and the earnings fundamentals become clearer to investors, we project ~94% total upside in 3 years, representing a 25% IRR. Again, these metrics are before additional benefits that may accrue from continued strong capital allocation.

Catalyst

Automotive retail divestiture

Continued contract wins

Pure play distribution will be clear at next earnings report

November CMD

Capital allocation - buybacks and acquisitions