Description

Pendragon (PDG LN) – Long @ 32p – April 2014

Full write-up with charts will be uploaded onto dropbox separately, will provide link to it in the thread.

Company Overview

Pendragon (PDG) has a market cap of £437mn, net debt of £140mn and trades an average of £1.5mn worth of shares per week. The top three shareholders are Odey (18%), Schroder (15%) and Axa (9%); management holds c.3%.

Pendragon is the UK’s leading automotive retailer, with 240 franchise points for 26 brands, and has a also a small presence in California. It focuses on selling new and used vehicles and providing contract hiring and after sale services. At the end of FY13, Pendragon generated revenues of £3.8bn, gross profit of £499mn and PBT of £39mn.  

Summary of Opportunity

We believe Pendragon is well positioned to benefit from the return to growth of the UK autos-market. Given its broad portfolio of brands, we expect Pendragon earnings growth will benefit from (1) new car sales growing at double digit rate (28% of group gross profit), (2) from continued growth in its adjacent used car sales segment (29% of group gross profit) where it is gaining market share, and most importantly (3) from a pick-up in activity in its higher margin aftermarket business (38% of group gross profit) which traditionally lags the former two segments by circa 12-months. In addition, following repairing its balance sheet in FY11 and materially reducing its leverage ratio, we also expect Pendragon’s valuation discount to its peers to narrow significantly. Our base case implies +78% potential upside.

Key downside risks to our thesis include: (1) negative operational gearing in case of a cyclical contraction, (2) return to deployment of capital into value-destructive acquisitions and (3) deterioration in relationship with manufacturers and/or increased competition.

Brief Recent History and Strategy

Pendragon was spun out of Williams Plc and listed in 1989; the business since then has been managed by the very same CEO and COO. Historically, Pendragon grew through acquisitions partly funded by debt: it took over CD Bramall in 2004, Reg Vardy in 2006 and made an unsuccessful approach for Lookers in 2006; subsequently the company struggled with its high debt and focused on downsizing. In 2011, Pendragon had a £75mn right issue: thereafter management has been focused on deleveraging the balance sheet which reached a leverage ratio of 1.3x at the end of 1H13.

Pendragon’s stated public strategy is focussed on maximising returns in its 3 key segments –aftersales, used-vehicles sales and new-vehicles sales in order of importance – through relying on its 4 “strategic pillars”, which are: (i) number one online motor retailer, (ii) value pricing, (iii) national footprint and scale and (iv) a superior IT platform. 

Indeed, management believes that (i) a strong online presence it’s key to success in retail, (ii) value pricing ensures consumers are offered the best pricing proposition in the industry; (iii) a national footprint and scale enables to reach consumers locally and provides a number of efficiencies and economies of scale within procurement, fixed overheads, shared services and central marketing; and finally (iv) a superior integrated IT platform (Pinewood) ensures the group can monitor, control, report and analyse accurately its own progress against its objectives.

Business Segments

Pendragon operates across several brands/business units:

• Stratstone (38% sales, 37% EBIT) is the leading luxury autos dealership in the UK, holding franchises with Aston Martin, BMW, Ferrari, Honda, Jaguar, Land Rover, Lotus, Maserati, Mercedes-Benz, MINI, Morgan, Porsche and Smart; Stratstone has 98 franchise points over the UK, and its FY12 gross profit of £180mn was split as follows: aftersales (43%), new (33%) and used (24%);

• Evan Halshaw (54% sales, 39% EBIT) focuses on mass market vehicles, holding franchises with Chevrolet, Citroen, Dacia,Ford, Hyundai, Kia, Nissan, Peugeot, Renault and Vauxhall; Evans Halshaw has 133 franchise points and generated gross profits as follows: aftersales (41%), used (36%) and new (23%);

• California (5% sales, 7% EBIT) is a small dealership in the US California state, which specializes in Jaguar, Land Rover and Aston Martin; California has 9 franchise points in the US its FY12 £28mn gross profit was split as follows: aftersales (44%), new (43%) and used (13%);

• Quicks (1% sales, -2% EBIT) is a smaller recently set up chain focusing exclusively on used vehicles;

• Support (2% sales, 20% EBIT) complements the group dealership activities by offering leasing and contract hire (Contracts & Leasing), IT systems (Pinewood) and a wholesale parts distribution business (Quickco).

Summary Investment Thesis / Highlights

In our view PDG offers a compelling long opportunity given (1) its leading competitive positioning in the recovering UK auto-market and (2) its cheap valuation relative to peers.

With UK new car registration volumes growing double digit (+11% in 2013), we believe PDG earnings growth is poised to accelerate in the forthcoming quarters as better volumes feed through into the higher margin aftersales segment of the business (38% of gross profit). This acceleration in growth will be further supported by continued growth in the adjacent used car segment of the business, where Pendragon has been consistently gaining market share over the last couple of years (from 2.7% to 3.6% of the UK franchised market).

In addition, following the company successful repair of its balance sheet in FY11 and consequent deleverage in FY12 and 1H13, we believe the stock’s valuation discount versus its other publicly listed peers Lookers and Vertu is no longer justified. On our numbers PDG trades on FY14 EV/EBITDA of 4.8x and PE of 11.5x, which compares with the peer group average of 8.4x and 14.0x respectively.

Under our base case, we forecast group gross profit to grow from FY12 of £481mn to £548mn in FY15, implying a +4% growth CAGR. Given the high operational gearing within the business, this translates into a forecast +20% growth CAGR in PBT over the same period; we believe such earnings growth is not reflected in the current share price.

Applying to our 2015 estimates an EV/EBITDA multiple of 7.0x slightly below peers, gets us to a value per share of 54p, or equivalently +78% potential upside. Conversely, our worst case scenario sees 25% downside, under what we believe are overly pessimistic assumptions (Lehman’s style crisis); if we assume 2009 trough EBITDA of £82mn and apply the average historic EV/EBITDA multiple of 5.8x, we get to a value per share of 23p.

Catalyst

Pendragon is due to issue an IMS for 1Q14 in May; until then, industry data showing continued strength in new car registrations and used car transactions should further support the shares; the next release from the UK SMMT office is scheduled for April 4^th 2014.

Management and Competitive Positioning

In terms of management tenure, the CEO, Trevor Finn, has been managing the company since 1989 prior to the demerger of Pendragon from Williams Plc; by contrast the Finance Director, Tim Holden, joined Pendragon later, in 2008; he became CFO in 2009. Importantly, management seems to have switched away from an empire-building mentality (in line with its acquisition spree in 2004-07), focussing more on opportunistic bolt-on acquisitions in geographies where the group is not yet present. Careful deleveraging has also been a core part of PDG’s strategy in the last year and a half.

We believe PDG has a leading market position in the competitive UK retail-auto market, which would require non-trivial investments to be replicated by competitors. Indeed, Pendragon has both (i) a broad portfolio of differently priced automotive brands (which mitigates any ad-hoc franchise decrease in activity), (ii) a widespread geographic dealership network and (iii) a leading IT platform and a thriving internet presence.  Notably, PDG generates the largest proportion of its earnings from aftersales, which have a defensive and recurring business nature.

According to management, most of PDG’s franchised relationships with the manufacturers have lasted for over 10 years. PDG’s numbers of franchised-dealers by brand (premium vs volume) and a table comparing to peer Lookers are shown below. 

Summary Forecasts by Business

New-Vehicles

UK new private car registrations grew 2% in the quiet Feb-14 month, but grew +16.5% in Jan-14. In addition we note September 2013 marked the first month since 2007 that the UK market saw total new car registrations north of +400k units. Nevertheless, we note the overall size of the UK car market of 2.2mn units in the LTM is still well below the peak level reached in 2007 of 2.5mn. 

Given increased consumer confidence and a broader improvement in the UK economy, we forecast strong new-car sales to continue in 1H14 and thereafter: we forecast +9% in FY14 and FY15 respectively, based on a return to UK private new car registrations volumes in line with 2005 levels. This assumption compares with the industry body SMMT forecasting new car sales of +1% in FY14.

In addition, we note that new car registration volumes are not only benefitting from a nascent UK economic recovery, but also from a layer of structural growth which originates from manufacturers increased focus on offering discounts to improve financing available to retail customers; the FLA (the UK Finance and Leasing Association) estimates that in  2013, c.75% of UK private new cars sales have been financed by FLA members; this compares with pre-recession levels around 50%, the US average of over 90% and EU countries such as Germany below 50%.

Aftersales

There are two key determinants of aftersales performance: (1) the size of the national car parc and (2) the age profile of the car parc. Pendragon has historically had a greater exposure in the less than 3-year old vehicle segment, given its significant new car presence. 

On the back of the strong new car registrations rate experienced in 2013, we believe aftersales performance should pick up in the next couple of quarters. Indeed, the car parc for less than 3-years old vehicles plateaued in 1H13, as can be seen in the chart above as well as in the return to positive growth in 2h13: 1H13 aftersales posted -1% yoy which compares to +1% yoy in 2H13; we forecast a mild pick up in FY14 of +2% and then +5% in FY15. 

Our aftersales forecasts imply a 12-month lag between the pick-up in new car registrations volumes and aftersales activity: this in line with commentary from both PDG management and the sell-side.

Used-Vehicles

The UK used-car transactions volume has been flat in 2012 and 2013. Nevertheless PDG outperformed the market and grew used gross profit by +3% in 1H13, due to its strategy focused on online visibility, extensive national footprint and value pricing. By focussing on these three pillars, PDG estimates its used vehicles market share in the franchised dealer market has increased from 2.3% to 3.9% over the period 2009-1H13, with used transaction volumes rising +50% in the last 4-years according to management.

We forecast used car segment gross profit to increase +5% in 2014 vs +4% in 2013 and +4% thereafter in 2015, as a consequence of recent stronger new car registrations.

Support Services

We believe the Support Service businesses should remain stable over the next few years with some opportunities for slow growth in the Pinewood IT platform business; we forecast gross profit of £30mn by FY15, in line with its 4-year historic GP average.

Operating Costs and Profitability

Pendragon business is operationally geared given its relatively high fixed cost base. We reflect this into our estimates and forecast SG&A growth to be stable at low-single-digit over the next three years; the acceleration in revenues is in turn expected to lead to a strong pick-up in profitability: we forecast EBIT of £84mn and £91mn respectively for FY14/15, which compares with Bloomberg consensus of £80mn and £82mn.

Valuation

We believe PDG is currently trading at a particularly compelling valuation. On our numbers (using 2013 net debt) PDG trades on FY14 EV/EBITDA of just 4.8, well below the peer average of c.8.4x.

We focus on EV/EBITDA multiples as opposed to P/E to reflect the differences in capital structures across peers. Under our base case, we assume a target EV/EBITDA multiple of 7.0x in line with peers; applying this to our 2015E above-consensus forecasts gets us to a value per share of 54p, +78% above the current share price.

Downside Risks

Key downside risks to our thesis include:

(1)    Negative operational gearing in case of a cyclical contraction; our worst-case scenario assumes Lehman style recessionary performance and thus predicts c. -25% downside; this is derived by assuming 2009 trough EBITDA of £82mn and applying the average historic EV/EBITDA multiple of 5.8x (when the company was much more geared), to get to a value per share of 23p.

(1)    Return to deployment of capital into value-destructive acquisitions.

(2)    Deterioration in relationship with manufacturers and/or increased competition.

Catalyst