Description

We believe shares in Pendragon plc (“PDG”) have the potential of returning 38-84% in a take-out over the next 6-9 months with minimal risk of permanent capital impairment. 

This asymmetric skew of positive potential outcomes is a function of recent developments which created a special situation with dynamics akin to a merger arb. More specifically, we believe Pendragon’s largest shareholder has likely leaked to a credible UK reporter that they approached the board and made a bid for the company at 28p (vs. current share price of 22p) and that the shareholder is contemplating a new, higher offer.  From researching the situation— and in particular constructing a mosaic from speaking with UK M&A lawyers about the steps the shareholder has been taking and speaking with U.K. market participants about the credibility of the news leak—we think it’s highly likely that a formal, higher bid materializes in the coming months.  In the event that it doesn’t, we see limited near-term downside as the shares are trading at levels near where they were prior to the news leak. Moreover, we believe the shares are absolutely and relatively cheap, the fairly new CEO, Bill Berman, is a “rockstar” and he is implementing a compelling value creation plan that should drive attractive standalone returns.

Business Background

Pendragon is a combination of three distinct but integrated businesses:

• Pinewood – A high-margin, sticky, recurring revenue DMS (dealer management system) software business, installed in over 1,000 dealerships in the U.K. (~20%+ market share) and with a small presence in continental Europe, South Africa and Asia

• While this business only represented 11% of PDG’s 2021 EBIT, we believe it’s a highly desirable asset and underpins the value of the entire group.  We think this business alone is worth £250-£300 million today (14-17x EV / 2022E EBITDA), or 82-99% of PDG’s current market cap. 

• In 2020 CDK Global sold their international business to Francisco Partners for 16x EV/EBITDA (now known as Keyloop in the UK)

• CDK Global (CDK) itself also just agreed to sell to Brookfield for $8.3 billion, highlighting the interest in the space from financial sponsors

• Cloud-native and user friendly, Pinewood’s products are far superior to offerings from CDK/Keyloop or Reynolds & Reynolds

• This business has grown revenue 10% annually historically with minimal investment in the salesforce.  There is an opportunity to meaningfully accelerate the revenue growth through entering new international geographies, picking off Keyloop’s customers (as its new P.E. owners raised prices) and introducing new product “modules” (equity mining, used vehicle management, F&I tools, technician apps) to existing and new customers

• Franchised U.K. Motor – The third largest automotive dealership group in the UK with 140 dealership sites across premium (Stratstone) and mass-market (Evans Halshaw) brands

• This business has a similar model to U.S. dealerships with defensive Parts & Service revenue accounting for a significant portion of earnings

• Notable OEM exposure: Ford, Vauxhall, Mercedes-Benz, BMW, Porsche, Jaguar, Land Rover, Citroën

• PVM – A high-return vehicle leasing (fleet and contract hire) business in the U.K. that earned £18 million in operating profit in 2021

Quick Background / Rejected 28p Offer

On March 19th Mark Kleinman of Sky News reported that Pendragon’s largest shareholder (with a 26.2% stake), Anders Hedin of the “Hedin Group”, made an offer to acquire Pendragon for 28p/share, which was rejected by the company’s board.  

• https://news.sky.com/story/pendragon-shareholder-hedin-group-in-400m-raid-on-car-dealership-giant-12569980

Kleinman has a reputation of breaking corporate news stories in the U.K. and the article went on to state that the Hedin Group was weighing whether to return with a revised offer.  As a result, PDG shares initially rose from 23p to roughly 28p/share, pricing in a good chance of a revised bid modestly above the first one.  However, a sell-off in the U.K. market and negative sentiment in consumer discretionary names weighed on PDG shares which have since retreated to below where they were when the offer was leaked and are now sitting at 22p.  We believe it is likely someone from the Hedin Group leaked news of the bid to Sky because the Board wasn’t communicating the bid with shareholders.  Now that it is in the public domain we think shareholders will be consulted by the board if future offers arise.

We believe the Hedin bid was credible and think the group will likely return with a higher offer. Given the intrinsic value of Pendragon’s businesses, the understanding of fair value by analysts and the turnaround plan in place under CEO Bill Berman, we think a second bid by Hedin likely takes place at least in the low-to-mid 30s share price range (i.e. 38-61% upside):

• It should be noted that the Hedin Group operates a number of dealerships across Sweden, Norway, Belgium and Switzerland and in October—just after disclosing a >25% ownership in Pendragon— the group raised ~$430 million in equity capital, suggesting the group has a reasonably-sized war-chest to pursue the remaining 74% of Pendragon it doesn’t own 

• https://www-realtid-se.translate.goog/erik-selin-ny-delagare-i-hedin-bil?_x_tr_sl=SV&_x_tr_tl=EN&_x_tr_hl=en-US&_x_tr_pto=nui [www-realtid-se.translate.goog]

• The equity stake in the Hedin Group was sold to Erik Selin, a Swedish property developer billionaire (worth $5.4 billion according to Forbes)

• In early 2021, Hedin hired the former CEO of Pendragon, Trevor Finn, to his board as a non-executive director.  Finn still owns ~1.5% of PDG and he and Hedin are viewed as acting in concert in the eyes of the UK regulator

• Pendragon is the only publicly-listed equity stake owned by the Hedin Group

• Looking through Hedin Group’s annual reports, the company appears to have a history of obtaining minority stakes in businesses before then increasing its ownership to obtain majority control 

• We have heard through our research that the Hedin Group 1) has ambitions to have a truly pan-European dealership group (which includes the UK) and 2) is a customer of Pinewood and likes the software 

Beyond the interest from the Hedin Group, we think the leaked bid effectively puts Pendragon “in play” and could potentially lead to interest from other strategics.  We think any interloper bid would likely need to take place at least in the 35p-40p share price (61-84% upside) range to incent Hedin to sell (assuming the interloper wants to pursue an acquisition under a UK Scheme of Arrangement vs. a Takeover Offer) 

• Constellation Automotive Group, formed by TDR Capital, owns the Carvana-like used car player, Cinch, and recently made two strategic acquisitions in the UK public dealer space.  In late 2021, Constellation acquired Marshall Motors (MMH LN) and in early 2022 acquired a 20% stake in Lookers plc (LOOK LN).

• Cazoo (CZOO) is another Carvana comp that came public last year via a SPAC, is struggling with used vehicle availability and acquiring physical dealerships locations could make a lot of sense.  Within one month of Pendragon officially launching its new “Car Store” omnichannel used car strategy, it already has more cars listed on its site than Cazoo

• U.S. dealers – Penske Automotive (PAG) and Group1 Automotive (GPI) have UK operations and any acquisition in the 40p range would be meaningfully EPS accretive.  Other U.S. dealers may be interested as well given the uniqueness of Pinewood and the rare strategic opportunity to enter the UK market in a major way at a time when industry volumes are still depressed

Given there are multiple potential paths for a Pendragon sale, it may be appropriate to weight the probabilities of the various outcomes when thinking about the upside to the shares:

We also think the board may have a credible defense tactic at its disposal in potentially selling one or more of their assets to unlock value.  Management’s plan over the medium-term (3-5 years) was to split Pinewood from the rest of the business.  The leaked Hedin approach may accelerate this plan, even if another bid doesn’t arrive.  Put differently, if no bid comes and shares remain where they are today, other shareholders will likely be motivated to push management to sell Pinewood.  

Why does the opportunity exist?

Institutional investors in the UK have a negative association with Pendragon resulting from the shareholder value destruction that occurred under the former CEO, Trevor Finn.  The shares were previously written up on this site back in early 2014 at 32p.  While the UK automotive backdrop has been weak since then due to Brexit, the bulk of the share price underperformance over the past seven years came from Finn souring relationships with auto OEMs and aggressively deploying capital into a misguided standalone used car store strategy which led to significant inventory write-downs.  Finn was pushed out by the activist investors Teleios Capital (since exited), Odey (still involved) and Anders Hedin himself (who first entered the shareholder register in 4Q 2018).

The activists initially brought in Bill Berman—the former President of Autonation (AN)— to the board before asking him to take over as CEO in February 2020. Berman is highly regarded by his peers in the automotive industry and we have found him quite impressive in person.  

The fundamental equity story at Pendragon has been attractive since Berman joined as CEO but his turnaround has been under-appreciated by the market due to PDG’s low free float, small ADTV, negative sentiment towards the sector and fatigued UK institutional investors.

In the event that an M&A bid falls through, we think Berman has a compelling plan to unlock value.  The company put out a strategy presentation back in September 2020, outlining the path to the business earning £85-£90 million in normalized pre-tax profit (on a £303 million market cap today).  We think the outlook has only improved since that presentation was put together and we see upside to the targets from both Pinewood and the omnichannel used car opportunity.  With a high likelihood of more noise around other bids, we don’t think it’s likely the shares will remain where they are today (below the price they were trading at prior to the leak of the Hedin offer). 

Valuation Frameworks

• Multiple of Pre-Tax Profit

• While “normalized earnings” are difficult to decipher in today’s environment, with low new & used volumes and still elevated GPUs (Gross Profit per Unit), a simple way of estimating earnings power is by looking to management’s 2025 targets (which are based on mid-cycle market assumptions).  Taking the midpoint of management’s £85-£90 million 2025 Pre-Tax Profit, discounting it back at 12.5% p.a. and applying an 8x Pre-Tax Profit multiple (in line with precedent transactions in the space) would result in a 39p share price (80% upside)

• This approach implicitly values Pinewood earnings at the same multiple as auto dealership earnings, which seems punitive 

• Sum-of-the-Parts – Separating Pinewood and Leasing from core Franchised U.K. Motor

• Breaking out the value of Pinewood and the leasing business separately results in a value of 44p/share (103% upside).  This includes dinging the SOTP for tax leakage, Pendragon’s net pension liability (NPV of roughly £31 million), and the NPV of “onerous leases” (another £36 million, see below) 

• Liquidation Value / Break-up

• Based on our analysis, if the Board were to propose liquidating the group and selling off the individual pieces (including real estate and the individual dealership licenses one-by-one, etc.), a share price of 45-50p can be justified.

Additionally, sell-side analysts believe PDG fair value is well above where the 28p bid took place: 

Appendix - New & Used U.K. Market Dynamics

• While Pendragon’s 2022 Pre-Tax Profit of £83 million was clearly inflated due to vehicle supply shortages leading to elevated used and new car margins, 2022’s estimated pre-tax profit of £55 million (sell-side consensus) is a bit closer to a normal year.  Used and New GPUs should continue to come down throughout 2022 but this should be partially offset by higher new and used volumes

Pendragon - Franchised U.K. Motor - Lease Considerations

• When comparing to other publicly-listed U.K. auto dealers (MMH, VTU, LOOK, CAMB), roughly two-thirds of Pendragon’s sites are leased (vs. owned), whereas one-third of sites are generally leased for peers. 

• Roughly 60 of Pendragon’s 140 dealership sites have leases that are notably above market, the result of a poor sale-leaseback transaction entered into under previous management in 2005.  These leases generally roll off in either 2025 or 2031.  We estimate the net present value of the above-market rents through the terms of these leases is ~£36 million.  We treat this amount as a liability in our sum-of-the-parts calculations

Latest PDG Investor Presentation: https://www.pendragonplc.com/-/media/pendragonplc/pdfs/finance/2022/fy21-full-year-results-presentation.ashx

Disclaimer: This report is the work of an investment adviser affiliated with the author. The report is the result of the adviser executing its investment strategy. The adviser holds a position in the security, however there is no assurance that the adviser will continue to hold the investment or make additional investments and will not update the information to reflect future changes in the adviser’s assessment of the investment.

Catalyst

• Announcement of a formal takeover offer
• Acceleration in Pinewood revenue growth
• Continued roll-out of UK omnichannel used car platform