Description

In short, this is a UK auto dealer roll-up with excellent management. The business is often penalised for low margins  (1-2% EBIT) however it actually generates very good returns and has a significant aftersales business.

The share price has halved in the past 6 months, and I believe it is an opportune time to pick up shares on the Brexit sell-off. I believe we have an opportunity to buy a business generating in excess of 15% post tax unlevered ROIC, with a net cash balance sheet at close to tangible book value and at 6x EPS (and growing subject to economic fluctuations - see valuation section).

Why now?

At less than 40p, the share price has halved from 80p. Tangible book value was 37p per share at the end of 2015 or £127m. This is a relatively transparent value: £23m in net cash, £150m PP&E which is mostly freehold property and some leaseholds, -£37m working capital, -£9.4m other. Given the equity raise and cash generated during FY17 (end Feb), this year should be closer to 0.41p per share of tangible book value. I'm not going to opine on what Brexit does to freehold property values etc but directionally, the stock has decent asset backing and downside protection, trades at close to book despite being consistently profitable even during 08-09.

Is it actually a good business? 

The returns in the sector have actually been decent. The large listed peers are Pendragon and Lookers. Lookers for instance has generated consistent mid to high teens ROIC including during the significant 07-08 downturn. Despite depressed margins, Vertu's ROIC has averaged double digits since 2008.

More important to the investment case are Vertu's incremental returns on capital employed to see whether their roll-up and turn-around is being successfully executed. Since 2008, I calculate that £105m of capital has been invested in the business (retained net income + equity raises + changes in net debt) which has resulted in 22% incremental returns. Any 5 yr cumulative period since 08 shows 18-24% returns. The same exercise can be done for 1, 2, 3, 4 year incremental returns on capital employed. The shorter the time period, the more variability in the result obviously. The only period with negative returns is a single year period: FY12 (c. CY11) on a 1 yr basis.

Has anything changed since last year?

At the company level nothing has changed. They have continued to execute their M&A roll-up with £70m of purchases over the last year. This includes a push into premium brands and adding new volume brands to the portfolio (e.g. Toyota). Very recently in March 2016, the company raised £35m of capital at 62.5p, almost 60% above today's prices to finance these acquisitions. The results have been as expected. LFL group revenues in FY16 (end Feb) were +7.3% which continues to imply the company is gaining market share.  Consolidated gross margins declined marginally due to the strong new car business being dilutive to the mix. However, underlying gross margins by divisions are mostly up. And due to op expense leverage, op margins increased and op profit was up +26% vs +17% on revenues. EPS was +25% and net cash balances grew yoy.

So why is it cheap / why did it decline in price?

This is the main point of contention and probably the main counter argument against establishing a position. Auto dealerships are obviously a cyclical business. New car registrations declind by -17% in 07-09 and somewhere between -17% and -28% if you exclude volumes bought under scrappage incentives. There are puts and takes: less new car sales might lead to increased used car sales which carry gross margins 2x as high. Also aftersales can act counter cyclically. The gross margin mix currently is new 29%, used 32%, aftersales 39%. Therefore they may not be as cyclical as you might think however overall its better to be in a good economy than in a bad one.

And we are definitely not in a low point in the cycle. Much like US car registrations, UK car registrations have recovered strongly since the 2011 low. 2015 was a record year with 2.634m new car registrations versus the prior peak in 2004 of 2.567m and the market was ontrack to surpass 2.7m in 2016 before Brexit with volumes +3.2% ytd through June.

Looking at life of the UK vehicle parc implied by the most recent annual new car registrations, it was about 10-10.5 years in early 00s, 11.5 years going into the crisis, increased to 14-15 years in 09-12 as fewer cars were being bought and has now come back down to 11.5 years in 2015.  

This suggests the UK consumer is not delaying car purchases and we are at normalised behaviour. It will be easy to defer purchases from current run-rates should confidence decline / incomes shrink.

On top, there are various Brexit risks. The GBP has declined -14% against the EUR ytd. This will effect pricing of imported cars and affordability. And obviously we generally do not know what confidence effects Brexit might have on the consumer (all UK retail stocks have been pummelled). 

Why Vertu?

The other big listed UK focussed auto dealers are Pendragon and Lookers. Both of them also trade at low LTM multiples. While Vertu trades below 6x EPS, Lookers is just above and Pendragon a little more expensive still. What I think is interesting about Vertu is that it has a pristine balance sheet (net cash vs Lookers over 1x levered and Pendragon 0.4x levered). Vertu also has an overfunded pension scheme which increases its cash conversion compared to its peers. In addition, it has the multi year margin tail wind from turning around previously acquired dealerships and getting its mix of aftersales more inline with Pendragon and Lookers. 

In addition, Vertu currently spots a market cap of £160m versus £430m for Pendragon and £400m for Lookers. Eventually, Vertu could be consolidated.

Lastly, there is significant embedded upside as the business earns 1.2% EBIT margins versus peers closer to 2.0% margins. Vertu has employed a strategy of acquiring underperforming dealerships and growing the used car and aftersales part of the business over a period of 4 years to get margins up. Future earnings power should be significantly higher once margins normalise (see previous VIC write-up) and this would provide further upside to our base case.

Valuation

On face value EPS, all the UK car dealerships look like bargains. Hence the share prices are pricing in a deterioration in EPS.

For instance, Pendragon was trading at 13-16x EPS in CY13-15 and has now de-rated to 8x. Vertu was trading at 10-14x EPS in FY12-16 (end Feb) and has now de-rated to 6x.

We think Vertu should be worth 12x EPS at normalized margins which approximates 7p in FY17 and gets to a valuation above 80p. We think in a moderately negative car market, Vertu can earn 4-4.5p EPS without any expense cuts and simply eating the negative operating leverage. We think a controlled car downturn + expense cuts, Vertu can still earn 3.5-4.0 EPS putting the business on a 10x multiple on depressed earnings. In a severe downturn, its worth noting that Vertu can easily survive due to its rock solid balance sheet and overfunded pension scheme. Hence we think the downside is limited and the returns will come when the market sees there is no downturn or sees the recovery after a downturn. 

PE and EPS are difficult measures for a cyclical business as earnings can change quickly. To double check statistical cheapness, we can also look at price to tangible book. Besides Feb 09 when the stock traded at 0.37x tangible book, it traded in a 0.75-1.00x range in FY08-13 (end Feb) before breaking out to 1.60-1.80x in FY14-16 and peaking at 2.00x. We are now back down to 1.0x.

What is fair? Arguably, as underperforming dealerships have been turned around and underlying margins have increased, the fair price to tangible book multiple should also increase over time (due to higher returns generated). Note the tangible book multiple gives no credit to the accumulating goodwill on the balance sheet reflecting the acquisition strategy which has been value creating so far. On a straight price book multiple and giving credit for goodwill, the stock is trading at the bottom of the FY08-13 (end Feb) range besdies 2009. Therefore I think the historical book value trading range corroborates that the stock offers good downside protection and significant upside.

Conclusion

Personally I think its a good risk reward. A recession might push out the returns however these returns should be in excess of 100% therefore waiting an additional 1-3 years seems ok.  

Risks

Longer term consequences of AV should not impact the investment case. Much more rapid uptake of technology could impact the investment case negatively.

Cyclicality / Brexit: it's hard to come up with a downside scenario. Vertu earned 6.3p in 2016 and has already allocated another £35m it raised at much higher prices therefore ex market movements, EPS in 2017 should be higher. Looking at EPS declines of Lookers during the crisis suggests a deep recession EPS over 4p per share putting the business on 10x trough earnings currently. But this is not a high confidence number.

Catalyst

Delivery of growth plans

Increasing margins

Take-out