Description

Summary:  Vertu Motors (VTU.LN) is British rollup of auto dealers with 124 outlets around the UK.  While the UK auto market has begun to slow, we believe that Vertu will manage through the downturn better than the current price implies, resulting in significant potential upside.

Business Overview:  Vertu was formed in late 2006 to roll up UK retail auto dealerships.  The company’s main strategy is to buy dealerships in need of a turnaround, then implement a 4-year process in which the sales mix and margins are improved.  The largest brand exposure by number of dealerships is PSA/Vauxhall with 14 Vauxhall dealerships and 9 PSA dealerships.   Total sales in the fiscal year end Feb 2017 were £2.8 billion.

Key Pillars of the Thesis:

1.       Management.  The company founder remains the CEO.  We believe he has done as excellent job managing the growth of the company from nothing to nearly £3 billion in sales.

2.       Solid balance sheet.  The company has net cash on the balance sheet, almost no debt, available liquidity, and a fully funded pension.

3.       Flexibility in the face of a slowdown in British auto sales. As the industry slows, we believe the company can work to improve its own margins, optimize its portfolio or make opportunistic acquisitions.

4.       Attractive valuation.

#1.  Management.  Founder and CEO Robert Forrester has led the company since its creation in 2006.  He was trained as an accountant then worked for several years in property investment before entering the auto business.  One of the things that has impressed us about his approach to the business is that he doesn’t seem to have any sentimental attachment to his properties.  Underperformers are closed and sold. For example, in FY2017, the company closed or sold 10 outlet.  He has been willing to let go of brands he doesn’t like.  As we enter into an uncertain period in the UK auto market, we think his approach to portfolio management will serve the shareholders well.  Additionally, he has already seen the 2 auto cycles play out, having worked in the space since 2001. This company is his baby, and he owns 6.9mm shares. While we appreciate this evaluation is a set of “soft” factors, we believe they give some comfort in his ability to lead the company through more challenging times.   

#2.  Solid Balance Sheet Allow Management Flexibility.   In February, the company had net cash of 21mm, with total debt of only £19mm (in the form of a working capital revolver and used-car financing).  Its pension plan is slightly overfunded.  As of February, 53% of dealerships were owned freehold.  As a general matter, the company has avoided significant long-term debt.

Earlier this year, they refinanced their bank facility with Barclays to support acquisitions.  The 5-year facility an initial limit of £40mm with an accordion for an additional £30mm, priced at L+130-220.  If anything, the company seems to be setting itself up to have firepower for opportunistic acquisitions in the event of a slowdown.  This company’s early years were in a marked slowdown it the UK auto market, so we’d expect they can repeat a similar play book in the upcoming downturn.  If anything, they will be a more competitive acquirer than their competitors, Pendragon and Lookers, both of whom have debt.

It is notable that during the last year (and the last few weeks), they’ve buying back shares consistently at current prices.  From the company’s founding in 2006 until last year, they did no buybacks.   Instead, they used internally generated cash flow or share issuance in order to support acquisitions.

#3.  Flexibility in the face of a slowdown in British Auto Sales.  The long-feared slowdown in British new car sales has arrived.  After peaking at 2.7mm in 2016, year-to-date new car registrations have fallen 2.4%, with August sales down 6.4%.  Used car sales have been more resilient, on track to grow approximately 2% this year to 8mm units.

Currently, competitor Pendragon is predicting a 3.5% decline in overall new cars sales this year, followed by a 2.5% decline in 2018.  It is tough to predict how the cycle will play out here.  In the early 2000s, new car sales remained around 2.5mm units per year for several years then dropped down to about 2mm in 2009 and 2010.  By contrast, in 1990 they were running at 2mm per year, then dropped quickly to 1.6mm in 1991 and 1992, followed by a rise to 1.7mm in 1993.

To get some measure of what the downside could look, we went back to analyze the 2008/09 recession’s impact on Vertu and its two main competitors, Pendragon and Lookers.  From 2007-2009, Vertu’s Revenue and EBITDA actually grew, since they were just starting their acquisition program and had no real legacy sales to worry about.  In Pendragon’s case, both sales and EBITDA declined 37% from 2007 to 2010..   As a result of acquisitions, Lookers actually saw a slight revenue increase, though EBITDA declined by 21%.   A 30-40% decline in EPS at Vertu would imply EPS of 4-5p.  We believe, though, that there are several offsets that could help mitigate this impact:

Mix Shift/Margin Improvement:  New car and fleet sales are the lowest margin components of the Vertu business.  In the most recent fiscal year, New cars (32% FY17 sales) had gross margins of 7.5%.  Fleet (23% of FY17 sales) had Gross Margins of 3%.  Used cars (37% of total sales) had slightly higher gross margins of approximately 9.7%.  In contrast, Aftermarket (parts, service, etc) was 8% of sales, with 44% gross margins.

In theory, there is significant opportunity for Vertu to improve its margin profile by shifting its sales mix.  Per Lookers, demand for used cars in the UK is currently outpacing supply.  As the market slows down,  as long as there isn’t a severe drop in sales, the company should naturally see more sales in used cars, which should help the margin profile.

Additionally, Vertu’s entire strategy is based upon targeting underperforming dealers for acquisition.  As the portfolio seasons, margins from these acquired dealers should improve.  Additionally, Vertu is highly focused on cost containment.  The competitors give some guide as to the potential improvement:  while Vertu currently produces 1.5% EBITDA margin, Lookers and Perndragon are at 3% or better.  The competitors do not have the same mix of business as Vertu, and they are much larger (theoretically benefitting from scale), but they point the direction in which Vertu might go.  Vertu’s margin has been rising slowing over time, from 1.0% in 2013 to 1.4% in FY2017.

Portfolio Optimization (including financial engineering):  They recently did a sale-leaseback on a dealership in Leeds for £14mm that had been carried on the balance sheet for £10mm.  While they’ve indicated they are not going to start a regular program of selling off owned dealership property (they prefer to own their land freehold), they will do these deals opportunistically.

We also believe that any downturn could provide them with significant opportunity to acquire some of their competitors.  Lookers has presented a chart showing the number of car dealers in the UK has been in steady decline for the past 20 years.  In 1997, there were nearly 7,000 dealers in the UK.  This year, there are approximately 4,600, despite the fact that overall unit car sales are the same/slightly higher.  This consolidation has occurred because smaller dealers have a tough time competing against scale players and because the auto manufacturers have tended to like more financially secure dealers.  We believe that Vertu will want to take advantage of any weakness in the industry to become an opportunistic buyer.

Potential Sale:  On the opposite end of the spectrum, Vertu could decide to be the seller rather than buyer.  It is notable that Robert Forrester’s previous role was as Managing Director of Reg Vardy, another chain of auto dealers, which he sold to Pendragon for £500mm (11x trailing earnings) in 2005 (only months after the last auto sales peak) following a bidding war between Pendragon and Lookers.  Vertu’s current Board Chairman Peter Jones was CEO of Lookers until 2013.

#6.  Attractive Valuation.   Market expectations for the entire sector are fairly muted, but are the lowest for Vertu.  It is currently trading at only 6x the Feb 2018 consensus of 7p in EPS, and 3.3x EV/projected EBITDA.   The official consensus estimates assume revenue and earnings remain flat over the next 3 years.  We believe that the current low multiples imply the market assumes a significant decline.  The company’s market cap is currently 1.1x net tangible assets of £156mm, and the gains on the recent sale leaseback transaction leads us to assume that the stated book value for the company is understated.   Its dividend yield is in excess of 3%.  In other words, if anything goes right here, you could see significant gains.

Catalyst

Execution