Steve and I recently spent a few weeks visiting portfolio companies and potential investments in Europe. The UK automotive dealership sector was a major focus, it has become quite prospective lately.
There are numerous listed auto dealership groups in the UK. Lookers (LSE:LOOK), Pendragon (LSE:PDG), Marshall Motor Holdings (AIM:MMH) and Vertu (AIM:VTU) all own at least 100 dealerships. There are additional listed players with smaller footprints, and others with a small number of mega-sites.
Our interest was piqued by the superficially cheap stock price tags—most have fallen a lot over recent years, now trade below book value and sport earnings multiples of 5-7 times. They’re cheap, but not as cheap as first glance suggests. And that gets down to financing.
The most acute adoption of pay-by-the-month financing is in the new car market. A product called a PCP (Personal Contract Purchase) has come from nowhere 10 years ago to dominate. The fact it shares an acronym with an addictive drug is, presumably, coincidental.
A traditional car loan runs for five years and leaves the owner with an unencumbered vehicle once paid off. In contrast, a PCP typically runs three years at lower monthly amounts, but requires a ‘balloon payment’ (equal to the expected value of the car at three years of age) for anyone wanting to take full ownership. Instead of making that payment, most consumers hand the three-year-old car back to the financier (usually the automaker) and then sign a new PCP on a new vehicle.
Rather than financing a whole purchase, you’re financing the depreciation over the first three years of a car’s life. Rather than paying a loan off and then owning an asset, you are committing to a lifetime of financing payments.
The change has been dramatic. Chart 4 comes from one of the largest dealership groups, Lookers. The percentage of its new car sales being financed has risen from 50% in 2006 to north of 80% in 2017. And that growth is entirely due to PCPs. One in three financed vehicles at Lookers were done so via a PCP in 2006. That figure is now more than five in six. While this chart is specific to Lookers’ 150 odd dealerships, the numbers for the UK industry as a whole are similar.
PCP is the way new cars are now bought in the UK. Even customers complaining about not earning interest on their bank balance are opting for a PCP and paying circa 10% effective interest rates. Anecdotally, we’ve heard of cash buyers walking away from a car they were ready to buy because the dealer was so emphatically trying to push a PCP rather than a cash sale.
It has allowed dealers to disingenuously advertise a new BMW as being ‘cheaper’ than a Vauxhall, because the monthly payments are lower. And consumers have taken the bait—in 2001 just 12.5% of vehicles sold in the UK were premium vehicles, today it is approaching 30%.
As a result, the UK as a whole is buying new cars more frequently than they once did, with a higher average sticker price, and using more interest-bearing financing to fund it all. Clearly, more of the household budget is being directed to automobiles than was the case in the past.
The emergence of PCP financing has been a massive tailwind to car dealerships over the past five years. That tailwind is turning benign and may indeed develop into a headwind. New car sales are likely to fall, at least modestly, for a few years yet. Adjusting for that, auto dealers’ shares are still pretty cheap, but they might get cheaper yet. We’ve done the work and are ready to pounce.
Auto Trader a Better Alternative
The Fund has, however, already taken the opportunity to invest in a related business that’s been lightly tarred with the same brush. It’s one of the finest business we’ve ever owned.
Auto Trader Group plc (LSE:AUTO) has been on Forager’s wish list since returning to public markets from private equity hands in 2015. Continuing growth, combined with understandable pessimism over the UK car retailing industry, has put it in our buying zone.
The company is an online classified for used cars—the UK equivalent of carsales.com Ltd (ASX:CAR). Autotrader started as an auto classifieds magazine in the 1970s. Unlike many traditional media players, its owners didn’t miss the transition to the online world and it became the dominant online site for researching available used-car inventory.
Of the roughly eight million used cars that are sold each year in the UK, about five million go through car dealerships and the rest are mostly private deals between buyer and seller. Private sellers are usually most focused on advertising cost and final sales price, so that business has largely shifted to free classifieds like Gumtree.
Car dealerships are additionally, and acutely, focused on speed of sale. Dealer 1 might sell its cars for an average gross profit (the difference between sale price and purchase price) of £1,300 while Dealer 2 might achieve £2,000. But if Dealer 1 takes an average of 30-40 days to sell its cars, while Dealer 2 takes 90 days, Dealer 1 is going to be a far more profitable enterprise.
Thus dealers are prepared to pay for eyeballs. And by a massive margin, those UK eyeballs are looking at Auto Trader.
The current management team has been in place for five years. In that time, the print classifieds were shut and the company introduced a transparent rate card which reduced unnecessary friction. The group has released numerous new live data-rich products (some free, some subscription based) that help dealers manage inventory and profitability. It helps entrench Auto Trader into the whole trade. But it also helped shift the relationship with many dealers from confrontational to collaborative.
Since the last print run of the magazine, the online business has grown revenues 8-10% p.a.—only about one third of this has come from price rises, with the rest attributable to new products and features and increasing penetration (more dealers putting more of their stock on the site). The business is absurdly profitable, achieving operating profit margins of 65%.
The Fund bought Auto Trader on a price earnings multiple of 19 times (for the year ended 31 March 2018). A Ben Graham bargain it is not. But Auto Trader is one of those rare businesses that require minimal capital to grow—the chief input for new product development, which is done almost entirely in-house, is staff costs. These costs are fully expensed and already reflected in the profit margin discussed above.
Invert a 19 price earnings ratio and the stock trades on a post-tax earnings yield of a touch more than 5%. Effectively all of this is paid to shareholders—1.6% being the dividend yield and the rest via ongoing share buybacks.
We’re not counting on 8-10% revenue and profit growth in future. While used cars are less cyclical than new, they’re still cyclical. And any downturn that impacts auto dealers’ financial health will impact the amount they’ll spend on Auto Trader. But we expect it can grow at least 5% annually over the next 5-10 years.
A 5% starting yield plus 5% revenue and earnings growth gives us a 10% annual return expectation on the Fund’s investment. There are numerous reasons to hope the investment might do better. There are several new products already developed and paid for that are yet to generate revenue. Auto Trader is a wonderful company at a fair price.