Interactive Investor

Stockwatch: have these two UK stocks run out of road?

26th August 2022 12:30

Edmond Jackson from interactive investor

Companies analyst Edmond Jackson examines the investment case for the second-hand car market.  

A year ago, and primarily in relation to Vertu Motors (LSE:VTU), I posed the question whether auto-dealers constituted attractive risk/reward. The used car market was going gangbusters, partly because consumers are awaiting a reduction in electric car prices, and battery duration is also leading charging facilities to improve. 

I drew attention to Vertu at 47p as a “buy”, also peer AIM stock Marshall Motor Holdings at 247p – where both were enjoying strong trading and had serially upgraded expectations. I had some concern as to how durable were such prospects: auto-dealers tend to be rated low for reasons of cyclicality; in the fullness of time a pattern of upgrades is liable to turn into downgrades. 

A takeover at a 60%+ premium may have lent a false impression 

By the year-end, Marshall’s was being taken over at 400p a share, as if the industry scorned investors’ judgement of fundamentals.  

Yet as 2022 got going, investors again tilted towards scepticism: having reached 75p, Vertu fell to 60p in January and has blipped around this level - currently 51p - despite a 2 March update upgrading profit expectations once again, by 7%. Sector tailwinds and limited vehicle supply were augmenting margins.  

Most auto-dealer charts exhibit this trend of 2018 to 2020 decline, which turned around coincidentally with the monetary and fiscal stimulus linked to Covid.   

Vertu’s annual results to 28 February showed an operating margin advance was from 1.2% near 2.4%, although this hardly leaves scope to cope with higher costs. Pendragon (LSE:PDG) achieved 3.3% last year and Lookers (LSE:LOOK) 3.8%, quite exceptional in a long-term context. 

All these stocks have been volatile and traded sideways, with analysts generally reacting positively to updates – entertaining much higher price targets. But I suspect the fundamentals have changed since the invasion of Ukraine and higher inflation becoming ingrained. While that was hard to foresee last January, a wary stance towards auto-dealers late in the economic cycle is on balance now proving fair. 

The Bank of England, in particular, cannot raise interest rates much without causing a debt crisis, and higher rates will anyway have only a modest tempering effect given supply issues are largely driving current inflation. The outlook for firms on slim margins is becoming more challenging. 

Already, profits are starting to slip: Lookers' latest interims show a 1% decline at the pre-tax level despite revenue up 3.6%. A resilient narrative helped its shares rise from 75p near 83p. Its price-earnings ratio (P/E) is just over 6x, and the stock yields nearly 4% - if forecasts are reliable. 

Recession is liable to gnaw at recently strong demand 

The second-hand market may continue to benefit from scepticism towards electric cars, also buyers avoiding new purchases, as budgets become constrained. 

Yet tightening credit conditions in due course seem likely to have an effect on the availability of finance, which I suspect was a key driver under looser monetary policy from 2020. 

As with much else, discretionary buying, an element of delay in replacing vehicles is liable to creep in – as the effects of higher living costs sink in from this autumn. A tangential example is the recent shock profit warning from educational supplier RM (LSE:RM.) involving energy costs because they compromise school budgets. 

Higher energy costs are set to affect all businesses and barring exceptional luck for a negotiated settlement over Ukraine, this situation looks likely to continue for as long as it takes, hopefully, for Russia to back down. In the short to medium term, however, Vladimir Putin is entrenched to eradicate the Ukrainian state. 

I therefore see a best-case scenario for UK-oriented auto-dealers as involving mean-reversion of their operating margins back to past levels; although circa 1% to 2% leaves little leeway.  

Despite the consensus of analysts firmly asserting that auto-dealers offer value, at this point I am sceptical. It may not take much change in demand or margin, but I would expect both to ease on a six to 12-month view. Stock prices lack enthusiasm because enough investors do not trust forecasts; and I think that is fair. 

Vertu Motors - financial summary
Year-end 28 Feb

 201720182019202020212022
Turnover (£ million)2,8232,7962,9823,0652,5483,615
Operating margin (%)1.11.21.00.51.22.4
Operating profit (£m)32.132.329.016.531.685.7
Net profit (£m)24.024.720.53.016.360.0
Reported EPS (p)6.06.25.40.84.416.0
Normalised EPS (p)6.05.64.44.64.315.2
Earnings per share growth (%)2.1-7.3-22.46.4-6.1250
Return on capital (%)11.911.28.54.07.217.6
Operating cashflow/share (p)12.64.813.35.220.018.4
Capex/share (p)7.56.28.94.24.04.4
Free cashflow/share (p)5.1-1.44.41.016.014.0
Dividend per share (p)1.41.51.60.60.01.7
Covered by earnings (x)4.34.13.41.30.09.4
Cash (£m)39.841.766.540.867.883.8
Net debt (£m)-21.0-19.30.312595.672.7
Net assets (£m)246264277263276332
Net assets/share (p)62.368.973.871.776.393.4

Source: historic company REFS and company accounts

Lookers and Vertu both yield just shy of 4% with good earnings cover near 4x and well-backed by free cash flow. This might help sustain their stocks through difficult months ahead, justifying a “hold” stance unless you think the narrative within future updates can only worsen. 

Pendragon, however, is yet to resume dividend payouts since Covid lockdowns struck, nor is it forecast to. Its first-half-year update last July, was broadly in line with the industry: anticipating a slight fall in underlying pre-tax profit from £35 million to £33 million, like-for-like. Yet management firmly asserted “continued delivery of strategy to unlock value in the franchised UK motor division, grow and diversify Pinewood and standalone used car retail”. 

Inchcape - financial summary
Year-end 31 Dec

 201620172018201920202021
Turnover (£ million)7,8388,9539,2779,3806,8387,640
Operating margin (%)3.54.41.74.8-1.33.0
Operating profit (£m)278394161449-91.6227
Net profit (£m)18426832.4323-140117
Reported EPS (p)42.663.67.878.4-35.629.6
Normalised EPS (p)61.564.766.060.636.154.4
Earnings per share growth (%)25.65.22.0-8.2-40.450.8
Return on capital (%)15.217.07.421.4-5.112.5
Operating cashflow/share (p)62.892.610579.563.395.4
Capex/share (p)21.730.230.016.910.616.4
Free cashflow/share (p)41.162.374.762.652.679.1
Dividend per share (p)23.826.826.88.96.922.5
Covered by earnings (x)1.82.40.38.8-5.21.3
Cash (£m)645927590423481597
Net debt (£m)12838949725067.5-54.9
Net assets (£m)1,3441,3891,3381,2571,0421,109
Net assets/share (p)319335322315265289

Source: historic company REFS and company accounts

Time will tell whether it proves better to trust managers’ message – at a point when the economy may be on the turn – or your own instincts. I think they are likely swayed by good times and thin margins do not allow investors scope for mis-judging these stocks. 

Another aspect about Pendragon is how – in contrast with the big premium paid for Marshalls – in early August it was announced that a large international company had pitched a 29p a share takeover offer and four of Pendragon’s five largest shareholders were willing to accept.  

While this represented an approximate one-third premium to a median price level around 22p this year, it is low in historic context – signalling how professional investors are alert to the chance to exit at modest valuations, given uncertainties ahead. Most likely, they sense that if lucky enough to get an offer for their relatively illiquid stakes, they should leave something on the table for the bidder.  

The offer fell through, however, because one such shareholder declined to engage. 

Does Inchcape offer a lower-risk alternative to UK dealers?  

This UK-based distributor has a genuinely global operation, such that Europe in its entirety represents 35% of revenues and 23% of operating profit. 

Its stock enjoys a relatively stronger chart than UK dealers’ and assuming forecasts for over 25% earnings growth near 70p this year, followed by a consolidation, around 780p currently the forward P/E is just over 11x. A strategy to become “the undisputed leading distribution partner for automotive manufacturers” helps although Inchcape (LSE:INCH) would not be immune to global recession. 

Operating margins roughly twice its UK-oriented rivals, and a robust free cash-flow record offer better security for its circa 3.6% prospective yield. 

As of the end-July interim results, management anticipated improved vehicle supply (as Covid-related disruption continues to ease) and “robust demand”, whereas I am more sceptical towards auto-dealers generally that the good times can continue. 

Inchcape’s end-June, £557 million financial debt including leases, was well-offset by £655 million cash, and intangibles were not excessive at 41% of net assets, hence the balance sheet is in a strong position to weather tougher times. 

My essential view of the sector is Inchcape constituting a relatively preferred “hold”. Ratings on UK dealers may or may not discount the extent and length of recession ahead. You need therefore to decide your risk appetite if holding any of these stocks. I would downgrade Vertu at least to “hold”, and notwithstanding ongoing takeover potential, I think it premature to buy any auto-dealer.  

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.

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