Interactive Investor

Stockwatch: uncertain road ahead for these small-cap stocks

3rd December 2021 12:31

Edmond Jackson from interactive investor

Our companies analyst reviews prospects for a sector that has enjoyed a stellar summer bounceback but could be hit by tax rises.

A strong run in motor stocks over the last 18 months met with late-summer profit-taking, in common with many other small-cap stocks. Yet the proposed £323 million takeover of Marshall Motor Holdings (LSE:MMH) at 400p a share marks a premium of more than 40% to its pre-bid price, and 87% to the historic 12-month average price. Either there are strong perceived benefits of integration, or the market continues to rate motor dealers modestly, or both. 

Single-figure PEs not unusual over the long run  

Cynics might say these companies get so buffeted in a downturn that by the time the price/earnings (PE) multiples are into mid-teens after a period of buoyant trading, it is time to sell.  

Long-term followers of Pendragon (LSE:PDG), for example, will recall how it has appeared perennially cheap, yet its long-term chart has rewarded trading rather than holding. After an early noughtiesrally from about 30p to near 100p, it slumped below 2p in early 2009 and has been in a range between 45p and 8p (in March 2020) since. 

I drew attention to the stock as a ‘buy’ at 9.5p in May 2020, and at 22p it continues to edge up after a 1 December trading update provided the second pre-tax profit upgrade in two months – from £70 million to £80 million, which is material for a company capitalised at £260 million, despite it being around 120% geared. Yet the forward PE looks to be only around 4.4x. 

Pendragon - financial summary
Year end 31 Dec

  2015 2016 2017 2018 2019 2020
Turnover (£ million) 4,454 4,537 4,324 4,149 4,084 2,767
Operating margin (%) 2.7 2.2 1.8 -0.7 -2.8 0.5
Operating profit (£m) 122 100 77.9 -27.3 -115 12.5
Net profit (£m) 72.9 55.5 53.3 -50.5 -117 -24.7
Reported EPS (p) 5.0 3.8 3.3 -4.1 -10.7 -1.6
Normalised EPS (p) 5.2 4.0 3.0 2.7 -1.4 0.7
Earnings per share growth (%) 51.8 -24.1 -23.5 -14.3    
Return on total capital (%) 16.2 13.3 10.0 -3.7 -15.4 1.8
Operating cashflow/share (p) 5.1 4.1 6.5 3.7 1.5 2.1
Capex/share (p) 9.4 10.1 13.5 9.5 8.3 4.3
Free cashflow/share (p) -4.3 -6.0 -7.0 -5.8 -6.8 4.3
Dividend per share (p) 1.3 1.5 1.6 1.5 0.0 0.0
Covered by earnings (x) 3.8 2.6 2.2 -2.7    
Cash (£m) 139 84.0 53.3 51.4 55.7 56.0
Net debt (£m) 79.6 91.7 124 128 381 344
Net assets (£m) 395 373 425 346 169 127

Source: historic company REFS and company accounts

Profits boosted by pent-up demand and vehicle shortages  

Where might underlying trading settle after a rather exceptional period – and how could tax rises, and possibly interest rate increases too, affect discretionary purchases? 

After dealerships re-opened from last April, they enjoyed record sales plus higher margins on both new and used vehicles. Component shortages hit deliveries of new cars, which increased demand for used ones.  But even if microchip shortages look set to persist, when I quizzed my local garage – which offers good-quality used cars – last week, its forecourt manager said that sales have dried up. 

Looking at the reports of various companies, the outlook statements typically give little indication of this trend, but tend to hedge around ‘fundamental uncertainty in the Covid era’. 

More specifically, if you listen to commercial radio you cannot fail to be aware of relentless advertisements from online competition such as Cazoo and Motorway, which is liable to affect long-established dealersmargins and market share.  

Motor dealers typically have some degree of operational gearing, so if 2022 results in a more cautious buying mentality – and perhaps an interest rate rise or two affects their credit plans – then the 2023 earnings scenario could easily change. The obvious question is by how much, with company-specific forecasts showing a wide range. 

Marshalls takeover is an exercise in vertical integration 

An exit PE of 8x consensus earnings per share expectations for 2021 for the UKs fifth-largest motor dealer group looks cheap, but the PE rises to about 15x if 2022 forecasts are fair. Having made around £15 million net profit in the last three years, £40 million is projected in respect of 2021, easing to £20 million in 2022. 

And after recent yearslosses for Pendragon (see table), it is expected to tip radically into £45 million net profit this year, then £35 million in 2022 – a genuine re-rating, if it’s achievable. 

Constellation Automotive Holdings – the owner of online used car dealer Cinch, and We Buy Any Car vehicle auctions – has effectively closed the Marshall deal, with support from Marshalls 64% shareholder. Constellation sees scope to exact synergies by combining its online capabilities in used cars with Marshalls new car sales, show-sites and manufacturer relations. 

The freehold property element on Marshalls and other dealersbalance sheets may also offer scope for sale-and-leasebacks, although I tend to find motor dealersbalance sheets already support a fair element of leases. 

It is possible that private equity buyers may take a closer look at the sector as a result of this offer; but they will likely have to consider businesses on a standalone basis.  

New CEO may justify ‘hold’ for Pendragon  

A key element of my earlier ‘buy’ case for Pendragon was the potential catalyst for long-term value through the appointment in February 2020 of Bill Berman, the ex-CEO/president of AutoNation – the largest car retailer in the US. Such a change should have effects lasting longer than 18 months, which is possibly why the consensus view is for only a modest drop in profit for 2022.     

Berman says that despite an ongoing shortage of new vehicles, customer demand and order levels have persisted at a higher level than last year; and moreover, that the shortfall in deliveries in October and November was lower than anticipated. Used vehicles are said to have performed robustly, despite the fact that my local garage has experienced a sudden drop. 

However, although 2021’s profit is effectively now bagged, Pendragon retains statutory caution about further potential disruption from Covid. Additionally, debt and leases mean that even during a buoyant period, a third of Pendragons interim operating profit was lost to net finance costs, making this stock sensitive to changes in underlying trading and interest rates.

I would not dispute anyone locking in some gains but reckon an overall ‘hold’ stance is fair. 

Motorpoint keeps its aim to more than double revenue  

In May 2020, I also rated Motorpoint (LSE:MOTR) a ‘buy’ at 232p. The company is the UKs largest independent vehicle retailer, focused on cars up to two years old with up to 15,000 miles clocked. This strategy has played well into the recent environment with the stock hitting 385p last September, though it has since declined to 335p. 

The 25 November interim results to 30 September showed strong advances in key variables contributing to a record first half: pre-tax profit up 39% to £13.5 million, on revenue up 56% to £605 million. Consensus expects a 123% surge in net profit to £18 million for the current year to March 2022, advancing another 20% in 2023, for a PE multiple of 18x easing to 15x.  

That would appear to represent peak progress/expectations, were it not for significant investment in the period on people, technology upgrades and marketing” (although the interim cash flow statement shows only £3.4 million investment on property/plant/equipment). 

A key reason for the 2020 ‘buy’ rating had been the objective to at least double revenue to more than £2 billion; just over £1.2 billion is now expected for the current year to March 2022, and £1.5 billion in 2023.  

Trading conditions will substantially determine what is achieved, but despite the lack of dividend resumption (as with Pendragon) to affirm managements optimism, I adjust my stance modestly to Hold

Vertu Motors - financial summary
Year end 28 Feb

  2016 2017 2018 2019 2020 2021
Turnover (£ million) 2,423 2,823 2,796 2,982 3,065 2,548
Operating margin (%) 1.1 1.1 1.2 1.0 0.5 1.2
Operating profit (£m) 27.2 32.1 32.3 29.0 16.5 31.6
Net profit (£m) 20.7 24.0 24.7 20.5 3.0 16.3
Reported EPS (p) 5.9 6.0 6.2 5.4 0.8 4.4
Normalised EPS (p) 5.9 6.0 5.6 4.4 4.6 4.3
Earnings per share growth (%) 22.7 2.1 -7.3 -22.4 6.4 -6.1
Return on capital (%) 12.1 11.9 11.2 8.5 4.0 7.2
Operating cashflow/share (p) 16.2 12.6 4.8 13.3 5.2 20.0
Capex/share (p) 6.0 7.5 6.2 8.9 4.2 4.0
Free cashflow/share (p) 10.2 5.1 -1.4 4.4 1.0 16.0
Dividend per share (p) 1.3 1.4 1.5 1.6 0.6 0.0
Covered by earnings (x) 4.6 4.3 4.1 3.4 1.3 0.0
Cash (£m) 43.9 39.8 41.7 66.5 40.8 67.8
Net debt (£m) -23.1 -21.0 -19.3 0.3 125 95.6
Net assets (£m) 395 373 425 346 169 127

Source: historic company REFS and company accounts

36% advance in Vertu Motors within four months 

Comparing Vertu (LSE:VTU) with Marshall last August, I was positive on both – partly because they had been swift to offer guidance on dividend resumption – although at 47p Vertu was fully backed by net tangible assets per share.  

It has achieved record interim results to 31 August, with adjusted pre-tax profit of £52 million versus £17 million in the more appropriate comparator of two years before. A published consensus forecast of £51.3 million net profit for the full year does not appear to have caught up, hence you could also question the near £24 million targeted for 2023. 

A whopping £64 million interim free cash flow was generated, pushing balance-sheet cash up to £113.5 million – which supports a share buyback programme and provides scope for acquisitions. 

Again, I find it premature to downgrade so far as ‘sell’; we shall have to monitor what 2022 brings. Hold. 

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

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