Stockwatch: Value opportunity or fool's gold?

There could be short-term pain, but these stocks trade on cheap ratings and a credit bust could clear out any excess, argues companies analyst Edmond Jackson.

Is it worth buying into current weakness after a 20% slide in September car sales?  

I put together a table of key statistics where for example mid-cap stock Inchcape yields a prospective 5.4% covered 2.5 times by projected earnings, having plunged from 800p mid-year below 500p recently, now 530p.  

With international sales and a bias to premium/luxury cars, the group raised its operating margin from a recent years' annual average around 4.75% to 5.3% in 2017, much better than small-cap Lookers on 1.2% or Pendragon on 1.7%, although Lookers' net tangible assets are now over 72% of market cap and Pendragon yields 6.6% covered 2.3 times by projected earnings.  

Superficially, this suggests value assuming forecasts are fair, although the market's de-rating of motor dealer shares could be a classic sign how cyclicals fall ahead of the business cycle.

Recent updates present a mixed bag

Pendragon's 26 October trading update captures the state-of-blame: on "WLTP", a worldwide harmonised light vehicle test for fuel consumption and CO2 emissions.  The process has delayed supplying some new vehicles to dealers hence "a short-term dilutive effect on profitability".

It started with the luxury vehicles Inchcape retails and now affects mass market brands that Pendragon and Lookers engage (though they also sell luxury).  

But, while Pendragon's new car revenue fell 9.1% in its July to September Q3, used-car revenue fell 6.3% like-for-like, the situation was saved by margin improvements which boosted used-car sales' gross profit by 13.7% and mitigated pressure on new cars to maintain gross profit.  

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Underlying Q3 pre-tax profit has thus turned around from a £1.9 million loss in 2017 to £1.1 million profit. Full-year underlying pre-tax profit is guided at about £50 million versus a consensus for £60 million as of 4 September, if Company REFS is correct.  So, despite resilience by way of cost initiatives, the overall trend looks downwards and other challenges (I suggest below) may entail.  Pendragon rounds off positively though, talking about used cars being "a key growth area for the business in 2019".

Inchcape's interims last July showed (pre-exceptional) profit before tax growth of 2%, albeit down 15.6% at the reported level, on 6.8% revenue growth at constant currency or 3.8% actual.  

The higher-margin distribution side was boosted by strong performance in Singapore and Hong Kong, underlining Inchcape's exposure to the more dynamic Asia-Pacific region and its growth in status symbols; similarly, Inchcape's Russian business turned from loss into a £5.0 million profit.  However, the retail side (relatively smaller) saw profits plunge over 61% in "very challenging conditions".

Lookers' message from its August interims was "gaining share in a challenging market" and being in line with expectations, albeit a similarly mixed profile with adjusted profit down 14% on revenue up 5%, and caution about how WLTP is liable to cause volatility in new vehicle supply.

Source: Company REFS

All this conveys a sense of managing through change but I am wary of systemic dilemmas for motor dealers.  These three issues could easily conflate:

More customers will await electric vehicle advances

Dedicated internal combustion engine - "ICE" - vehicles are becoming history.  While the UK plans to ban the sale of new petrol/diesel cars by 2040, some MPs are calling for this to be brought forward by eight years.  

It reflects a trend among governments to prove they can tackle carbon emissions also health risks to people living by roads, also the car industry hastening a transfer to electric, e.g. all Volvo cars to be electric or hybrid from 2019.  

Love or loathe him, Elon Musk's exploits may be helping boost electric cars' image from a staid to hipster tool, with customer reviews of Tesla asserting "there's no going back".

In such a context, who wants to commit to an ICE vehicle with the risk of rapidly increased depreciation? The chief hurdle looks to be development of charging supply and the time involved, especially for rural areas.  But there's a growing risk, people who need to replace vehicles in the next few years will sit on their hands, wait and see how technology evolves, maybe plug the gap with a second-hand car.

Lax credit supply has stoked up problems

In August 2017, Morgan Stanley's auto analyst warned of parallels between UK car finance and the US mortgage market in 2007, suggesting the £41 billion car credit market is unsustainable. 

Cheap "personal contract purchase" (PCP) loans have been used to buy 82% of new cars, enabling drivers to pay less than full value and putting new cars in reach of people who could not normally afford them.  The outcome will be a glut of cars onto the market, and PCP terms anyway require dealerships to take cars back if owners decide they don't want them.  

A parallel existed in the 2008 US housing crash when homeowners couldn't afford mortgage payments, nor sell their houses, they simply mailed keys back to the bank and walked away – the asset becoming the bank's problem.  

Car leasing/finance companies could similarly end up with big losses if they then have to rid their balance sheets of such cars, and which would depress prices.  Good for consumers in the transition to electric cars, but dealers on low margins would need to be highly adept.

The car market is only about 10% the size of the housing market, but PCP loans have not been tested in a recession and the method works only if the dealer/finance company correctly estimates the second-hand value of the car, three years hence.  If my point about rising depreciation on ICE vehicles is born out, a car-credit bust could follow.   

Brexit uncertainties could compound all this

You don't need to subscribe to Project Fear 2.0 to recognise a risk of short to medium-term disruption and some extent of demand shock.  Economic fall-out could mean job-losses thus undermining credit appetite and big-ticket purchases.  

Not to get carried away by negatives, but the possible scenarios justify why motor dealer shares are modestly-priced.  Operational gearing has benefited them in good times, and will work against the economy turns down.

Accordingly, and on an investment view, I'd avoid the sector, even Inchcape which has started this week rebounding from 500p low to 530p.  It's a cautious view, but trade tensions and interest rate rises could check sales of luxury cars, even in the Far East and, as I explained in my last macro piece, the business cycle may have peaked.  

Ideally, a credit bust will follow boom, clearing out excess, with car finance firms taking a hit and re-designing product.  Motor dealers will in due course represent a better-risked buy as they capitalise on quality used cars and gear up for electric sales. Buy on weakness.  

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