Vertu Motors — Defensive qualities shine through

Vertu Motors has again responded well to a much more challenging trading environment, producing a sound set of interim figures. Group revenues were nominally reduced by 0.6% to £1,446m, while the gross profits shortfall was just 1.2% at £159.1m, as gross margins edged slightly lower from 11.08% to 11.01%. New car sales were adversely affected by the impact of weaker sterling on prices, while parts of the used car market struggled with the uncertainty ahead of the general election; demand for nearly new and premium marques was slower at a time of rising availability during the April to June period. The total number of vehicles sold by the group reduced by 6.3% (5.0% like-for-like) to 84,309. There was continued steady progress in the core higher-margin aftermarket segment of the business.

Operating expenses as a percentage of revenues reversed last year’s modest increase, enabling the group to lift operating margins from 1.42% to 1.48%; adjusted operating profits rose by 4.8% to £21.4m. There was also a big drop in financing costs, helping the group deliver a 7.2% increase in underlying PBT to £20.9m. Adjusted EPS was lifted by 4.4% to 4.24p. The interim dividend was lifted by 10% from 0.50p to 0.55p.

In terms of the dealership network, there were no acquisitions and a few disposals/closures, leaving the group currently with 124 sales outlets. Several acquisition opportunities were assessed, but management was determined not to over-pay and stick to its valuation metrics, believing that valuations over the next 18 months are likely to be more attractive.

However, Vertu has continued its extensive capex programme, although a few projects are running a little behind earlier schedules. Several substantial investments are still planned for completion during H2 of the current year and in FY19.

New car retail unit sales fell by 14.7% to 19,273. The private UK new car market did well in March, but has fallen away consistently since, with SMMT figures showing a much smaller shortfall in the number of retail registrations of 6.4%. As happened last year, we understand from management, that there was considerable self-registration activity as dealers fought to achieve their OEM targets, to secure bonuses, especially in the volume segment. We are quite relaxed about the Vertu sales figures, which are probably more representative of the true retail trading situation. The increase in like-for-like (lfl) gross margins from 7.2% to 7.5%, with the group earning significantly higher cash profit per vehicle while meeting OEM sales targets, bears testimony to the underlying quality of Vertu’s new car business. The performance in Motability was also sound, with a 5.0% reduction in) lfl unit sales to 5,747 vehicles much in line with the 4.6% SMMT figure. The overall result from this segment of the Vertu business is far more robust than that indicated by the bare unit sales figures, with revenue down by 6.9%, while the reduction in gross profit was limited to only 2.0%.

The obvious question mark in relation to the immediate future remains the impact of further exchange movements and their consequences for the sustainability of the market support from the OEMs. The market is clearly under pressure, with new car sales likely to be lower in both the remainder of the current year and into next year. Several OEMs have already adjusted UK targets, with certain supplies switched to key continental markets that are in recovery mode. We believe that unit sales will continue to edge lower, but the reduced availability of vehicles, especially in the volume segment, should limit the pressure on margins.

The pressure on unit sales was prevalent in both of these segments. Fleet car volumes fell by 4.3% lfl to 9,480 vehicles in a period when UK fleet registrations were reduced modestly, by 0.5%. The light commercial vehicle market also slipped back, with Vertu delivering a 9.6% lfl reduction in unit sales to 8,210 vehicles in a market that was down by 3.2%. The structural change in the quality of business being secured was again demonstrated by a further useful rise in the average profit per vehicle; revenues in this segment were sustained, while gross profits rose by 3.9% to £10.8m.

The attraction of this sector to Vertu remains the relatively low cost base, while sales add volume to help achieve OEM targets and provide some PDI (pre-delivery inspection) work for the group aftermarket operations. We sense that the coming year will remain challenging, but the strategy of avoiding low-margin volume business should continue to deliver steady progress.

Like-for-like used car unit sales are reported to have risen for the 12th successive half-yearly period. Unit sales actually slipped marginally by 0.9% to 41,599 vehicles, but after adjustment for closures/disposals, the group delivered underlying lfl growth of 1.1% in a much more challenging market. Gross profit per vehicle was also reduced, with lfl gross margins slipping from 10.2% to 9.5%. Reflecting a higher average price per vehicle, revenues rose by 4.1% to £546.9m, but gross profits came back by 4.8% to £49.8m.

The fundamental problem occurred in Q2 of the calendar year. The market had been positive during March, with record demand for new cars filtering through to the used car market. However, the high proportion of self-registration activity (many franchised dealers trying to achieve OEM sales targets) fed into the used car market, alongside the increased flow of part-exchange vehicles at a time when consumer uncertainty was building up ahead of the general election. This caused considerable pressure on residual values and, hence, on margins, especially in the nearly new and premium segments of the market, which took some three months to clear through the system. In addition, the adverse and often poorly informed publicity about diesel engine emissions also unsettled one of the core segments of the used car market. We understand from Vertu management that conditions have stabilised since July, as the subsequent steady fall in new car registrations has reduced the supply of used cars – indeed, there currently appears to be a shortage of quality used cars, with margins firming up again.

Vertu has specialist expertise in this segment of the market, which points positively to the future. The used car returns being delivered on those businesses that have been in the group for several years contrast markedly with the returns from many recent acquisitions. Group skills in the sourcing of vehicles, advising dealerships about appropriate inventory profiles, high-quality staff training and, in particular, carefully structured marketing support, especially on the internet, all point to continued market share growth over the medium term, without relinquishing margin.

We are optimistic that the stabilisation of margins can be sustained during H2, pointing positively to the full year result; however, it is too early to reflect this in our estimates. We expect the group to continue gaining share in the used car market over the medium term and, although margins may again come under pressure from time to time, the key disciplines on stock turn and pricing have enabled this segment to deliver positively when challenging conditions have been experienced in the new car market.

The performance of the group aftermarket operations (service, accident repair shops, parts) remains the most consistent aspect of the group results. External revenues rose by 1.9% to £115.5m, including like-for-like growth of 3.3%. Gross margins reduced nominally from 55.9% to 55.5%, with gross profits rising by 1.3% to £64.2m. The gross rate of return is slightly overstated, because the division generates a margin on an additional £12m of internal revenue, which does not show in the consolidated group results. The aftermarket remains the biggest contributor generating over 40% to group gross profits.

The key factors remain the effective use of CRM and the successful marketing of service plans. Vertu, like several other large dealership groups, is clearly clawing back business that had previously shifted to the independent sector as vehicles got older, especially past the age of three to four years. In addition, the recovery in new car sales in recent years has led to a steadily increasing vehicle parc.

The cumulative number of service plans (excluding OEM plans) is now 104,142, compared with 39,040 four years ago, lifting the quality of earnings. The slight reduction in margins stemmed from a number of factors, notably an increase in the amount of lower-margin warranty work, which absorbed a higher proportion of charged time in the workshops. In addition, there is a growing shortage of experienced service technicians, which has forced up pay rates and led to an increase in the number of apprentices. Vertu’s strategy and the market dynamics suggest that the steady growth in aftermarket revenues will continue in the foreseeable future.

The key messages in the trading statement suggest a degree of caution. Exchange movements are having an impact on new car prices, with several OEMs restricting supply and introducing a differing range of sales inducements to attract customers. SMMT figures show retail registrations down by 8.8% in the key month of September; we believe that Vertu’s like-for-like shortfall of 14.8% is, again, more representative of the true retail market position, especially in the context of management reporting robust margins, with OEM sales targets continuing to be achieved. Both used cars and aftermarket operations continue to perform well, with the more stable margins in used cars continuing into the group’s Q3. Equally significant is the remaining tight control on costs, which will support the group bottom line. The board has indicated that full year results are anticipated to be in line with market expectations. However, we have decided to lower our FY18 underlying estimate from £32.0m to £31.5m; at the same time, the reduced capital following the 3.8m share buy-back will help EPS. We now estimate FY18 diluted adjusted EPS of 6.45p, slightly above the 6.43p of the previous year. We still expect that the 0.05p rise in the interim dividend will be repeated in the final, making a total of 1.50p, for a cover of 4.3 times.

The margin for error in assessing profitability for FY19 seems wider than for some time. The conflict in consumer markets remains; growing uncertainty, fuelled by the political situation, is balanced by record levels of employment and continuing low interest rates, which make for attractive affordability statistics. Modest reductions in new car registrations seem likely to continue, at least in the short term, while there is a natural fear that the margin pressures that restricted margins in Q2 of the current calendar year will recur. Past experience shows that such market aberrations tend to be relatively short-lived, but it is too early to be confident that the recent restoration of margin stability can be sustained. It should also be noted that group investment strategy involves optimising returns from specific acquisitions over a period of typically up to four years, often after reduced profits in the short term. In this context, there will always tend to be latent earnings growth potential in any year, as earlier acquisitions move towards their full potential.

At this stage we have decided again to take a cautious stance. We are cutting our FY19 adjusted PBT estimate from £35.0m to £30.5m. We look forward to the next trading update from management in late February next year when, hopefully, we may be able to take a more optimistic position.

Vertu has been cash generative in recent years, helped by the VAT benefit on new car consignment inventory from certain OEMs, although management has consistently explained that the position will change in proportion to shifts in the level of consignment inventory. This reversal took place during the first half of the current year when operating cash flow fell from £26.4m to £1.7m, with a £24.4m adverse movement in working capital. Tax, dividends and interest payments absorbed another £6.7m. There were no acquisitions, while capex was sharply lower at £8.2m (still well above the £4.7m depreciation charge) and £1.2m was spent on the share buy-back. However, with £14.2m generated from the sale and leaseback of the Leeds JLR facility, group net cash was little changed over the six months, falling by just £0.2m to £20.8m.

As previously indicated, capex will be at significantly higher levels over the next 18 months, rising to more than £20m in the current half year, followed by up to £30m in FY19. Our current estimates assume little further change in working capital ratios and no further acquisitions. On this basis, the group should show net cash in the range of £4.0m to £5.0m at February 2018. Again, assuming little change in working capital ratios, we believe that the following year’s heavy investment programme can be financed from cash flow.

The group balance sheet is well able to support continued expansion. Management has indicated that capex will ease back after next year’s major investments, leaving the group with ample firepower at its disposal. Current facilities include a £40m five-year acquisition facility, which can be extended by a further £30m, if required – £10m of this facility has been drawn down.

Vertu has made no acquisitions in the past 15 months. Several interesting opportunities have been assessed, but management has continued to stick with its valuation metrics. With such change currently taking place, we believe that asking prices may well drop, especially for independently managed businesses where succession is not in place and the proprietor’s future visibility is becoming less clear. Vertu is capable of responding quickly and effectively to such opportunities and some potentially attractive deals could well emerge in the coming months.

The motor retail sector has stabilised over the past year, following sharp reversals in the early part of 2016, when it became apparent that the steady rises in new car registrations were coming to an end. The Brexit referendum result was fundamental, with fears about the likely impact of weak sterling likely to lead to higher selling prices. As so often happens, when reality stepped in, the fears had already been discounted and share prices have edged higher, despite the more challenging trading climate. Each of the share prices in our table is higher than it was 12 months ago, although the average gain is quite modest at 6.8%.

With the exception of Inchcape, which is principally a global distributor, prospective ratings for 2017 cover a very narrow band, mostly at just over seven times earnings. There is a greater disparity with regard to CY18 estimates, but we believe that this probably reflects the varying extent of analyst caution about the widening margin for error than a disparity in likely performances.

Motor retailing has, for many years, been seen as the poor relation in the retail sector. The gap between average prospective UK motor retailing P/E ratings and those of the FTSE All-Share General Retailers Index has, in our view, been far too wide for many years. Current ratings for the sector of 7.1x for both CY17e and CY18e prospective earnings are little more than half the corresponding figures (14.1x and 13.2x, respectively) for the retail sector as a whole.

The stock market seems to look at the low margins and then take a view of spending on high-ticket consumer durables. We feel that neither the limited importance of new car sales (only 28.6% of current gross profits) nor the industry dynamics, which favour the larger dealership groups, are fully recognised. The impact of the online presence, the financial strength and the quality of management of the market leaders are already evident in the movement of market share in used cars and the aftermarket; we believe this shift will continue over the medium term, and could well accelerate over the next 12 months as trading conditions remain challenging.

Vertu has established itself as the sixth largest UK dealership group in less than 10 years. It has an impressive record based on acquiring and resuscitating businesses, using a consistent and successful formula that often involves an early reduction in profits, but building towards their full potential over four to five years. With a substantial part of group revenue generated in businesses acquired or opened in recent years, there is latent medium-term profits growth. The company has a strong balance sheet, with the facilities to continue with its investment strategy. Moreover, it showed better resilience than most when conditions were really tough, back in 2008/09.