Marshall Motor Holdings — Record first half but a testing H2

MMH delivered growth at the profit before tax level of 1.2%, in line with last month’s pre-close statement of ‘marginally ahead’. The company reported a better-than-expected net cash position of £0.9m, swinging from net debt of £2.2m at the start of the year. The company has restated FY17 to reflect the continuing operations following the disposal of the leasing business in November. In general, while delivering a record first-half performance, MMH is likely to continue to face challenging conditions in H218. However, the company is demonstrating how well its acquisitions, such as Ridgeway in May 2016, are working with its increased premium brand franchise mix (76% of portfolio including alternative premium), and it retains the financial capacity and managerial resource for further deals.

Group revenues for the continuing business fell by 0.4% as challenging conditions persisted in the new car market, especially in the first quarter where the comparison with Q117 was an all-time record. The comparatives eased in the second quarter and, while MMH outperformed the new car market, it still experienced a 4.4% sales decline, more than offsetting modest growth in revenues for both the used car segment and aftersales. Overall group gross profit margins were broadly maintained at 11.5%, and the gross profit contribution for the ongoing business was almost unchanged at £133.3m (H117 £133.7m).

Management kept a tight control on costs with like-for-like operating cost increasing by 1.3%, leaving underlying operating profits at £19.7m marginally below £19.8m recorded for H117. Following the disposal of the leasing business, interest payable fell sharply due to structurally lower financial debt. The half year finished with net cash of £0.9m, although there was a modest increase in stock financing charges. This left underlying profit before tax ahead 1.2% at a record £16.4m.

Management maintained the interim dividend payment despite the reduction in reported underlying EPS due to the disposal of the leasing business late in 2017. Ongoing underlying EPS rose by 8.0% to 17.5p per share.

This division was able to outperform a tough market backdrop. The Society of Motor Manufacturers and Traders (SMMT) indicated that the total number of new registrations in H118 decreased by 6.3% y-o-y. For MMH, new retail units decreased by 5.9% to 15,803 (H117 16,902) on a like-for-like basis. Although MMH’s market position is strengthened by its strong premium brand portfolio, the historic weighting towards diesel had a disproportionate impact on H118. Looking forward, the company believes the increased petrol contribution from premium brands should increase to meet customer demand.

Fleet unit sales decreased by 14.5% to 9,396 (H117 11,026) on a like-for-like basis. The company decided last year to exit certain lower-margin daily rental fleet business, which is reflected in the H118 result. If this is stripped out, MMH’s overall H118 New vehicle unit sales decline was just 3.5%. While the overall gross margin for the new car segment fell by 40bp y-o-y and by 20bp sequentially, in future the improved profitability of this business should be visible.

MMH continues to consider Personal Contract Purchase agreements (PCPs) as an important driver behind both attracting and retaining customers for new retail sales, especially in the premium segment. PCPs accounted for 80% (H117 83%) of new vehicle sales, with 66,540 active PCP customers at 30 June 2018 (H117 66,450). The use of PCPs also provides a ready flow of three- to four-year-old good-quality used cars for its used car operations. It gives improved visibility and connection with customers and facilitates aftersales in conjunction with service plans. We continue to regard the concerns over the use of PCPs as a finance method as more of a concern in the lower end of the market, which is not where major retailers such as MMH operate. Creditworthiness checks against customers are already an established requirement in new car markets.

Although there was marginal decline in unit volumes, performance from the used car segment showed revenue and gross profit growth. Unit sales of 22,659 (H117 23,716) declined 0.3% on a like-for-like basis. The group’s focus on gross margin retention drove gross profit up by 9.2% y-o-y and 18.7% sequentially on H217. The company is also using wider external market data to optimise used-vehicle pricing and to ensure it is competitive. The company remains committed to its 56-day stocking policy, supporting a reduction in used and demonstrator inventory levels. Use of PCPs remains supportive for MMH’s used car operations, accounting for 63% of sales in H118 (H117 62%).

The aftersales business demonstrated strong revenue and gross profit growth both y-o-y and sequentially, although the gross profit margin fell 37bp y-o-y. The fall in margin was largely explained by an increased mix of lower-margin parts sales, reduced internal PDI (pre-delivery inspection) work due to reduced new vehicle sales as well as less warranty related service work.

The group’s use of service plans allows customers to spread the cost of maintenance and gives the company greater visibility on aftersales profits while helping to build customer retention levels.

The SMMT new car registration forecast for 2018 has been revised up fractionally as the year has progressed. The forecast released in early August, which is derived from the average consensus of a panel of forecasters, is now for a decline of 4.1% to 2.436m units from 2.541m in 2017. A further 1.9% decline is anticipated in 2019. New light commercial vehicle (van) sales are expected to fall by 0.8% to 0.359m vehicles this year and remain broadly stable in 2019. Both car and van sales remain at very high levels in historical terms.

The implication is the new car market will see a more moderate fall in sales of c 2% in H218, compared to the 6.3% decline in H1.

While the distortion in the new car market caused by the April 2017 Vehicle Excise Duty changes have now largely worked through the comparisons, the confidence of buyers remains low, both for business and private consumers. This is despite what we would consider are supportive overall economic fundamentals in terms of labour markets and the low interest rate environment. The tarnishing of diesel as a main engine choice, which in our view may be misguided given the improved emissions of Euro 6-compliant diesel engines, continues to defer purchase decisions. Diesel’s share of the new car market continued to fall sharply in H118 to 32.3%, down from 47.7% in 2016 and a peak of 50.8% in 2012.

We feel the concerns of the FCA regarding the use of PCP plans has been addressed in the main, especially with regards to larger dealerships and new and younger used car sales. The main stumbling block appears to be Brexit which continues to weigh heavily on the timing of vehicle replacement decisions.

As mentioned, the SMMT forecast has just been modestly improved to a decline of 4.1% in the current year. However, it is unclear how much allowance this makes for what appears to be the potential for significant supply-side disruption in H218 from the introduction of the new vehicle testing regime in Europe, the WLTP. MMH continues to view ongoing economic uncertainty and consumer confusion around diesel vehicles as the key negative impacts on the market for H218. Concerns over supply-side disruption in H2 temper optimism as producers implement the WLTP from September, coincident with the second-busiest registration month for UK new vehicles.

The Worldwide Harmonised Light Vehicle Test Procedure (WLTP) is a laboratory test being introduced in the European Union to measure fuel consumption and CO2 emissions from passenger cars, as well as pollutant emissions. It follows recent emission testing scandals and is designed to provide more realistic and accurate data. It replaces the previous regime from the 1980s called the NEDC (New European Driving Cycle). The main difference is the NEDC lab test simulated a theoretical driving cycle, whereas WLTP tests models over a variety of driving conditions, and includes actual driving data.

For every car type, every engine variant is tested for the lightest and heaviest version. The regime is therefore more complex for manufacturers in terms of the numbers of models to be tested and processed.

Initially coming into force from 1 September 2017, WLTP is to replace NEDC for all vehicles from 1 September 2018. The interim period has been one of transition. Any vehicles produced since 1 June 2018 can only be sold after 1 September 2018 if they are processed under WLTP. Cars produced before this date that are not WLTP tested have a 12-month derogation period for up to 10% of a manufacturer’s total sales volumes during which time they can be registered. It appears that manufacturers may encourage some pre-registration of non-compliant vehicles before the September deadline.

In addition, the supply of compliant new vehicles in the busy September registration month may be abnormally constrained and possibly spread new registrations more evenly through the end of 2018 and even into 2019. With pre-registrations likely to unwind after the deadline, the supply of high-quality, nearly new cars could boost used sales but at a likely detriment to margins.

MMH is not expected to be alone in being affected by these factors as WLTP is an industry-wide issue. Clearly the impact for each retailer is likely to be dependent on brand mix. We thus expect to see lower-than-expected new car revenues for MMH in H218 due to the potential supply-side constraint, strong used car sales and a solid aftersales performance. The overall retail operating margin is likely to remain subdued due to the factors affecting both used and new car markets.

Despite the record H118 performance of ongoing activities, we are continuing to forecast a significant y-o-y decline in underlying profit before tax in H218 as the disruption from the WLTP introduction takes hold. We believe MMH will continue to control costs as it has demonstrated in H118, and management’s expectations for the full year remain unchanged.

We have reduced our new car sales expectation for H218 significantly and now estimate a decline of close to 10% for MMH. In addition, we have trimmed our used car sales expectation. The finance charge on debt is expected to be significantly lower than we had forecast, although charges payable on stock financing are expected to increase.

Overall we have increased both our pre-tax estimates and EPS estimates for 2018 and 2019 by around 3%. The increase reflects the continued resilience of MMH in challenging markets.

The company remains essentially ungeared following the disposal of the leasing business late in FY17. We do expect a modest H2 outflow as capex picks up, compounding the usual seasonal weakness in trading made worse by the potential market disruption. We thus expect a modest year-end net debt position of around £4–5m compared to the £0.9m net cash position at the half year. In addition to the strong balance sheet, MMH has extended its £120m revolving credit facility until 3 June 2021, enabling it to pursue appropriate M&A opportunities when they arise.

As for the dividend, the interim was held at 2.15p per share as the policy of 4–5x earnings cover is maintained following the disposal of leasing that diluted earnings but strengthened the balance sheet. We still expect a modest full-year increase as the progressive element of the policy is pursued, assuming the outlook for EPS growth in FY19 is maintained. If the balance sheet is used to make acquisitions, we would expect these to enhance EPS and support the progressive policy.

Exhibit 7 summarises the auto retail segment on three valuation multiples, using current market consensus forecasts. We choose to exclude Inchcape from the average comparative multiples due to its very international distribution model, whereas the others have a fundamentally UK footprint like MMH. We include Inchcape’s valuation metrics for information. We also note that our capped DCF value is 202p (little changed from when we initiated coverage in May 2017). We use six years of cash flow forecast then the terminal value is calculated on a zero-growth basis, with working capital normalised to zero and capex equalled to depreciation. To further constrain the model, we have averaged the terminal cash flow to equate to the average over the forecast period rather than the peak in the terminal forecast year. A calculated WACC of 9.7% derived from a cost of equity of 10% and a pre-tax debt cost of 5.5% is used to discount the cash flows.