Lookers — Restoring reputation as the market EVolves

Despite the travails of 2019 and 2020, Lookers remains the second-largest car dealership group in the UK. While dealing with the legacy issues of a Financial Conduct Authority (FCA) inquiry into the potential mis-selling of regulated products and the uncovering of fraudulent activity, the company continued to face challenging trading in the UK vehicle markets due to issues such as Brexit and emission regime changes. All of these were exacerbated by the disruptive impact of COVID-19 that commenced in Q220 and continues today.

The new management team successfully navigated the bulk of these challenges and has emerged from the share suspension in apparently good fettle. The disruption caused by the pandemic during the three national lockdowns in the UK has had a more limited impact than we feared. Government aid and support from brand partners helped cushion the financial impact in H120, as did management actions to protect cash flows and optimise operational structures and processes. The subsequent catch up in demand in H220 produced unusually strong levels of profitability for both new and used car segments, with a recovery in high-margin aftersales.

Although challenged by the third national lockdown, the momentum in used car markets continued in H121 and again produced exceptional levels of profitability, more than compensating for supply headwinds in the new car segment. As a result, management has indicated a stronger FY21 performance than consensus analyst forecasts. In addition, the FCA announced the closure of its investigation on 2 March 2021, noting concerns over the historical culture but not applying any sanctions as Lookers has implemented a remediation plan. The 2019 provision of £10.4m against potential liabilities that might arise was reversed in the FY20 accounts. We believe that despite major changes anticipated in both the ways vehicles are sold and the electrification of the industry, larger dealership groups should be better positioned to cope financially with the challenges. A revitalised Lookers appears well placed to fully participate in the evolution of the UK vehicle market.

The current issues surrounding the car market may be transient and dissipating, but the whole traditional franchise dealership model may transform over the next decade to an agency model. The change is likely to be driven by the market shift towards online buying and a desire by OEMs to be more directly connected to the ultimate consumer. With the rapid transition of new cars sold in the UK to be EVs by 2030 driven by UK government policy, there is an inevitable change in the balance of value accretion between the new, used and aftersales segments. It remains our view that larger dealerships have the financial capacity to support the investment required in technology and facilities to support these changes, and that further consolidation of the competitive landscape in automotive retail is inevitable, with fewer larger dealerships emerging. Lookers looks well positioned to participate in such a development.

We are restoring our estimates and forecasts with a slight year-on-year increase in revenues in FY21 and further progress in FY22. We expect a more normal trading pattern to persist in both years, with Q1 and Q3 providing the strongest performance due to the registration plate changes, and less disruption in Q221 as the national lockdown was lifted and showrooms reopened. In turn the group’s underlying PBT should improve substantially this year.

Lookers is a pure UK automotive retailing group and is now the UK’s second-largest franchised motor distribution group by revenue, selling well over 200,000 new and used cars and vans in a normal year. Revenues are generated by the sale and leasing of new vehicles, trading of used vehicles and provision of aftersales services and repairs. The Lookers dealership network consists of 164 franchises operating at 106 locations representing 32 manufacturers’ (OEM) brands. The group has national coverage, although there are several major regional clusters, notably in Northern Ireland where the group is the clear market leader, trading as Charles Hurst. Other key regions are the North-West & Midlands, the North East (strengthened by the acquisition of S. Jennings Group in September 2018), South-East England, and southern Scotland where it trades as Taggarts. Lookers represents all of the leading marques and has developed important long-term relationships with each of its OEM suppliers.

The strategy of the right brands in the right location with excellent execution remains appropriate, although the strategic investment priorities have evolved during the pandemic to support a more integrated omnichannel offering. Lookers continues to outperform the UK new car retail market with its share rising to 6.2% in FY20 (FY19: 5.9%), and up from 4% in 2011. It has been built by a combination of organic growth and acquisitions, delivering an impressive and consistent trading record over many years. It has strong relationships with its OEM partners and has established a number of strong geographical sales territories, from which the group can generate consistent and growing returns. In addition to new car sales, Lookers operates a growing range of used vehicle and aftersales activities (servicing, repairs and the provision of franchised parts) in its franchised dealerships, which together normally contribute around 65% of gross profits.

Organic growth is achieved largely by maximising the throughput of each location. Historically, this has involved extending the higher margin used car and aftermarket operations in each franchise, and by lifting the finance penetration, most notably the use of personal contract purchase (PCP) finance and service plans. The objective is to increase the profitability of each dealership by increasing revenue without a commensurate rise in infrastructure costs. The optimisation of the used car inventory profile can also have a material impact on returns. Moreover, there is a clear link between retail vehicle sales and the resulting aftermarket demand, which helps to increase higher margin aftersales revenues. Group capex has also been deployed by management to upgrade, extend or relocate premises to support the franchise aspirations and relationships and increasingly for technology to support the dealerships and develop the online offering and presence.

The new management team led by CEO Mark Raban has evolved the strategy, but retains at its core the focus on the right brands in the right place with excellent execution. To achieve the core strategic aims, the business priorities evolve with market developments. The current strategic priorities are:

While the chairman and interim CFO are both moving on with replacements being sought, we feel the company is now positioned to resume a more active role in the consolidation of the sector, supported by the strength of its balance sheet. The company had an adjusted net cash balance at the end of June 2021 of c £30m. We expect a modest level of net cash (£1.8m) at the year-end as working capital increases in support of improved trading volumes and some government assistance unwinds. In addition, Lookers’ £300m property portfolio underpins the asset base. The strength of the balance sheet should allow the group to pursue growth opportunities if they arise, alongside continued organic investment especially in technology to support the transitioning markets.

All locations were shut from 23 March 2020 until mid-May to protect employees and customers from the pandemic and in accordance with government guidance. 31 locations were able to provide essential repairs and servicing to key workers during the lockdown, supported by 10 parts distribution centres. Sales processes were adapted to achieve contactless interactions. These served the company well during the subsequent second lockdown in November 2020 when showrooms again closed, as was also the case in the third lockdown in Q121. Operations have been fully reopened since 12 April 2021.

In addition to the operational responses, management also focused initiatives on protecting the balance sheet. In this regard capex was reduced to essential requirements with various programmes delayed, a focus on tight control of working capital, discretionary costs were reviewed and reduced and FY20 dividend payments were cancelled. The group utilised government schemes such as the Coronavirus Job Retention Scheme (CJRS), furloughing the majority of colleagues during the temporary closure while taking an exceptional £4.4m in H120 to top up to 100% of salaries. Some senior management and the board took temporary voluntary base salary reductions of up to 30% until 1 September 2020.

The company announced a restructuring programme on 4 June 2020 that identified further portfolio optimisation measures, identifying a further 12 franchises for closure. In addition, a headcount reduction of 1,500 employees was undertaken to right size the workforce for the anticipated longer-term structural changes following the pandemic.

The two main legacy issues that faced the company in 2020 appear to have been largely resolved. These led to delays in reporting FY19 and H120, creating uncertainty and causing the suspension of Lookers listing on the London Stock Exchange from 1 July 2020 until 21 January 2021.

The accounting issues related to the identified fraudulent transactions announced on 10 March 2020, which also led to correction of the misapplication of some accounting policies, were largely dealt with in the FY19 accounts, including prior year adjustments to accounts. A further restatement of FY19 was required to further correct the application of IFRS 16 on certain activities.

The FCA investigation into the possible mis-selling of regulated products between January 2016 and June 2019 by Lookers was concluded on 2 March 2021. No sanctions were applied, although the FCA noted several concerns relating to ‘the historic culture, systems and controls’ of Lookers, which the company has sought to review and strengthen. As a result, the £10.4m provision taken in FY19 to cover potential liabilities was reversed in FY20 non-underlying items.

The UK automotive market has been evolving rapidly in recent years as digitalisation and online retailing have altered the way car buyers come to market. As a result, all of the large retail groups have been investing in their online and omnichannel platforms, as well as using digital engagement to enhance customer experience and track data. This has occurred in a market that has been softening since the peak in new car sales in 2016 for a variety of reasons, including Brexit concerns, the demonisation of diesel engines, concerns over finance products and changes to emission testing regimes. The pandemic appears to have accelerated the evolutionary trend as enforced closures of showrooms led to more online contact. We do not believe the changes that have occurred and are likely to present themselves over the next decade will lead to the disappearance of the bricks and mortar element of retailing. Customers in the UK still largely want to have direct physical and local contact points. Cars remain the second-largest value purchase for most households after the home itself, and as such a feeling of security and trust is important to buyers, underpinned by aftersales service. In our view the large dealership groups are best positioned to finance the investment requirements.

Clearly the three national lockdowns in the UK caused by the COVID-19 pandemic have been highly disruptive to new car sales. Monthly UK new car registration data is normally erratic but seasonal, with the two registration plate change months of March and September normally seeing the highest volumes and being the most important to profitability for dealerships, as manufacturer volume target bonuses are achieved (or not). However, the impact of COVID-19 can be most readily seen using 12-month rolling data.

As can be seen, new car registrations bottomed out in February 2021 at just over 1.5m units, coinciding with the start of the first lockdown in March 2020. The impact of COVID-19 in aggregate across the lockdowns has clearly disrupted new car demand by more than the financial crisis of 2009. Q220 numbers were very low at 165k units sold and Q221 saw registrations almost treble to 485k units. April 2021 alone was equivalent to 83% of Q220 new car registrations. However, May and June have been more subdued, with reasonable demand but without the benefit of the catch up as the first lockdown eased last year, and with increasing supply-side issues.

The Society of Motor Manufacturers and Traders (SMMT) April 2021 forecast expects 1.86m new car registrations for FY21, up modestly from the February 2021 estimate and compared to 2.31m registrations in 2019. Car dealerships reopened showrooms from 7 April 2021 after the third lockdown and the vaccination programme appears to have paved the way to a more normal trading environment. We expect a more normal trading pattern to result as the year progresses, albeit at a lower level due to the economic damage reaped by COVID-19, for example higher unemployment. However, the various releases of pent-up demand after lockdowns in 2020 and 2021 may defer the return to usual market seasonality until FY22.

It seems plausible to us that even with a weaker Q321 due to the post lockdown bounce back seen in Q320, there could be an improvement on the SMMT estimates this year, with new car registrations perhaps recovering to closer to 1.9m vehicles for FY21 overall. Some of the main factors that are likely to affect new car demand are as follows.

Positives:

Negatives:

Most important among these in terms of disruption is the chip shortage, which is leading to some brands suspending production and supply, with volumes available reduced and affecting dealerships. In response, some finance packages are once again being extended notably on PCPs, which has a knock-on effect for quality used car availability as natural vehicle replacement schedules are being deferred. We would hope that the issue would resolve as FY21 progresses leading to more normal market supply next year.

Overall, we feel the emergence from COVID-19 should have a beneficial impact in FY21, and FY22 should see some further improvement as supply chain issues moderate and economic recovery starts to increase employment levels once more.

The COVID-19 pandemic appears likely to have accelerated online engagement with customers. Certainly, in the third UK lockdown from the start of 2021 until 7 April 2021, the closure of dealership showrooms was mitigated by more use of remote engagement both by telephone and online, with click and collect services allowed to operate and aftersales services operating more normally.

In addition, there is the accelerating pace towards adopting EVs over the next decade, at the absolute expense of internal combustion engine (ICE) powered cars, both diesel and petrol fuelled. Other technologies may also grow, for example hydrogen powered fuel cells etc, although that has been a developing technology for at least 25 years.

What appears clear though is the transition away from ICE power is likely to lead to a change of business model for both the manufacturers and the retail network. Today aftersales and spare parts are important profit and cash generating elements for both. In the future, the frequency and value of available service work is likely to diminish as there are likely to be fewer serviceable parts in EVs, and intervals for motive power replacement already extend over eight years. There will also be a greater emphasis on electrical rather than mechanical engineering services, requiring investment in both people and facilities.

In our view, the technology and model transition are still likely to favour the larger, financially more capable dealership groups, and we can envisage a change to more agency-based distribution models, accelerating the pace of dealership consolidation. None of these factors will have an impact overnight and some may not occur at all, but the market should continue to evolve rapidly with traditional franchise dealers also having to compete against new entrants in all segments of the market using disruptive asset-light and technology-based models.

It appears from commentary from other used car market participants that demand and pricing remain extremely strong at present. Comparison to the period a year ago is again unhelpful, as showrooms were shut in the first lockdown in the spring and transactions slumped around 50%. However, even compared to 2019 levels, which were more ‘normal’, it appears that the market has held up well in Q121 as online and remote engagement and click and collect have allowed consumers to complete purchases despite showrooms being shut once again.

Several factors are supporting the market. As well as the additional household wealth and private/public transport stimulants that are also aiding new car demand, the squeeze on new car supply due to supply chain disruptions means increased demand for high-quality used cars. In addition, previous supply-side disruption largely caused by the emissions regime change as well as the declining market since 2016 had already meant some pressure on used car availability.

As was seen following the first lockdown, we do expect to see some pent-up demand being released from Q221 following the reopening of sites from 7 April 2021, as people look to travel more both for work and leisure. The physical element of car purchasing should be noted, as online selection is possible, but inspection and test drives remain important to consumers. We would expect the volume improvements to moderate as prior year comparisons get tougher in H221, but still expect healthy demand levels and firm pricing through the period. However, as supply improves, we expect used margins to moderate in 2022, creating a further headwind for retailers.

Aftersales represent a high-margin and significant segment for all car retailers and manufacturers in terms of parts supply. In the near term, we expect volumes to recover and the very high margins to be maintained as the service contracts generate a more normal flow of activity. In the longer term, we feel the model is likely to adapt as EVs are progressively introduced. With greater electrical engineering skills required, the amount of service parts content likely to fall and service intervals potentially extending, there is likely to be a substantial shift in the value proposition for retailers and manufacturers as well as a recapitalisation of service facilities. We would expect the cash impacts to require a compensatory increase in new car prices and margins on car sales for retailers.

FY20 was an extremely challenging year for the new management team. On top of the pandemic and the normal supply and demand induced challenges in the UK car retail market, the company was also faced with an internal fraud investigation and an FCA inquiry relating to the sale of regulated financial products. The resolution of these issues led to a significant delay in reporting both FY19 and H120 results. The delay was so extended that trading of the shares had to be suspended while the issues were resolved and FY19 results were published.

In addition, management had to deal with the disruption caused by the COVID-19 pandemic, which led to unprecedented trading conditions especially during the full shutdowns required in the first national lockdown in the UK. The result was a year of two distinct halves, neither of which reflect the normal historical seasonality in trading nor the likely shape of trading as normality resumes in FY21 and FY22.

Key highlights of FY20 were:

H120 was affected by the almost total lockdown of the UK automotive retail sector starting in March, usually the busiest trading month of the year. Showrooms were shut and only aftersales services for key workers’ vehicles was permitted with just 41 locations opened for the purpose. While the market started to recover when restrictions were eased in early June, it was too late in the period to make a significant positive impact despite the release of pent-up demand. As a result, group revenues fell 40% or more than £1bn as new, used and aftersales segments were all affected by operations being closed, and deferred finance contract renewals and MOTs as well as normal service work. Car traffic levels fell by around 75% in April 2020 according to Department for Transport data, reducing the number of repairs required as well as wear on components. Management responded with a focus on employee welfare and protecting financial performance.

Management also identified further portfolio optimisation and restructuring measures that included the closure of a further 12 sites, taking the total to 27 in 2019 and 2020. A reduction in headcount of 1,500 employees was also undertaken to adjust to anticipated future structural requirements. The associated non-underlying costs and asset impairments totalled £13.7m in FY20 and should lead to cost savings of £50m per annum.

The total net non-underlying charges were £12.1m (FY19: £49.7m) including the restructuring. Other non-underlying charges included non-recurring professional fees of £9.2m and other goodwill and intangible impairment of £3.6m. These were offset by the reversal of the £10.4m FCA provision, property profits of £3.1m and other credits totalling £0.9m.

Government and brand partner support was significant with deferred business rates and furlough schemes helping to mitigate costs, although a £4.4m charge to top up salaries of furloughed employees was incurred.

Lookers’ H120 new car sales fell by 46.8% (45.3% like-for-like), outperforming the broader UK market, which saw new car registrations fall by 48.5%, with weakness in demand apparent before the pandemic compounded by the first lockdown. Gross margins fell by 27bp as lower manufacturer bonuses reflected the demand slump.

During lockdown, management increased the integrated online offering for both new and used cars, including the introduction of a multichannel Click and Drive functionality that included finance package processing. The enhancements proved extremely helpful in the subsequent second and third lockdowns. All showrooms were progressively opened in June.

All aftersales locations were reopened by mid-May following the introduction of new operational processes.

The release of pent-up demand resulting from the suspension of operations in H120 led to a record performance in Q320, driven by a very positive used car segment, where buoyant gross margins reflected strong demand and the proactive measures taken in H120 to reduce inventory levels. The positive momentum continued in Q420, although the new lockdowns did constrain new car volumes.

The profit performance also benefited from the cost reduction measures as well as continued support from government assistance schemes (CJRS £36.9m, business rates relief £10.2m) and brand partners. As a result, H220 adjusted profit before tax was an exceptional £50.2m, more than offsetting the £36.1m loss incurred in H120 and compared to the £18.1m loss reported in H219.

Less than a month after releasing FY20 results, Lookers issued a further H121 trading update on 29 July 2021. After several upgrades already this year, the release indicated that management expected to beat FY21 market consensus estimates for adjusted PBT of c £50m, which it expected to generate in H121 alone. The performance reflects the positive market fundamentals that have been reported by Lookers and other dealership groups. Strong consumer demand for new and used cars and tight new car supply is driving exceptionally strong margins for the used car segment. As we have said, caution remains over the further tightening of supply that seems increasingly likely in H221, which may prove disruptive to new and used volumes, potentially adversely affecting dealership performances. In addition, we expect used car pricing to moderate from the exceptional levels currently being experienced as new car supply recovers from the production halts, although that is not yet a given. These potentially negative trends seem likely to persist into FY22, which will also see some additional headwinds as costs normalise. The £50m benefits of the restructuring programme should alleviate some of the pressure.

We expect to see a very strong H121 performance, moderating in H221, with the exceptional levels of margin and group profits to moderate in FY22. We are reintroducing our forecasts for Lookers as shown below.

As a result of the issues that arose in 2019, both the board and the executive management have been totally revamped. Mark Raban was elevated to CEO in February 2020, having joined Lookers as CFO in July 2019. Mark had previously been the CFO of Marshall Motor Holdings, including the IPO and the transformational acquisition of Ridgway and its integration. He had previously held financial director positions in the automotive and retail sectors at Inchcape Retail and Selfridges Retail, and was CFO for the UK and Ireland at Borders Group.

Following the resolution of the legacy issues, Chairman Phil White is to leave the company, and the search for a replacement is underway. He has been chairman since 2006. In addition, the interim CFO Anna Bielby is to leave the company and a search for a replacement for her has also been initiated.

Like all UK car retailing groups, Lookers is exposed to factors that affect most of its peers in a similar timeframe. Few, if any, dealership groups are immune from market driven influences, although in recent years behaviours in the market such as the increased use of PCPs may provide a greater element of stability than may have been experienced historically. Combined with Brexit and the other issues that were already challenging the market, the pandemic has severely tested the operational and financial models of the large, quoted UK car retailers. It would appear that all participants are generally following similar model developments having proven surprisingly resilient given the operational disruption experienced over the last 18 months, albeit partially mitigated by government support.

Sensitivities include:

Despite the pandemic, the share prices of Marshall Motor Holdings, Cambria Auto and Vertu Motors are all higher than at the start of 2019. However, Lookers continues to trade some 30% lower despite a strong recovery since its listing resumed, with the legacy issues undoubtedly damaging investor perception. Management needs to continue to restore reputation and confidence as trading conditions normalise into 2022.

Brexit has now become a reality and while it is difficult to judge its impact given the supply chain issues for manufacturers, the more favourable FX rate for importers may alleviate some of the concerns as pricing should not be a current issue. What we would say is that once again the car retail segment appears to have weathered another significantly adverse economic event in reasonably good health, albeit with unprecedented government financial support. In our view, Lookers’ historical significant discount to general retailers is unwarranted as segment cyclicality appears to have been moderated. Certainly challenges remain, not least the emergence of new online alternative models and the accelerating transition to EVs. In our view, the larger retail groups should be well positioned to cope with these, even if their role changes to an agency rather than a franchise basis. We expect industry consolidation to continue as the investments these factors are likely to incur start to weigh on less financially capable retailers.

The P/E discount of the automotive retailers to the FTSE All Share General Retailers Index remains substantial. We include Cambria Automobiles in the group, although as it is in the process of being taken private by the major shareholder and CEO under a recommended cash offer at 80p this is purely a reference, and we have not used it for calculating the multiples.

As can be seen from Exhibit 7, the ratings across the sector do not vary materially from the simple average and all remain on single-digit multiples in FY21 and FY22. Lookers trades at the lower end of these ratings, which is perhaps not surprising given the turbulent factors over and above the pandemic factors that have affected the company since 2019. As it executes its strategy and progressively restores its reputation, there are clearly opportunities for the discount to peers to reduce.

In addition, we would normally expect the sector to experience multiple expansion as market recovery commences and growth resumes. The extended discount to the wider retail peers suggests this is not occurring, and we feel that the headwinds and ongoing operational disruption in the new and used car markets caused by supply shortages potentially into 2022 has increased investor caution. As more normal trading and growth resumes in 2022, we would expect some multiple expansion as prospects for higher future year profitability become more visible.

In addition, the lack of yield support that resulted from the pandemic response to protect balance sheets has also been a factor holding back investors. Management is to resume payments as soon as possible with a review at the preliminary results next February. As these are progressively reintroduced, we feel investors may take a more positive view of the investment proposition.

Adjusted net debt (excluding £144m leases) was significantly reduced during FY20 to £40.7m (FY19: £59.5m) as proactive management actions to manage the fleet business and control stock and debtor levels proved effective. In addition, there was a net capex inflow with disposals outweighing additions (£16.8m) by £4.2m and dividend payments were suspended. The cash performance was also helped by the VAT deferral and business rates relief schemes introduced by the government to assist during the pandemic, but these should end in FY21 creating a significant headwind. The year-end adjusted net debt position had moved to a net cash balance of £18m by the end of May, but with more normal trading in H221 and the support schemes becoming a headwind, we expect a modest level of adjusted net cash (£1.8m) by the year end.

While capex has been tightly controlled during the pandemic, we expect higher levels of investment in digital marketing and online portals as well as in maintaining the high standards of customer facilities to resume from next year. We believe this programme together with working capital demands can be financed from cash flow and still facilitate potential acquisitions to optimise the portfolio.

Management amended and extended its revolving credit facility (RCF) with its existing group of bankers in May 2021. The facility of initially £150m compares to £238m in place at the start of FY21 with a margin of 3.25% and 4.25% above SONIA contingent on drawings, and now expires on 30 September 2023. It is subject to quarterly covenant tests on leverage, interest cover and a minimum level of EBITDA per rolling 12-month period. These should be comfortably met in FY21 given the anticipated low level of year-end adjusted net debt (excluding leases) and the strength of the H121 trading performance.

Having realised £17.1m in FY20 from disposals of freehold and leasehold property assets no longer required following the closure of a further 12 sites, assets held for sale increased to £13.0m at FY20 from £10.0m at FY19. The company retains a strong property portfolio, worth £300.7m at the end of FY20, equivalent to 77.1p per share (FY19: £321.5m or 82.4p per share).