Vertu Motors — Update 17 October 2016

Vertu Motors has again responded effectively to a challenging trading environment, producing a sound set of interim figures. Group revenues were ahead by 17.7% to £1,455m, consolidating 4.7% like-for-like growth. The rise in gross profits, at 23.1%, indicates a modest recovery in gross margins from 10.59% to 11.08%. There was a strong performance in used cars, where the group delivered 8.5% like-for-like growth in volumes and higher margins. By contrast, the new car market became much more challenging, although there was continued progress and better returns in the higher-margin aftermarket segment of the business. There was an 11% increase in the total number of vehicles sold to 89,707, including like-for-like growth of 2.2%.

Operating expenses as a percentage of revenues edged higher, with the group accelerating its infrastructure investment, especially in sales and marketing, ahead of the next stage of growth; keeping operating margins flat at 1.4%. Underlying operating profits rose by 18.3% to £20.7m. Despite higher interest charges, underlying pre-tax profit rose by 14.7% to £19.5m.

Dilution from the £35m equity funding in March restricted the increase in adjusted diluted EPS to just 1.8% to 3.98p. The interim dividend was lifted from 0.45p to 0.50p.

In terms of the dealership network, there were several acquisitions and a few disposals/closures, leaving the group currently with 129 sales outlets spread across 107 sites. The largest acquisition introduced Mercedes Benz to the group, with three franchises in the Thames Valley. Other acquisitions involved Jaguar in Leeds to go alongside the existing Land Rover franchise, which will shortly be moving to new premises close to the city centre. In another key deal, to acquire the Derbyshire-based Gordon Lamb, the group secured its first representation for Toyota, plus two Skoda dealerships and one each for Land Rover and Nissan.

Vertu has also continued its extensive capex programme: the new Nissan dealership in Glasgow is nearing completion, where it is now the sole franchisee for the city; the new Honda outlet in Morpeth is up and running adjacent to the longstanding Ford franchise; several key Ford locations have seen or are in the process of receiving major upgrades; improvements to the group’s VW Group franchise network are also close to completion.

The rationalisation process has also continued, with the group exiting from Fiat, Alfa Romeo and Jeep in Newcastle. In addition, the Fiat representation will be removed from the group’s outlets in Cheltenham and Derby at the end of 2016.

The 8.3% increase in new car retail unit sales to 22,825 was entirely down to acquisitions. The private UK new car market began to decline in registrations from April 2016, with a fair degree of self-registration activity as dealers fought to achieve their OEM targets. We consider that, while SMMT retail registration figures suggest that the retail market was a nominal 0.8% lower, the 4.2% like-for-like shortfall by Vertu is more indicative of the true picture and represents a sound performance. The nearly sustained gross margins, at 7.2% (profit per vehicle actually rose) bear testimony to the quality of new car business done across the group’s franchise network. The performance in Motability was similar, with a 1.3% increase in unit sales to 6,089 vehicles, also due to acquisitions; like-for-like sales were 3.0% lower.

The market continues to be stimulated by the OEMs, offering significant sales incentives (mostly attractive financial packages) as they fight for market share. Group management had flagged that the battle for market share could result in both margin and market share slippage. However, the group appears to have achieved its OEM targets, without surrendering margin.

The obvious question mark in relation to the immediate future remains the sustainability of the market support from the OEMs, especially in the context of the recent weakness of sterling. Most industry commentators are suggesting a reduction in registrations in 2017. Current SMMT forecasts indicate 2.5m registrations, 6.1% below the likely current year figure.

Action taken by management to develop the group business should ensure continued profit progress next year, although like-for-like figures will almost certainly remain subdued. We believe that the strong relationships that Vertu has developed with its OEM partners will help cushion the challenge, with gross margins likely to be largely sustained.

Again, there were contrasting performances between the segments. Fleet car volumes fell by 10.6% on a like-for-like basis in a period when UK fleet registrations rose by 6.1%; the group had a much reduced involvement in the very low-margin daily rental channels as its OEM partners supplied reduced volumes into this segment. By contrast, the light commercial vehicle market remained sound, with Vertu achieving 11.6% like-for-like volume growth in a market that was up by only 3.9%. Overall fleet and commercial unit sales rose by 7.6% to 17,515 vehicles. The structural change in the quality of business being secured is exemplified by a useful rise in the average profit per vehicle; gross profits in this segment were up from £7.9m to £10.4m, with margins widening from 2.6% to 3.1%.

The attraction of this sector to Vertu stems from the relatively low cost base, while sales add volume to help achieve OEM targets and provide some PDI work for the group aftermarket operations. We sense that the coming year will be more challenging, but the strategy is clearly delivering consistent year-on-year progress.

Used car unit sales rose for the tenth successive half-yearly period. The 17.5% increase to 41,972 vehicles involved the group delivering like-for-like growth of 8.5% in a market that we believe has probably been more benign than for some time. Gross profit per vehicle increased by 6.0%; gross margins edged up from 9.8% to 9.9%, with gross profits up 24.5% year-on-year.

We had been expecting a more challenging trading climate in used cars, with the consistent revival in new car registrations over the past four years leading to increased vehicle availability. Moreover, there is increased competition from the new car market, because of the continued attractive finance and increases in self-registrations. In the event, the used car market has demonstrated resilience as OEMs have worked to keep supply and demand in equilibrium. Also, several finance providers have now introduced PCP schemes for used cars, helping to sustain the market.

The group 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 with 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 without relinquishing margin.

We expect the group to continue gaining share in the used car market over the medium term. Margins may come under more pressure from time to time, especially if consumer markets become more challenging. However, the key disciplines on stock turn and pricing have enabled this segment to deliver positively in the more severe conditions seen in the past.

The performance of the group aftermarket operations (service, accident repair shops, parts) remains the most consistent aspect of the group results. Revenues rose by 21% to £113.4m, including like-for-like growth of 5.8%. More significantly, overall aftermarket margins were again lifted from 45.9% to 46.3%. In the key service segment (41% of aftermarket revenues), revenues rose by 26.6% (6.6% like-for-like) to £45.5m, with gross margins lifted from 77.1% to 78.3%. The aftermarket remains the biggest contributor to group gross profits.

The key factors remain the effective use of CRM, successful marketing of service plans on new and, in particular, used car sales, targeting increased sales per customer visit and the growing use of the central telesales team, which is increasingly focused on aftermarket work. 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 over the past three years has led to a steadily improving vehicle parc.

The cumulative number of service plans (excluding OEM plans) is now 97,427, compared with 39,040 three years ago, lifting the quality of earnings. During the period under review, the group retained 63% of new car and 46% of used car customers as service clients. Vertu’s strategy and the market dynamics suggest that the consistent growth in aftermarket revenues will continue in the foreseeable future.

The key messages in the trading statement remain positive. Trading in the key month of September showed new car throughput in line with the market and continued progress in both used cars and aftermarket operations. Profits were ahead of the corresponding month in 2015 on a like-for-like basis, with an additional boost from the acquisitions that were completed during the first half of the year. The board has indicated that full year results are anticipated to be in line with market expectations.

On this basis we have decided not to adjust our estimates. Our target of underlying pre-tax profits of £30.5m in the current year represents an increase of 11% above the £27.4m delivered in the year to February 2015 and is a little below the market consensus of £31.3m. However, the dilution impact of the £35m fund-raising in March means that diluted EPS will be down slightly, year-on-year, from 6.31p to 6.07p. We look for a 0.05p increase in the final dividend (similar to the increase in the interim), making a total of 1.40p; this would be covered 4.3 times.

It has been group policy since the inception of Vertu, back in 2006, to raise funds ahead of acquisitions, rather than risk the vagaries of the market when funds are required. Development strategy involves optimising returns from specific acquisitions over a period of typically three to four years, which can often lead to 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.

In looking ahead to the year to February 2018, there is currently a conflict in consumer markets; 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. As indicated earlier in this report, returns from new vehicle sales will probably be reduced next year on a like-for-like basis; on the other hand, action by management points to continued progress in used car and aftermarket operations, while the latent growth potential from recent acquisitions will also come through to profits. We lifted our next year adjusted pre-tax estimate to £34.5m at the time of the last sizeable acquisition in June. We do not propose to change this figure at this stage.

Like many leading dealership groups, Vertu is cash generative in most years, helped by inventory financing plans agreed with the OEMs. During the first half of the current year, operating cash flow totalled £26.4m, including a £2.1m positive movement in working capital. With tax, dividends and interest payments absorbing £7.3m, £19.1m was available for business development. In addition, the group raised £35m (£33.6m net) from an equity placing last March at 62.5p, which was earmarked for acquisitions.

With acquisitions absorbing £50.6m and net capex of £10.4m (well above the £4.1m deprecation charge), there was a net outflow of £8.3m. After other adjustments, such as the purchase of treasury shares and loan arrangement fees (£1.9m), there was a net movement in net funds of £10.2m, reducing net cash from £23.1m to £12.9m over the half-year to August 2016.

The likely slowdown in the new car market suggests to us that some of last year’s positive working capital movement will be reversed during the second half. In addition, capex will be at significantly higher levels over the next 18 months, rising to around £18m in the current half year. Our current estimates suggest that the group balance sheet will show modest net borrowings (£2.4m) at February 2017, although this may prove conservative. During the following year, to February 2018, spending will probably peak at just over £30m; this should be largely financed from group operating cash flow.

While it has been group policy to raise funds ahead of major acquisitions, the group balance sheet is well able to support continued expansion. We understand that capex will ease back after next year’s major investments, while the group has ample firepower at its disposal. Current facilities, which are largely unused, total £134m – these include a £40m acquisition facility and £79m related to working capital and used vehicle funding, of which just £9.2m is being used currently.

Clearly, Vertu is capable of responding quickly and effectively to acquisition opportunities that may arise in the current more challenging new car market.

The motor retail sector has seen falling share prices since early 2016, when it became apparent that the strong consistent rise in new car registrations was coming to an end. The Brexit referendum result added to uncertainties, with fears about the likely impact of weak sterling exacerbating the situation and leading to further falls in share prices.

Motor retailing has, for many years, been 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 6.9x CY16e and 6.2x CY17e prospective earnings are little more than half the corresponding figures (13.3x and 12.7x respectively) for the retail sector as a whole.

The market seems to look at the low margins and then take a negative view of spending on consumer durables. We feel that neither the limited importance of new car sales nor the industry dynamics, which favour the larger dealership groups, is fully recognised. The impact of the online presence and financial strength and the quality of management of the market leaders is already evident in the movement of market share in used cars and the aftermarket; we believe this shift will continue over the medium term. Less than 30% of group profits are related to new vehicle sales.

Vertu has established itself as the fifth largest UK dealership group in less than 10 years. It has an impressive record based on acquiring and resuscitating businesses, using a standard 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. Vertu has a strong balance sheet, with the facilities to continue with its investment strategy.