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What's left in the tank for car retailers?

Sales of new cars are booming, but some car dealers may be driving on fumes
February 27, 2014

Car retailers enjoyed a smooth ride last year as double-digit growth in the UK new vehicle market propelled revenue and sent their shares cruising down the fast lane. But with growth expected to moderate after two years of frenzied acceleration, and signs that green shoots are emerging in Europe, how much more is left in the tank to keep driving car retailers forwards?

It's the recent uptick in Continental car sales that could be bad news for the UK dealerships. In December, most countries in the European Union grew and total car registrations rose 13 per cent. They rose 5.5 per cent year-on-year the following month. But dealerships here have been able to pass on the benefit of generous financing deals lavished on them by car manufacturers desperate to ramp up sales. Because their fixed costs are so high, car manufacturers need to run at a certain capacity to make ends meet. So the danger is that if Europe picks up, lucrative offers enjoyed by Britons could be watered down as manufacturers turn to other fast growing markets.

However, we don't buy into this scenario. Remember, growth in Europe is coming from a very low base. Volumes in January were still the second lowest for that month on record. December's vehicle volumes were equally weak. In fact, last year as a whole was pretty grim for the continent, where sales fell 4 per cent in Germany and 7 per cent in both France and Italy. Overall, EU car registrations dipped 1.7 per cent, the sixth year of consecutive annual decline and the worst since records began.

In contrast, the UK has consistently outperformed. After sales leapt by almost a quarter in December, total sales for 2013 increased by 11 per cent to 2.26m, beating forecasts from the Society of Motor Manufacturers and Traders (SMMT). In fact, Britain was the only region in Europe to grow continually last year and is now Europe's second largest car market. The new year has started well, too, as an 8 per cent improvement in January marked the 23rd month of consecutive year-on-year growth.

This suggests to us that while new car sales on the continent might be picking up, they're nowhere near pre-recession volumes, so there's still an enormous amount of overcapacity in car manufacturing plants, which will have to be picked up by the UK consumer.

Michael Sherwin, finance director at Vertu Motors (VTU), agrees. He believes demand remains fragile in Europe and that the UK will continue to take up the slack. That targets set for Vertu by manufacturers for the first quarter of 2014 point to very heavy growth is a good sign. First-quarter targets, Mr Sherwin said, tend to set the trend for the rest of the year.

Positive economic news in Britain is another reason to be bullish on the sector. Our economy is growing faster than at any time since 2007 and the Bank of England recently raised growth forecasts for this year to 3.4 per cent. Unemployment is falling and wage growth is edging closer to inflation-beating territory, too, which will help spending on discretionary items such as cars.

"Where there is 2 per cent or more GDP growth in the UK, the new car market tends to pick up," said Mr Sherwin. "UK consumers are willing and able to purchase and we aren't seeing a let-up in the financial deals being offered from manufacturers." In fact, the IC understands that car retailers will see more generous financing deals coming from Ford this year, whose Fiesta is one of the top selling cars in the UK, while Vauxhall has volume problems and expensive factories to run, so it too needs to get rid of its cars.

If anything, the biggest risk this year isn't a lack of product, it's that the targets set by manufacturers will be so high that retailers will have to sell aggressively in the marketplace to meet those thresholds. This leads to discounting and squeezed margins. Given that margins on new cars are already the lowest part of any car retail business, heavy pricing could dent profits.

However, in an industry where it's all about volume and scale, the potential for higher pricing pressure means the big guys, which includes all of the listed retailers in the sector, will win out and have more opportunities to snap up smaller dealerships. "Market dynamics mean efficient motor retailers will talk about having a good year in 2013, while the worst will have had a bad year and these guys are ripe for acquisition," said Mr Sherwin.

The other reason to believe the outlook is rosy is fuel efficiency. Demand for alternatively-fuelled vehicles that go easier on the juice jumped by a quarter in January. And more of us are being lured by models that are typically 27 per cent more efficient than a seven-year-old motor. Add to that five years of deflation in new car prices, and for penny-pinching customers buying a new car is a no brainer: they save money on fuel, get a car at lower or equal cost and will usually pay less for insurance.

This year, the SMMT expects the UK new car market to stabilise with "more moderate growth of around 1 per cent". This sounds low, but it's actually a more sustainable long-term rate. What's more, there are signs that the surge in new car sales seen over the past two years is finally starting to filter through into increased aftersales. These account for a massive chunk of car retailers' total profits and because they are much higher margin, a small increase in sales results in a big rise in profit.

Pendragon (PDG) recently reported that its aftersales were at a turning point, while Lookers (LOOK) believes the business, which was flat at the half-year stage in August, will tick up soon. Vertu Motors (VTU) has already had great success here. In October, it reported that like-for-like aftersales, which accounted for roughly 40 per cent of group profit, rose 7 per cent, the strongest performance to date. This reflected higher volumes, but also the success of Vertu's customer retention strategy based around selling more service plans. Higher aftersales revenue should also mean that operational gearing revs up across the sector.

CompanyPrice (p)Market cap (£m)Net debt (cash) (£m)Forward PE ratioShare price change six months (%)
Inchcape (INCH)  612   2,792   (70) 141
Lookers (LOOK)  130   504   61144
Pendragon (PDG)  34   485   140 141
Vertu Motors (VTU)  61   204   (26) 1516
Cambria Automobiles (CAMB)  51   51   16 1563

FAVOURITES:

Cambria (CAMB), a recent buy tip (47p, 5 Dec 2013), is tightly run, has a strong balance sheet and sector-beating returns on capital from which to fund growth. Vertu Motors, meanwhile, will benefit from its acquisition strategy and it's strong aftersales division.

OUTSIDERS:

In October, we recommended taking profits on Inchcape (INCH) at 644p, which turned out to be the right call. Inchcape's strength is its vertically integrated model and geographic diversification, but global exposure has also become a weakness, as certain markets, including Russia, South Asia and Europe, are stifling growth. We remain wary of further margin pressure, too.

Pendragon's (PDG) recent results were slightly below forecasts at the trading profit level and performance at its main motor operations, Stratstone and Evans Halshaw, haven't been as strong as some industry analysts had hoped.

THE BROKER'S VIEW:

The UK motor retail industry continues to see a perfect positive storm of strong new car sales momentum, stable used car prices and a growing UK car parc, which should benefit aftersales in future years. UK economic growth is expected to improve and the new car market is still off its previous peak. While the wider European market may have troughed, a sustained recovery here is certainly not in sight.

The sector now trades on 14 times forward earnings, which although ahead of the mid-cycle average of 13, is backed with positive EPS momentum averaging 15 per cent in 2013 and forecast at 8 per cent in 2014. Sixteen months ago, it was trading on under 10 times forward earnings, so we have seen a healthy re-rating. Our blue sky analysis shows there is on average 60 per cent EPS upside to go for across the sector, with this momentum likely to be the key driver of share price outperformance.

In our view, car retailers will have another bumper year. We believe the sub-sector should deliver growth in most quarters in 2014 given the strong market conditions. The re-rating has been backed with consistent earnings upgrades and return on capital employed improvements, too. We believe all companies are well poised for further upgrades during 2014. Vertu (Buy, target price 77p) should make considerable EPS progress this year as it re-invests the placing proceeds, Lookers (Buy, TP 147p) should be a source of reliable upgrades, and Inchcape (Buy, TP 675p) is a key beneficiary of Japanese Yen weakness. We have initiated coverage on Cambria Automobiles (Buy, TP 61p), while Pendragon (Hold, TP 35p) remains our least preferred stock in the sector. Forecasts are well set for this year, with more consolidation likely driving further earnings upside.

Mike Allen is an analyst at Panmure Gordon