The share price action is certainly at odds with the operational performance of the company. Indeed, in yesterday's full-year results to end-February 2016, the company lifted adjusted EPS by a quarter to a record 6.46p and beat expectations of analyst Mike Allen at house broker Zeus Capital by around 4 per cent. As I had noted when I updated the investment case at the time of the pre-close trading update ('Lowly rated car dealers motoring back', 7 March 2016), improvements in the recently acquired businesses are helping to drive gross margin, revenue and profits, as is an impressive performance from the used car segment and single-digit underlying growth in new car retail volumes.
The company is an impressive cash generator, too, so much so that net funds ended the financial year up by almost half to £23.1m, a sum worth 10 per cent of the current market capitalisation of £238m, even though Vertu invested £45.3m in acquisitions of businesses, new dealerships, refurbishments projects and IT capital expenditure in the 12-month period. Operating cash flow of £65.8m was more than twice operating profit of £28.6m, albeit this was aided by an inflow of £30.5m from working capital movements.
Since the year-end, the company has spent £28m on acquisitions, and raised £35m in a placing at 62.5p a share at the end of March 2016 to fund further bolt-on deals, so pro forma net funds is around £30m, a sum worth 7.5p a share. Vertu also refinanced some of its debt facilities, so has ample headroom to meet its working capital needs and flexibility to tap credit facilities to fund further bolt-on deals.
I would also flag up that excluding the freehold properties acquired with the Mercedes Benz dealerships in March, all of which are located in attractive motor retail locations in the Thames Valley - Reading, Ascot and Slough. Vertu has freehold and leasehold property worth £150m on its balance sheet equating to 37p a share, or 63 per cent of its market capitalisation. In other words, cash and property alone account for around 76 per cent of the current share price. That's very solid backing. In fact, the shares are being priced on just a 2 per cent premium to book value after accounting for the share placing, a miserly rating considering the property and cash holdings, and on eight times cash adjusted earnings for the new financial year. That's a thumping discount to the UK general retail sector average and is in my opinion largely down to the increased perceived risk caused by the forthcoming EU Referendum and potential of a UK economic slowdown, Brexit or no Brexit.
That said, there is marked difference between the behaviour of consumers buying cars from Vertu's network of 127 dealerships in the UK and the ultra cautious approach being adopted by investors. Indeed, there were 519,000 new car registrations during the key registration plate change month of March, the highest level since the new plate system changed in 1999. Moreover, if Brexit is causing uncertainty then it certainly didn't show up in April's sales figures when Vertu enjoyed stable new retail volumes. It hasn't shown up in used car buying activity either, as the company's like-for-like retail volumes are up almost 6 per cent since the February year-end with stronger margins, too, which have led to "a significant increase in year-on-year profitability".
Profits set to continue moving forward
This upbeat trading performance, combined with the benefits of a raft of acquisitions made in the past 12 months, explains why analyst Mike Allen at Zeus predicts that Vertu's revenues will rise by around 12.5 per cent to £2.7bn in the 12 months to end-February 2017 to lift pre-tax profit by 11 per cent to £31m. I would point out that Vertu has a record of outperforming forecasts, a testament to the ability of its management team to source bolt-on acquisitions and drive operational improvements. And, of course, it has a cash-rich balance sheet to deploy on further acquisitions which will help keep profits motoring ahead. Mr Allen believes the company is in a strong position to drive EPS to 8p once it deploys its capital. I would not disagree with this prediction.
Shareholders can also expect a continuation of what is a very progressive dividend policy. The payout last year was raised by 24 per cent to 1.3p a share and analysts are pencilling in a dividend of 1.4p in the current year.
The bottom line is that even after factoring in the dilutive impact of the new shares in issue from the placing in March, and ignoring the distinct possibility that Vertu will deploy these funds on further bolt-on acquisitions to drive EPS higher, a cash adjusted PE ratio of eight is too low. In fact, and as was the case with Aim-traded Cambria Automobiles which reported results earlier this week ('Priced to motor', 10 May 2016), I feel that the risk premium embedded in the current valuation is simply too high given that I feel that the UK will vote to stay in the EU next month. If I am right then it's only reasonable to expect shares in all the car dealers to motor ahead as this risk premium unwinds at the end of June.
On a bid-offer spread of 58.5p to 58.25p, valuing the equity at £238m, I rate Vertu's shares a buy and have a fair value target range of 85p to 90p. Buy.
