It's also clear to me from the recent trading statements from the industry's largest car dealers that the dynamics driving the new and used car market, and which I outlined when I initiated coverage on Cambria, are highly supportive of the sector-wide earnings growth analysts are predicting this year and beyond. These factors were evident last week when Vertu Motors (VTU: 66p), an Aim-traded company with a market value of £221m and the sixth-largest car dealer in the UK, released a pre-close trading update ahead of half-year results in mid-October.
Driving new and used car sales
Cambria's revenue for the first five months of its financial year rose by almost 14 per cent and by around 5 per cent on an underlying basis after stripping out the contribution of acquisitions. In particular, the company reported a strong like-for-like order book for delivery of new vehicles to private customers in the all-important registration change month of September. This is being driven by the strong push of new cars by vehicle manufacturers into the UK and reflects the continued strength of sterling versus the euro, which is enhancing profit margins earned by the carmakers, and the positive domestic consumer and business outlook, too. Economists are predicting that the UK economy will grow annually by around 2.5 per cent this year and next.
So, unless you expect a reversal of the relative strength of both the UK economy and sterling - the euro has depreciated by 6 per cent against sterling this year, reflecting a divergence in economic growth rates between the eurozone and the UK and the monetary policy being pursued by the respective central banks - expect carmakers to continue targeting the UK market. In turn, this should prove a nice little earner for Vertu as new car sales accounted for a third of sales of £2.1bn last year and 22 per cent of gross profit of £228m.
It's also worth pointing out that with new car sales recording growth for 41 consecutive months, and the UK economy recovering strongly back to levels last seen before the 2008 financial crisis, used car prices have proved far more resilient than many experts had expected. The ongoing strength of new car registrations - 8.3m new cars have been sold in the UK since the start of 2012 - is highly supportive of part exchanges on new car sales and the supply of second-hand cars coming on to the market. Vertu, which operates 115 car franchises, achieved over 63,000 used car sales in its fiscal year to the end of February 2015, representing underlying growth of 9 per cent, and this momentum has continued into the new financial year, with used car sales up 4 per cent in the past five months.
Furthermore, I would expect this positive trend to continue. Vertu's experienced management team, led by former Reg Vardy managing director Robert Forrester, indicates that market conditions in the used car market are showing every sign of returning to the norms of a few years ago. This segment accounts for around a third of Vertu's gross profit and sales, so maintaining growth here is a key driver in boosting group profitability.
After-sales key to Vertu's growth
Another knock-on effect of the growth in new car registrations is the impact on aftersales. This segment accounts for 40 per cent of Vertu's gross profit and is hugely profitable. To put this into perspective, Vertu earned a gross profit margin of 43.5 per cent on after-market sales of £168m last financial year to earn gross profit of almost £90m compared with a 7.5 per cent margin on new car sales of £679m, which produced gross profit of £50m. The servicing and vehicle maintenance side is more stable too, helped by a push by Vertu to sell service plans on used cars.
In fact, over 30 per cent of the company's service work last fiscal year was undertaken on cars more than five years old, compared with only 25 per cent four years ago, while the number of service plans rose from less than 29,000 in 2013 to over 71,000 by March this year, and to in excess of 75,000 now. With the newer (one to three years old) vehicle parc growing, and sales of service plans on the rise, too, then prospects for after-market sales look well supported.
It's also worth noting that Vertu has been gaining market share in the highly profitable Motability vehicle market, which now accounts for over 21 per cent of its new car sales. Given the disabilities faced by these customers, this segment provides high levels of aftersales retention during customers' three-year contract period and offers potential for repeat business when leasing contracts expire. Last year, Vertu sold around 10,500 Motability vehicles.
Profits on upward trajectory
Vertu was formed in 2006 to acquire and consolidate UK motor retail businesses and its profits have been on a steady upward trajectory over the past nine years, during which time the business has become one of the largest automotive retail brands in the UK. The company now operates 22 Ford dealerships, 10 Nissan franchises, and is the largest operator of Honda dealerships in the UK. Other car manufacturers represented by the company include Jaguar, Land Rover, Fiat, Alfa Romeo and Jeep.
The acquisition strategy is worth considering because around 41 per cent of Vertu's revenue in the last financial year was derived from bolt-on acquisitions made in the past four years. So, even without making any new acquisitions, it's only reasonable to expect further profit progression as overall efficiency levels at franchises acquired are raised and the used car element builds, with a positive impact on after-market sales and profits, too.
But with the benefit of £15.7m of net cash on its balance sheet, and £103m of bank facilities in place, there is ample scope for further bolt-on deals. Vertu is also making decent progress here, having acquired its first Skoda dealership, Blacks Autos of Darlington, in the summer. The business operates from leasehold premises adjacent to Vertu's Nissan business in the town and generated pre-tax profit of £372,000 on revenue of £9.8m in 2014. The purchase price of £1.5m equated to four times pre-tax profit, so was sensibly priced. The company is also churning the tail of the estate in order to focus investment on areas generating much higher returns. Underperforming assets such as a small lossmaking Peugeot dealership in Dunfermline have been sold, and Vertu has recently exchanged contracts to sell a vacant property in Crewe for £1.1m.
It's only reasonable to expect further acquisitions as the year progresses. But even then analysts predict Vertu will increase revenue from £2.07bn to £2.25bn in the 12 months to the end of February to drive up pre-tax profit by 11 per cent to £24.5m and deliver EPS of 5.63p and a 14 per cent hike in the dividend to 1.2p. The cost of that dividend is just over £4m, or only a fifth of the £20.9m of net cash flow generated from operating activities last year, so can be easily funded.
On this basis, Vertu's shares are being priced on less than 11 times cash-adjusted earnings and offer a prospective dividend yield of 1.8 per cent. There is decent asset backing, too, with the company's shares priced only 25 per cent above book value of 52.7p, and property on the balance sheet worth 40p a share. That doesn't seem an exacting valuation for a company that has grown net assets per share by 15 per cent in the past five financial years, increased EPS by 130 per cent from 2.26p to 5.06p in the same period, and more than doubled the dividend in the past four years.
In other words, Vertu is doing something that few companies achieve: enhancing shareholder value by boosting net assets per share - a key metric I focus on - while at the same time returning some of the annual profits earned back to shareholders through a progressive dividend policy.
Risk assessment
Of course, no business is immune to risk and the most obvious one facing Vertu, and all car dealers for that matter, is the UK economic recovery going into reverse. This is a highly economically sensitive business; the rolling 12-month new registration figure bottomed at 1.8m cars in the summer of 2009 and has since surged by more than 40 per cent from those lows. Admittedly, a reversal of the UK growth story looks highly unlikely at the moment, but it's worth being aware of the cyclical nature of the motor trade.
Another risk is deterioration in used car values, which would hit margins for car dealers such as Vertu. At the end of the last financial year the company held £82m-worth of used cars in its inventories. However, industry experts seem to agree that the used car trade is returning to more normal times, and Vertu has proved it can manage inventory risk well to date.
And, of course, there is execution risk on acquisitions to deliver efficiency gains. That said, Vertu has delivered on previous bolt-on purchases and there is every reason to believe that it will pay sensible prices, and buy wisely, in the future, too. Indeed, analysts point out that the industry dynamics now favour larger dealers such as Vertu, rather than the smaller family businesses which still control over 60 per cent of the UK market. That's because the carmakers are becoming less tolerant of underperforming franchises and, after enjoying three years of benign market conditions, independent retailers are now under increasing pressure to invest substantial sums to upgrade dealership facilities. This should benefit the larger dealers such as Vertu as the industry consolidates.
Target price
Interestingly, having rallied strongly from 40p in the summer of 2013 to a closing high of 65.5p in late January 2014, Vertu's share price has been consolidating gains in the past 18 months as its operational performance plays catch-up with a rating that had factored in a steep rise in earnings. But with Vertu delivering the goods operationally - pre-tax profit rose 25 per cent to £22m in its last fiscal year - the consolidation period is now coming to an end. Indeed, the share price has been pressurising the 66p level all summer and from my lens at least it appears that the resistance level is poised to give way.
The technical indicators certainly point to a major share price breakout and one that could see the price rally to my fair value target price range of 80p to 85p, a level at which the rating would be a reasonable 13 times cash-adjusted earnings for the fiscal year to the end of February 2017 based on a further rise in pre-tax profit to £26.5m to drive up EPS to 6.1p. That valuation would be underpinned by another double-digit increase in the dividend to 1.35p a share as analysts predict. Analysts target prices are 87p (Panmure Gordon), 100p (Liberum Capital) to 107p (Zeus Capital).
So, with a chart breakout looking imminent, I feel next month's bumper set of half-year results will be the catalyst for the next leg-up in Vertu's share price. Trading on a bid-offer spread of 65.5p to 66p, it's time to bag a bargain off the stock market's forecourt. Buy.
MORE FROM SIMON THOMPSON...
I have published articles on the following companies in the past month:
■ Non-Standard Finance: Buy at 107.5p; Software Radio Technology: Buy at 27.5p, target 40p; Character: Run profits at 500p; Communisis: Hold at 50p ('Value judgments', 3 Aug 2015)
■ Fairpoint: Buy at 138p, target 190p; Creston: Run profits at 155p; Sanderson: Buy at 71p, target 80p to 85p; Renew: Buy at 340p, target 375p ('Break-outs looming', 4 Aug 2015)
■ Globo: Buy at 42.75p, target 69p; Cambria Automobiles: Run profits at 72p ('Short sellers in for shock treatment', 5 Aug 2015)
■ Cohort: Run profits at 357p, target 375p; Cineworld: Run profits at 530p; Paragon: Buy at 412p ('Acquisitive growth drives re-ratings', 6 Aug 2015)
■ PROACTIS: Buy at 93p, target 117p ('Procuring growth', 10 Aug 2015)
■ Town Centre Securities: Buy at 310p, target 350p ('Equity market watch', 11 Aug 2015)
■ Equity market strategy ('Equity market watch', 11 Aug 2015)
■ KBC Advanced Technologies: Buy at 122p, target 165p; Getech: Buy at 59p, target 80p ('Fuelled for strong growth', 12 Aug 2015)
■ Pure Wafer: Run profits at 162p, target 178p; Inland: Run profits at 71.5p, next target 80p; Macau Property Opportunities: Take profits at 189p ('Bumper cash returns', 13 Aug 2015)
■ Inspired Capital: Accept cash offer of 21.5p; Record: Buy at 40p; Pittards: Buy at 128p; Netplay TV: Buy at 9.5p ('Bargain shares updates', 17 Aug 2015)
■ Equity market strategy ('Stay calm', 25 Aug 2015)
■ Capital & Regional: Run profits at 67p; Redde: Run profits at 152.5p; Cineworld: Run profits at 578p; Cohort: Run profits at 375p; H&T: Buy at 195p; Record: Buy at 33.5p; Bioquell: Buy at 137p, target range 170p to 185p ('Running bumper profits', 27 Aug 2015)
■ Equity market strategy ('A sense of perspective', 1 Sep 2015)
■ LMS Capital: Buy at 73p ahead of tender offer; STM: Buy at 53p, target 60p; Entu: Hold at 65p ('Shareholder activism works', 2 Sep 2015)
■ Henry Boot: Buy at 235p, target 260p; Amino Technologies: Run profits at 162p, target 180p; PV Crystalox Solar: Hold at 9.5p ('Planning for success', 3 Sep 2015)
■ Simon Thompson's book Stock Picking for Profit can be purchased online at www.ypdbooks.com, or by telephoning YPDBooks on 01904 431 213 and is being sold through no other source. It is priced at £14.99, plus £2.95 postage and packaging. Simon has published an article outlining the content: 'Secrets to successful stockpicking'
