Will Aston Martin's IPO put investors in the fast lane?

The business

The company makes luxury cars with an average selling price of around £150,000. Its target customers are the growing number of very rich people around the world (high-net-worth individuals are defined as people with investable assets – excluding their home residence – of more than $1m).

The nature of its business and the cost of its products means that it is operating in a small market. It faces strong competition from other luxury and performance car manufacturers, including Ferrari (US:RACE), McLaren, Rolls-Royce, Lamborghini and Bentley.

Aston Martin’s core products are its DB11 grand tourer, the Vantage sports car and the Rapide S sports coupe. These models will be complemented with the launch of new ones, such as the DBS Superleggera sports coupe, the Valkyrie hyper car (in 2019), an electric RapidE and the DBX sports utility vehicle (SUV).

Each car model has a seven-year life cycle before it is refreshed or replaced. The cars are made in Gaydon in Warwickshire, with a new plant in South Wales due to start production in 2020.

Is Aston Martin a good business?

Its cars have a reputation for being high-quality. This doesn’t necessarily mean that the business can produce the kind of financial performance that will keep investors in its shares happy and make them richer over the long run.

Aston Martin has a chequered history and has been declared bankrupt several times, and was losing money as recently as 2015. However, since implementing a new business plan in 2015, the company is currently achieving a respectable level of profitability with the ambition of improving further.

Profit margins and return on capital employed (ROCE) are now at reasonable levels, but are not yet representative of an outstanding business in my opinion. To be fair to the company, an increasing chunk of its capital employed has been invested in development projects and new plant in recent years and is not yet producing meaningful profits, which depresses its ROCE.

However, as with many businesses you often get a better idea of what’s going on by looking at the cash flows. A closer look at Aston Martin’s cash flows reveals lots of interesting things.

As profitability has improved, so too has its trading or operating cash flow. Yet a big chunk of trading cash flow improvement in 2017 came from customers paying deposits to secure upcoming new models. This flatters operating cash flow as cash is received by the business before any profits are earned.

Even with this benefit, free cash flow (FCF) is barely positive due to heavy investment in new models and the new plant in South Wales. During the last year, the company has ploughed back more than its operating cash flow back into its business and debts have increased as a result.

A key issue to be aware of is that Aston Martin capitalises the majority of its research and development (R&D) spending on its car models. What this means in practice is that most of the money spent goes on to its balance sheet rather than as an expense, which reduces profits. This is allowed under accounting standards and there is usually nothing wrong with doing this. In the case of Aston Martin, it can explain big differences between its profits and its free cash flows.

The table shows the difference between the cash spent on R&D and how much of it was expensed and amortised (spreading the cost over its useful life) in the income statement. You can see that the differences have been quite big and would have resulted in overall losses if the money had been expensed in full. If you are thinking of investing in Aston Martin shares then you must be confident that the cash invested will produce a decent cash return in the future. More on this shortly.

You will also notice that Aston Martin has a lot of debt. Its net debt to Ebitda (earnings before interest, tax, depreciation and amortisation) ratio – a measure of a company’s ability to cope with its debt load – is quite high at 3.9 times. Anything more than three times for a non-financial or non-utility company is getting uncomfortable. This is a key risk for investors and the company will be under pressure to reduce its debt by generating lots of free cash flow from its new car models. This is because the proceeds raised from its stock market flotation are probably going to the selling shareholders and not to the company.

Even though Aston Martin’s profitability has been improving, it is still a long way from matching its rival Ferrari’s, which is more profitable and has considerably less debt. This is something to consider when working out what might be a reasonable valuation for Aston Martin’s shares.

Where is the profit growth going to come from?

The company has set out an ambitious growth plan to woo investors. It is not without risks, in my opinion.

It involves making and selling a lot more cars than it does now. Production is expected to go from 6,200-6,400 cars in 2018 to 7,100-7,300 cars in 2019 and 9,600-9,800 cars in 2020. Further out, it wants to eventually get to selling 14,000 cars a year and achieving a trading profit margin (by this I mean Ebit or operating profit and not Ebitda margins) of more than 20 per cent.

Given that margins are expected to be around 13 per cent for 2018, this ambition has all the right ingredients to come up with a very bullish outlook for the business in an attempt to secure a very high valuation for the selling shareholders.

Achieving this goal will not be easy. One of the key disciplines of luxury car manufacturing is not to make too many cars. A feeling of exclusivity is what makes the brand desirable to owners and potential customers, which can easily be lost if there are perceived to be too many of them on the road.

Aston Martin knows this and has cited an optimal production level on its core brands (DB11, Vantage etc) of 7,000 per year. The growth on top of that figure is expected to come from new passenger models and SUVs.

To give it the ability to grow, the company has been increasing its production capacity. This, in turn, brings with it an increase in fixed overheads that need to be paid for. Growing capacity will increase the operational gearing of the business (the sensitivity of profits to changes in sales) in what has historically been an industry where ups and downs in demand are quite common. This is quite risky to say the least.

The manufacturing plants need to be kept busy to make good profits and returns on the money invested in them. If they are not then this task becomes much harder and profits can fall substantially. The key to the success or otherwise of this new capacity will rest heavily on Aston Martin’s ability to sell in new markets where it has not done so before – particularly SUVs.

So, in order to grow, Aston Martin is arguably increasing its business risk. When combined with the current high levels of debt and financial risk, any potential shareholder needs to be aware of this. I think it is a risk that should be factored in to the valuation of the business.

Another issue to consider is whether Aston Martin has been too reliant on price increases to increase profitability in recent years. Between 2007 and 2017 it increased the average price of its core models by 114 per cent. The changes in the past couple of years are shown in the table below.

It's not unreasonable to ask how much more scope there is to keep on doing this. Beyond a certain point the line between something that is reassuringly expensive and something that is too expensive will be breached. This is before the response of competitors is taken into account.

The right valuation for Aston Martin shares

Many newspapers have been talking about a price tag that values Aston Martin as highly as £5bn. Based on my rough and ready valuation approach I’d say that looks to be very punchy, but stranger things have happened in stock markets.

Because companies have different tax rates and different levels of debt, valuing them on the basis of comparing price/earnings (PE) ratios (which is based on after-interest and after-tax profits) makes valuation – which is a subjective exercise in itself – much more prone to inaccuracies.

I’ve always found it better to estimate a value for the company’s trading profits (often referred to as earnings before interest and tax or Ebit) or enterprise value (EV) as a better method as it gets around the problem with using PEs. Once you have an EV, you then take away the value of debts and pension liabilities to get an estimate of a company’s equity value.

Most people looking to value Aston Martin will look at the value of Ferrari NV, which is quoted on the US stock market. Ferrari has been performing very well and its shares are highly valued at 26.5 times its current trailing 12-month (TTM) trading profits. Applying the same multiple to Aston Martin gives an EV of £3.5bn and an implied equity valuation of £2.7bn. This is a long way short of what has been touted in the financial press.

In fact, there are good grounds for arguing that Aston Martin is not as good a business as Ferrari due to its inferior profitability. This would warrant a reasonable valuation discount for Aston Martin.

The wrong type of IPO?

Call me old fashioned, but for me, the whole purpose of the stock market is for companies to raise money from investors to grow their business and provide shareholders with a decent return on their money. This IPO is not doing this. No money is being raised for investment. It is being used as a way for the selling shareholders to cash in their investment.

At the right price tag, Aston Martin could be a very interesting and good investment, but it still has much to prove – even more so if the shares are priced expensively.