What next for car dealership shares?

UK quoted car dealerships' price performance and valuation

Source: SharePad

It is very easy to dismiss car dealerships as cyclical businesses with poor long-term profitability. For quality investors such as myself, I could never see them becoming a core part of a long-term share portfolio.

However, as I have been saying for some time, I see large global quality shares as an increasingly crowded – an expensive – trade that brings with it a lot of risks. There are signs that value might just be making a comeback in recent weeks as shown by the recent takeover of brewer and pub company Greene King (GNK).

But are car dealerships value investments or value traps – companies that are cheaply valued because they deserve to be? At the moment, the sector seems to be facing up to lots of threats while opportunities to prosper seem scarce.

How car dealerships make money

Revenues and profits come from four main sources:

• Selling new cars.
• Selling used cars.
• Aftermarket services such as car servicing and repairs.
• Commissions from selling credit and insurance products.

Selling new cars tends not to be that profitable an activity, but it is at the heart of the dealership’s ecosystem. New cars eventually become used cars and all cars need servicing and repairs from time to time. What’s going on with the new car market is therefore very important.

UK car dealerships: trailing 12-month split of gross profits

Source: Company reports

In terms of profitability, we can see that new and used cars account for roughly 60 per cent of a car dealership’s gross profits where profit margins are similar. The profits made from aftermarket sales are much more significant and are very lucrative. Motorpoint makes most of its profits from the sale of nearly new, used cars.

The UK new car market

Up until a couple of years ago the market was booming. The key driver of it has been easy credit in the form of personal contract plans (PCPs) where consumers rent rather than buy a car. They had typically been signing up to three-year PCPs where they paid the depreciation on the car plus interest. The monthly payments were reduced by any money they put in up-front in the form of a deposit.

A lot has been written about the growth in PCPs, which account for around nine out of 10 new cars bought today compared with just over a third in 2008. The Financial Conduct Authority (FCA) has been sufficiently concerned about the surge in this credit that it has thoroughly reviewed the market and concluded that it is not yet a threat to financial stability in the UK economy.

They are also not a threat to the financial health of car dealers as they are not lending any money. This is being done by the financial arms of the big car manufacturers. The hit to the car dealers is essentially limited to lower commissions if this market falls out of bed.

What is more worrying is that the new car market looks very much like a debt binge by consumers, which will not last forever.

The Finance and Lease Association (FLA) publishes monthly information on the car finance market and it currently makes for alarming reading.

Cars bought on finance by retail consumers through UK dealerships

Sources: FLA, Investors Chronicle

Despite the actual volumes of new cars bought on credit peaking in 2016, the amount of money lent against them continues to increase. It is currently running at £19.3bn – more than double the amount lent in 2012. The average amount lent per car is over £20,000, which is 44 per cent higher than in 2012. 

Some of this will be explained by price inflation of the cars bought, but against a backdrop of almost stagnant wage inflation – until recently – it still shows in my view that consumers are prepared to borrow significant amounts of money to drive a new car.

A similar trend is being seen in used cars, where the amount of credit and credit per car has increased. Be in no doubt that both the new and used car markets are driven by access to ever-increasing amounts of debt and that is not a healthy backdrop. More than £37bn has been lent in the year to June 2019, up from £16.6bn in 2012.

There are now increasing signs that consumers are finding it more difficult to finance PCPs and this is affecting the demand for new cars.

The main cost of a PCP is depreciation. This is the difference between the new car price and its value at the end of the contract – its residual value. The boom in new cars from 2013 onwards has seen PCPs increasing the supply of used cars three years later and this has been pushing down residual values in recent times.

The fall of residual values increases depreciation and the cost of new PCPs. It also means that there is usually no equity left in the car at the end of the contract (its actual value is often less than the guaranteed future value in the contract) to roll over to buy a new car. PPI windfalls from banks had been a significant source of money, but that source is drying up now.

To make PCPs more affordable, the manufacturer finance arms are having to contribute more to the initial cost, but also increasingly spread the cost over four rather than three years to keep the monthly payments affordable.

This creates a problem for car dealers as four-year PCPs mean that consumers return to their showrooms less frequently. Yet despite this, the key problem of rolling over into a new PCP at the end of a contract remains. Where is the money going to come from?

If this wasn’t bad enough. The new car market has had to cope with the demonisation of diesel vehicles and the growth of electric ones, which has undoubtedly confused consumers and perhaps led them to wait before buying a new car. Tough new real-world emission standards have also delayed the launch of new models onto the market.

Dealers have been fortunate that fleet demand had been pretty robust. But here, too, new cars bought are currently down by 1.5  per cent in the year to August 2019.

Used cars

A soggy new car market might see consumers buy used instead. Yet sales in this market are down by 1.7 per cent in the year to June 2019. However, there has been a sting in the tail in that used car supply has surged, reflecting the boom in new PCP sales three years ago. 

This has put downwards pressure on selling prices and cut the profit margins of many dealers. Cars that sit on the forecourt for too long have always burned holes in dealers’ pockets, but this seems more relevant than ever in the current market and has seen some dealers experience some painful falls in profit or warn that future profits will be lower.

This is the big cloud hanging over the sector and could be a source of future profit warnings. Eventually, the PCP-driven increases in supply will stabilise, but dealers are not out of the woods yet.

Aftermarket – servicing and repairs

This part of the market seems to be holding up well at the moment. PCPs have been good at putting servicing business through dealership workshops – as they have to be serviced regularly as a term of the contract – where profit margins have always been lucrative. 

The main issue for dealers has been having enough trained mechanics to do the work. Many are having to pay higher wages and this is eating into profit margins.

Another risk to consider is what a shrinking PCP market means for future aftersales business volumes and margins. While on a PCP, the customer will service their car through a dealership. Owners of older cars that are not on a PCP and may no longer be subject to a warranty may not do so.

There’s no doubt that consumers pay high prices for main-dealer servicing and can make significant savings by using trusted independent garages instead.

Are motor dealerships good businesses?

I think it’s fair to say that car dealerships are not producing great financial returns.

Car dealerships: key financial returns

Source: SharePad

Profit margins are wafer-thin and are expected to remain so. This is a big red flag, as in any business. Thin profit margins can quickly become non-existent if a business experiences a deterioration in trading. Pendragon (PDG) is a good recent example of this happening.

To make acceptable levels of profit, car dealerships have to sell lots of cars. The sales intensity of the business – as measured by its capital turnover or sales per £1 of capital invested – is therefore an important measure.

Unsurprisingly, Motorpoint (MOTR) scores the best on this measure as its whole business model is based on turning its stock of used cars into cash as quickly as possible.

The businesses are also poor generators of free cash flow (FCF) for their shareholders as evidenced by very low FCF margins.

On return on capital employed (ROCE) – for me the go-to measure of company financial performance – Motorpoint stands out as a company producing very decent returns, which would encourage me to take a further look at the business.

Shares to consider

This is not a sector I warm to. I do not think there is much potential to compound big increases in value in the future. However, I think Motorpoint, Marshall Motor (MMH) and Vertu Motors (VTU) could present interesting trading opportunities. Pendragon and Lookers (LOOK) still seem to have significant issues with their businesses and are best avoided in my view.

I quite like the look of Motorpoint and its business model. It is the largest independent car retailer in the UK. It sells cars up to two years old with fewer than 15,000 miles on the clock. Its strategy is to pile them high and sell them cheap while keeping its cost base lean and focusing on customer service. 

Its big range of car brands has generated significant levels of repeat business from customers and has allowed it to take a bigger slice of a difficult market. A 13th site opening in 2020 should help it continue to take share from weaker competitors.

The business seems to be very well run, with stock control and losses from stock having been well managed in recent years.

Motorpoint forecasts

Source: SharePad

That said, it is the increase in used vehicle stock that concerns me and that Motorpoint may find it harder to keep its profits growing. There is a possibility that profit forecasts are too high.

Profit forecasts for 2020 have been coming down for the past year or so. The company has already warned that falling used car prices will mean that its profits for the six months to the end of September will be lower than last year.

The fear is that price weaknesses could continue. There are still a lot of PCP cars from new sales in 2017 to come on to the market, while a soft UK economy could see consumers holding on to their cars for longer. The jump in profitability from 2020 to 2021 assumed by analysts looks quite big to me and I wouldn’t be surprised to see that revised down.

A badly managed director share sale last week has seen Motorpoint’s share price fall. At 146p, the shares on a rolling one-year forecast price/earnings ratio (PE) of 10.4 times are more expensive than its peers, but I think that is justified. The dividend looks safe and the group’s expansion plans suggest that future growth is realistic. If used car volumes and margins can hold up then the company looks to be well positioned. This is far from certain, but I think this is a company that is well suited to investors’ watchlists.

Value investors will surely be intrigued by Marshall Motor (MMH) and Vertu. Both are looking to grow by buying up car dealerships and have the financial strength to do so. Both companies’ shares are trading at very low valuations, with Vertu’s trading below the value of its net tangible assets. The company has also been buying back lots of shares while keeping a net cash balance sheet position, which looks like a good strategy.