UK Auto Dealerships
head to head!
Part 2!
By Manuel Maurício
May 28, 2021
Last week I began doing a comparison between 4 of the most important auto-dealerships in the UK.
Let me warn you that this write-up is heavily focused on financial metrics and accounting intricacies, so it might not be as enjoyable as others for novice investors.
We’ve already seen that the auto-dealership businesses all have thin margins which are, in great part, controlled by the OEM’s (Original Equipment Manufacturers – Think VW, Fiat, etc).
So if the margins are dictated by the suppliers, how can these companies differentiate themselves and produce better returns on capital? Well, one way to do it is to move up the quality ladder and sell higher priced cars. That way, even with the same margin in percentage terms, they’ll end up earning more money.
What else? Another way of improving their returns is by selling more cars – turning their inventory faster. This is pretty obvious right? If you sell more, you get more money.
That’s why the inventory turnover is one of THE metrics to look at in this industry.
At first, I was expecting Cambria to have lower inventory turnover for the simple fact that it sells higher ticket items (it’s easier to sell a Ford Focus than a Lamborghini), but that doesn’t verify.
Not only Cambria has the higher margins of the group, it also has the higher inventory turnover at 5.7x.
The management is laser focused on inventory turns. They call it the “velocity trading”. Right now, the industry average is 4.5x and Cambria wants to go from 5.7x to 18x!!!!
“Why 18?” you might ask? Because they actually calculate it the other way around. Instead of thinking of how many times they can turn their inventory, they think of how long that inventory sits on their floor.
So if Cambria currently turns its inventory 5.7 times, that means that it holds its inventory, on average, for 64 days (divide 365 by 5.7) whereas Vertu holds it for 81 days. Looked at it in this way, I believe, makes it easier to grasp the huge difference. So when Cambria says that it wants to turn its inventory 18 times in a year, they’re actually thinking to take its Inventory Days from 64 to 20 days!!!
I doubt that’s possible, but it’s good to have lofty goals.
I suspect that the size of each location and consequent capacity to hold inventory – 150 cars on average per location for Cambria vs 350 for Vertu – influences in some way the inventory turns, but I can’t confirm that at this point.
Then there are two other efficiency ratios to bear in mind: The Receivables Days (how long it takes to collect from its customers after a sale is made) and the Payables Days (how long it takes to pay to its suppliers).
Here, again, Cambria is the better of the four. It collects after 4 days while the other three range from 5 days for Vertu and 10 days for Lookers.
What about the time it takes to pay to the suppliers? My first thoughts were that the bigger the company, the higher the bargaining power.
And as we can see, Pendragon, which is the biggest of the four, takes 102 days, on average, to pay to its suppliers whereas the other three take anywhere in between 85 and 88 days (the higher the better).
This gives me mixed information and I don’t really know what to make of it. If size mattered, we would be seeing Cambria having to pay its suppliers earlier than Vertu or Lookers, and that hasn’t been the case.
Which one has the highers Return on Invested Capital?
Ok, so why on earth am I explaining all of these metrics? Well, first because I think they’re important and I like these intricacies (a bit of a nerd, I know). Then, because these are the building blocks needed to construct the Return-on-Invested-Capital.
After calculating all of them – and it was no small feat, especially the Days Payable Outstanding, since the four companies report their numbers in different ways – everything led me to believe that Cambria had the higher Return-on-Invested-Capital: Higher margins, lower inventory needs, collecting first, and paying later (Pendragon won on this one, but…).
But the truth is that, for the years of 2017, 2018, and 2019, Vertu got the better Return on Invested Capital. I was pissed. How come? Every metric led to Cambria, not Vertu.
“What else goes into my calculation of ROIC?” I thought! Humm, the Property, Plant & Equipment (land and buildings). I went looking.
In the most recent years, Vertu has been able to get better returns on its Property, Plant & Equipment. “Why is that?”, you may ask my young Padawan.
That’s because – in recent years – Cambria has been investing heavily in new locations which have not yet matured (they have to sell cars to gain Aftersales business), leading to a lower return on capital because there’s more capital tied up in locations that are earning less money.
If we zoom out and compare Cambria to Vertu over the years, it becomes clear that Cambria has been the best business in all but the last couple of years (and 2009).
For me, Cambria wins the Return-on-Invested-Capital fight!
*By the way, in case you were wondering, here’s how I calculate the ROIC:
Return on Invested Capital = Inventory + Receivables + Property Plant & Equipment – Trade Payables.
Which one has the strongest Balance Sheet?
Turning now to the balance sheet, there’s a long winded discussion amongst investors about what should be considered debt for car dealerships. You see, most dealers will “buy” the cars from the manufacturers, but they’ll have around 90 days to pay for them. After those 90 days are due the dealers will start paying interest (of around 6%). After 180 days, they’ll have to buy the car outright.
Most dealers account for that consignment liability under the “Trade Payables” line, not under “Short term debt”.
On top of this, the dealers will also contract debt to buy used cars. These loans are called “Stocking Loans”.
Depending on which dealership you’re looking at, you’ll see a different mix of both.
I’ve talked to the industry expert Mike Allen of Zeus Capital and he gave me many great insights into the industry. Thanks Mike! But one thing left me thinking. He mentioned something like “Cambria prides itself of not having issued any shares since the IPO, but they’ve been funding themselves through this undercover debt, while Vertu hasn’t“.
That was interesting. I went checking.
In calculating the debt ratios for these companies, analysts don’t usually include the consignment liability (for new cars) nor the stocking loans (for used cars). But I wanted to check if what Mike told me was true.
It turns out that it wasn’t. When we factor it all in, Cambria has the lower Debt/Equity profile of the four.
Truth be told, Mike could’ve been talking about just the Stocking Loans (for used cars) because those are indeed interest-bearing whereas the consignment liability may or may not bear interest. Under that light, Mike was right. Vertu has the most conservative balance sheet.
What about the ability to pay for the interest?
Both Cambria and Vertu are able to cover their interest obligations 13 and 12 times over. They could obviously handle more debt.
With an Interest Coverage Ratio of 3x and 2x, if I were a shareholder of Lookers or Pendragon, I would be worried about their ability to service debt.
Let’s do a quick stress test to the balance sheet and say that the volumes will go down by as much as they did on the Great Financial Crisis.: new cars -17% and used cars -11%. I don’t have data on the Aftersales drop, but let’s say that it will go down by -5% as it’s the most resilient segment.
Gross margins will stay flat as they’re totally variable and the operating costs will also stay flat as they’re mostly fixed. Even in this scenario, Cambria would be able to cover its interest obligations more than 5 times. That’s pretty good. Again, these companies have too much availability on their balance sheets.
Now, I know what you’re thinking. I’m not accounting for the added interest expense that would come from the cars that couldn’t be sold. And that’s true, but I don’t have enough data today to re-create such scenario. And I don’t think I need to as the business model will probably be changing in the next few years. We’ll get to that in a minute.
And what about Capital Allocation?
Let’s talk about capital allocation. I won’t be talking about Lookers and Pendragon as at this point I kind of lost interest in them.
The first thing I’ll want to be doing is to check if these two companies have grown by issuing shares or by taking on debt. I might’ve spoiled the surprise back there, but let’s look at the charts.
Cambria hasn’t issued a single share since the IPO…
Whereas Vertu was issuing shares up until 2016, and buying them back ever since.
This happens because Vertu didn’t want to use debt to grow and opted for equity to fund itself. Vertu grows by acquiring under-performing dealerships and turning them around, much like Cambria did before it turned to the luxury segment.
I would argue that in our day and age, where the interest rates are so low, Vertu’s CEO made the wrong choice up until 2016. From then on, he seems to have done it right. In fact he could’ve increased the debt to buy back its own shares. That would be a major tell sign of a great capital allocator.
There’s a lot more that could be said about the different capital allocation decisions for these two companies, but I will just leave you with the price charts for both and let you decide which one has been the best.
Here’s Cambria going from £0.60 to £0.81…
And here’s Vertu going from £0.7 to £0.42. Ouch!
Agency
But things are changing in the auto-dealership industry and all of these might not matter as much in a few years.
I’ve been explaining the traditional way that cars get sold. Dealers buy the land and build the building, they order the cars from the manufacturer, they get them for 90 days interest free credit, and then they sell them at low margins. By the way, the reason why they own the land and the building is to use them as collateral so the OEM’s can give them the cars on consignment.
But along comes a guy named Elon Musk. If you don’t know who he is, you haven’t been living on this planet for the past, what, 5 years? Elon Musk is the famous founder of Tesla. And always the rule-breaker and the industry disruptor, he asked himself why on earth does Tesla need the car dealerships when it can sell its cars online?
Tesla still needs the dealerships, but it needs fewer of them and, I suppose, needs less cars in each of them. It just needs to have a few test-driving models.
This way Tesla can collect all the data from its customers. It can control the distribution and own the customer.
And what did the other car manufacturers do? Nothing at firs, but they’re following Tesla’s steps now. They don’t want to get left behind. Stellantis and Volkswagen have already announced that they’ll shift to an Agency Model.
That means that the car dealers – instead of buying the car and being responsible for selling it or else buy it themselves – will become a pure service provider for the OEM’s.
The exact details of how it will work aren’t known yet, but some changes are already apparent.
First of all, the dealers will get a fee for each car sold which will probably be lower than what they get today because they won’t bear the risk of having an unsold car on their floor – this is called the residual value risk.
For the used cars and the Aftersales, I still don’t know how it will affect them, and I don’t think anyone does yet. Stellantis and VW (on a leaked memo) both announced that they’ll cancel all of their contracts with the dealerships immediately and will design new contracts from scratch.
A few years back, Warren Buffett bought the Van Tuyl group, the fifth largest auto-dealership retailer in the US: At the time he mentioned that as long as it’s a big-ticket item, people will want to negotiate. I believe Elon Musk has proven him wrong.
People will want to negotiate if they know that they can get a better price, but if the OEM’s control the price making it irrelevant if you’re buying a new VW Golf in London or Cambridge, you’ll probably buy it online. I’m not sure if the same will happen with used cars, but this is a big shift in how the industry works.
This new Agency Model may change things drastically for dealerships. I think it’s apparent that they won’t need so many locations as people get better at finding the information they need online without having to visit the dealership (think Youtube).
Buffett also talked about the lack of economies of scale for these businesses. My research of the past financial metrics led me to conclude the same. But what Tesla has shown us is that it scale is needed to set up and maintain the software as well as the call centers handling the huge number of incoming calls.
If there weren’t any economies of scale previously, with the agency model that might be changing. Humm… thinking a bit more about it, it’s going to be the OEM’s that will need to bear those cost, not the dealers so…
I’ve expanded on this subject on the latest episode of Ações & Companhia that will air tomorrow. If you want to learn more, check it out.
“The dealer no longer has to finance vehicles in advance. We also bear inventory cost and the costs associated with showroom vehicles. We are offering dealers an extremely attractive leasing concept for demonstration vehicles.” Volkswagen leaked memo
Valuation
For companies such as these, where their earnings power is directly correlated to their assets, I like to look at the equity and the return on equity.
At £0,8 share price, Cambria is trading at book-value and getting 17% return on it.
This means that, without taking into account any multiple expansion (or contraction), and if the company reinvests all of the profits back into the business at similar rates of return, investors should expect a return on the stock of about the same 17%.
But the company has been paying 10% of those profits as dividends so only 90% get reinvested back into the business. That would lead to a CAGR of around 12% to 14% for the next three years (in the long term it would approximate to 15%).
Now, the company is trading at 5,8x earnings. That’s cheap. If it re-rates to 8x we could be seeing an annualized return of 25%. And I’m not even considering the fact that there’s all that real estate that can be monetized nor am I considering the likelihood of the CEO increasing its take-out price.
A word about the real estate. I’ve previously said that the management could do a sale-and-leaseback deal to unlock its value, but after realizing that the consignment liability is secured on that real estate, I’m not so sure about that anymore. On the other hand, the agency model would allow to “free up” that real estate as the OEM’s would be the ones bearing the residual value risk. Interesting.
What about Vertu?
Well Vertu has a book value of £256 million and it’s trading for £156 million. That’s a Price/Book of 0.6x. Clearly Mr. Market believes that Vertu is worth more dead than alive.
Vertu is ridiculously cheap on a Price/Book perspective, but the reality is that its return on equity has been 6% for the past 3 years against the 17% for Cambria and Cambria’s management team is undoubtedly better. Either way, maybe I should consider owning Vertu as well.
Conclusion
The conclusion is that over these past two weeks I’ve been having a thrill learning about this industry and I will keep my ownership of Cambria even with the high uncertainty going forward. I believe that the business is worth a lot more and that’s what investing is. In the meantime, we could be seeing the share price go down a lot if the CEO withdraws his offer. I’m prepared for that, although I would obviously prefer if he were to increase his offering price to, say… £100?
DISCLAIMER
The material contained on this web-page is intended for informational purposes only and is neither an offer nor a recommendation to buy or sell any security. We disclaim any liability for loss, damage, cost or other expense which you might incur as a result of any information provided on this website. Always consult with a registered investment advisor or licensed stockbroker before investing. Please read All in Stock full Disclaimer.