EUR 850.00 For Business Accounts Only

Morningstar | We Initiate Coverage on AP Eagers

We initiate coverage on narrow-moat-rated AP Eagers, the second-largest Australian listed automotive dealership, at a fair value estimate of AUD 9.00 per share. This valuation reflects our expectation the firm will successfully acquire market leader Automotive Holdings (it already holds 28.8%), with the combined entity proposed to be renamed to Eagers Automotive Holdings. Our fair value estimate incorporates standalone AP Eagers, and Automotive Holdings' valuation of AUD 7.50, and AUD 2.60 per share respectively. In addition, we value the synergies at approximately AUD 0.60 per AP Eagers share. At the current price, AP Eagers is slightly undervalued relative to our valuation. In the event the merger falls through, our fair values would revert to the standalone values above.

The near-term outlook for new vehicle sales remains challenging, although we forecast this to improve over the long term. The declining residential property market, and consequential negative wealth effect will remain a headwind for at least the next 12 months. Upon completion of the merger, the combined entity will operate a much more geographically diverse business. AP Eagers’ operations are skewed to the Australian east coast, whereas Automotive Holdings is heavily exposed to Western Australia which has endured a multiyear house price correction.

While the recent lull in new vehicle sales has a modest impact on the vehicle fleet composition, we believe this will be temporary. We don't envisage any major change in long-term vehicle ownership rates, number of vehicles sold per capita, or the average vehicle age. We expect consumers to extend the life of their vehicle during the current challenging times, but at some point these vehicles will need to be replaced. Hence, we expect an acceleration of vehicle sales in the outer years of our explicit forecast. Over the long run, this translates to around 1%-2% growth in the number of new vehicles sold per year, in line with population growth.

Over the next few years the company should recover some of the margin recently lost due to the ASIC reform on finance commissions, through less discounting on vehicle sales and lower trade in prices. Accordingly, we forecast AP Eagers’ gross margins to improve by 50 basis points to 17% over the next five years. EBITDA margins should grow slightly faster at around 100 basis points, supported by operating leverage and scale benefits as the firm grows its market share and revenue. Management estimates pretax cost synergies or the proposed merger with Automotive Holdings at AUD 13.5 million per year, and we believe these are achievable by removing duplicated costs across the merged entity, including head office, board, senior executive and technology costs.

We assign AP Eagers a narrow economic moat rating. Despite operating in highly fragmented markets, the company boasts several competitive advantages--namely, its cost advantage and intangible assets. The core automotive division, which generates the majority of group EBITDA, is Australia's second-largest automotive retailing business. The firm boasts an estimated market share of around 5% (as at fiscal 2018 year-end), trailing behind narrow-moat-rated Automotive Holdings with an approximate 7% share. The size and scale of this business underpins its cost advantage and permits it to earn margins above its smaller peers, and broadly line with its main rival Automotive holdings. As one of the largest dealers in the market, AP Eagers can centralise back-office operations, and amortise these fixed costs over a significantly larger volume and revenue base. Within the automotive division, we believe the parts and service operations are a vital source of competitive advantage. The warranty log books of new cars give larger dealerships an intangible advantage over smaller standalone dealerships, as well as independent parts and smaller service providers. This intangible asset allows dealers to charge a premium for vehicle servicing, with the hourly labour charge anywhere upwards of 50% more than an independent workshop.