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Morningstar | Strong Exports Drive ARB's Solid Fiscal 2018 Performance; FVE Increased to AUD 15. See Updated Analyst Note from 22 Aug 2018

Fiscal 2018 was another solid year for ARB, which reported underlying net profit of AUD 54 million (excluding an underprovision for tax in prior years), a 10% increase on the prior year. While this was in line with our expectations, we have increased our fair value estimate by AUD 0.50 to AUD 15 per share to reflect slightly stronger offshore growth. Despite raising our fair value estimate, the stock is expensive at the current price. We project 10% annual EPS growth on average during the next five years, compared with 3% generated on average during the past three years. The board declared a fully franked final dividend of AUD 19.5 cents per share, bringing total dividends for the year to AUD 37 cents per share, fully franked, equivalent to around 55% of underlying earnings.

Revenue was strong during the year, growing 12%, with solid performance in each region. The main driver of sales growth was the core Australian market, which distributes to ARB stores, auto dealers, and fleet operators. Locally, sales grew 11% and exceeded our expectations, underpinned by new store openings, new product releases, and market share gains. The Australian aftermarket accounts for around two thirds of group sales, marginally higher than in fiscal 2017. This level of growth is unsustainable in the mature local market, especially given our weakening outlook for the mining sector and Western Australia economy. We estimate the market grows at around 3%-4% per year, reflecting annual growth in in four-wheel drive sales, and we expect ARB can increase local revenue around 6% on average in the near term, with continued new product releases and further share gains. We expect domestic EBIT margins to remain flat at around 20%. During the past decade, domestic revenue and EBIT have grown at the same pace; we attribute this to relatively low operating leverage and large exposure to inputs costs including steel, which the firm generally passes through to customers.

Exports are likely to be the main growth driver for the foreseeable, and we expect offshore earnings to double over the next decade, reaching 20% of group earnings. During fiscal 2018, exports grew 15% and now represent approximately 28% of group sales. With the Reserve Bank of Australia firmly on hold, the subdued Australian dollar should provide a tailwind for continued growth in exports. Despite this strong growth, exports still generate less than 10% of group earnings as a result of their significantly lower operating margins; this has been relatively steady for the past decade. Management is targeting exports to increase to 50% of sales, which we estimate will take at least a decade to achieve, despite our expectations for around 15% annual growth. In any case, ARB does not possess the same brand equity and pricing power offshore as in the core domestic market, where it is the leading name in 4WD accessories. We expect offshore aggregate EBIT margin will double to 16% within the next decade, albeit below the 20% generated in the core domestic market.

Despite net cash decreasing to AUD 5 million from AUD 28 million, the balance sheet remains in pristine condition. The reduced cash balance was mainly an outcome of lower free cash flow, which fell to AUD 3 million from AUD 40 million due to the major investment in the Thailand and Victoria warehouses as well as the opening of two new stores and the rollout of a new store format. An additional AUD 20 million in inventories also dragged on free cash flow, although this should help accommodate sales growth in future years. Strong cash conversion and reduced capital expenditure will further fortify the balance sheet, and we are confident ARB can sustain a dividend payout ratio of around 60% of underlying earnings for the foreseeable future.