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Morningstar | Automotive Holdings' FVE Cut on Weaker Volume and Margin Pressure, but Shares Undervalued

Narrow-moat-rated Automotive Holdings is in the middle of a perfect storm, with regulatory pressure weighing on profit margins, weaker residential property prices dampening new vehicle sales volumes, and competitors behaving somewhat irrationally, in our opinion. While it is no surprise new vehicle sales are volatile from month to month, we now think the challenges weighing on volumes recently are likely to linger in the near to medium term, for a longer period than our prior expectation. Consequently, we’ve cut our fiscal earnings estimates by around 17% on average during the next five years, and we now project EPS growth of around 8% per year on average. Additionally, we’ve trimmed our fair value estimate to AUD 2.80 from AUD 3.30 per share. Despite our lower valuation, we believe the stock has been oversold and is offering an attractive yield and considerable upside at the current share price.

Automotive Holdings is experiencing the flow-on effect of the declining property prices, and the consequential negative wealth effect. Australian residential property prices have declined over the past 12 months, which we attribute to the Royal Commission, tighter lending standards, rising borrowing costs, and cyclicality. This has impacted consumer confidence, and buyers are opting to delay large discretionary purchases such as vehicles. Consequently, new vehicle sales volumes have declined by 5% per month (on average) during the past three months, compared with the prior corresponding months. Given the backdrop of falling property prices, rising borrowing costs and soft wages growth, we expect the weak volumes to linger for the next two years.

But while this weakness will impair Automotive Holding’s earnings for the medium term, we don’t expect a major change in long-term vehicle ownership rates, or the average vehicle age. The average age has been stable at 10 years for the last decade, and while during more challenging times, consumers may stretch the life of their vehicle, at some point, these vehicles will need to be replaced and we expect an acceleration of vehicle sales in the outer years of our explicit forecast. Fiscal 2019 and 2020 are likely to see the number of vehicles sold on a per capita basis drop by around 5% per year, to 42 vehicles per 1,000 by fiscal 2020 from 48 in fiscal 2018. Nonetheless, we believe this is cyclical and should rebound to around 47 vehicles by fiscal 2023, broadly in line with the long-run average (last 15 years). Over the long run, this translates to around 1%-2% growth in the number of new vehicles sold per year, broadly in line with population growth.

A key contributor of our fair value cut is a rebasing of our margin forecasts. We had previously expected margins to start improving from fiscal 2019 onwards, however, the weak volumes, negative operating leverage, and challenges recapturing the margin lost through regulatory reform are making this more challenging than we had envisaged. We now forecast automotive EBITDA margin of 2.7% during fiscal 2019, around 30 basis points below our prior estimate. While the change does not sound like much, the impact on earnings and valuation is meaningful given the low margin nature of the business

As discussed in previous notes, a meaningful portion of the company’s earnings previously came from the sale of finance and insurance products, which are highly lucrative, especially in comparison to new vehicle sales which offer little-to-no profit margin. These products are however facing regulatory headwinds, with the Australian Securities & Investments Commission significantly reducing the amount of commission generated by the dealer on their sale. While we expect that over time this additional cost will be passed onto consumers in the form of higher vehicle pricing, this has not gone as smoothly as expected. As a result of the weaker volumes across the industry, many of the smaller competitors are playing the volume rebate game with manufacturers and maintaining lower pricing to drive turnover. In doing so they are most likely losing money on a per car basis with the hope of reaching a manufacturer target and receiving a volume bonus. While this is impacting the firm’s near-term sales, we believe it is unsustainable for the smaller dealerships in the long term. Accordingly, we expect prices to start adjusting, and Automotive Holdings to resume growing auto margins by around 10 basis points per year from fiscal 2020 onwards, stabilising at around 3.2% by fiscal 2023. This is the point at which we estimate the company will again see ROICs above cost of capital, leading us to maintain our narrow moat rating for the company. However, our outlook implies the company only partly recaptures the margin lost over the next several years, which we believe is reasonable given the many challenges.

Despite the near-term earnings pressure, we remain comfortable with the balance sheet health, and we believe the firm can ride out this trough period. We forward fiscal 2019 net debt/EBITDA of around 1.7 times (excluding floorplan finance), and while this is considerably higher than recent years, it remains below management’s 2 times threshold. As earnings recover over the next five years, net debt should fall towards 1 times EBITDA.

We also think the company will continue to consolidate the fragmented car dealership space, further strengthening its competitive advantage. However, we expect the pace of acquisitions to slow temporarily to preserve the balance sheet, although given the structural and cyclical pressure we wouldn’t be surprised if the firm can snap up distressed dealerships at attractive prices. From fiscal 2021 onwards, we expect acquisitions to resume at the normal pace, taking the firm’s market share to around 10% by fiscal 2023, up from the current 9%. We continue to see benefits of being larger, and by increasing scale the firm should improve its sustainable cost advantage.