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Morningstar | Automotive Holdings Group Underperforming in Weak Market, FVE Cut to AUD 2.60

Narrow-moat-rated Automotive Holdings revealed trading for the first four months of fiscal 2019 has been softer than both our and market expectations. We recently cut our earnings estimates, but it appears we were still too optimistic, as the firm guided to fiscal 2019 net profit after tax of between AUD 56 and AUD 59 million, 6%-11% below our previous AUD 63 million projection. This guidance factors in the potential near-term impact of regulatory changes to finance and insurance, which officially came into effect on Nov. 1.

With further deterioration in the Australian residential property market, and the consequential negative wealth effect, the health of the automotive market will likely worsen before it improves. The near to medium outlook for property prices is negative, which will continue weighing on volumes. Meanwhile, the recent unfavourable regulatory reform will continue to weigh on margins. The company will focus on cost control to mitigate this, although given the high degree of operating leverage, we are doubtful costs can be cut quick enough to offset the top-line pressure. Accordingly, we’ve cut our fiscal 2019 and 2020 EPS estimates by 10% to AUD 0.17 and 0.18 per share, respectively.

Our fair value estimate falls by AUD 0.20 to AUD 2.60 per share, following a downward revision of our earnings estimates, reflecting further weakness in new vehicle sales, and lower margin expectations. Notwithstanding, we continue to see upside in Automotive shares at current levels. New vehicle sales are cyclical, and we continue to believe sales will revert to normalised levels as the property market stabilises. We expect earnings to start recovering from fiscal 2021 onwards, which incorporates improving volumes, along with higher margins through both operating leverage (as the company resumes consolidating the fragmented market) along with higher vehicle pricing as the industry adjusts to recover the forgone finance and insurance commission.

The core automotive division’s EBITDA fell by 16% in the first four months of fiscal 2019, compared with the previous corresponding period, or pcp. The company cited weak private buying, particularly in New South Wales and Victoria which have been affected by falling house prices and weakening consumer confidence. This outcome is especially disappointing considering new vehicle sales volumes only declined by around 5% on average during the same period. While some of this shortfall is likely to due to margin pressure, we estimate the group's sales volumes are also lagging the broader market. We attribute this to smaller competitors continuing to discount vehicles in pursuit of manufacturer volume bonuses, despite the forgone margin on finance and insurance commissions.

Nonetheless, we see this behaviour as unsustainable, and over time in the industry will adjust, and pricing should increase (an outcome of less discounting, and stricter pricing on trade-ins) to reflect the regulatory changes. In the meantime, we believe smaller competitors in the market are behaving irrationally.

Refrigerated logistics is tracking slightly ahead of our expectations, with EBITDA up by 6%. This reflects improved performance on the back of the recent transformation program and an improving sales pipeline. The company indicated the second half performance in the refrigerated logistics division should be a substantial improvement over the pcp. While we expect earnings in the refrigerated logistics division to continue improving, we believe the company will still try and divest this.

Based on our revised earnings estimates, net debt will be close to 2 times fiscal 2019 forecast EBITDA, the company’s upper comfort limit. Divesting the refrigerated logistics at a fair price would be a good outcome, and the company could utilise these proceeds to reduce debt and resume consolidating the fragmented automotive dealership space. Given the current state of the balance sheet, we don’t expect the company to make any meaningful acquisitions, at least until earnings start to recover.