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Morningstar | Corporate Action: We Recommend Automotive Holdings Shareholders Accept AP Eagers’ Takeover Offer

The Automotive Holdings board has recommended that shareholders accept AP Eagers’ improved offer once the "no material adverse change" condition is waived, in absence of a superior proposal. This is despite the independent expert’s report which concluded the improved offer is not fair but reasonable. The improved offer has increased the consideration to one AP Eager share for every 3.6 Automotive Holdings shares owned, compared with the prior offer of one for every 3.8. In addition to the slightly higher ratio, AP Eagers waived the general market fall bid condition. While the total value of merger is not impacted, Automotive shareholders will walk away with a slightly larger portion of the combined entity. Accordingly, we raise our Automotive Holdings fair value estimate by 4% to AUD 2.40 per share. The impact on our AP Eagers valuation is immaterial, and as such, the fair value estimate remains at AUD 9.00 per share. Both companies are fairly valued at current levels.

We recommend Automotive Holdings shareholders accept the offer, consistent with the board’s recommendation. At discussed in prior research, we believe the merger is in the best interest of both parties, and in our opinion the implied price is fair. The combined entity will benefit from larger operational scale with a combined market share of around 12%, along with increased brand and geographic diversity which should help smooth volatility in new vehicle sales. Additionally, the firm will emerge with a sound balance sheet, benefit from cost synergies, both of which will see it in a better position to grapple with the cyclical and structural headwinds. In the event the offer is withdrawn, both share prices are likely to fall, and our Automotive Holdings and AP Eagers fair value estimates would revert to their standalone valuations of AUD 2.60 and AUD 7.50 per share, respectively.

Automotive Holdings also provided a trading update with its fiscal 2019 net profit guidance cut to AUD 50 million, compared with the previous range of AUD 52-56 million. We had previously expected the firm to struggle to achieve the guidance, but we have now further trimmed our fiscal 2019 forecast to the revised AUD 50 million, from our current AUD 51 million estimate. This revised guidance reflects the ongoing softness in new vehicle sales volumes and margins, along with a weaker than expected showing in the refrigerated logistics division on the back of softer Easter trading. The company also flagged it will be undertaking a review of the carrying value of receivables. While this could potentially impact the fiscal 2019 earnings outlook, it is unlikely to have a major impact on cash flows beyond fiscal 2019 or our fair value estimate. AP Eagers also updated the market on current trading and, in light of the challenging new vehicle sales, guided to a 7%-10% drop in operating profit in the first half of fiscal 2019. This is broadly in line with our current forecast for an 9% decline in operating income for fiscal 2019.

Our longer-term earnings assumptions for both firms are broadly unchanged. We continue to project mid-single-digit EPS growth on average during the next five years. This hinges on a cyclical recovery in industry vehicle sales volumes, reverting to 1%-2% growth per year, along with modest low-single-digit price increases. In our base-case scenario, we forecast incremental market share gains for both firms. We expect the combined entity to grow its market share to around 15% within five years, compared with the current 12%.

In addition, we believe the initial target of AUD 13.5 million in annual pretax cost synergies is achievable, and the present value is factored into our current valuations. As highlighted in previous research we see potential upside to this target, and could extract up to AUD 30 million in annual cost synergies, more than double the original target, and representing almost 2% of the combined cost base. This would add approximately AUD 1.50 per share, taking our AP Eagers valuation to AUD 10.50 per share, approaching our bull-case scenario. Automotive Holdings has undertaken its analysis of the synergies and estimated that if 100% of the shares are acquired the pretax synergies could reach AUD 31.3 million annually, similar to our estimate.