Zeus Capital Head of research Mike Allen talks to DirectorsTalk about the UK Motors Retail Sector. Mike explains the key pressures for 2017, material changes post brexit, his thoughts on valuation and key stock picks.
Sector sentiment is at a low point with clear uncertainty around 2017/18 earnings. We are attempting to cut through this, and believe the share price falls more than price in the earnings risk. Following a robust September, we would expect a strong 2016 performance, which has been confirmed by all dealers, but do expect conditions to get more difficult from here. We continue to favour stocks with flexible balance sheets at this stage of the cycle.
§ Sector thoughts. Following on from our “Post Brexit Thoughts” piece in July, market conditions have remained robust with the industry seeing solid trading patterns in September. However, we do expect to see market conditions deteriorate during 2017-18, and have attempted to factor this into our forecasts.
§ Market Dynamics. We remain in uncharted waters, with consumer confidence likely to be more fragile reflecting greater levels of uncertainty/volatility. Sustained sterling weakness/uncertainty against the Euro and Yen will remain especially as OEM hedging strategies roll off through H1 2017. That said, interest rates are likely to remain low for the foreseeable future, and we continue to believe the PCP cycle will result in greater activity levels potentially providing a shallower trough point vs. previous economic cycles. A weaker new car market should also benefit future residual values further down the line, as it alleviates the margin pressure on 0 – 3 year-old cars, which has a greater impact on the operational gearing of motor retailers. Aftersales will continue to benefit from high levels of new car activity since 2011.
§ Forecast Assumptions: We apply EPS downgrades of 8.3%-14.5% in FY1 and 8.1%-15.2% in FY2. We have assumed this is driven by volume weakness in the new car market coupled with cost pressures identified in our analysis. Balance sheet strength across the sector is generally robust, and we are likely to see further consolidation activity as smaller operators become more distressed in our view that may help to negate such pressures.
§ Valuation. On our revised estimates, which are below consensus across the board, the dealers are trading close to previous trough multiples at 8.0x P/E (EV/EBITDA of 4.7x). We believe that even if there is 20% EPS further downside the sector would still be on a P/E of sub 10x, which would be undemanding in our view ahead of a new cycle emerging.
§ Outlook. We think these earnings downgrades have been more than priced in at current share price levels. The depressed nature of the share prices and low multiples could make the sector more attractive to US/Chinese operators/investors who may see this as a consolidation opportunity. We continue to believe that the comparison to 2008 is overdone with most companies having better balance sheets and systems, and also benefiting from shorter buying cycles via PCP, giving greater visibility on earnings.