Powering ahead

PORTFOLIO POINT: Demand is outstrripping supply for 4WD vehicle accessories business ARB.

Amid news of Qantas’ latest conniptions and Spain’s arrival on the set of the great euro drama (Italy and France to enter stage right shortly), one Aussie company is quietly going about its business.

That business is ARB Corporation (ARP, Skaffold Quality Score:A1), and its compelling fundamentals are the reason we have held the company’s shares in the Montgomery Private Fund since inception.

Those fundamentals have also helped to produce acceptable results (Figure 1) amid an otherwise manic, depressive market.

Fig. 1 Results are net of all fees.

Guided by its founder, Roger Brown, ARB designs, manufactures and distributes accessories for 4WD and light commercial vehicles – something it has focused on solely and successfully for almost as long as I have been alive.

And while producing and selling accessories for 4WDs doesn’t sound like an overly exciting business, consider the fundamentals over the past 10 years.

Since 2002, ARB has managed to grow its after tax earnings from $8.36 million to $37.8 million – a compound growth rate of 18.25% per annum. This is a fantastic achievement and largely organic because it has required just $133.5 million of retained profits and equity – the latter from the issuance of options.

In 2002, $8.36 million was generated on $31.2 million of shareholders’ equity, generating a return to owners of 26.8%. Fast forward to 2011 and returns are equally impressive. $37.8 million is being generated on $129.3 million or 29.2%. Many businesses have also grown their profits over the same period of time, but it is far more often that growth has been 'acquired’ and declining return on equity suggests those acquisitions have been expensive.

As the business has grown and developed its economies of scale, returns have actually improved. This is a rare achievement in practice and a development which creates significant value for shareholders.

If you were a part owner of the business in 2002, your shares would have grown steadily in value (not share price) from $1.91 to $8.09. If you believe Benjamin Graham’s observation that in the long run, the market is a “weighing machine’, then you must agree that prices follow valuations over the long run. Provided you can see which businesses are able to increase their per share intrinsic value, there is no longer any need to try and predict share prices! Simply buy high-quality businesses – with rising intrinsic values – at discounts to that intrinsic value.

Figure 2 reveals the change in the ARB’s valuation mapped against its share price over the last decade.

Fig. 2

This represents a total value increase over the period of 353.93%. Including $1.76 in fully franked dividends, the business has generated a total return over the past 10 years of 446.1%. Suddenly selling bull bars gets a whole lot more exciting doesn’t it?

Fig. 3

ARB Corporation’s rising valuation and share price clearly reflect the high-quality nature of the business and superior investment fundamentals. You can understand why it’s something we have been attracted to for some time.

Last week we asked whether Thorn Group’s (TGA, Skaffold Quality Score:A1) recent outperformance was sustainable. The reason to ask is because it’s not the results of the past that will deliver returns to new shareholders, but whether the future matches that which is currently estimated.

To some extent, this question was answered for ARB by its management at the start of May – “The Board expects sales for the full year to be up by about 4% and for profit after tax to be in line with the previous year.”

While it is a slightly disappointing development – the market was expecting more – we think that any growth sans acquisitions in the current economic climate is not something to sneeze at. The business has faced challenging conditions this year following the Japanese earthquake, tsunami and Thailand floods, which together dramatically impacted the supply of new 4WDs. The key risk ahead is what proportion of their sales is impacted by declining iron ore prices feeding into a lower level of capex by mining companies.

Conversely, there is pent-up demand from a lack of vehicles being available for sale in the first half. May car sales data continued to show a strong rebound and indeed a record 38,000 new 4WDs sold out of a total 96,000 in total new cars in Australia. A record and, of course, ARB’s most important business segment.

Add to this the associated pent-up demand of accessories to fit out these new vehicles and what ARB is faced with is a current order book heading into the last three months of the financial year where demand is outstripping supply. An enviable position to be in.

Coupled with a highly capable management team who have not only controlled the businesses operating expenses at a time where sales and revenues were severely impacted, but have also used their conservatively managed and high quality balance sheet to continue expanding their production and distribution capacity to support future growth plans, we think the business has not hit its straps. And remember there are less than 50 stores worldwide.

Until our view changes, which is unlikely, this remains to us a business that is already succeeding in expanding overseas, a business that we will happily hold and a business for whom any share price weakness is a signal to accumulate more.

Roger Montgomery is an analyst at Montgomery Investment Management and author of Value.able, available exclusively at rogermontgomery.com.