Most car dealerships lose money on the sale of each vehicle. They make it all up – and more – by selling you finance, insurance, servicing and parts. But there’s a problem – ASIC wants to crack down on what it sees as usurious interest rates charged to some car buyers.
This is just one of the risks faced by Automotive Holdings Group (AHG), Australia’s largest car dealership company. Indeed, ASIC’s potential prohibition on flex commissions – whereby dealers earn greater commissions for charging higher interest rates to car buyers – occupied a good chunk of time on the 2016 results conference call.
Who knows where ASIC will draw the line? Our bet is that the reforms will be watered down. But AHG seems to be counting on a sizeable increase in the number of loans it sells to offset any potential downside, something that seems unlikely.
Decent result from Automotive business
Dragged down by Refrigerated Logistics
Downgrading to Sell
If you were conspiracy-minded, you might think this risk was at least partly behind the decision of long-serving managing director Bronte Howson to sell some AHG shares in March this year (see this review from April 2016). You might even think it was behind his decision to step down from the managing director role this coming December.
Watch for pedestrians
The truth is it was probably time for Howson to move on. AHG has been the also-ran of the sector, with earnings per share increasing by a pedestrian 29% over the past five years.
AP Eagers, AHG’s smaller but more expensive competitor (and a 20% shareholder in AHG), shows that car dealerships can be a good business. AP Eagers has been one of the best-performing stocks on the ASX over the past five years, helped by earnings per share growing 85% over the period.
|Year to 30 June||2016||2015|| /(–)
As AP Eagers’ performance shows, the car dealership business is better than its low margin, high asset intensity and indebtedness might indicate. High volume, low margin businesses like car dealerships can produce excellent cash flow, but return figures tend to be depressed by high property and inventory holdings, while floorplan financing (the non-recourse financing used to fund the vehicle inventory) inflates the net debt-to-equity ratio.
AHG’s 2016 results show why it takes the sector’s wooden spoon award. The company’s Refrigerated Logistics business is a significant drain on its Automotive (car dealership) division. Whereas Automotive’s operating profit rose 11% in 2016, Refrigerated Logistics’ operating profit fell 34% (see Table 1). Despite a 7% lift in overall revenue, AHG’s underlying net profit rose just 3% in 2016 (see Table 2).
Despite all the capital allocated to Refrigerated Logistics over the years, it is, to put it bluntly, a dud business. Heavy ongoing capital spending is required, with management having made significant investments in technology, warehouses and fleet in recent years.
|Year to June ($m)||2016||2015|| /(–)
|* Interim dividend 13 cents, ex date 15 Sep|
|Note: Figures are underlying results|
Unfortunately, customers are also big and powerful. Management explained that the poor result from Refrigerated Logistics in 2016 was partly due to ‘competitive market conditions with significant pricing pressure from customers impacting margins’.
Despite years of acquisitions and investment, the return on assets in the Refrigerated Logistics division has deteriorated to just 5%. Management has belatedly recognised the problems and revealed on the 2016 conference call that it is ‘certainly ... not wedded to this asset’. But the board also appears unwilling to cut Refrigerated Logistics loose after having invested so much time and capital into it.
Poor businesses have a habit of continuing to siphon off capital from good ones, which is exactly what’s happening at AHG. While 2016 operating cash flow was $140m, a big turnaround from the weak performance in the first half (see Moving AHG to Hold), the combined business continues to produce weaker free cash flow than it should. In 2016 AHG produced $80m of free cash flow, but $55m of that came from the sale of property, plant and equipment.
Over the past five years, AHG has produced average free cash flow of less than $40m a year (see Table 3). This is an inferior performance to AP Eagers and suggests that AHG’s capital allocation has been sub-optimal. Much of the blame lies with the Refrigerated Logistics division in our view.
|Operating cash flow ($m)||86.9||91.8||102.2||113.3||139.8|
|Capital expenditure ($m)||(42.1)||(67.0)||(111.4)||(98.4)||(113.9)|
|Sale of property etc. ($m)||6.1||9.0||9.2||17.1||54.5|
|Free cash flow ($m)||50.9||33.8||0||32.0||80.4||39.4|
|Source: Capital IQ|
Weak free cash flow – combined with a too-high dividend – also explains why AHG keeps raising money from shareholders. It raised $83m in 2011, $145m in 2014 and following the 2016 result it has launched yet another $110m raising.
Without the free cash flow to support its acquisition strategy – this year it has bought Hyundai, Mitsubishi, Jaguar, Audi and Mazda dealerships – AHG must fund them through capital raisings.
While acquisition-based strategies rarely delight us, the ongoing consolidation of the car dealership market makes some sense. Generally earnings multiples are low and efficiencies can be obtained by standardising systems. Operating margins in AHG’s Automotive business have expanded from 2.9% to 3.4% over the past five years, which makes a big difference on $4.7bn of revenue.
I'll tumble for ya
The question now is whether any skeletons will tumble out of AHG’s closet after Howson departs. At least new chief executive John McConnell looks like a good choice. As the former finance director for Inchcape PLC, one of the world’s largest automotive retailers, he should bring greater financial discipline to the company. With any luck he’ll sell AHG’s logistics businesses.
At this point, though, the poor performance of Refrigerated Logistics, combined with management change and regulatory risk mean it is time to return to the sidelines. If there’s evidence that the new managing director is taking steps to improve AHG’s performance then we’ll revisit the company.
As part of AHG’s recent capital raising, shareholders were given the opportunity to participate in a Share Purchase Plan at a price of $4.52 a share. If you’ve already participated, you will shortly receive shares at a small discount to the current price. If you haven’t though, we recommend ignoring the offer (which is due to close tomorrow, 9 September).
AHG’s share price is up 6% since AHG stronger than ever from August 2015, and you will have received dividends totalling 22.5 cents over the past year as well. But with more risks on the horizon, we recommend that you SELL.
Note: AHG goes ex a 13 cent fully franked dividend on 15 September.