Lookers — Update 14 March 2016

Lookers is a leading UK franchised motor distribution group. It has been built by a combination of organic growth and acquisitions, delivering an impressive and consistent trading record over many years. It has strong relationships with its OEM partners and has established a number of strong geographical sales territories, from which the group can generate consistent and growing returns. There are key regional presences in Northern Ireland, Scotland, the South-East and across northern England. Lookers also operates a specialist automotive parts distribution business (17% of profits), operating a distinctive logistics operation, supplying urgently required product into the independent automotive service/repair sector via the network of motor factors across the UK.

Ratings across the UK motor retailing subsector cover a narrow band of between 9.0x and 10.2x prospective 2016 earnings; Lookers is at the upper end of this range. Historically, motor dealership groups have been rated at a substantial discount to the FTSE All-Share General Retailers Index. There has been a narrowing of this discount in recent years as markets have begun to recognise the resilience of the subsector and the improved quality of management. Lookers has a remarkable long-term trading record of consistent growth in a mature market, effectively managing its franchise portfolio and a series of strategic acquisitions to raise returns. It has the added attraction of its Parts business, which is cash generative and counter cyclical. We believe that the current rating fails to recognise Lookers’ ongoing potential.

We have upgraded our FY16 estimates slightly and publish our FY17 estimates for the first time.

In theory, motor retailers would be expected to see their fortunes fluctuate with shifts in consumer confidence. In practice, the market has been remarkably resilient, with its highly fragmented nature enabling the leading operators to respond effectively to predictable challenges. The UK new car market is mature; record new vehicle registrations in 2015 were marginally above the previous record, which had been established in 2003. However, there is much more to motor retailing than new car sales: Lookers operates an effective and growing used vehicle business in its franchised dealerships, while aftermarket operations in the form of service and parts is a relatively high-margin consistent support business, generating around 50% of gross profits. These downstream activities often have different cycles.

Lookers performed strongly in 2015, again taking full advantage of a benign trading environment. Revenues rose by 20% to £3.65bn, generating 11% like-for-like growth, with the balance contributed by acquisitions. Gross margins slipped back from 13.0% to 12.4%, largely as a result of the mix of business shifting further towards vehicle sales. Operating margins edged slightly lower, but remained healthy at 2.4% (2.5% 2014), while there was a similar impact on pre-tax margins, down from 2.1% to 2.0%; these margin movements had been anticipated early in the year, stemming from a more competitive new car market and the improved availability of used cars up to three years old. Underlying pre-tax profits rose by 11% from £65.0m to £72.1m, slightly above our own and market estimates. Adjusted diluted EPS rose by 13% to 14.88p. The dividend was lifted by 10% to 3.12p, covered 4.8x by adjusted earnings.

The main changes to the franchise portfolio came with the major acquisition of Benfield Group, announced in early September. At a cost of £102m (including debt acquired), Benfield added 30 dealerships to the group portfolio, although some £12m has since been recouped, following the disposal of a small number of outlets which did not fit in with the group’s longer-term strategy. Other transactions were minor, reflecting the ongoing process of weeding out underperforming operations and strengthening the group’s exposure to its core OEM partners, especially in the premium segment of the market. Lookers also exited from its used car supermarkets, which have not delivered to management expectations.

Impressive preliminary results from the Motor division saw revenue up 21% to £3.43bn and pre-tax profits up 11% to £64.5m. Market conditions were favourable throughout the period, with continuing strong support from the OEMs enabling UK new car registrations to rise by 6.3% to 2.63m, including a 2.5% advance in the retail segment. As always, statistics on used car transactions are less easy to calculate; the consensus view in the motor market is that volumes probably rose modestly. There was a small recovery in the parc of vehicles up to three years old, suggesting improved conditions for aftermarket sales.

New cars: New car revenues rose by 24% to £1.84bn. On a like-for-like basis, the group reported revenues up by 11% and gross profits by 12%, indicating a modest rise in margins. The group had been running 9.4% ahead on new car revenues at the interim stage, so the year end result represents a very sound performance. We had expressed a cautious note this time last year, with the targets being set by the OEMs likely to put pressure on retail margins, while the shift in the market toward fleet would also have led to reduced returns. Retail sales rose by 4% and fleet by 24% growth in the latter stems from a strategic move to concentrate on smaller fleet buyers, including the supply of light commercial vehicles, for which there has been a resurgence in demand.

The support from the OEMs, largely in the form of vehicle finance offers (PCPs), reflected the fact that the UK continued to be seen as the only buoyant major European market; several other markets have shown useful recovery from depressed levels, but remain fairly fragile. Some commentators have expressed concern about the likely impact of the recovery in the euro relative to sterling, which is narrowing OEM margins, but Lookers’ management remains comfortable with current exchange rates, given the perceived quality of the UK market and continuing manufacturing over-capacity.

Industry estimates suggest a small rise in new car registrations in both 2016 and 2017. The current year has started well; indications for the crucial March trading month look encouraging. Margin pressures will continue, but we believe that Lookers will continue to deliver useful progress.

Used cars: Lookers has built further on the strong performance of the previous three years. Used car revenues rose by 21% to £1.21bn, including a 7% like-for-like rise in unit sales and, benefiting from a slightly higher average price per vehicle, an 8% rise in like-for-like revenues. In the context of an indicated relatively modest rise in the market, the group will have again lifted its market share without yielding margin, despite the increasing availability of vehicles up to four years old.

This progress stems from consistent recent investment involving improved vehicle sourcing, with greater attention paid to the inventory profile and a much improved stock turn. More significantly, Lookers has responded to the changing market dynamics, improving the quality and reach of its website visits to the website rose by 27% last year to 9.54m, while the number of unique leads rose by 67.5%, indicating an improving conversion rate.

Used cars is still seen by management as a fundamental medium-term growth opportunity. The variation in performance between the franchises is significant. The 1.2:1.0 ratio between used and retail new car sales is less than half that of the group’s most successful outlets; action to narrow this gap can be expected to build on the 55% lift in used car unit sales seen over the past four years. With the growing involvement of the OEMs to offer PCPs on newer used cars, we look for continued increases in market share over the next two to three years, at sustained margins.

Aftermarket: The fundamental factor for the group’s aftermarket operations has been the recent recovery in the size of the parc of vehicles up to three years old. During the previous period when demand was drifting, Lookers invested in CRM, including electronic vehicle health checks and the sale of service plans on used cars, to extend their customer profile to include an increasing proportion of older vehicles to sustain profits.

Revenues rose by 9% to £382.9m last year, including like-for-like revenue growth of 6%, with gross margins widening from 42.2% to 44.2%. Investment continues, with online service bookings now available, while attention to detail in terms of customer management extends further the positive customer experience. The improved trading climate enables us to look ahead with confidence for the current year and into the medium term.

The Parts division continues to recover from the profits setback in 2012, despite the continued challenging trading climate. Turnover rose by 6% to £218.8m with a slight narrowing of margins as pre-tax profits moved ahead by 3% to £12.6m. The Parts division supplies principally into the four to nine year-old vehicle segment of the market, where the size of the parc is still falling and has yet to respond to the recent recovery in new car registrations. According to SMMT figures, this parc stood at around 14.5m vehicles in 2010 and had fallen steadily to some 11.9m vehicles last year; this figure is expected to edge lower again in 2016, but will then respond to the recovery in new car sales, rising progressively to around 13.8m vehicles by 2020.

We understand that all three businesses participated in the progress delivered last year. The main company, FPS (75% of divisional sales), saw its revenues respond to extensions to its core and wider product range delivering encouraging growth. APEC Braking continues to benefit from the introduction of Brakefit, its new budget brand, which is steadily becoming established in its own right. Similarly, the extension of the range into more specialist products at BTN Turbo is enabling it to sustain a useful momentum.

We are encouraged by the recent investment in business development across the division. Although relatively modest progress is expected in the current year, we are becoming increasingly confident of an accelerating rate of growth over the medium term. Acquisitions remain on the agenda, potentially broadening the product range further – we understand that several opportunities have been assessed over the past three years, but vendor price expectations remain high.

The dynamics of the market are looking similar to those of last year. SMMT figures show a positive start to the year, while several leading dealership groups have expressed optimism about the key month of March. Figures for January and February indicate a 4.7% rise in registrations, but with retail markets showing the main momentum and fleet demand lagging. Industry forecasts imply a modest year-on-year rise in registrations from last year’s 2.66m to 2.70m. However, ambitious targets being set by a number of OEMs suggest that several dealership groups may struggle to earn full bonuses. This will almost certainly lead to some pressure on new car margins.

We have already mentioned the likely impact of increased product availability on used car margins. This could intensify if the OEMs press their franchisees to increase new car sales, which can often be at the expense of demand for newer used cars. Again, the impact will tend to be on used car prices, rather than volumes, but the need to control inventory and turn over stocks more quickly will be stronger. As was seen in 2015, the larger groups, such as Lookers, are better equipped to respond effectively to the challenge.

Aftermarket operations within the franchises should respond positively to the improved trading climate, to deliver useful progress. The Parts division will have to wait another year before its industry dynamics turn favourable, but management action over the past few years should enable the division to again deliver steady progress in 2016.

Lookers has reported a good start to the year, with a healthy order book for the important month of March. First quarter trading is indicated to be in line with earlier management expectations, while last year’s major Benfield acquisition will contribute to the bottom line for a full year. We have decided to nudge our earlier estimate of underlying pre-tax profits of £79.0m up to £80.0m,

We remain positive about Lookers over the medium term. Increased vehicle sales over the past four years will have a knock-on effect as they impact on the various downstream group activities. We see a stable market over the next two to three years, with immigration and the improving economy suggesting further modest growth in vehicle ownership over the medium term. We have, for some time, been drawing attention to the shift in motor industry dynamics favouring the larger players in the sector: they have the financial strength and depth of management to help create and respond to enhanced customer expectations. Investment in CRM, in modern facilities and the group’s leading online presence combine to suggest that Lookers will continue to be a key beneficiary of this shift toward the leading groups. Acquisitions will continue on a selective basis – management has indicated that the availability of potential deals has increased in recent months, as the challenges for the independent retailers become more intense.

Performing in a mature market: Management has acted to preserve and win share in a mature and competitive market. While the very severe market conditions encountered in 2008 and 2009 affected all motor dealers, Lookers' management has since invested in increasing the sizes of its franchise territories, enabling the group to employ local management more effectively. At the same time, Lookers has extended its used car and aftermarket operations across the network, adding considerable gross profit, without a commensurate rise in establishment costs.

Macroeconomic factors: Like other dealership groups, Lookers cannot be immune from either a major downturn in demand or an unexpected downturn in used car values (as happened in 2008). However, because vehicles deteriorate with age, there is a built-in replacement cycle (usually up to three years), to which most motorists seem to subscribe. Registration plates showing the age of a particular vehicle seem to encourage this trend to continue, while the company car is still seen as one of the most important business perks. The UK automotive market is mature; record new car registrations in 2015 were only nominally above the previous record established 12 years earlier, in 2003. High levels of immigration in recent years suggest that the overall parc of vehicles will continue to rise modestly into the future. Group adjusted diluted EPS has increased consistently from 5.17p in FY03 to 14.88p in FY15, despite the flat new car market.

Performance of individual marques: The trading performance of specific OEM franchises can be affected by the timing of new model introductions, temporary reliability problems and the effectiveness of sales incentive schemes for dealers; last year’s difficulties at VW reinforce this factor. However, there is a greater degree of immunity in larger dealership groups such as Lookers because of their spread of business, so that any adverse impact with one OEM will be balanced by the stronger performances elsewhere. Another factor will be the trend in consumer preference towards and against prestige models. The two years to 2014 saw a strong shift towards upmarket models, partially prompted by strong finance offers, which have encouraged certain buyers to be more positive. More recently offers on volume cars partially reversed this trend, although the current climate is more balanced. Lookers’ portfolio of franchises is well balanced between volume and prestige vehicles.

Pension deficit: Lookers now operates three defined benefit pension schemes, each of which is closed to new entrants; the third came in with Benfield and is well funded. The combined actuarial value of liabilities and the fair value assessment of the scheme assets increased over the year to December 2015. At that date, there was a net deficit, after deferred tax, of £44.2m.

Share prices in the motor retail subsector have held up well in recent months. The Lookers share price is up by 3% over the past year, outperforming a dull market. While motor retailing has, for many years, been considered the poor relation in the retail sector, the average prospective P/E ratings for 2015 and 2016 are now much closer to the FTSE All-Share General Retailers Index. The market has obviously acknowledged the rise in new vehicles registrations and is recognising the improved quality of management at the quoted dealership groups. However, we feel that the change in industry dynamics, whereby the sector leaders can consistently out-perform is still not fully recognised. We believe that the consolidation process of a very fragmented market may accelerate over the next two years, as the challenges for the independent operators intensify.

With the notable exception of Inchcape (a global vehicle distribution business), ratings across the sector do not vary materially from the simple average. Lookers has performed consistently over many years, delivering record pre-tax profits in 2009, the year after the major industry profits setback. It has since more than doubled those profits, while UK new car registrations have only just returned to the previous record achieved in 2003. It has an above-average exposure to the higher-margin aftermarket segment of the market through its Parts division. We believe that the modest premium rating to the other UK motor distributors is fully justified.

Net borrowings at 31 December 2015 of £161.7m were above our £130.2m estimate, largely because of a bigger than expected rise in working capital and the level of borrowings at Benfield on acquisition. Funds generated from operations totalled £58m, after adjustment for the working capital increase and net investment in the hire fleet. With tax, dividends and interest absorbing £37m, some £21m was available for investment. Capital and acquisition expenditure totalled £28m and £104m, so that after a few minor adjustments, there was a net £110m increase in net debt over the year. Gearing at the year end was 54%, compared with 20% 12 months earlier.

We have already mentioned the need for increased capital investment to meet the business needs related to digital marketing, while management is determined to offer facilities of the highest standard to meet customer aspirations. In this context, management has indicated capex continuing at a high level (c £25m pa) over the next two to three years. Our calculations suggest that these commitments and the ongoing working capital demands can be financed from cash flow and still leave substantial funds available for other types of investment, including acquisitions.

New banking facilities were negotiated in September last year at the time of the Benfield acquisition. There is a term loan of £100m and a revolving credit facility of £150m, making a total of £250m; annual repayments on the term loan are £10m. In addition, there is potential to increase the term loan by £30m, to support acquisitions. We are comfortable with the current level of borrowings, which offer substantial headroom to respond quickly to major investment opportunities. We suspect, however, that management would prefer not to lift gearing materially higher, other than on a short-term basis to facilitate acquisitions.