Small Caps | Jun 01 2021
This story features PETER WARREN AUTOMOTIVE HOLDINGS LIMITED, and other companies. For more info SHARE ANALYSIS: PWR
Peter Warren Automotive is on track for sustainable growth and a further re-rating of the stock is likely from industry consolidation
-Highly-fragmented automotive industry ready for consolidation
-Property ownership reflected in strong margins relative to peers
-Will Peter Warren Automotive be impacted by the push to an agency model?
By Eva Brocklehurst
Consolidation opportunities are likely to abound in the automotive industry over 2021 and Peter Warren Automotive Holdings ((PWR)) is well-positioned for that eventuality. The integrated network operates at scale in NSW and Queensland and has long-standing relationships with original equipment manufacturers (OEM), providing access to capital.
Morgan Stanley expects sustainable growth will be driven by cyclical tailwinds amid continued execution across the company's multiple strategic initiatives. The business has around 2% share of new vehicle volumes which compares with the top operator's 11% share and national presence.
The broker finds upside potential and a further re-rating highly likely from industry consolidation, comparing the opportunity in M&A to that of Eagers Automotive ((APE)), which scaled up to more than $120m in pre-tax profit in 2015 from just $40m in 2010.
Were this to occur for Peter Warren, the broker estimates consolidating the family-owned Toyota assets could add around 12% to pre-tax profit, and having Toyota representation would enable much broader M&A.
Jarden also believes the highly-fragmented automotive dealership network in Australia is primed for consolidation. The broker estimates a theoretical, fully debt-funded acquisition of $20m could potentially add an incremental 5-8% to FY21 pre-tax profit, assuming a 4-6x acquisition multiple.
Peter Warren Automotive has 27 OEMs under its belt and owns two properties including the flagship Warwick Farm site in western Sydney and this is a key consideration for valuation, in the broker's view. Jarden believes property ownership is reflected in the strong margins relative to peers.
Morgans envisages Victoria as a natural market for expansion, anticipating the industry could consolidate at a fast pace over the next five years. In this way, Peter Warren, being well capitalised, can take advantage. Debt facilities are likely to be easily obtainable, given the strong asset backing, and scrip could also be an attractive option for vendors.
While its FY21-23 forecasts signal a relatively steady growth pattern the broker does not factor in the likely M&A potential. Morgans would prefer a greater discount in the stock's multiples compared with Eagers Automotive yet believes industry conditions will favour the business and initiates coverage with an Add rating and $4.05 target.
Prior to the pandemic, the Australian new car sales industry was in the midst of a downturn and this was then exacerbated by the onset of the pandemic. November 2020 was the first positive month for new car sales growth since March 2018.
From that point monthly growth has continued to accelerate and Morgans suspects the recent surge in demand could last for some time. Production cuts by OEMs have been compounded by chip shortages but in April deliveries were at record levels, which signalled plenty of stock is arriving. Thus, Morgans believes demand will be the main driver of the strength in margins.
The broker points out most industry participants expect chip shortages will last into 2022, implying car supply is likely to remain constrained and there is an increasing likelihood OEMs will keep supply closely matched demand going forward.
Jarden has initiated coverage with a Buy rating and $4.12 target, calculating pre-tax profit margins of 3.5% for FY21. The broker believes earnings drivers over the medium term will include macro economic strength and housing, as vehicle sales strongly correlated with house price growth.
Leading indicators are signalling 20% upside in house prices and Jarden notes the recovery in automotive sales is already evident, estimating a six-month lag in new vehicle volumes versus housing price gains.
The stock is not trading at peak earnings, Morgan Stanley adds, despite the recent trading update lifting FY21 guidance above the prospectus forecasts. The main concern is the elevated margins but these can remain elevated for longer amid a structural changes in the supply dynamics.
Small improvements in growth or margin can also be material for earnings, the broker points out and initiates coverage with an Overweight rating and $4.40 target.
Peter Warren has a licence to operate the Honda agency model and could be a Mercedes-Benz agent as well. Morgan Stanley flags the implementation of the dealer code by the federal government as providing an additional layer of earnings protection for dealerships.
The main downside, in the broker's view, is if gross margins revert back to pre-pandemic levels faster than previously anticipated. There is also the prospect that demand has been pulled forward and the company is unable to participate in M&A at attractive valuations.
Global production shortages have led to demand outstripping supply and consequently higher margins per vehicle sold. Yet, as Australia is a right-hand drive market it is likely to experience supply constraints for longer, as left-hand drive and large-volume markets are prioritised.
The main risk, in Jarden's view, is the cyclical industry in which the company operates, changes in consumer sentiment as well as macro factors that constrain discretionary expenditure.
Also, dealerships are operated under franchise agreements with manufacturers and changes in these relationships can lead to a reduction in earnings. Morgans points out, in its favour, Peter Warren Automotive has operated for 60 years, providing a full service model across industry. Therefore, it is too early to tell if it will be better or worse off financially under an agency model.
The agency model involves OEMs retaining ownership of the car ex factory until it is sold to a consumer as opposed to selling the stock to a dealer. The model removes any requirement for price haggling, as prices will be set by the OEM on a national basis.
Morgans notes a push towards an agency model ensues from the significant amount of change affecting the industry over the next decade, such as electric vehicles and autonomous vehicles. With a flat commission structure the broker expects dealer gross profit margins will be lower but inventory carrying costs will also be removed, smoothing the overall earnings position.
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