Why Inchcape looks primed for a re-rating

When Puffin Books decided to expurgate its 2022 run of Roald Dahl’s collected stories, one pernicious stereotype escaped the publisher’s crack team of sensitivity readers: the scheming used-car salesman.

Matilda is home to a defining example of the trope. The wunderkind’s dad, “a small ratty-looking man whose front teeth stuck out underneath a thin ratty moustache”, earns a bent living shifting clapped-out bangers whose speedometers he winds back with an electric drill and gearboxes he fills with sawdust. These, Mr Wormwood says, are the “trade secrets” to con customers, who only exist “to be diddled”.

In a display of saintly self-restraint, the National Franchised Dealers Association – the “voice of automotive retailers” in the UK – did not step into this front in the culture wars to ask why the damaging depiction hadn’t been edited out.

But it probably missed a trick, because even unfair caricatures are hard to shake. When I recently bought a 2018 VW Polo, I kept wondering how I was being swindled, despite all assurances from the lovely Aaron, and the offer of an extended warranty. A heavily discounted price only served to set off my internal dashboard warning light.

The reality is that it’s hard to make it as a dishonest professional car seller today. The internet, first stop on almost every buyer’s journey, has armed consumers with a good sense of the trade-offs between value for money and every other variable. Online consumer reviews, while imperfect, have boosted the industry’s accountability and the need to maintain reputations.

But contrary to perceptions, life for an honest car dealer isn’t much easier. If the listed sector is any guide, dealerships in the UK can count themselves content with a net profit margin of around 1 per cent (see table). Especially among franchise dealers, manufacturers’ rebate and incentive structures effectively put a cap on profitability. Naturally, thin margins are tolerable if fast selling can juice asset turnover and returns on capital. Demand patterns, increasingly well-tracked and fairly reliable, can also help. But when activity proves slow, high fixed costs can decimate earnings. Understandably, shares in the sector rarely attract premium ratings.

Secondly, there is the growing trend toward disintermediation. In their biggest markets, a growing number of car makers are either toying with direct-to-consumer channels or taking some of the value captured by middlemen. Long term, if manufacturers' marketing can put their own channels ahead of marketplace platforms or forecourts, they have a chance to boost their own thin profits.

Feeding into all of this is an arguably oversupplied retail market. In the UK, an industry that over more than a century evolved around family-run dealerships has created myriad regional and brand-based independent businesses, wide fragmentation and limited opportunities to capitalise on the scale advantages that can come with wider access to stock and flexible selling strategies.

The recent evaporation of the listed UK sector is testament to each of these challenges, and the opportunity that (often North American) scale players sense. It began in 2022 with the takeover of Marshall Motor by the private-equity-backed Constellation Automotive. Last year, the Altrincham-based Lookers was acquired by Canada’s Alpha Auto, while Pendragon – parent to the Evans Halshaw and Stratstone brands, and which held its own merger discussions with Lookers in 2020 and 2006 – sold its dealerships to US giant Lithia Motors (US:LAD).

For investors with the not-unreasonable working assumption that this sector is up for sale, two listed groups remain: minnow Caffyns (CFYN), and Vertu Motors (VTU), where Constellation owner TDR has gradually built up a 9 per cent stake over the past two years.

However, it’s the tyre marks left by those exits that today look most interesting.

Pendragon is now Pinewood Technologies (PINE), a pure-play software-as-a-service business for car dealerships, in which Lithia has maintained a holding. Its shares currently trade at 38.8p apiece. Following the retail carve-out, shareholders on the register on 22 April will get a 24.5p transaction dividend for each share, and a stake in a joint venture between Pinewood and Lithia that plans to roll out Pinewood’s software across the “highly attractive North American market”.

But in the push for a better capital base and operating model, Inchcape (INCH) looks to have the brightest strategy in the sector showroom. This week, the FTSE 250 group agreed to sell its UK car retail arm to Group 1 Automotive (US:GPI) for approximately £346mn in cash. In doing so, Inchcape will give up a business that contributed just under a fifth (£2.1bn) to the top line in 2023, and around 7 per cent of operating profit. Bar a small presence in Poland, the disposal also effectively completes its exit from the retail market, following similar disposals in Russia in 2022 and China in 2019.

Group 1, meanwhile, gets a chance to double down on the UK, where it already represents 15 original equipment manufacturers (OEMs) across 55 dealerships, largely in the south-east and east of England. Although a run of acquisitions has pushed up the group’s leverage, its operating margin – which, at 5.5 per cent, was more than double Inchcape’s UK retail arm in 2023 – reflects its greater focus on higher-margin parts and servicing work. That offers a hint as to its strategy in making the purchase.

Inchcape, which received several competitive bids for the division, can legitimately claim to have sold at a good price. Ahead of analyst estimates, and priced at seven times operating profits, the biggest impact is likely to be felt in the capital intensity of its balance sheet, and a gain stemming from a difference in property values. While Inchcape referred in its announcement to £183mn of freehold property (understood to be held at amortised cost), Group 1’s appraised value of the same real estate assets sits at £220mn.

However, the real value in Inchcape’s disposal could be a shift in investor perceptions. With all associations to UK forecourts now gone, the group can set about burnishing its image as a distribution partner to OEMs across some 40 international markets. It’s a role that, incidentally, Inchcape has been cultivating for a century, and which was most recently given a shot in the arm by the takeover of Derco, the largest automotive distributor in Latin America.

The immediate conduit for this shift is the return of £100mn of those cash proceeds, via a share buyback. With the deal unlikely to complete until the third quarter of this year, investors will have to wait a little while for any price kicker to arrive, although should financial engineering propel Inchcape’s market capitalisation north of £4bn, FTSE 100 tracker funds could soon be forced to join in the buying.

Prospects for a fundamentals-based re-rating rely on a few things going well. Most critical is a robust consumer backdrop. Although Inchcape describes its markets as “high growth”, this is sometimes the product of low starting volumes, and evolving (read ‘tbd’) vehicle purchasing habits. Occasionally, stronger major international currencies are hard to digest for customers in some emerging markets. And while it counts multiple OEM relationships in almost every country, this doesn’t always mean Inchcape is exposed to the most in-demand or lucrative brands. In less mature markets, the price for greater expansion potential can be a more variable rate of growth. This year, the business expects to get bigger, albeit at a “moderated” pace.

Second is keeping good relationships with vehicle makers. Here, all seems rosy, although one wonders whether Inchcape’s long-term success in its largest markets could result in OEMs looking to take back a slice of the value chain, as they do in the UK, the US and China. Chief financial officer Adrian Lewis is unfazed by such a move, which he says has never happened, given the much larger challenges in international vehicle makers’ in-trays. It’s far less complicated and costly, from the perspective of Toyota’s chief commercial officer, to use a knowledgeable agent in a sub-scale market such as Greece or Belgium, than set up shop there itself.

Third is maintaining strong relationships with the in-country dealerships that ultimately develop the markets into which Inchcape supplies vehicles. Here, an element of co-dependency, as well as geographic and customer diversification, are obviously strengths.

All told, this week’s sale creates a cleaner investment case that should further boost Inchcape’s margins and returns on equity (see chart). By exclusively drawing profits from its intangible assets, contracts and the logistics of matching OEMs to dealerships, Inchcape’s transition from a capital goods business (where operating margins rarely exceed 2 per cent) to a services business (where margins typically range from 5 to 7 per cent) is now complete.

That won’t free it from the economic cyclicality of the global automotive industry. Ultimately, its earnings are also still tied to the salesmanship of the dealers it works with. But with improved profitability, Inchcape has greater scope to redeploy capital into the highest-return projects. That should mean more value for shareholders, who should raise their expectations accordingly.