Nation's biggest car dealer drives earnings higher

Eagers Automotive is Australia’s largest automotive dealership group. Listed in 1957, it has grown to more than $9bn of annual revenue, 7,300 employees and 11% of the Australian new vehicle market.

In 2019-20, it generated 57% of its revenue from new vehicle sales, 24% from used vehicle sales and most of the balance from parts and services. Eagers represents most major automotive original equipment manufacturers, including the top 15 brands by volume.

Similar to many other retailers, Eagers had a strong 2019-20, with profit before tax jumping to $209m from $100m in 2018-19. So is Eagers just another COVID beneficiary, soon to face declining earnings as conditions normalise?

Once you pop the hood, it becomes clear that there is far more under the bonnet. This wire discusses Auscap’s investment thesis for Eagers.

Business quality

Eagers has a history of strong financial returns. Based on FactSet consensus for 2020-21, Eagers is on track to increase revenue at a 14% compound annual growth rate and net profit at a 21% CAGR since 2005. This has been achieved with an average return on equity of 12% over the last decade.

As of 30 June 2021, Eagers Automotive had just $31m of net corporate debt, down from $316m in 2018-19, leaving it well placed to fund future growth initiatives. While Eagers has funded some of its acquisitions by issuing shares, it has not raised equity from existing shareholders since 2006. 

The outperformance of Eagers starts at the top. Automotive entrepreneur Nick Politis has sat on the board since 2000 and now owns 27% of the company, which is currently worth approximately $1 billion.

Newly appointed CEO Keith Thornton has been with the business since 2002 and has accumulated $4 million of shares since joining the business. Thornton’s remuneration incentives are based on long-term earnings targets with 2019-20 set as the base year for growth.

When Thornton was appointed CEO, highly regarded outgoing-CEO Martin Ward, who also has skin in the game with ownership of 1% of the business, purchased an additional $500,000 of shares on-market and remains within the business. Politis also purchased $1.2 million of shares on market at that time.

We are encouraged by such a vote of confidence in Thornton as the new CEO. The alignment of interests with shareholders has underpinned the long-term thinking within the business that has generated strong financial returns over many years.

Growth options

Cyclical turnaround

Australian vehicle sales have been depressed since 2018, primarily driven by a large credit contraction, falling property prices from 2017 to 2019 and COVID-19. But in November 2020, after 31 consecutive months of declining sales, vehicle sales finally turned the corner, driven by the strong consumer environment.

While this recent strength is encouraging, Australian vehicle sales are still only annualising 1.1 million units, the same level as 2008 and at a similar level on a per capita basis to the depths of the global financial crisis.

Australia’s car park is ageing, with the Australian Bureau of Statistics estimating that the average Australian vehicle is now 10.6 years old.

This suggests the medium-term outlook for new vehicle demand remains favourable.

Operating margin expansion

Automotive dealerships have historically operated on thin margins. In recent years, Eagers has achieved a group-wide gross margin of 17–18%, translating to an average profit before tax margin of 3%. This means that small changes to the cost base can have a large impact on the bottom line.

Eagers has flagged this margin optimisation opportunity as a key strategic priority. Most of Eagers’ operating costs consist of property expenses and people costs. As the automotive industry continues to evolve and grow in sophistication, Eagers believes fewer showrooms will be needed.

This creates a significant opportunity, as property consolidation and scale allows Eagers to improve its operating efficiency. A first step of Eagers’ cost-out plan was achieving $36m of synergies following its 2019 merger with Automotive Holdings Group.

Stage 2 was $100m of annualised cost savings following the COVID-19 pandemic. These two initiatives, according to management, have lifted Eagers’ sustainable PBT margin to 4.5%, up 50% on pre-COVID levels, even allowing for the unwind of the margin benefit gained from current strong industry conditions.

While the proof will be evidenced once current tight supply pressures ease, management have a strong track record of delivering on their plans.

 

Eagers’ ex-CEO Martin Ward is currently working exclusively on optimising the property portfolio to further improve margins. This involves consolidating existing dealerships into fewer and more strategic locations with an improved funding structure.

In Brisbane, Eagers is embarking on an ambitious project to consolidate its large Brisbane dealership presence into a flagship Auto Mall site near Brisbane Airport, integrated with a 2.3 kilometre Mark Skaife-designed racetrack.

This will be a one-stop-shop for purchasing new and used cars, accompanied by concept display stores in shopping centres adjacent to service centres. The expected synergies of the project are significant, with shared parts and service capabilities on site, optimised staff costs and an attractive long-term rental deal.

When benchmarked to US peers, Eagers’ 4.5% PBT margin appears sustainable. If Eagers achieves further success with its cost out opportunities, significant profit growth could follow.

Market share growth

Eagers has grown from 3.7% of Australian new vehicle sales in 2010 to 11.1% in 2020. The industry remains highly fragmented and dominated by privately owned dealership groups.

The consistent industry feedback is that multiple independent dealership groups are currently considering succession planning, are conscious of the looming market evolution and view the recent improvement in industry conditions as a sensible catalyst to sell their businesses.

We believe Eagers has considerable scope to increase its market share over the longer term. Eagers has $661m of liquidity currently available, which provides substantial firepower for accretive acquisitions.

Importantly, Eagers’ success in property optimisation, finance and insurance penetration and used vehicle growth is difficult for smaller independent dealerships to replicate. This means that the earnings potential of a prospective acquisition grows materially once Eagers has the keys. Eagers can therefore pay a price that a vendor finds acceptable, whilst still creating significant shareholder value.

Used cars

Each year, roughly three times more used cars transact relative to new vehicles across Australia. Whilst the used car market is large, the sales process is widely disliked by consumers.

Consumers lose considerable value when they trade in a car, and feedback suggests a general aversion to haggling on price and concerns around a vehicle’s true condition when purchasing from a private seller. A large market with unhappy consumers creates a significant opportunity for disruption.

Having closely watched developments in the US market, EasyAuto123 is Eagers’ solution for the Australian market. The EasyAuto proposition is simple:

• A wide selection of quality-verified used vehicles browsable online or at large one-stop-shops
  
• A fixed price on vehicles (no haggling) with a best price guarantee (if you find a cheaper price they will beat it) and a seven-day money-back guarantee
  
• For trade-ins, reasonable prices, a valuation within minutes and payment within 24 hours.
  

This model’s consumer appeal is obvious, but do the economics work? Eagers actually plans to generate more than $1,000 less gross profit per vehicle in EasyAuto than they would through their dealer network.

However, the EasyAuto cost base is very different to a dealership network, due to its scalable business model. EasyAuto’s cost base is largely fixed, meaning there is significant scope to fractionalise costs as the business grows.

EasyAuto was inherited by Eagers as part of the 2019 AHG merger as a loss-making concept. It is now profitable and is annualising 13,256 used vehicle sales a year, despite limited marketing to date.

Eagers has set an initial target of 50,000 annualised used vehicle sales as a first step for EasyAuto, which would represent a used vehicle market share of 1.3%, a fraction of Eagers’ new vehicle market share of 11%.

In addition to the profit potential, EasyAuto is also highly strategic, creating a powerful position for Eagers within used vehicles and improving Eagers’ importance to OEMs.

Few research analysts covering Eagers currently reference EasyAuto in their valuation, but it is easy to see why management views it as a huge opportunity to create shareholder value. 

Risks

Unsustainable trading conditions

The automotive market is currently experiencing very strong trading conditions that Eagers is no doubt benefitting from. New vehicle gross margins across the industry have improved materially post-COVID, as strong demand conditions and disruption to global supply chains have removed the need for dealers to discount cars.

While these conditions will ease at some point, feedback suggests it is unlikely to occur any time soon.

Supply bottlenecks and growing demand are creating good visibility for dealers and manufacturers. We expect these conditions will last well into 2022 and potentially beyond.

Since the initial COVID-19 outbreak, Eagers has sold more cars than it has delivered in every single month (shown below). This means that Eagers’ order bank is continuing to grow.

Even after the disruption of recent lockdowns, Eagers has said that its geographical weighting to Western Australia and Queensland has resulted in this trend continuing into July and August.

 

Further, a large portion of new vehicle revenue historically came from incentives paid by OEMs for meeting sales targets. The current industry dynamics have led to a reduction in the size of these incentives.

Another high margin component of new vehicle revenue has been the sale of finance and insurance products. Market penetration of these products has dropped recently as OEMs have temporarily pulled back on finance campaigns, long delivery lead times have reduced the need for point-of-sale financing and consumer wealth effects have reduced demand.

Eagers estimates that current industry dynamics have boosted its PBT margin by just 20 basis points, or 7%, relative to its long-term average and still below the gross margin Eagers was achieving in FY15.

This 20 basis points of margin expansion will eventually disappear, but in addition to the opportunities for margin improvements outlined above Eagers has also called out a material opportunity to increase its finance and insurance penetration over the medium term, which may well more than offset this margin contraction over time.

 

Disruptive threats

The second risk to Australian dealerships is more existential. Could OEMs cut dealers out of the selling process by selling vehicles directly to consumers with a fixed price omni-channel model?

With Tesla already pursuing this model, the shift to electric vehicles, which currently have lower margins for OEMs relative to internal combustion engine vehicles, could be a catalyst for such a change.

Honda has recently begun the process of experimenting with an agency model, with Mercedes planning to follow in 2022. Under this model, dealers do not own any vehicles, do not have the flexibility to negotiate a price and are paid a set fee per vehicle sold.

While these developments need to be monitored carefully, there are a few things worth noting. Within the last month all 12 of the largest OEMs in Australia, representing 80% of vehicles sold, have reaffirmed their commitment to their current selling model to automotive industry publication Drive.

On further analysis this is perhaps not surprising. A new vehicle sale often involves a used vehicle trade in, financing, and a parts and service commitment. OEMs are ill-equipped to manage a used car trade-in process and they generate significant profit from finance, insurance and aftermarket services without having to manage daily operations, so they are not incentivised to disrupt this.

To date, any shifts to agency models have led to a consolidation of servicing and parts responsibilities, often at attractive margins, into the hands of the largest dealership groups, effectively offsetting any reduction in new vehicle gross margins.

We would expect Eagers, as the largest player in the domestic market, to benefit from such a consolidation, but we will continue to closely monitor any developments and risks on this front.

Summary

Eagers is a high-quality business with an enviable financial track record, a strong balance sheet and significant insider alignment.

We expect Eagers to achieve a strong profit result this year, with many of the sector tailwinds continuing well in 2022.

After accounting for the value of its property portfolio, we estimate Eagers is currently trading on a price to earnings multiple of approximately 12x. Given the significant scope for long term profit growth through improved sustainable margin expansion, growth initiatives including EasyAuto and both organic and inorganic growth, we remain positive about our ownership of this high-quality business.

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