One opportunity we found during this crisis – Bapcor

During the recent market rout, the Montgomery Small Companies Fund picked up several high-quality small caps with solid growth potential at bargain prices. One standout is leading auto parts distributor, Bapcor (ASX:BAP), which has since rebounded strongly.

The BAP share price more than halved from pre-COVID levels to their March lows (falling from around $7 to just above $3), which suggested an overly pessimistic outlook for a relatively resilient business, in our view.

We like BAP’s defensive-growth attributes. Around eighty percent of earnings are derived from auto parts supply to the trade sector (workshops), where demand largely reflects miles driven – Australia has 19 million cars on the road which need to be serviced. Accordingly, earnings visibility is quite high; BAP’s Burson Trade business has sustained a relatively stable organic sales growth rate of c.4 per cent over the past five years.

And unlike car dealerships, BAP appears positioned on the right side of industry trends; new car sales volumes have been declining for two straight years, meaning the fleet is ageing and older cars require more maintenance (average age of an Australian car is now pushing on 10 years). The shift towards SUVs and utes also benefits BAP given their substantially higher service costs relative to smaller cars.

The growth strategy involves consolidating a highly fragmented industry, driving further penetration of higher-margin private label products (targeting 35 per cent) and expanding into adjacent markets (eg trucks) and geographies (eg S.E. Asia). BAP’s competitive advantage is its extensive distribution network which ensures swift parts delivery to trade customers and acts as a barrier to entry (hard to replicate).

Although historically proven resilient and deemed an essential service, BAP wasn’t immune to the COVID-19 disruptions. Government restrictions curtailed demand from late March onwards as households isolated and commuters worked from home, particularly in New Zealand which went into full lockdown (NZ accounts for about 13 per cent of earnings).

Management acted decisively as the operating outlook deteriorated, cutting costs and raising roughly $200 million of additional equity in mid-April. Balance sheet metrics significantly improved with ND/EBITDA reduced from 2x to around 1x (based on normalised earnings), providing BAP with ample liquidity to weather a potentially prolonged shutdown and to continue pursuing organic and inorganic growth initiatives. Removing balance sheet concerns from the investment thesis was a major de-risking event for us. We also saw deal value as compelling; the $4.40 price implied c.9.5x pre-COVID19 FY20 EBITDA ($175 million) and 15x PE, a substantial discount to historic trading ranges.

Presenting virtually at a broker conference, recent company feedback sounded very encouraging. Management highlighted that the downturn has not been as severe as expected while the recovery over May and June has been much stronger than envisaged. Although BAP has refrained from proving FY20 earnings guidance, we see potential for a sharp ‘v-shaped’ recovery with upside risk to consensus estimates.

We can’t ignore that some of the snap back may reflect pent up demand for car servicing returning post lockdown, and that there could be less cars driving on the road until working from home trends normalise. However, we also see some offsetting tailwinds – commuters may prefer to drive into work rather than catch public transport plus BAP should benefit from increased domestic road-trip holidays while the country’s boarders are closed. Another potentially positive driver for BAP is increased demand for cheaper independent servicing in a tougher macro backdrop.

A stronger earnings recovery coupled with a balance sheet now well positioned for growth has driven a solid rally in the shares, back trading close to $6.00 which implies 12x pre-COVID19 EBITDA. We continue to view valuation as undemanding considering the quality and growth potential of the business.

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