Vertu Motors: A Cheap and Safe U.K. Car Dealer
Vertu Motors owns more than a hundred car dealerships in the United Kingdom. About half of the time – so, at 50+ locations – Vertu Motors also owns the land on which the dealership is built. They lease the other half of their locations. The stock trades on the London Stock Exchange (the AIM market, specifically) under the ticker “VTU”.
Back on November 14th, 2017 Focused Compounding member Kevin Wilde sort of wrote up Vertu Motors. He did an idea exchange post on U.K. car dealers. The stock he focused most on was Vertu Motors.
Why?
Why focus on Vertu Motors specifically?
And why focus on U.K. car dealers generally?
Publicly traded U.K. car dealers seem to trade at lower prices than their U.S. peers. In the U.S., car dealerships are usually sold at a premium to tangible book value. Car dealer stocks tend to trade at a premium to tangible book value. In the U.K., some publicly traded car dealers – like Vertu Motors – have shares that can be bought below tangible book value.
We can try to come up with arguments for why U.S. car dealers should be more expensive than U.K. car dealers. But, the math isn’t very convincing. For example, if we look at the rate of growth in Vertu Motors’ tangible net assets per share over the last 5 years – it isn’t lower than what U.S. car dealers would be able to achieve. At times, Vertu Motors stock has grown net tangible assets per share by 10% or more a year while also paying a dividend. The company was not very successful growing PER SHARE asset values in the years immediately after its founding (though it did increase the size of the company and improve its economics during this time). Since scaling up, the company seems capable of getting a 10% growth rate in net tangible assets without using leverage. Car dealers often use some leverage. And – as I said earlier – Vertu Motors stock can sometimes be bought below its tangible net assets. The company’s management includes their own 10-year calculation of free cash flow generated versus assets employed and comes up with a number around 10% a year. If I take the most recent half of the company’s existence and use the rate of compounding in net assets per share (instead of FCF like the company uses) I’d get a similar rate of value creation. Basically, I’m going to assume here that Vertu Motors can generate about 10% worth of “owner earnings” relative to its net tangible assets.
We can use that information to answer the question: “Is it cheap?”
When first looking at a stock, I often ask 5 questions: 1) Is this stock overlooked? 2) Can I understand this business? 3) Is the business safe? 4) Is the business good? 5) Is the stock cheap?
Because I started today’s discussion with the company’s ability to generate earnings relative to tangible equity – let’s start with #5.
Is Vertu Motors stock cheap?
Yes. As I write this, Vertu Motors stock trades below 40 pence. On October 10th, 2018 the company provided balance sheet information as of August 31st, 2018. At the end of last August, net tangible assets per share were 46 pence. The company has reduced the number of shares outstanding since last August. And the purchases of stock the company made between the end of last August and the time I’m writing this were done at prices below net tangible asset value. So, we can assume the market price of this stock is somewhat below 40 pence and the tangible asset value per share is somewhat above 46 pence. If we assume your annual total return as a shareholder will be roughly equal to 10% of starting net asset value – then, the company’s normal “earning power” right now should be about 4.6 pence (0.10 * 46 pence). The stock price is 40 pence. So, 4.6 pence divided by 40 pence is 11.5%. If you bought at today’s price, you might expect a return of between 11% and 12% a year from this stock.
That’s for U.K. based investors. They have Pounds right now they want to use to buy this stock and get Pounds back in dividends received, proceeds from the stock sale, etc.
For U.S. (and other non-U.K. investors), an investment in VTU would work differently. First, the buyer would convert their currency – in this case, I’ll assume U.S. dollars – into Pounds and then they’d buy VTU stock. Any dividends received would be paid in Pounds (not dollars). And then the stock would – perhaps many years from now – eventually be sold in Pounds. Finally, the investor would convert these Pounds back into U.S. dollars.
For this reason, it matters what the exchange rate is between Pounds and dollars right now. In fact, it matters in much the same way that VTU’s own price to net asset value matters.
Let me explain.
VTU’s internal rate of return – the company’s own Pounds generated on Pounds tied up in the business – might be 10%. However, an investor – even a buy and hold forever investor – will make a somewhat different return on their shares than VTU makes on its business, because this investor is not paying 1 Pound for every 1 Pound of tangible net assets tied up in this business. You – the U.K. based shareholder – are getting your shares of VTU at a 13% discount (0.87x net tangible asset value), because you are paying 40 pence today to get an interest in 46 pence of net assets inside the company. You can see how this 0.87 modifier wraps around the company’s own operations. The company is generating a 10% – we’re assuming for the sake of illustration – return on its money. But, you are buying in at 0.87 times tangible book value. So, your initial investment return here would be more like 10% / 0.87 = 11.5%. Now, it’s worth mentioning that as the company reinvests money in its own operations, your return would trend closer to the company’s own returns on capital. So, you’d start with an expectation of 11.5% a year but this would trend down toward 10% a year as you held the stock forever. There is another aspect – the “trading return” – to this that I’ll discuss later. Right now, I’m only discussing the “hold return”. This means that buying at a slightly lower price-to-book ratio than 1 (in this case, 0.87) will make a difference – but not a huge difference – for a buy and hold investor. And, the cheapness of the stock will matter most the shorter your holding period while the quality of the business will matter most the longer you hold the stock.
For an investor, the VTU price-to-book ratio here works the same way as the Pounds-to-Dollar exchange ratio. If the Pound trades above purchasing power parity versus the dollar – this will negatively influence long-term returns for American investors the same way buying above book value would. If the Pound trades below purchasing power parity versus the dollar – this will positively influence long-term returns for American investors.
Right now, the Pound trades below purchasing power parity with the U.S. dollar.
In fact, we have 3 speculative “timing” type issues here going for a U.S. investor buying stock in VTU and holding it.
Vertu itself may earn only a 10% unleveraged return on its investment. However…
1) The company’s leverage ratio is lower than many companies (it has close to no net debt)
2) The company’s price-to-book ratio is below 1
3) The Pound’s exchange rate with the U.S. Dollar is below purchasing power parity
This means, that while a U.S. investor owns shares in Vertu Motors, they might experience 3 tailwinds:
1) The company increases leverage
2) The stock’s price-to-book ratio rises
3) The Pound rises versus the dollar
All 3 factors would increase returns for American investors. Moving in the opposite direction – declining leverage, a falling price-to-book ratio, and a weakening Pound would hurt returns.
In the long-run, the odds are definitely stacked in favor of higher leverage, a higher price-to-book ratio, and a stronger Pound.
But, trends could go the other way for a few years. Three years from now, you might have leverage just as low or lower. You might have the price-to-book ratio of the stock even lower than it is today. And, you might have an even weaker Pound.
We don’t know. We can’t predict the future. So, why buy Vertu Motors stock?
The basic reason is that you have 3 speculative one-time potential upside events combined with one investment long-term trend that is – on its own – sufficient to hold the stock.
You can bet on currencies directly. But, you aren’t paid 10% a year to make that bet. Here, you are. You can buy a ton of stocks with price-to-book ratios less than 1. However, very few stocks that trade below 1 times tangible book value are expected to generate as much as a 10% annual return relative to that book value. And you can bet on stocks that have surplus cash, no debt, etc. hoping they will add debt over time. But, many of those stocks are not the shares of companies with capital allocation plans that would generate returns any time soon.
Vertu has bought back stock recently. It has long said it will start generating more free cash flow starting in the second quarter of 2019. It’s likely to use this free cash flow – whenever it can’t buy other car dealerships – to simply buy back its own stock. The company’s stock trades below book value. And the company seems capable of earning 10% on its book value. This means that any stock buy backs should generate returns above 10% a year (because, they’d generate 10% a year if done at book value – but these will be done below book value).
Should – especially American – investors buy Vertu Motors stock?
Probably. A good rule of thumb would be to simply buy VTU shares at prices below the last announced net tangible asset per share figure. The last announcement – from last year – was 45.9 pence. Just truncate that number for the sake of simplicity – to make sure you aren’t buying above tangible book. That’s 45 pence. Whenever the stock is below 45 pence, buy shares. If you do this – you’d also get the benefit of any buy backs done while you own the stock having to be done at less than tangible book value. Of course, if the stock rises above 46 pence – those buy backs wouldn’t be generating as much value. You might consider selling the stock only when it surpasses tangible book value. Till that happens, just hold the stock indefinitely.
But, is the stock a huge bargain? Is there a big margin of safety?
No. If you consider all these dealerships to be worth only tangible book value – then, it would make sense to set your bid price for this stock at a level that is some level below tangible book value. Ben Graham often talked of buying at two-thirds of intrinsic value. Here, intrinsic value – conservatively calculated – might be tangible book value. So, you could decide to buy the stock whenever it traded at 2/3 of tangible book value. Right now, that’s about 30 pence. If you were really a Ben Graham type investor – you might even set your buy point at about 30 pence and your sell point at tangible book value. In other words, buy the stock at 30 pence or less. Sell the stock at 46 pence or higher.
What if you’re a longer-term investor?
This should work fine as a buy and hold stock. While you own the stock, it might compound at 10% before we take any increase in leverage, increase in price-to-book, and increase in the value of the Pound into consideration.
If the company really can generate about a 10% return on tangible book value year-after-year, then the stock should be considered as good or better than the S&P 500, the FTSE, etc. whenever it trades around tangible book value. This is because market indexes do not return more than 10% a year. So, if given the choice between owning an index at its current price or owning a car dealer at tangible book value – you shouldn’t be any worse off picking the car dealer.
Is the stock safe? Is the business good? Etc.
The industry should be safe enough and good enough. VTU’s record so far has very little volatility in results. Margins, returns on capital, etc. have all been very stable. A lot of the company’s value come from after market revenues (servicing cars the company sold). About 70-75% of the company’s profits come from service revenue and used car sales combined. New cars drive a lot of revenue, but have much less influence over profits.
It’s hard to speculate about the long-term future of cars. Certainly the safety and quality here both seem adequate. The quality – especially if the company never leverages up – may never be above average. But, it could be average. Safety may be above average. Historically, this company’s results haven’t varied much. And, historically, car dealers have had above average business safety. Right now, the business is not leveraged. Half of locations are owned. It’s definitely a safe stock for now.
If VTU stock was trading at or below 30 pence a share, this stock would already be getting something like a 90% initial interest from me. But, today VTU is at more like a 15% discount to tangible book value than a 35% discount. This means there isn’t much of a margin of safety. If I was very certain about the company, the industry, etc. that might be acceptable. Right now, that’s the issue.
Someone recommended I look at another U.K. car dealer – Cambria Automobiles (CAMB) – and I’ll certainly do so. It’s always a good idea to look at a few peers at the same time. We’re probably in the early days of my research into VTU. I’ll look more at this stock for the managed accounts. And there’s a good chance I’ll write it up again here on Focused Compounding.
I’ve started scoring stocks on how well they do on my 5 initial interest questions combined. A clear “yes” to any question gets you a plus one (+1). An iffy “maybe” to any questions gets you a zero (0). And a clear “no” to any question gets you a negative one (-1). I sum up the five figures to get a more objective assessment of how the stock looks on my 5 initial interest criteria. My “initial interest level”, however, remains completely subjective.
- Is the stock overlooked? – Maybe (0). Vertu Motors has a market cap of less than 150 million Pounds. This puts it slightly less than $200 million U.S. Dollars. That’s often used as a cut-off for what defines a “micro-cap”. However, Vertu has been public for a long time, it’s not a spin-off, etc. And it’s part of a well-known industry group (car dealers) with publicly traded peers. The company does quite a bit of investor outreach. I can’t call this one overlooked. But, it is a borderline micro-cap.
- Do I understand the business? – Yes (+1). I didn’t talk about the business in this particular write-up. But, car dealers are fairly easy to understand. I’ve looked at others before – both in the U.S. and U.K. Margins, returns on capital, etc. are more stable in this industry than in most. This particular company has been getting more and more earnings from service revenue. The industry changes pretty slowly. Market share is extremely fragmented. Car dealers as a business model are probably easier to understand than 90% of the industries out there.
- Is it safe? – Yes (+1). Car dealers are pretty durable. This company doesn’t have a lot of debt. It does have hard assets – land and car inventory – that are easy to borrow against. Compared to other car dealers, VTU appears safer than most.
- Is it good? – No (-1). Car dealers don’t have especially high returns on capital. And neither does Vertu. Car dealers aren’t bad businesses. But, unleveraged returns on capital are no better than you could get just by buying into the stock market as a whole. In other words, if you put equal portions of your savings into a collection of car dealerships at tangible book value and an S&P 500 index fund on your 45th birthday, I’m not sure – without the use of leverage – which of the two piles would be larger on your 75th birthday. Car dealers do have increasing returns with scale. VTU can get bigger and maybe more profitable than it had been in the past. But, we could also have been in an especially good part of the cycle for these 5-10 years. Much of my data is skewed toward looking at the last 5 years at the shortest and last 8 years at the longest. The car business in the U.K. had been getting a bit better each year for much of that period. I’m not sure this company can generate returns on capital much above 10% a year. It’s an okay business. It’s not a good business.
- Is it cheap? – Yes (+1). An established collection of car dealers with scale – Vertu is bigger than all but a handful of competitors in the U.K. – should trade at a premium to tangible book value, never at a discount. Vertu’s definitely a cheap stock.
“Objective” initial interest scorecard: 2 out of 5
Geoff’s “subjective” initial interest level: 70%