Vertu Motors (VTU): A U.K. Car Dealer, “Davis Double Play”, and Geoff’s Latest Purchase
Accounts I manage own some shares of Vertu Motors (VTU) – bought last week – but, far less than a normal position. Whether we end up owning a full position – that is, having something like 20% of the portfolio in Vertu – or not depends mostly on whether the stock’s price comes down and stays down for a while. As I write this, shares of Vertu trade for about 40 pence. They were as low as 31 pence not too long ago.
I wrote the stock up last year. For my initial thoughts on Vertu, read that post. For a good overview of the entire U.K. auto industry and the various publicly traded companies in it – read Kevin Wilde’s post.
I’m going to spend most of this post talking about whether Vertu is cheap enough to buy now. Before I do that, I should talk a little about Cambria Automobiles (CAMB). I had planned to do a write-up of Cambria before writing up Vertu. I decided not to. My reason for skipping a write-up of Cambria is that I realized I just didn’t have much to say about the stock. Cambria has somewhat better margins and inventory turns than Vertu. So, the actual business provides a bit higher returns on tangible invested capital. On top of this, Cambria has not issued more shares over time while Vertu has. Vertu did two very costly capital raises – both many years ago – that severely diluted existing shareholders at low values versus tangible book. This has had a big influence on the outperformance of Cambria as a stock over Vertu. One possible explanation of this is that top insiders at Cambria own between 40% and 50% of that company. At Vertu, the two biggest insiders combined own something closer to 5% of the stock. Management’s incentives for compounding PER SHARE wealth at Cambria are greater than they are at Vertu. Until recently, Cambria’s management talked a lot more about the kind of metrics shareholders care about than Vertu did. In the last couple years, this seems to have changed – with Vertu’s management using a lot of the usual buzzwords about shareholder value. And then – in the very recent past – Vertu’s actions followed those words. The company bought back over 2% of its shares outstanding in the first 6 months of this year. Those purchases were done at very big discounts to tangible book.
That explains my increased interest in Vertu today versus years ago. It doesn’t explain my reasons for preferring Vertu over Cambria. I should be clear here. I don’t really think of it as preferring Vertu over Cambria. Ultimately, I didn’t decide Cambria wouldn’t outperform Vertu – it may FAR outperform Vertu for all I know – I just decided to pass on Cambria. In a recent podcast, I told Andrew “We almost never bet on change.” I suppose you could argue a bet on Vertu is a bet on a change in its capital allocation. Management is the same. But, I’m betting the company won’t do as dilutive capital raises as it did in the period about 5-10 years ago. If it goes back to doing those while I’m a shareholder – then, clearly I was wrong to buy the stock now. But, putting aside capital allocation – and I should say that it’s only ever been the capital raising (not the capital deploying) part of Vertu’s actions that bothered me – Vertu is undergoing much less change than Cambria. Cambria is investing very heavily in new dealerships, upgrades, etc. right now. As a rule, a company with above average returns on capital versus peers, versus businesses generally, etc. that suddenly grows assets a lot is one you want to be careful about. The easiest way for return on capital to decline is for a business to rapidly grow its capital base. Vertu is already generating a lot more free cash flow this year and last than Cambria was (I’m talking relative to reported earnings and things like that) and Vertu’s guidance is for much, much lower capital outlays in the next two years than it had in the previous two. Meanwhile, Cambria has shifted its business more than I like to see. It might be a really smart shift. But, it’s still a shift. Cambria has gotten rid of some dealerships it had. And it has added very high end dealerships – like McLaren, Lamborghini, and Bentley – that I just don’t want to bet on. These franchises are very exclusive. They usually have much higher returns on capital – they have both higher margins and higher turns than a Ford dealership would, for example – than mass market type brands. But, it’s just the part of car dealers I least want to be involved with. It may be a great business. But, I’m less confident I know where in the cycle we are with super luxury stuff. And, some of these brands sell very, very few cars in the U.K. In the long-run, I am most confident in the earning power of car dealers that get a lot of parts and service revenue from the cars they sell. Brands like Lamborghini – and, to be fair to Cambria they are combining some of these super luxury franchises in the same big locations in part probably to deal with this issue – sell so few cars that I worry drivers are far distant from service centers. I’m not sure that’s true. Cambria is much more skewed in terms of geography to the London area. And extremely wealthy people in the U.K. are disproportionately in that part of the country. In fact, I’ve called Cambria a “United Kingdom” car dealer group – but, if I’m reading the map right, I think they’re really just an “England” car dealer group. I don’t see any clusters of locations much outside England itself. In the long-run, I’d be more worried about direct selling of very expensive cars than things like Ford. I don’t want to overstate the difference between Cambria and Vertu in terms of brands here. Vertu does have Land Rover and Jaguar dealerships which – while not in the class of McLaren, Lamborghini, and Bentley – are luxury cars. And Cambria has some of the same mass market brands that Vertu has. It’s just that when I look at the capital allocation plans of Vertu and Cambria – I feel like I see a pivot at Cambria towards more of these extremely pricey cars and towards investing a lot in building the best dealerships in the best locations. Finally – and this last point is subjective, you can read both companies’ earnings releases from the last year or so – I think Vertu’s recent results look better and more stable to me. It’s harder for me to tell if Cambria’s older, non-luxury dealerships are holding up well at all. Some of the same store sales (“like-for-like”) numbers look poor to me. Vertu’s numbers look solid. I have no reason to believe Vertu stock will outperform Cambria stock. But, I don’t think it’s really a critical part of my job to pick between the two stocks. All I need to do is find one I’m comfortable enough with at a cheap enough price. I think I found that in Vertu. Cambria checks the right boxes as a stock. It looks better than Vertu on many measures. But, my confidence level in Cambria is just lower than it is in Vertu. So, for me – Cambria was definitely a pass. And then it was just a question of whether I’d buy Vertu and at what price.
I recently re-read “The David Dynasty” which is about 3 generations of investors in the Davis family. The first owned insurance stocks on margin. A term repeated over and over again in that book is “The Davis Double Play” which means: 1) The stock’s EPS rises while you own it and 2) The stock’s P/E multiple expands while you own it. It’s the combination of these two things that drives really good results in stocks that are neither deep value stocks nor super fast growers. Although I don’t think I’ve ever used the term “Davis Double Play” on the podcast – it’s clear that the combo of EPS growth and P/E multiple expansion is a big part of the winning stocks I’ve had. The first Davis generation focused on insurers. And that was a particularly good group – as compared to say technology companies – to focus on when trying to find a “Davis Double Play”. The advantage of insurers is that as long as they survive, they don’t become obsolete. So, there will usually be a high point in the cycle again where investors put a high enough P/E on an insurer. Insurers aren’t fads.
Neither are car dealers. I think U.K. car dealer stocks can give investors a “Davis Double Play”. I have no idea what will happen with Brexit and its immediate aftermath. There could be some terrible recession that eats into auto sales for 3 or 4 or 5 years. But, putting that short-term to medium-term risk aside, I’d say we appear to be at roughly the mid-point of the car sales cycle in the U.K. Basically, I think today’s earnings at a company like Vertu are roughly “normalized earnings”. Over the next couple years, Vertu will probably convert a lot of EPS into free cash flow. But, normally, I’d expect car dealers could convert as little as 2/3rds of EPS into free cash flow. I use normalized FCF ratios rather than P/E ratios when analyzing a stock. So, let’s start with that assumption. Vertu’s current P/E is 8. That would translate into perhaps a Price/Free Cash Flow as bad as 12 (or 8.33% FCF yield). Vertu has basically no net debt. It leases half its locations. And it finances its inventory. It has some cash. Overall, I’d say it does have some debt. But, it uses less leverage than almost all car dealers in the U.K. or U.S. would consider normal and prudent. It’s basically unleveraged.
There are other ways to try to come up with the current price. The one I just gave you says the normalized FCF yield would be greater than 8%. Another approach is to use EV/Sales. In recent years Vertu has had operating margins of 1.1%. EV/Sales is 0.05 right now. Eventually, the U.K. tax rate is expected to decline to 17%. Taking these 3 figures together we get 1.1%/0.05 = 22% pre-tax yield on the stock times 0.83 equals 18% after-tax yield. Then we once again assume EPS converts to FCF at 2/3rds rate. This brings us down to a 12% FCF yield assumption. So far we have one method telling us it’s an 8% FCF yield and another saying 12%.
We can also use the price to tangible book approach. Vertu now trades at 0.9x tangible book. Adequately performing dealerships – even single locations – tend not to go for less than tangible book in negotiated sales. I would assume a sale of all of Vertu’s dealerships together to some competitor bigger than Vertu would be done at closer to 1.2 times tangible book than 0.9 times tangible book. In recent years – I used the last 4 years for this one – Vertu’s EPS divided by its STARTING net TANGIBLE assets per share for the year was in the 12-17% range. In other words, if returns on tangible assets were the same going forward – they’d be about 12/0.9 = 13.3% to 18.8% (17/0.9).
I don’t expect Vertu’s actual returns to be that high. It has a lot of goodwill and intangibles. These don’t matter if the company doesn’t buy more dealerships at above tangible book value in the future. But, I expect it will. So, returns will not be as good as like teens returns on reinvested earnings.
The stock pays a 4% dividend yield which it covers about 3 times (company guidance is to pay a dividend it can cover at least 3 times).
If we are in a normal point in the cycle and dealerships can grow in line with nominal GDP and U.K. nominal GDP grows at about 5% a year for the next 10 years – then, we can assume things like EPS, dividends, etc. will grows about 5% a year before adjusting for share issuance and buybacks.
Let’s just assume 4% annual growth. Population growth is quite low in the U.K. Inflation is not terribly high. And the entire car industry doesn’t grow faster than the economy (though I suspect big dealers like Vertu will take share from small dealers either organically or through buying them).
Let’s assume Vertu is trading for somewhere between 5 (that is, an 18% FCF yield) and 12 times normalized FCF (that is an 8% FCF yield). You can check the methods above for trying to determine normal earnings. I’m going to go with 10%. That may be low compared to what FCF will be these next couple years. But, in the long-run, I’m not sure car dealer EPS converts to FCF very well. Still, I do think the stock is trading at about 10 times its normal FCF.
Normally, I’d expect to sell a stock at around 15 times free cash flow. That is, I’d expect a durable business – like a car dealer – to eventually trade for 15 times free cash flow.
So, let’s assume normal free cash flow here is 4 pence a share. It compounds at 4% a year for the next 10 years. That’s 5.92 pence. I’m going to call that 6 pence in free cash flow expected in 2029. That’s an expected share price of 90 pence. The capital gain over 10 years going from a 40 pence share price to 90 pence share price would be 8.5% a year. The dividend yield is 4% right now. Presumably, the dividend would grow along with EPS – but I’ll ignore that. You add the dividend yield to the 8.5% a year capital gain and get a 10-year expected return of 12.5% a year. This assumes the stock eventually trades at 15 times free cash flow. Vertu hasn’t traded at that in the past. But, it’s been my experience in investing that if you are right about what the company will look like down the road – the market will award the multiple you expect regardless of what past multiple it assigned the stock. In other words, if Vertu doesn’t issue more shares at low prices, if it does buy back stock, if it does keep raising its dividend, if it does earn a teens type ROE excluding acquisitions – it’ll eventually trade for a “normal” stock price of like 15 times free cash flow (which, remember, is not a very high P/E if conversion from EPS to FCF is as poor as I think it can be). In this calculation, we’ve also omitted the other 6% of the current purchase price that I expect to be normal FCF that isn’t paid out in a dividend. Ideally, Vertu would use this to buy back stock. But, I’m skeptical. At best, they’ll buy back like 4% of their shares this year. At worst, more like 2%. Some U.S. car dealers – most notable AutoNation (AN) – have been way, way more aggressive with buybacks. I don’t think Vertu will ever get that aggressive. But, if the stock stays cheap – you’ll get a very good return on any buybacks done with that extra free cash flow. I don’t know what Vertu will do with the extra free cash. But, it’ll be something. Maybe acquiring stuff. Maybe buybacks. Maybe higher dividends. But, the company is already a bit overcapitalized by car dealer standards. It won’t just pile up the cash. So, something will be done that should add on to the already expected 12.5% a year return discussed above.
In this way, Vertu is a “Davis Double Play”. It can grow 4% a year or something without any buybacks. It might buyback a couple percent a year so EPS grows more like 6% a year. And then the multiple is likely to expand from a P/E of 8 to something closer to a P/E of 12 or more. Just an expansion to a P/E of 12 would add more than 4% a year to your return over 10 years. There’s also a dividend. Anyway I crunch it, I’m getting expected 10-year returns in like the 12-15% range.
In my experience, if you’re right that the return for a 10-year holder of the stock will be in the 10-15% a year range – you’ll end up making a better CAGR than that, because the stock will rise a lot faster than you expect and you’ll end up turning over the shares to someone else a lot quicker than 10 years from now. So, a stock that seems very likely to do better than 10% a year often gives you really good results over like a 3-year holding period instead.
Like I said, accounts I manage own some shares of Vertu. But, the number of shares they own right now is a lot les than what I’d like to own. I’m certain to bid for more shares in the future. But, it’s uncertain how many shares I’ll get at the prices I’m willing to bid at.