SIF Folio: Vertu Motors could tick all the boxes

In last week’s SIF update I tweaked my screen to find new stocks and found that electricity utility Drax was a near-perfect match for the buying criteria I use in this rules-based portfolio.

This week I’ve tried a slightly different approach, stripping out my dividend requirements to find companies whose payouts were suspended last year but which otherwise pass all of my tests. I was hoping to find a company whose dividend is expected to resume this year in line with pre-pandemic levels, rather than being rebased -- or cut, as you and I might call it.

Car dealership group Vertu Motors (LON:VTU) ticked all of the boxes in my screen except for a dividend payout. Fortunately, management have already said they’re confident dividend payments will be resumed for the current (FY22) financial year. Broker forecasts suggest a payout of 1.6p per share this year, only marginally below the FY20 payout of 1.65p per share. 

(Of course, these are only forecasts at this stage, but I feel it’s reasonable to compare them with similar forecasts for other companies which suggest material dividend cuts are likely when payouts resume.)

Vertu Motors (LON:VTU)

AIM-listed Vertu was founded by CEO Robert Forrester in 2006, to act as a consolidator of UK motor retail businesses. Its best-known brand is probably Bristol Street Motors, but Vertu also operates under a number of other brands. The company says it is now the fifth-largest motor retailer in the UK, with 149 outlets representing many of the major manufacturers. 

The three executive directors all worked together at dealership group Reg Vardy until 2006, when that company was sold to listed operator Pendragon. 

Vertu has a market cap of £163m and turnover of £3.1bn, pre-pandemic. Margins are low, as is the norm in this sector, but the group has a strong balance sheet and has historically been quite cash generative.

Stockopedia’s algorithms like the stock, awarding it a StockRank of 98 and Super Stock status. 

I’ve taken a look at the numbers behind these factor scores to find out more. Should I add Vertu Motors to SIF?

Value: below net asset value

Car dealership groups usually trade on modest multiples of earnings, so I’d expect Vertu to score well for value. It does, with a ValueRank of 98.

The shares currently trade on less than 10x pre-pandemic earnings, with a historic dividend yield of 3.6%. (I’ve disregarded the 2020/21 pre-tax profit of £22.4m. This appears to have been entirely generated by government support measures totalling £36.5m, which the company does not intend to repay.)

Most other car dealers also look cheap relative to past earnings. But one thing that differentiates Vertu is its sizable freehold property estate. The latest accounts show a tangible net asset value of 50.2p per share. The share price is 45p at the time of writing, pricing the stock at a 10% discount to NTAV. That seems cheap to me, especially since the group ended last year with an adjusted net cash position of £1.4m. 

I think Vertu shares look genuinely cheap -- freehold property will normally find buyers even in distressed times. The current valuation suggests to me that the market is assigning a very low value to Vertu’s operating business. I’m not sure that such a pessimistic view is justified.

Quality: better than it looks?

Vertu’s QualityRank of 71 might seem counterintuitive for a business with an operating margin of 1.2% in a good year.

How can a business that appears to be only marginally profitable score well for quality?

I think there are a couple of points to make here.

Profitability is about returns as well as margins: Vertu’s operating margins are slim, but this isn’t the only way to judge profitability. A more meaningful measure, in my view, is to look at the returns on capital employed generated by the business. 

Car dealers normally use a secured credit facility to fund their stock. This enables them to magnify the returns they earn on each car sold. Vertu’s six-year average ROCE is 9.2%, which is significantly better than its operating margin might suggest.

Aftersales work also makes a strong contribution to these returns, as profit margins are much higher on servicing and repairs. Vertu says that aftersales work generated a gross profit margin of 49% last year, compared to a gross margin of 4% on new vehicle sales. In the year before the pandemic, aftersales generated 43% of the group’s gross profit. 

I think that the superior profitability and less cyclical nature of aftersales revenue supports the case for physical dealership networks. Although some car sales are shifting online, I reckon dealers with physical locations should still be able to add value versus online-only offerings.

F-Score shows improving fundamentals: Profitability is one important element in quality scoring. But the F-Score measure of fundamental health is also heavily weighted in the QualityRank. The F-score measures trends for nine factors including margins, cash generation and leverage. Vertu scores quite well:

Free cash flow: I normally focus quite heavily on free cash flow, but I haven’t with Vertu. The reason for this is that the company’s cash movements last year were heavily distorted by circumstances. 

Net cash from operating activities rose from £19.5m to £74.9m during the year to 28 February 2021. The main driver of this was a £29.6m reduction in working capital, which fell as reduced sales resulted in lower inventories and receivables. Business rates relief of £8.7m also resulted in additional cash being retained within the business. I’d expect that such cash flows would reverse and normalise this year, so I don’t intend to place much emphasis on last year’s bumper cash performance. 

These factors may have boosted some of Vertu’s quality metrics, although I don’t think the overall impact on the QualityRank should be too significant.

Momentum: solid outlook

In my view, Vertu’s value and quality metrics do not flag up any serious concerns. I also think the current valuation offers good downside protection, thanks to the extensive property backing.

However, cheap small cap stocks will sometimes stay cheap for long periods, if they’re unable to demonstrate that they deserve a higher valuation. 

This is where momentum becomes important. This factor has two primary components - earnings growth and technical momentum, which is driven by price action.

Vertu’s MomentumRank of 88 suggests the stock scores quite well in both regards, so let’s take a look.

Price momentum: Vertu’s shares have outperformed the market over the last year, resulting in strong relative strength scores. Volumes appear to have weakened over the last couple of weeks, but I’d expect this as the buying activity triggered by May’s results dies down. Small caps are less liquid than larger firms, but this isn’t necessarily significant. 

I’m pleased to see the shares are still trading above their 50-day and 200-day moving averages. Technically, this suggests the current uptrend may still be intact.

Earnings estimates: May’s full-year results triggered a round of earnings upgrades for Vertu. Note that FY23 growth is expected to be minimal, after a stronger recovery this year:

These have returned the earnings outlook to pre-pandemic levels:

These forecasts price Vertu shares on eight times forecast earnings, with a dividend yield of 3.6%:

Share buybacks? The company has said that share buybacks may be used to soak up “excess FCF [free cash flow] at share prices below intrinsic value”. So if trading remains strong and the share price remains below its tangible net asset value, we may see some buyback activity later this year. This might help to support a higher share price.

On balance, I think Vertu’s momentum looks appealing. Demand for cars appears to be strong and broker forecasts suggest that the group’s profits could exceed pre-pandemic levels this year. Based on this outlook, the current valuation looks very affordable to me.

My decision

The outlook for UK car retailers isn’t without risk. A global shortage of semiconductors is threatening to limit supplies and distort the pricing of new and used cars. Broader inflation could also make a return after years of absence, putting pressure on household budgets.

Another concern for me is that we don’t yet know how the economy will behave when government support measures - especially furlough - finally come to an end. 

However, my policy with SIF stock selections is to (mostly) avoid macro issues and focus on fundamentals. Vertu looks attractive to me on this basis.

I’ve decided to add Vertu Motors shares to the SIF folio and to my personal holdings this week. As always, I’ll make the trades after this piece has been published. 

I’d be interested to hear your views on car dealerships and other consumer stocks. Is the good news already in the price, or can we expect to see a sustained period of strong performance as the pandemic eases?