SIF Folio: Is car dealer Lookers a true contrarian buy?

I think it’s fair to say that many of us feared the worst when Staffline shares were suspended at the end of January. So it’s a welcome relief to be able to report positive news this week for this SIF folio stock.

I’m also pleased to have a new stock to consider for the portfolio. Car dealership group Lookers is undoubtedly a contrarian choice at the moment, but I’ll be looking at the numbers and deciding whether to add the stock to the SIF folio.

Staffline: What really happened?

After shares in blue collar recruitment group Staffline (LON:STAF) were suspended following allegations “in respect of invoicing and payroll practices”, I took another look at the firm’s historic cash flow. I didn’t find anything resembling a smoking gun, but I was still concerned about the situation.

After an independent legal investigation, one problem has been confirmed. The company is working with HMRC “to quantify underpayments made in the past to workers, over a number of years prior to 2018”.

It seems the company may have breached minimum wage regulations by not paying staff in certain food production facilities for time spent donning protective workwear before their shifts. An existing provision for this problem has been increased by £3.5m as a result of this investigation.

My view: This news isn’t as bad as it might have been. I’m still a little unhappy to see exceptional charges of £23.5m this year, but on balance I share Graham Neary’s view that the shares should be worth north of 1,000p.

Lookers: Crazy or Contrarian?

I exited the automotive sector in January when I sold the SIF folio’s holding in used car supermarket Motorpoint.

But I’m now mulling a return. Car dealership group Lookers (LON:LOOK) has cropped up in my screening results this week.

This company’s history can be traced back to 1908, when it was founded as a bicycle retailer. Lookers started selling cars in 1910 and made its first acquisition in in 1960. Since then it’s grown steadily and now operates 154 franchised dealerships.

Last week’s 2018 results suggested that the company coped well with last year’s WLTP-induced new car supply restrictions:

• Revenue +4% to £4,880m

• Gross profit +2.3% to £515.5m

• Pre-tax profit -9% to £53.1m

• Net debt -11% to £86.9m (equivalent to 0.9x adjusted EBITDA)

In short, the company seems to have offset a 3.3% fall in new car sales with higher gross margins on in-demand new cars and a 14% increase in used car sales. Aftersales revenue also improved, supporting margins. Pre-tax profit fell due to rising costs and spending on upgraded dealerships.

With the shares now trading on less than nine times trailing earnings, this century-old firm looks like a lot of business for the money to me.

Stockopedia’s algorithms also seem to like the shares:

Let’s take a closer look.

‘Magic Formula’ value

Lookers’ ValueRank of 75 is only averagely good. But it contains one ratio that holds a big appeal for me:

Earnings yield: Regular readers will know how much importance I place on earnings yield (EBIT/EV), a measure made famous as part of the Magic Formula stock ranking system developed by US fund manager Joel Greenblatt.

I like earnings yield because it gives us a clear indication of how much profit a company is making, relative to the value of its equity and debt capital. Lookers’ earnings yield of 14.4% is nearly double my minimum of 8%. Even after adjusting for last year’s property sales, earnings yield is still 12.9%.

This suggests two possibilities to me. Either the stock is cheap, or profits are about to collapse.

Last year’s figures don’t seem to suggest imminent collapse to me. Margins were stable despite sector headwinds and net debt fell, thanks to good cash generation and some property disposals.

Free cash flow: The ValueRank graphic above shows a price/free cash flow ratio of 53. What seems to have happened is that Stockopedia’s data supplier has stripped out the cash inflow from c.£35m of property sales, but included the cash cost of acquisitions and property purchases.

This seems inconsistent to me — if one-off disposals are stripped out, then I’d exclude acquisitions too. On this basis, my sums suggest a P/FCF of about 19. I can live with that, given that the group is working through a programme of capex to upgrade its dealership premises.

Is quality weakening?

The second ratio used in Greenblatt’s Magic Formula is return on tangible capital employed. This is designed to exclude sunk costs such as goodwill, which do not represent capital directly employed in operating a business.

I’m not sure I share Greenblatt’s view on this, especially for an acquisitive company such as Lookers. In my opinion, the price paid for acquisitions should be such that attractive returns can be produced including goodwill.

Happily, Lookers seems to be performing fairly well in this regard:

Lookers’ six-year average ROCE looks impressive, at 15.1%. But as sometimes happens, this average masks a less favourable trend:

Market conditions have got tougher since 2014, not least because of the diesel backlash that’s seen sales of new oil burners slump.

However, last year’s ROCE of 11.2% is still acceptable to me, assuming that profits aren’t expected to keep falling.

Momentum stats are mixed

Lookers’ momentum metrics paint a mixed picture:

Let me try to explain how I’ve interpreted these ratios.

The stock’s price momentum factors look fairly strong. But the outlook for earnings seems less reassuring, with recent downgrades for 2019 (FY1)  and 2020 (FY2).

Consensus forecasts now suggest a figure of 12.8p per share for 2019. My guess would be that the comparable figure for 2018 is 12.7p (adjusted earnings excluding property sales). On this basis, Looker’s profits are expected to fairly flat this year.

However, this outlook has been downgraded several times over the last year:

How much of this decline is due to analysts’ Brexit fears, and how much is down to worsening trading? It’s hard for us to know.

In his 2019 outlook statement, chief executive Andy Bruce said Brexit uncertainty was “unhelpful” but reported “a good start to the current financial year”. New car orders are said to be building in line with expectations. Further growth is expected in used car sales and aftersales, which collectively generated 65% of gross profit last year.

Stockopedia shows a rolling forecast price/earnings ratio of 8.0, with a 4.1% dividend yield. A return to earnings growth is forecast for 2020.

On balance, I’d say momentum looks positive if you can accept the cyclical risks.

My decision

Lookers’ modest valuation is paired up with a solid balance sheet and a £300m property portfolio. For a group with an enterprise value of £511m, I think this should provide a degree of downside protection.

Obviously there’s some macro risk here. Although a no-deal Brexit appears to be off the table, a protracted delay might not resolve the uncertainty that’s being felt by businesses.

The market appears to be wary of consumer cyclical stocks — an area where SIF already has more weight than average:

I’ve always been happy to weight the SIF folio’s sector allocations differently to the wider market, on the basis that to outperform the market you need to do something different.

Heavy exposure to consumer cyclical stocks obviously carries some risk. But I would note that one of my other holdings in this sector, Bloomsbury Publishing, generated 69% of group revenue overseas last year. Similarly, giftware firm Character Group sells many small-ticket and seasonal items. I’d expect these firms to be less impacted by Brexit uncertainty or cyclical shifts.

On balance, I think Lookers is an attractively-valued stock that passes all of my screening tests. I will be buying the shares for the SIF and for my own portfolio this week, after this article has been published.

As always, I’m keen to hear what you think. Are car dealers value traps, or a contrarian opportunity?

Disclosure: Roland owns shares of Staffline, Character Group and Bloomsbury Publishing.

Stockopedia