Author: Mike Allen (pictured), director, equity research, Zeus Capital
"Looking ahead to 2015, the UK motor retail sector looks undervalued in the current environment.
"Consolidation should continue next year, which should also add an additional growth kicker to earnings in our view. We believe the UK pure play businesses have an attractive risk/reward profile going into 2015, with Inchcape our least preferred play given its premium valuation and strategic uncertainty ahead of its new chief executive.
? Market dynamics. While the sector steadily moves out of its recovery phase and growth rates moderate as a result, we believe the sector still has plenty to offer as it moves into mid-cycle. We do not think we are at peak levels yet with the new car market seeing a fundamental shift into shorter buying cycles, which is more akin to the US market driven by attractive financing deals for consumers. The supply push into the used car market could create short term pricing pressure, albeit most dealers have strong processes and pricing discipline in place. The growing car parc should create more opportunities in aftersales, which remains a key margin driver.
? Forecast assumptions. While the sector outperformed 2014 expectations by circa 25% set this time last year, we have assumed modest organic volume growth for the year ahead and stable/modest pressure on pricing across the core markets. The biggest near term risk to earnings is on used car margins in our view, although growth momentum elsewhere should contain this.
? Valuation. The sector trades at a 24% discount to typical mid-cycle levels and a 29% discount to the general retail sector, despite having superior earnings momentum and free cash flow generation. The consolidation dynamics remain attractive, which should leave our current growth assumptions looking well underpinned.
? Key plc picks. We favour stocks that can outperform estimates on low ratings and have strong balance sheets to leverage in this market. Cambria Automobiles and Vertu Motors on this basis remain attractive consolidation plays in our view. We also believe the risk/reward profile at Lookers and Pendragon look positive both from an earnings and valuation perspective. Inchcape has some potential earnings upside but strategic uncertainty as a new CEO takes the reins at some point in 2015 has the least favourable risk reward in our view."