Inchcape

Company overview

First, I will address the question what is Inchcape? In the eyes of the FT we are looking at a “United Kingdom-based automotive distributor and retailer”. We observe that Inchcape creates revenue from 2 key sources. The retail segment and the distribution segment (with distribution making up 81.6% of operating income and the other 18.4% generated by retail).

The Distribution segment delivered a strong performance in year-on-year revenue by 16.5% and by 5.2% excluding the new South American operations. Hence the firms new operations in south America suggests some alpha generating opportunities for investors. Inchcape’s growth in market share in emerging markets, most notably their BMW business in Chile and Peru, along with Toyota in Ethiopia, suggest they are exploiting their already efficient distribution channels in Europe and North America and extending these methods to developing markets, creating an economic moat in terms of brand recognition (in this case by extending distribution channels to emerging markets Inchcape are trying to exploit first mover advantage and cement their position in emerging markets, where the power of Daimler group is less explicit.

The retail segment however displays less promising growth figures, this does need to be considered in terms of statistical significance on the equity valuation, Inchcape’s long term strategy is to increasing the influence of their retail segment, an allocation of resources towards this segment and an increase in working capital in retail however may have valuation effects and depress possible alpha generation capacity in the long run. However, the net effect of this is likely to be insignificant assuming we see the continued strong performance in EMEA, and the exposure to the full vehicle life cycle (after sales growth in 2017-18 was a key driver of growth, with the firm hiring more technicians and creating a new pay plan).

The company is also less likely than others to be affected by the possible US/China trade war. Despite the possibility of margin compression if Inchcape is unable to pass on higher retail/distribution prices I see this as only a short-term risk. Moreover, their strong presence in after sales (something many of the large groups like VW and Daimler lack), would suggest that even in times of uncertainty they have sufficient insurance against possible margin compression, by generating sustained growth in after sales (once a consumer has purchased a car the inability to pass on cost increases becomes irrelevant). Hence, I believe that despite the warnings issued by VW, Daimler and BMW. We should see robust growth in Inchcape’s revenues in the 3-5 year period.

Fundamentals

Economics

Inchchape’s economics are showing strong potential for alpha generation. Underlying ROCE is up 4.97% from 2016 at 19.36% (considering WACC is at 7.48%) this is a highly attractive figure and suggest an ability to create constant investor return, further reinforced by the consistent growth in ROIC since 2012. In addition, we observe free cash flow per share of 2x dividend per share, outlining Inchcape’s ability to create constant returns for investors whilst also having “owner earnings” left over to invest in growth and the creation of economic moats.

Furthermore, the current P/E valuation of 9.91 suggests a serious undervaluation in the market, low P/E can often be brought about by leverage problems. However, Inchcape is showing a current ratio of 1.04 hence do display sufficient ability to meet their short-term liabilities. Thus, I believe that this low P/E derives from 2 main factors, the first is the fact that there Inchcape has some mismatched currency exposure which may suggest leverage problems if we see the expected effects on the dollar and yen play out due to the US/China discount. A quick ratio of 0.49 is worrying, and if Inchcape was to face a crisis scenario then we may see collateral calls cripple the firm (see Lehman Brothers). However, I believe that in the long run Inchcape’s large free cash flow component is sufficient to offset this risk. In addition to this a P/B ratio 1.60 again reinforces the hypothesis that the market currently undervalues Inchcape’s, failing to see the robust cash flow generating potential that should drive investor returns.

Duration

In the view of the CFO “recent refinancing events (which have created 5,7 and 12 year obligations) extend the Group’s committed facilities at attractive financing rates”. This idea that the group has ensured their future operations sufficiently, is reinforced by similar previous financing activities, the group has seen no pre-crisis default on dividends (paying out in full for the last 10 years). However, we observe that statistically this is obsolete, as past performance is no indication of how future financing actives will effect revenue streams. Inchcape does display several enduring economic moats. The first is the large cost advantage deriving from economies of scale in their production process, the second the high barriers to entry created by their exclusive distribution agreements with the likes of Toyota, and finally a strong presence throughout the product cycle, which sees more consistent revenue streams and strong after sales performance than their competitors.

Governance

Inchcape displays a transparent and independent board of governors and senior management team. 80% of the boards 10 members are independent, and the firm makes no political donations. Such independence hence means that Inchcape’s C-Level executives have clearly defined targets when it comes to asset allocation, and growth targets. Moreover, the transparency in the compensation structure suggests a strong performance related pay bonus, will align managements interest with those of majority shareholders. Finally, Inchcape’s largest shareholders are Standard life, M and G and Black Rock, all of whom are known to take a hands off approach and allow management to pursue beneficial capital allocation and expenditure policies.

Technical and risk metrics

Inchcape’s underlying Beta volatility (β) is 1.1156. At a P/E ratio of 9.91 this makes for attractive risk reward ratio and some volatility that should help to drive long term alpha generation. However, beta volatility can be seen as obsolete in my hypothesis as regardless of the performance of the FTSE100 or SP500 (the benchmark we use to measure β volatility in this case), we should still see sufficient growth in underlying ROE and cash flow which will generate higher market valuation in the 3-5 year horizon.

The second measure I use is the 1 year normal distribution in price volatility. This indicates to us whether or not Inchcape’s current price provides a good entry point. Currently we see that year to date price volatility follows a (676,81) normal distribution hence at our current open price of 576 this provides a standardised normal probability of 0.1064 (for those interested this is generated form the R model pnorm(576, mean=676.7563, sd=80.86, lower.tail=T, log=F)). Meaning that 227/254 price closes in the last year have been at a price above 576, implying a solid entry level and sufficient scope for possible alpha generation. Again, I will preach obsolescence for these calculations in the long run. However, in the short run (less than 1 year) entry level differences could equate to a loss in α of up to 2.5%.

Final Recommendations

Ultimately Inchcape is undervalued by the market. This is mainly due to the markets inability to effectively price in the differences in poor industry alpha and good company alpha, and hence the first seems to be depressing the latter. Company fundamentals show a serious lack of valuation in comparison to competitors (with a P/E valuation of just over half of industry average) despite large ROE generation and the fact we are seeing owner earnings (free cash flow to equity) of 191.4 Million, which should contribute to the implied return from EPS growth.

My following predictions for returns are as follows:

To conclude I will mention some of my reasoning and justification for my thesis:

- First of all, I base all of my calculations on the share price at open on 11/01/2019 and all figures are correct to date.

- Second, I ignore the use of EBITDA, as in the eyes of buffet “Does management think the tooth fairy pays for capital expenditures?”, in other words the ignorance of amortization and depreciation are damaging to long run valuation analysis.

- Finally, I believe that there is little need to view the Sharpe ratio or moving average as theses are tools reserved for traders who are trading an intraday strategy and not looking at long term company fundamentals. Hence, I place considerably more weight on the company fundamentals than on the risk ratios and technical analysis.