Description

I am recommending an investment in Cambria Automobiles plc (AIM: CAMB). I have sized this to a 6.5% position.

Company Overview

Cambria is a £47 mm market cap multi-brand auto dealership in the UK that was founded in 2006. It was the 23^rd largest dealer group in 2013 (though I suspect it is now a top 20 group). The company owns 45 dealerships, including 19 in the high luxury / premium category, 24 in the volume category and 2 in motorcycle sales. The top brands (by number of locations) are Jaguar (6), Volvo (5), Fiat (5), Ford (5), Mazda (4) and Aston Martin (3). I believe it is the largest Aston Martin dealer in the UK. The company went public April 2010 with a plan to continuing to acquire struggling auto dealership and turn them around. It has made ten acquisitions since launch.

Thesis Summary

An investment in Cambria represents an opportunity to invest along-side an owner operator undertaking an attractive buy, turn and build, and eventual exit strategy. Investors get to participate at an attractive valuation supported by significant real estate aa a time when there is clear momentum behind the business. A strong balance sheet with additional capacity for further acquisitions supports further non-dilutive growth opportunities. The growing 0 to 3 year old car parc provides a potential tailwind for service growth. Currently modest margins provide significant room for continued margin expansion. All of this bodes well for equity holders over a multi-year period.

Position Sizing

• I have sized the position in the lower half of my expected range of initial allocation to ideas (5-10%).

• Current exposure to UK pound limits comfort level in going much beyond this allocation.

• I do note that, while attractive, the company has traded at much lower P/TBV ratios in the past. Were such an opportunity to present itself, this allocation would allow for additional purchases in meaningful quantities.

Why Does Opportunity Exist

• Cambria is relatively unknown and small company. While followed by two analysts, a small capitalization and large insider ownership result in a small float.

• The market has failed to recognize the power of Cambria’s most recent transaction, referred to as the Barnet dealership, at the end of FY ‘14. This large transaction was funded without dilution and, given timing, produced a small loss for the fiscal year.

• The market has failed to recognize the potential margin improvement possible from further improving acquired businesses which were poorly run and improving the company’s service offering.

• The market has failed to recognize the potential service tailwind as the 0 – 3 year car parc grows considerably following the recovery in the UK auto market after the GFC. It is estimated that a dealership retains approximately 80% of the service post-sale in this three year period. It should not be forgotten that service drives much stronger margin, as this segment contributes about 43% of gross profit at the moment.

Management and Incentives

• I would characterize the management team at Cambria as top-notch. I am excited to partner with the team, primarily CEO Mark Lavery and CFO James Mullins. The two bring strong knowledge of the industry, and, more importantly, strong beliefs on capital allocation and acquisitions. The team is quite skilled in turning around dealerships (as illustrated below).

• Mr. Lavery owns 40% of the shares outstanding. He has never sold a share. I suspect that when he does, we all will be selling.

• At current market prices Mr. Lavery owns a stake worth £18.8 mm. He is paid £400,000 in base salary. Total compensation last year was £750,000 including bonus. The stake in the business is worth 47x his base salary and 25x his total compensation last year.

• Management dislikes dilution. The company at IPO had 100 mm shares outstanding. There remain 100 mm shares outstanding today. Buybacks have not offset option dilution.

• Management dislikes goodwill. Until the most recent acquisition of Barnet, goodwill was minimal (a couple hundred thousand).

• Management has an aspiration vision of building a £1 billion group with a 2% pre-tax margin.

Additional Notes of Value

• The management team has been very good at making acquisitions since inception. Prior to the Barnet acquisitions, the company had acquired £9.9 mm in losses through nine acquisitions and had created a business that produced approximately £5.3 mm in pre-tax income. Most acquisitions have been either distressed business or acquired out of bankruptcy and have been at discounts to or at real estate value acquired.

• In July of 2015 Cambria acquired Barnet for £10.5 mm, marking the company’s entrance into the Land Rover market. While the company had been trying to enter this brand for several years, strong product introductions over the last number of years have made Land Rover the most coveted dealership acquisitions. Coveted acquisitions usually mean fancy prices. This is the first acquisition in the company’s history to generate any meaningful goodwill. The company paid approximately 15x pre-tax earnings. The house broker pegs first year pre-tax contribution at £1 mm. Management believes there are significant levers to pull for improved earnings. It also should be noted that first year results will benefit from a co-location of the jointly acquired Jaguar dealership which did not support trailing acquired pre-tax earnings. I look at Barnet as 10.5x first year pre-tax earnings, though it is still not quite the bargain of other transactions. The valuation compares favorably to other Land Rover transactions. According to management it is also a pre-eminent location.

• The company continues to actively search for acquisitions. I estimate that the company has the capacity to do a further £24 mm in transactions over the next 12-18 months without dilution. This number is reached by adding current cash (£10 mm), funding capacity (£9 mm) and likely cash generation in 2015 (£5 mm). As noted, I think highly of the company’s acquisition strategy and historical execution and expect future transactions to be accretive to intrinsic value per share.

• The UK dealership market seems ripe for further consolidation which would support Cambria’s efforts. Approximately 60% of the UK industry is owned by entrepreneurs owning 1 or 2 locations. The largest 10 groups account for approximately 23% of the industry. With 5,000 total dealers and the still fragmented nature of the business, the opportunity set seems quite real.

• The company’s exposure to the Jaguar brand ought to serve it well over the next 3 fiscal years. Multiple dealers, including Cambria, are excited about 3 upcoming launches. According to sources, Jaguar believes its next introduction, the XE (which occurs in Cambria H2) will double new car sales in the country. While I am unable to get brand level sales and profitability, the 6 dealerships (which represent 13.3% of the total dealerships) ought to provide additional tailwinds. I am assuming there will be little cannibalization as the XE will go up against BMW, Audi and Mercedes where the company has no dealerships at the moment. Future product will also include the anticipated CX-17, a new SUV product.

• The company has significant room for margin expansion and is targeting a near double in return on sales. In its most recent fiscal year Cambria generate a 1.31% EBIT margin. Multiple competitors are operating at superior margins, including Lookers plc at 2.31% and Pendragon plc at 2.17%. I believe this is a legacy of Cambria acquiring underperforming dealerships that haven’t completely gotten to top tier performance as yet. Additionally, and perhaps related, the company will admit that it has to improve its service business. If you were to assume better, though not superior margins, underlying earnings power might be considerably higher than recent reported results. A 2% EBIT margin would imply £3.1 in incremental underlying EBIT power. Taxed at 22% that would imply about £2.4 mm in incremental underlying earnings power on the current level of business.

• Since coming public the company has delivered an average ROE of 15%. Management, in improving margins and the service offering, believes ROE should improve over time.

• The UK has benefited from poor sales trends in continental Europe. Relatively decent demand out to the UK and really poor demand out of continental Europe has caused OEM’s to offer strong incentives to consumers in the UK. This appears likely to continue, though sales in Europe have been improving. Notably, recent declines in Russian business due to the massive devaluation of the Ruble have impacted a glimmer of hope for the continental OEM’s who had seen Russia as a growth market. Additionally, the strength of Sterling relative to the Euro has been a tailwind, as this has improved reported earnings into the continental OEM manufacturers. This has also driven OEM incentives as reported profits out of the UK are quite strong.

• The company has significant real estate backing. I believe much of this real estate was acquired at good prices for shareholders. Net book value of land, buildings and long leaseholds is £35.7 mm.

• In the company most recent update at final year results that “the Group's performance in the first two months being both ahead of our business plan and significantly ahead of the year under review.”

• Thus far in the company’s 2015 fiscal year, new car sales are up 8.04% (September through November).

Valuation, Potential Return and Downside Protection

• The company is currently trading at 11.3x FY ’15 earnings. Adjusted for the Barnet acquisition (just on prior year earnings) it would be trading at 10x FY ’15 earnings.

• The company’s house broker pegs FY ’16 earnings at £5 mm and the current market cap would suggest 9.4x this earnings estimate. These earnings include just the anticipated benefit of Barnet (£1 mm pre-tax) and no underlying improvement in the pre-Barnet business. Given recent company comments noted above, the underlying growth thus far in the new car market and the other tailwinds also noted, it would stand to reason that this earnings estimate may be quite conservative if the remainder of the fiscal year is modestly improved from last year. A 20% underlying earnings improvement in FY ’15 in addition to Barnet would imply £5.76 mm in FY ’15 earnings and Cambria would be trading at 8.2x an improved FY ’15 earnings number.

• Transaction multiples in the space would seem to suggest significant upside if and when a transaction occurs. While size, real estate owned and brands represented play a role in valuations, the following might be illustrative:

• HR Owen – was purchased in late 2013 by Berjaya Philippines Inc. (PSE:BCOR) for about £40 million at 3x TBV and 24.5x ttm net income.

• Reg Vardy – was purchased in late 2005 by Pendragon for about £500 million at 2.5x TBV and 18.4x ttm net income.

• Allen Ford – was purchased in October 2014 by Super Group for about £52 million at 10x ttm net income. (The company had been restructured and revenues had declined nearly 40% over the prior few years).

• To be sure, Cambria trades at a significant premium to tangible book value. It also trades at a premium to liquidation value. While the company’s balance sheet could be understated due to the company’s historical acquisition strategy, an investment relies on the earning power of the business for downside protection. Given recent acquisition activity, potential tailwinds and room for margin expansion, I feel comfortable in assuming that earnings over an appropriate time horizon of 3 to 5 years will be significantly ahead of current earnings. Given the modest current multiple assessed to those earnings, this should provide a fair bit of downside protection against permanent capital loss.

• If management were to achieve their aspiration vision with no dilution (as their track record suggests is possible), the potential IRR would be quite attractive. It took them 8 years to build the first £500 mm in revenue and if it took them another 6 years to build the second £500 mm in revenue and reach their margin goal, the IRR would approach 30% with a 14x terminal or exit earnings multiple.

Potential Catalysts

• H2 2015 results show strong continued growth driven by performance “significantly ahead of last year” (noted above), continued improvement in the overall market (noted above), and from the inclusion of Barnet results.

• Continued growth in the dividend in accordance with earnings.

• Additional acquisitions. As noted previously, the capacity for further acquisitions is significant and management’s track record is commendable.

• Eventual sale of the business when Mr. Lavery has concluded building the group.

Risks

• Decline in new car sales. New car sales have rebounded off remarkable lows that followed the GFC. Over the last 12 months new car sales have totaled 2.46 million. Average monthly growth over the prior year during that period has been 9.8%. The total new car volume approximates the years leading up to the prior peak new car registrations in 2003 when new car registrations totaled 2.58 million. The calendar year low for new registrations was in 2011 at 1.95 million. Despite being well off new car sales lows, the average age a vehicle remains a year older than it was in 2004.

• Something happens to management. It is a small team. Key man risk is something to consider.

• Continental Europe sales improve dramatically and result in OEM’s reducing incentives to UK customers. Additionally, the emerging Russia issue for OEM’s might be short-lived.

• Car sales are sensitive to the economic climate. A softening of the economic tailwind may at least provide temporary headwinds.

Catalyst

Potential Catalysts

2015 results show strong continued growth driven by performance “significantly ahead of last year” (noted above), continued improvement in the overall market (noted above), and from the inclusion of Barnet results

Continued growth in the dividend in accordance with earnings.

Additional acquisitions.  As noted previously, the capacity for further acquisitions is significant and management’s track record is commendable.

Eventual sale of the business when Mr. Lavery has concluded building the group.