Eagers Automotive (ASX: APE) announced a 65% investment in CanadaOne Auto for about $1 billion, comprising $386 million in scrip and $658 million in cash. The acquisition will be partly funded by an entitlement offer of $452 million and a separate placement to Mitsubishi Corporation.

Why it matters: We’re not surprised at Eager’s first international foray, given it has flagged the potential to enter other markets. However, while Eagers enjoys a strong competitive position in Australia, where it’s by far the biggest player, this won’t necessarily translate to success in Canada.

  • We think it’s paying a fair price for CanadaOne. Based on the 12 months to June, the deal is priced at an enterprise value/adjusted EBITDA of about 8, in line with our valuation of Eagers. A local TSE-listed rival of similar size, AutoCanada, last traded at an EV/adjusted EBITDA of about 10.

The bottom line: We lift our fair value estimate for shares in narrow-moat Eagers by 7% to $15, almost entirely due to the accretive impact of raising equity at $21, above fair value. On valuation grounds, we recommend investors do not participate in the offer, depending on individual goals.

  • Entitlements are priced at a 40% premium to our updated fair value estimate. While entitlements are nonrenounceable and priced at a 26% discount to the theoretical ex-rights price, to recommend subscribing when shares are so overvalued would be short-term speculation.
  • Eagers is materially overvalued. While we think profitability has normalized, the market is pricing in a rebound in margins. We think the underlying net profit margin of a little better than 2% is a new baseline, down from as high as 3.3% in 2021, but significantly better than precovid levels.

Between the lines: The $386 million in scrip and $50 million investment from Mitsubishi are both priced at $18 per share. The retail, 1 for 12 nonrenounceable entitlement offer, priced at $21 per share, opens on Oct. 8 and closes on Oct. 27.

Eagers business strategy & outlook

We forecast Eagers Automotive to continue to capture share in the highly fragmented auto retailing market. We estimate it now boasts share of about 14%. As the largest dealer in the market, Eagers can centralize back-office operations and fractionalize these fixed costs over a significantly larger volume and revenue base, affording a durable cost advantage over smaller peers. Accordingly, we estimate the company earns gross and net profit margins ahead of smaller competitors. We believe Eagers’ extensive size and scale should allow it to deliver midcycle profit before tax margins of about 3%-4%.

A typical dealership structure is broken up into front end, which includes new- and used-vehicle sales, and the back end, which is the spare parts, servicing, and finance business. Sales are heavily skewed to vehicles, with new and used accounting for around 65% and 15% of vehicle sales, respectively. These are the lowest-margin segments, which we estimate account for less than 50% of earnings. However, these segments act as a funnel for the more lucrative back end.

While the back end is estimated to contribute around 20% of group revenue, we estimate it accounts for approximately half of the company’s profit. This is based on our estimate of higher gross margins for spare parts and vehicle servicing, and as high as 100% for finance (although this is the smallest component by dollar value). We expect this significant contribution to profitability to be less volatile than new- and used-vehicle sales. Large dealers like Eagers are enjoying an increasing competitive advantage for repair work because most automakers require warranty work to be done by a licensed dealer. Given the company’s strong competitive position and narrow moat, we expect it to continue earning industry-leading margins for the foreseeable future.

Bulls say

  • Eagers is well positioned to participate in and to benefit from the consolidation theme in the automotive dealership industry through acquisitions and greenfield developments.
  • We expect Eagers should benefit from shorter motor vehicle lifecycles as newer vehicles with newer technology are rolled out, potentially stimulating replacement demand.
  • Eagers’ dominant position in the Australian market provides appealing economies of scale, resulting in strong operating margins.

Bears say

  • Easing supply constraints may see dealerships once again competing on price, putting pressure on Eagers’ margins.
  • Most of Eagers’ revenue is derived from new-car sales, which are highly cyclical and low-margin.
  • Autonomous vehicles and increased carpooling represent a longer-term threat to Eagers, potentially disrupting private vehicle ownership and hence the fortunes of the automotive retailing industry in general.

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Terms used in this article

Star Rating: Our one- to five-star ratings are guideposts to a broad audience and individuals must consider their own specific investment goals, risk tolerance, and several other factors. A five-star rating means our analysts think the current market price likely represents an excessively pessimistic outlook and that beyond fair risk-adjusted returns are likely over a long timeframe. A one-star rating means our analysts think the market is pricing in an excessively optimistic outlook, limiting upside potential and leaving the investor exposed to capital loss.

Fair Value: Morningstar’s Fair Value estimate results from a detailed projection of a company’s future cash flows, resulting from our analysts’ independent primary research. Price To Fair Value measures the current market price against estimated Fair Value. If a company’s stock trades at $100 and our analysts believe it is worth $200, the price to fair value ratio would be 0.5. A Price to Fair Value over 1 suggests the share is overvalued.

Moat Rating: An economic moat is a structural feature that allows a firm to sustain excess profits over a long period. Companies with a narrow moat are those we believe are more likely than not to sustain excess returns for at least a decade. For wide-moat companies, we have high confidence that excess returns will persist for 10 years and are likely to persist at least 20 years. To learn about finding different sources of moat, read this article by Mark LaMonica.