Car dealership tie-up a potential win

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Lex Hall: Hi, I'm Lex Hall, and welcome to the Morningstar series, "Ask the Expert." Today, I'm joined by Morningstar equity analyst Daniel Ragonese and we are here to talk about the mooted merger between Australia's two biggest car leaders, AP Eagers and Automotive Holdings Group. We're going to talk to Dan and why he thinks there's upside in this deal.

Dan, g’day.

Daniel Ragonese: Thanks for having me.

Hall: My pleasure. Now, before we look at the deal, let's look at the context in which it's taking place. It comes at a time when car sales have been pretty sluggish for the past year and dealership revenues have been under pressure. What do you put the falling car sales down to?

Ragonese: Yeah. So, it has been a challenging 12 months for new vehicle sales, obviously, declining during that period. Look, there's a couple of things behind it, but the main driver in my opinion is really that the declining residential property prices. And the consequence that's having is that negative wealth effect. So, what you're seeing is the average consumer a lot less confident and less likely to go out and purchase big-ticket items such as a new vehicle.

Hall: Because they think the value of their assets, in this case property, is falling and they feel less wealthy?

Ragonese: Just feeling less wealthy in general and less optimistic about things. But at the same time, this is something that in my view is not a structural issue. It's a cyclical issue and we are already starting to see that property market, the rate of decline starting to slow. So, we think as that market stabilises over the next 12 months that new vehicle sales should do the same and eventually start recovering. So, longer-term, we don't have any concern.

Hall: OK. Timing of the deal: do you see any significance in that?

Ragonese: Yeah. Look, it's come at an interesting time. I think obviously the challenges that the industry is going through, both regarding the declining vehicle sales but also from a regulatory standpoint, there's been some reform there, which has impacted them. Of the two firms, Automotive Holdings has really felt the brunt of that. And I think that was reflected in the share price prior to this deal.

Hall: I'll just jump in there and ask you about regulatory reform. What are you talking about there in specific?

Ragonese: Yeah. So, ASIC – the whole car dealership industry has been through a major review and basically ASIC has restricted the amount of commission that they can earn on the sale of finance and insurance products. And that was where the dealers were able to make a lot of their margins. So, obviously, that change weighing on their margins and consequently the share price as well. So, yeah, I mean, from AP Eagers’ standpoint, I think it definitely can be seen as an opportunistic deal in terms of timing.

Hall: Let's look at the deal itself, Dan. AP Eagers had a 29 per cent stake in Automotive Holdings Group and last month made a move to acquire AHG. You reckon that the deal will go ahead, and you see upside for both parties. What are the advantages of two companies like this coming together do you think?

Ragonese: Yeah. Look, I think, the deal is likely to go ahead. And from the company's perspectives, there's a lot of benefit for both parties. The first and the obvious one is by coming together they are going to be able to generate some cost savings. So, at this point, the companies have already called out $13.5 million per year in cost savings. I think that's conservative and I think there's upside potential to those numbers. So, this is the first thing.

Secondly is, obviously, the merged entity is going to be much more diverse on both the regional and the brand perspective and that should help smooth out some of the volatility with vehicle sales. And also, I think coming together and becoming a larger group, they are going to have quite a strong balance sheet. So, it's very well placed to continue taking market share, particularly as the market eventually starts to recover.

Hall: OK. But it's yet to go ahead, of course. What do you think is standing in the way of the deal, if anything?

Ragonese: Yeah. Look, in my opinion, it's likely to go ahead. Shareholder support has been quite strong. I think the main [point] outstanding at the moment is probably the ACCC, which is yet to rule on this. But in my opinion, this shouldn't be a major hurdle, particularly as the two firms are concentrated in quite different areas. So, Automotive Holdings is very much exposed to Western Australia whereas AP Eagers is heavily concentrated towards the East Coast. So, there's not a huge amount of overlap there. And in addition, the market is still very highly fragmented. So, on a combined basis, these firms are likely to represent maybe around 12 to 13 per cent of the total industry. So, still a lot of competition around.

Hall: And finally, Dan, I note in your report that you're still pretty upbeat on these companies. If the deal doesn't go ahead, they are both worth investing in obviously?

Ragonese: Yeah. Look, if the deal was to fall through, my fair values would revert to their standalone values prior to the merger being announced. But at the same time, I'm still being quite positive, particularly on Automotive Holdings which I've seen a lot of opportunity for upside, both in terms of revenue and recapturing a lot of that margin that they have lost in recent years. So, yeah, still quite positive longer term.

This report appeared on 2019 Morningstar Australasia Pty Limited

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