Stockwatch: A share to buy on the dips

Is Lookers a growth play, or symbolising a need to take more care with the debt-driven UK recovery? In recent years the FTSE Small-cap shares in this cars/parts distributor have more than trebled to 167p as the car market persists as a notably strong area of the UK economy, helped by convenient leasing deals. Yet the price briefly dipped about 10p despite the latest interim results affirming a seventh successive year of growth, with profit/earnings up 6% on revenue up 9% and a 10% rise in the interim dividend.

Post-results selling may reflect an element of investors not wanting to push their luck with the UK recovery after individuals and firms regained confidence to borrow, given the longer-term prospect of higher interest rates. Also, the Lookers' board appears to be targeting earnings cover over four times for the dividend, respecting cyclical risks, and the implied prospective yield of 2% isn't exactly a prop.

More positively as regards the stock's risk/reward profile, its 12-month forward price/earnings (PE) multiple has only edged up from 9-10 to about 12 times over the years, and the consensus expectation for 2016 - most significant for perception - is modest (see table). The last published forecast - 23 July by Peel Hunt - looks for £71.8 million profit and 14.5p EPS, ahead of consensus. This is the company's broker, so is likely to be supportive, but also possibly getting better guidance than others as to company budgeting. Obviously plenty depends on what happens to financing rates for car buyers, which are tricky to anticipate.

Changes in the way people buy new cars

In the six months ended June, total registrations in the UK new car market rose by 7% to 1.37 million - helped by some 80% of purchases which nowadays are linked to leasing arrangements offered by manufacturers, with Lookers taking a fee as intermediary and on the sale. Consequently, the car ownership cycle has reduced to only about 3 years, benefiting turnover in used cars also.

Actually Lookers' volumes have risen more strongly in the used segment, up 8% in the first half and 43% in the last three years, compared with new cars up 4% relative to 2014. Total gross profit (retail and business) from new cars is up 7% however, and Lookers cites "a healthy order book for the delivery of new cars in the important month of September...the UK new car market is expected to show modest growth during the rest of this year." Growth in the number of cars under three years old has also improved aftersales by 5%, helped by introducing service contracts in line with Lookers' "customers for life" strategy; and the parts division was said to have increased turnover and profit, albeit not quantified.

Cash flow/debt profile facilitates investment

In such a commercial context, Lookers has robust cash flow and modest net debt, enabling further investment. Admittedly, shifts in the working capital profile meant a fall in first-half operational cash flow from £55.9 million to £42.0 million; this being applied for example as £5.8 million on improving dealership facilities, £4.3 million on acquisitions and £13.7 million on reducing net debt to £38.2 million -representing gearing of 13%. The balance sheet benefits also from £194 million of £284.8 million net assets constituting freehold and long leasehold properties.

Mind, however, that tangible net assets per share are only at the top end of a 30p range compared with a share price over 160p, which doesn't offer much by way of downside protection. Perception will therefore stay attuned to Lookers' earnings trend. It's a significant factor to consider for underlying value and resistance to potentially tougher trading conditions: "We believe the significant investment we are making in upgrading our facilities to reflect the latest manufacturer retail standards and multi-channel customer experience will give us a competitive advantage and further improve our position of leadership in the motor retail sector."

Cyclical risks but good long-term prospects

Car ownership is ingrained into the British psyche as an extension of personal freedom and, despite medium-term demographic risks as the "baby boomer" generation expires, current trends in the birth-rate and immigration are rising, hence the long-term scenario is attractive. Investors' main challenge is anticipating business cycles, given the yield looks inadequate compensation for holding through a downturn. Politicians naturally like to tout "recovery continues" although the Western economic upturn is a mature six years - even if this was from a deep trough in 2009. It remains to be seen, what is the net result of George Osborne's raising the minimum wage on employment levels, just as China is exporting deflationary measures, also his pursuing spending cuts which will take an element of demand out the UK economy.

The current situation is therefore trickier than five years ago when I drew attention at 50p after a new chief executive snapped up a total £286,500 worth of stock and trading was cited ahead of expectations. The forward PE was not dissimilar, about 9 times, but net assets per share of about 40p meant risk more implicitly on the upside. Also in May 2013 at 107p as the UK car market defied a sense of wider economic stagnation, growing by 5.3%, although Lookers nowadays has greater financial substance and reduced some downside risks. The brokers' consensus is 'buy' - justifiably, if the UK economy can continue to muddle through uncertainties. An averaging-in approach would be wise: the months ahead may indeed be useful to accumulate on days of bad headlines, but keep attuned to overall economic trends.

For more information see: lookersplc.com.