Stockwatch: Significant potential for this share

Does a flat stock price in response to strong results and a confident outlook imply cyclicals represent good value, or a warning of inevitable downturn? It's a curiosity of sentiment, like the way miners, oil and related service stocks have risen hugely off February lows, while other cyclicals are mired despite a lower risk profile and healthy underlying progress.

A prime example is mid-cap car dealer Lookers, which has declared a seventh year of profits growth in 2015, with revenue up 20% to £3.65 billion.

As one of the principal UK motor retail and after-sales groups, it reckons new car sales will continue to grow, and the expanded stock of vehicles under three years old will also benefit the used car market, hence aftersales (services/parts) also.

Yet, at 163p, the stock remains down 12% from its 185p high last autumn, having sold off to 146p in the rout earlier this year. Clearly, the market is wary to discount further significant growth in what, at first sight, appears a lengthy upturn.

Stock falls between two stools

Enough capital growth investors are wary, while income buyers can find fatter yields elsewhere. Lookers' forward price/earnings (PE) multiple is a modest 10 times relative to annual averages in the mid-teens from 2013-15. According to Company REFS, the 2017 forecast scenario is less exciting, but mind that "consensus" figures so soon after results may be limited.

The UK car market has benefited from cheap finance and the extent of people's appetite for debt is key.So the stock is broadly feared "ex-growth" with insufficient yield to compensate: at 2.2%, albeit over four times covered by earnings, it is nothing special, despite respectable dividend growth (see table).

This is because cash generation has been primarily used for investment, which works well for the stock in an upturn and for so long as investors believe it will continue.

They are, however, likely prioritising stocks which are able to return cash today, lest George Osborne's "black clouds" surrounding the UK economy compromise all-round returns. But is this too negative a view, as has applied to Lookers before?

More optimistic than its trade association

After new car registrations rose 6.3% to 2.63 million last year, The Society of Motor Manufacturers and Traders believes 2016 sales will be roughly flat. Lookers, however, thinks they will continue to expand by about 5%, helped by pent-up demand after the recessionary years and further opportunities in the fleet market.

Some investors may be perceiving less exciting 2015 progress in Lookers' continuing operationsMind, the UK car market has benefited significantly from cheap finance packages, and while interest rates don't look likely to rise much - if at all - in the foreseeable future, the extent of consumer/commercial appetite for debt is influential.

New cars account for 48.5% of group revenue, used cars 33.2% and aftersales 18.3%. For 2015, Lookers achieved an 11% increase in new car sales, helped by more activity in fleet sales, where the market rose 9.9% overall and Lookers achieved 24% revenue growth. Used car sales are up 7% and aftersales by 9%.

Management continues to regard quality fleet sales with higher margins as "a major opportunity for additional profit generation", hence investment continuing in staff, systems and facilities. Overall order intake for March - an important month - is said to be tracking to plan.

Mind also that performance has benefited from acquisitions. Lookers doesn't specify exactly how much, but last September's £87.5 million acquisition of Benfield Motor Group compares with Lookers' market cap of £645 million, and there have been various "bolt-ons" e.g. Audi, Jaguar and Mercedes-Benz dealerships.

Fundamentally, it's a quality business based on having the right brands in the right placeThe cash flow statement cites net investment up from £34.5 million to £132.4 million, with £104.4 million representing companies acquired. This was helped by new loans up from £14.6 million to £62.2 million.

Pre-tax profit (adjusted for amortisation and exceptionals) is up 11% to £72.1 million and adjusted earnings per share by 12.7% to 15.24p. The various special costs were a net £9.3 million (up from £5.8 million), hence some investors may take a more conservative view of profitability, i.e. pushing up the PE.

Also, databases such as Company REFS have their own approach to a normalised view, which adds to complexity. So, besides wariness about the length of upturn in the UK car market, some investors may be seeing through to less exciting 2015 progress in Lookers' continuing operations.

Balance sheet could be better

The end-2015 balance sheet had £158.3 million of goodwill and intangibles, in context of £297.8 million net assets, with £170.0 million bank debt (up £109.8 million mainly as a result of the Benfield acquisition), plus greater capital expenditure and working capital.

Higher debt meant a £13.8 million net interest charge against £80.9 million operating profit, and there was also £3.9 million net interest on £55.3 million pension obligations.

Lookers has less risk than miners and oil stocks if the short-squeeze in commodities popsCash reserves are small in context: up from £5.9 million to £8.3 million, although the cash flow statement shows inventories up from £102.2 million to £267.2 million, quite the picture of running on full throttle in a strong market.

Such measures reflect a balance sheet that, while not stretched, could be better to cope with any downturn, and why dividend payments are relatively modest with £11.6 million being distributed.

Brokers say 'buy' with 35% upside

Following the results, the two company brokers have kept up support: Numis targets 220p and Peel Hunt 225p. However, independent broker Liberum Capital also re-iterates 'buy' and maintains its 215p target. Given the general economic uncertainties, I would target lower, also because cautious sentiment won't depart soon.

Lookers has overcome scepticism before, e.g. when I initially drew attention in June 2010 at 50p, the forward PE was similarly about 10 times, net asset value (supported by property) was about 40p/share and the chief executive was buying stock. I also flagged them in May 2013 at 107p, when the UK car market was defying a sense of wider economic stagnation, growing by 5.3%.

It's hard to separate a view on a stock like this from the wider UK economy, but fundamentally this is a straightforward quality business - based on having the right brands in the right location - which can mitigate a downturn.

The risk/reward profile, therefore, continues to look favourable for buyers; certainly with less risk than miners and oil stocks if the short-squeeze in commodities pops.

For more information see their website.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.