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Is there light at the end of the tunnel for automotive shares?

We look at the risks and opportunities for companies in the struggling car industry.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

The global car industry is in the midst of “one of the bleakest” periods in its history. The coronavirus crisis decimated new car sales at a time when many major manufacturers were already struggling.

Hopes of a resurgence in sales in September, driven by pent up demand, simply didn’t happen. In fact, new car registrations fell 4.4% compared to last year. That’s unusual because September has often seen a bump in demand as it’s when new registrations get released (this also happens in March).

What’s going on?

The motoring world is a classic case of a sector in flux. The UK car market was grappling with Brexit uncertainty and tougher regulation even before the current crisis.

Fewer people are looking to buy brand-spanking new cars, and the shift to electrical vehicles is gathering pace.

High fixed costs make sales slowdowns a serious issue for car manufacturers. That’s why we’ve heard chatter of some major mergers and acquisitions going on. Consolidation is a classic sign of a sector at a cyclical low point.

But what does this mean for UK listed companies exposed to the sector? One thing it doesn’t have to mean is the end of opportunity.

This article is not personal advice. If you’re unsure whether an investment is right for you, please seek advice. All investments and any income they produce can fall as well as rise in value, so you could get back less than you invest.

Looking at the car market

The mass closure of forecourts during lockdown held a particular sting for companies in the business of selling cars. Auto Trader, the UK’s largest online car sales platform, stopped charging corporate customers (essentially car dealerships) during peak lockdown to help them through the crisis.

There are longer-term headwinds too. A tough economic outlook has tended to see cars being rubbed off shopping lists, and that could see more dealerships close with knock on effects for Auto’s revenue.

However, on balance we think Auto’s in a good space.

As a website it’s a very capital light business – adding new customers and servicing existing ones doesn’t really cost a lot. Operating margins are a whopping 70% as a result.

Auto Trader operating margin

Source: Refinitiv 26/10/20

That nifty model means Auto Trader expected to finish the first quarter of the new financial year in a profitable position, despite being loss making in April and May. Crucially, since reopening, the car dealerships that sell through Auto Trader have reported strong demand.

We suspect this is at least in part down to the group’s exposure to second hand vehicles. Punters can pick up a car for as little as a few hundred pounds, going all the way up to £2m. That puts it in a much more defensive position than car manufactures themselves, who are reliant on shifting vehicles hot off the factory floor.

It's also important to note the shift to electric cars is less of a concern for Auto, compared to say a company that manufactures combustion engines. The volume, not type, of vehicles sold is what counts.

Looking ahead, Auto Trader wants to put a lot of resources into its digital capacity. Things on the wish list include having a website that allows vehicle part exchanges and finance, alongside the existing purchase function.

While we’re slightly dubious of the group’s mission to “become the UK’s most admired digital business”, we think there are genuine growth opportunities. If it can successfully bring together all the nitty gritty parts of car purchases, from buying to financing, that creates new revenue opportunities.

50.8m monthly visits makes Auto Trader a hugely important player in the car market. But crucially, we also think there’s room for further growth. Of course, the biggest issue with ambitious plans is one of execution – and for now it’s a case of “if” not “when”.

The market clearly has huge confidence in Auto’s ability to keep growing, with the price/earnings ratio 30% above its average since listing. But with great expectations come great responsibility though, and investors should keep in mind the share price will be sensitive to any disappointment and there are no guarantees.

See the latest Auto Trader share price, charts and how to trade

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So what about manufacturers?

We’ve painted the manufacturing picture as uniformly bleak so far. But there are some companies exposed to auto manufacturing that could offer opportunity.

One that springs to mind is Bodycote. Bodycote is a leading provider of thermal processing services. Its key customers span across aerospace and defense, energy, general industry, and auto. Its products include products to improve aeroplane landing gear, extend the life of industrial gas turbines, or heat treatments to boost the durability of car and truck components.

We think Bodycote is well positioned to take advantage of the shift to electric vehicles. For instance all vehicle wheels need some components to be heat treated, or they wouldn’t last a week. Bodycote pays no mind if these are the wheels of a truck, petrol fuelled or electric car. The same ethos can be applied across pretty much every aspect of a car, from engines to gearboxes.

Bodycote revenue by geography 2019

Source: Bodycote 2019 Annual Report

Bodycote revenue by market sector 2019

Source: Bodycote 2019 Annual Report

You’d be forgiven for thinking “doesn’t exposure to aerospace sound warning signs at the moment?” Aerospace and defence together with Auto makes up over 50% of Bodycote’s revenue, and the pandemic has indeed taken something of a hammer to profits. However, crucially, the group’s free cash flow has been strong (almost £70m in the first half) and net debt has remained very conservative at £23.6m, which is around 0.4 times cash profits (EBITDA).

That’s thanks to a step up in already planned cost saving plans. It now expects to save around £58m a year, following the closure of 18 plants (13 of which are automotive) and a reduction in headcount. Operating margins of a respectable 12.3% shows remarkable flexibility in the cost base for a capital intense business such as this.

Margins are expected to rebuild to around 16.6% next year. While revenues are expected to be around 99% of 2019 levels by 2022. Profits should in theory come along for the ride, although remember, there are no guarantees.

While we think management is adept at managing any torrid times, investors should remember that Bodycote is a classic cyclical company. That means its performance will move up and down with the economy.

Because the group is particularly exposed to civil (read: airliner) aerospace, this is expected to act as a drag for some time. And things in this department are expected to get worse before it gets better.

It also hasn’t escaped the slowdown in global car manufacturing, and has been stung by manufacturers running down their inventory levels. There are preliminary signs of improvement, particularly in the US where low fuel prices are feeding strong demand for SUVs. But a more severe or prolonged slowdown wouldn’t be good news for the top line.

Bodycote embodies the point that exposure to a supposedly struggling market doesn’t mean a company should be written off. The group’s huge reach and technical speciality means it’s in a much more defensive position than you might immediately assume.

Crucially, the pivot to electrical vehicles isn’t something Bodycote really needs to worry about. We have faith a strong management team will continue to guide it through bumpy economic cycles. We can’t stress enough though that investors are likely to see some ups and downs in the short-term, especially because at 17.8 times earnings the shares are trading some way above the average price/earnings ratio.

See the latest Bodycote share price, charts and how to trade

What to remember

Just because an industry looks to be struggling doesn’t mean you have to ignore every company exposed to that sector. There’s always potential to be found.

Unless otherwise stated estimates are a consensus of analyst forecasts provided by Refinitiv. These estimates are not a reliable indicator of future performance. Past performance is not a guide to the future. Investments and any income they produce can rise and fall in value so investors could make a loss.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.


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    Important notes

    This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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