it's interesting read but no ones seem to be excited! why?...

it's interesting read but no ones seem to be excited! why?

Australia’s largest automotive retailer
Australia’s largest automotive retailer
Tim Boreham January 5, 2018 CEO Interviews

• Automotive Holdings Group Limited (ASX: AHG) is Australia’s largest automotive retailer
• Conditions in its Western Australian home market have been a bit sluggish
• AHG has made a big call and has sold its refrigerated logistics division to a Chinese party for $400 million dollars

John McConnell is the CEO of the listed car dealer group Automotive Holdings. If you’re not aware, AHG is the country’s biggest dealer group and it represents most of the best-known car brands. Now it’s been an interesting and challenging time for AHG on a few fronts. Having said that its shares have held up well over the last year. But among the issues, conditions in its Western Australian home market have been a bit sluggish, partly of course because of the mining boom busting which has been a bit of a headwind.

Of AHG’s 110 or so car dealerships, 37 are in Western Australia and the company gleans about 30% of its revenue from the west, so the west is quite important. Secondly, all the car dealers have been under the hammer because of a regulatory crackdown on certain financing and insurance practices. But the big news for AHG is the company has made a big call and has sold its refrigerated logistics division to a Chinese party for $400 million dollars, that includes $120 million of finance leases which the buyer takes responsibility for. But this now means that AHG is a pure play car dealer again.

Here’s John McConnell, CEO of Automotive Holdings Group.


So starting with that news, John, why did the company sell a division which I guess was painstakingly built up over time through acquisitions and I guess was a hedge against a downturn in the car market?

Tim, I guess the primary reason is that we achieved a very good value outcome for shareholders in terms of the value of the business. As you know, we’ve been in a period of transformation for the refrigerated logistics business for a period of time. We have been progressively improving the earnings in that business but we still had significant work to do to actually get that business to a position that we thought was going to deliver the returns that we were expecting. We had an offer from HNA which essentially recognised the value through the cycle for the refrigerated logistics business and we felt that it was an opportune time to realise the appropriate value for shareholders.

Strategically, I think it made sense as well because it gives us an opportunity to reposition the balance sheet of AHG as well and it gives us an opportunity to pursue opportunities in automotive which is really the core of the business.

Yes, so basically it was an offer too good to refuse but the business wasn’t really being actively put up for sale?

Yeah, look I think, it was an offer that reflected the fair value for that business. In terms of what we thought the potential for it was and it obviously removed from our perspective, the executional risk in actually getting to that point. I think the offer was a good offer, it was a fair offer and it reflects, I think, the longer term value in the business. It wasn’t something that we were out actively marketing because our focus had been on making sure that the earnings trajectory in that business continued to drive positively, but we received an offer that we felt was appropriate and fair and basically eliminated the executional risk.

And the question now is of course what you do with the proceeds. If you gear up your borrowings to the target level, reportedly you’ve got $300 million war chest all up. You’ve mentioned automotive opportunities but there’s also the prospect of a capital return or perhaps both. Starting with the automotive opportunities, can you elaborate on what might be out there to buy?

Yeah, look, I think maybe in context first, Tim. I think if you look at the relative share of AHG in terms of the new car market to begin with, we have a 6.2%-odd market share of the new car market, so the market itself remains relatively fragmented and as you would also appreciate, we have a disproportionate share of the Western Australian market reflecting the heritage of the group where we enjoy, I think it’s about 24% market share in WA. The reality is that we are comparatively then underweight in terms of the east coast opportunities. I think when you look at the nature of the market that is fragmented, the fact that we are underweight in the east coast, then we have I think an opportunity to continue to further advance our number one position in the marketplace in terms of volumes.

I think the franchise in auto space is interesting and is still an opportunity for consolidation and aggregation. So, we intend to participate in that. I think equally we have an opportunity to continue to look at opportunities in the used car market through our Easyauto123 format, which should give us opportunities as well to build a national branded presence in the used car market. I think both of those represent exciting opportunities for us in terms of growth prospects moving forward. As you say, the opportunity for perhaps a branded return of maybe some return to capital to shareholders as and when the transaction completes in 2018. We will obviously have a discussion with a board and investors through the course of the next few months.

With the acquisition opportunities I presume it’s a case of baby boomer dealer principals getting a bit long in the tooth now and being more willing to sell, so I presume more assets are coming onto the market?

That’s a dispersion on some of my colleagues, I’m not sure that if I put an offer into the marketplace that some are classed as long in the tooth! But I think you’re right, I think there’s succession planning challenges perhaps for some groups and I think that does represent an opportunity for corporate groups to actually play in the marketplace. There are instances where some groups do not have potentially succession plans or they would like to crystallise gains from property portfolios for family reasons, whatever. There will be multiple perhaps drivers of change, of which succession planning is arguably one.

Yes, and you’d be talking about some pretty valuable land, wouldn’t you? Because by their nature, dealerships tend to be in prominent locations.

Exactly, and if you look at it, Tim, over the years, the reality is for those people that perhaps have been in the market for 20, 30 even 40 years, there’s been obviously an appreciable increase in the value of property portfolios than for those family businesses that have had the benefit of a holding property for a long period of time, then obviously that’s quite a valuable position to be in.

And their asking price is coming down to reasonable levels?

I think, as you mentioned at the beginning of the conversation, there are some regulatory challenges at the moment in terms of changes to finance and insurance, which in turn are probably putting some short term pressures on returns for businesses. To that end, as we look at opportunities in the marketplace we are mindful of some of those impacts on the ongoing profitability of businesses. It’s probably still relatively early days in terms of some of those changes flowing through into full year numbers but one would imagine that it is getting probably a little bit easier to buy. Expectation management is always a challenge in terms of making sure that the buyer and the seller have a meeting of minds over the value of the business. But certainly, some of the short term pressures may indeed present some better buying opportunities for us.

Yes, sure. Perhaps you could outline the regulatory changes just for the benefit of listeners? They relate to both the financing side and certain insurance products, is that right?

Yeah, I think you’re right. There are probably three elements, without getting too complicated. I guess the first impact that has been in the market for probably a bit longer has been the investigation by ASIC on responsible lending. To that end, it has meant that financiers have probably tightened somewhat the lending criteria against which they would be prepared to advance loans. That in turn has meant that arguably some of the deals that were written that were perhaps at a finance level in a dealership have been refused and rejected which has meant that the finance income has been under a bit of pressure from the fact that ASIC were trying to make sure that the responsible lending was absolutely driven hard in the marketplace.

We then had a second impact from the 1st of July, 2017, which was on add-on insurance. Again, ASIC were looking at the basic proposition of value for money for consumers and with the insurers. Essentially what has happened has been a reduction in pricing of insurance products in the market place, which has meant that there has been a commensurate knock-on into commissions that were being earnt by dealers for selling those products, so that has had a secondary impact in terms of the finance and insurance income.

The third element of F&I that is still as yet unfinalized has been the review of the flex-finance arrangements at a dealership whereby the amount of, again, commissions that were being paid, related to arrangements with financiers that reflected flexible interest rate charging. That, again, has been the subject of review and in probably end of 2018, perhaps into ’19, there will be the resolution of how changes to those practices may come into play. We don’t anticipate that to have a significant impact in terms of our earnings moving forward because we do believe that we are properly pricing for risk today in the marketplace and therefore, notwithstanding the fact that the way in which those commissions will be calculated in the future will change, we don’t believe that the economic substance of what is being done today is going to alter dramatically.

Which means that in turn our commission level shouldn’t be adversely affected, but those changes will be coming through prospectively.

Right, okay, so basically the flex commissions, the dealer’s financing added on an interest buffer over and above that charge by the financier, and so that’s a practice which basically has been curtailed?

Well, it’s the way in which rates are being set essentially. There’ll be base rates that will apply to the way in which you earn commissions, but then you will price basically on the credit risk of the consumer. You will apply a margin and it’s not dissimilar to the way in which positive credit reporting is used in the US, where you would walk into, for example, a dealer in the US market and you would have a personal credit score. That score basically reflects the fact that you are given a certain rating by financiers in terms of your ability to repay and your creditworthiness.

Then in turn you have an interest rate that is charged commensurate with the risk profile that you have. Whilst we go through the same process at a dealership in trying to ascertain a similar type credit score or worthiness of an individual, and in turn charge a rate, that process probably isn’t as transparent as it is in the US. Therefore, that I think is what ASIC are trying to address and to give more visibility, if you like, ultimately with positive credit reporting as and when it comes in. In the interim, they’re suggesting that the financier should be primarily responsible rather than the dealer per se for actually setting the rate. But I think in principle if we’re properly pricing for the risk attaching to the person that is looking to take out the loan, then I don’t think again that our finance commissions should be affected.

Right, okay. You’ve already put a figure on the impact of the insurance changes. That was $15 million of earnings before interest and tax, which I think is about 10% of total EBITDA. You’ve already said you’ll be less affected by the flex ban. I’m just wondering how the dealer community overall, how hard it will be for them to adjust?

I think it’s a challenge to the industry in general. I think everyone will be affected to a greater or lesser extent depending on their ability to have a good team of people writing finance and insurance products on paper. The reality is those dealers that are arguably better at having good business managers and providing lots of product and sales in that area, will obviously be more affected by those dealers that perhaps have been less good at actually writing finance and insurance. But yes, it will affect the industry broadly and depending on your ability to sell those products to a greater or lesser extent.

It sounds like the changes might play into the hands of the bigger dealer groups with better systems and credit processes and economies of scale.

Yeah, you’re probably right, but equally there’s also, as you would appreciate, the element of transition and change and we’ve seen a number of our business managers choose to leave the industry. I think where they’ve seen the conditions tightening and it being much more difficult to actually do their jobs. We, in the first instance, are not immune from some change in that space and that’s affected in the short run, a bit of staff turnover. I think we’ve been, like other dealers, a bit disrupted in terms of staff given the changes form the regulator. But that in turn will settle down and we should see that stabilise and normalise moving forward. I think we’ve been through that transition now and are coming out the other side.

In the meantime, how do you see the new car market? Official figures suggest that new car sales have tapered somewhat, but they’re still running at record levels and you also mentioned that there are some green shoots in Western Australia which of course is your biggest market.

Yeah, I think that’s right if we do it at the national level first. I think yes, the year to date performance has been broadly flat. I think the market is up 0.6% to November. I think there’s no doubt that the market is still at all-time record highs. At a national level that’s a reasonable picture. There’s no doubt probably the eastern states have seen a little bit of a slowdown over the last few months, again perhaps reflective of economic challenges, some noise around interest rate rises, pressure on house pricing which all goes to consumer confidence. The eastern states have probably been under a bit more pressure in the last few months.

Conversely, Western Australia is beginning to show I think in the last few months, the makings of some underlying growth which is a good position to be in because as I think we’ve said publicly previously, WA is now almost 25% away from its previous peak, notwithstanding the national market is at an all time high. So, whilst the last three or four years in particular have been very difficult for the Western Australian car market, I think a number of economic indicators would suggest that the market is beginning to turn. That is positive for AHG in particular, whereas you mentioned earlier we have a large exposure to the Western Australian market.

Yes. So in other words you’re cycling lower figures, so there’s perhaps more upside for you in the next couple of years having that over the odds West Australian presence, even though you do want to grow along there.

Yeah, absolutely. I think that there is a rebasing of the WA market and we’ve been through that, we’ve seen the adjustment in employment, we’ve seen the adjustment in house pricing. We are seeing some good news from the miners where you pick up daily almost press reports around – there was a headline yesterday in The Western Australian I think about mining jobs galore as the economy picks up, which again play into consumer sentiment in and around the acknowledgement that the market conditions are actually getting a bit better. I think the fact that truck orders for us in WA have improved as well, are all good lead indicators of the fact that at least for us a major portion of our portfolio is about to enter a different phase of an economic cycle, which is good news for us in the positive.

Okay, great. Has the closure of local manufacturing caused any disruption for you or for the sector as a whole?

I think the dye has been cast on local manufacturing for a number of years. I think the fact that some of the closures have been running through this year has probably been in some respects, for Holden for example, quite positive in that they’ve been running out obviously Commodore in the last year of its life. I think those things where there’ve been limited editions in the marketplace, I think there’s been some positives around that. But all the local manufacturers that are now moving to importing cars from offshore still have ambitions to retain and deliver market share over time.

As you know, we’ve had relatively narrow range of product that was being manufactured for the Australian market anyway. The bulk of the volume has been imported vehicles anyway, so I don’t expect it to be a major impact.

Okay. Some of the replacement Falcons and Commodores are meant to be pretty good, perhaps even better than the local models, which were actually okay in the end.

Yeah, we’ll see.

Just turning back to that capital return, you’ve got a lot of franking credits, haven’t you? I presume you’d be looking closely at doing that by way of a special dividend?

I think there are different options as you will appreciate in terms of how one returns capital. Obviously, the tax effectiveness of capital returns is something that we will bear in mind and yes, you’re right, we do have franking credits as well which means that we have some flexibility around how we may choose to return that capital.

Okay, and looking on with interest would be your biggest shareholder which is the listed rival, AP Eagers, which is Queensland based. They have a 23% stake I think and they’re controlled by Nick Politis who’s probably better known as the number one ticket holder for the Roosters rugby team. But I’m just wondering, have you chatted to Mr Politis of late? I’m just wondering what their intentions are or whether you think they’re just happy to be a shareholder?

I think that’s probably a question for Nick as to what their intent is…

Fair enough.

But we do have a very good and constructive relationship with Eagers and in particular, Nick. He was also at a function a couple of weeks ago where we were looking at broad industry matters with a number of dealers from across the country. There’s no doubt he is as active a participant in the Australian market as we are and I think some of the rationale for the ownership of AHG historically was to give them some exposure to the Western Australian market that they didn’t have through a direct participation, but the relationship we have is very good and solid, so it works well.

Okay, great, well it’s been great to speak with you, John. I look forward to seeing what this year brings for AHG. Thank you very much.

Thanks for your time, Tim. Cheers.

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