This stripped-back FTSE 250 star is ready to re-rate

The FTSE 250 group is starting from a strong position. It has just completed a disposal that has cemented its position as a higher-margin and less capital intensive business. It also boasts attractive return on capital employed (ROCE) and free cash flow generation, and is well placed for growth as the car market reshapes in the aftermath of the pandemic. The valuation offers investors an opportunity to buy in at an undemanding level, and a re-rating could be around the corner. 

A pure-play distributor

Inchcape has been transforming itself into a pure-play distributor for several years, and has just taken a major step forward. On 1 August it completed the sale of its UK car dealership business to Group 1 Automotive (US:GPI) for £346mn in cash. This follows the sale of retail operations in Australia, Russia and China, and means Inchcape's only remaining dealership is in Poland. A chunk of the proceeds from the latest disposal are being returned to shareholders through a buyback programme, which was recently increased in value from £100mn to £150mn. 

Inchcape's car dealerships generated about a fifth of group revenue last year, but they were a drag on margins and posted weak cash profits relative to peers. The distribution business delivered an adjusted operating margin of 6.9 per cent in 2023, compared with retail's 1.7 per cent, and group-wide profitability is showing clear signs of progress as retail operations are sold off.

At the same time as scaling back the retail segment, management has seriously beefed up the distribution arm. In January 2023, Inchcape bought leading Latin America distributor Derco for £1.3bn, and the business helped drive sales up by 40 per cent in the year that followed. Mega acquisitions obviously come with risks, but Derco delivered margins at the top end of expectations in 2023 and £21mn of cost savings. A further £50mn of cost savings are forecast for this year.

The latest distribution demand signs are also promising. Inchcape won four contracts in the first half of 2024, three of these with existing partners Ford, JAC Trucks and Changan, and one with new partner Forland.

Demand headwinds

Demand could still cause problems, though. Consumer purchasing power has been knocked by higher interest rates, while production has been normalising after supply chain problems suppressed new vehicle numbers and pushed up prices. Recent weak results from Stellantis (IT:STLAM) and Nissan (JP:7201) have raised fears that the auto sector is heading for a downturn as competition heats up and prices fall.

Inchcape's diversified business model should cushion it from the worst, however. The company has a footprint in around 40 countries across the Americas, Asia Pacific, Europe and Africa. Its focus is on smaller markets, where the car manufacturers prefer to outsource distribution and related services (Inchcape doesn't trade in the US or China). 

While emerging markets exposure brings geopolitical risks and adverse currency movements – there are hedging policies in place to manage these – the sheer geographic diversity on display helps reduce financial threats. 

The Americas, where Inchcape's 13 markets include Chile and Columbia, has grown rapidly in importance as Inchcape has scaled up through acquisitions. The region contributed a third of operating profit in the first half of this year, compared with 28 per cent from Europe and Africa. Asia Pacific, which includes Singapore and Australia, remains the biggest market, however, generating about 40 per cent of profit. 

Panmure Liberum analyst Sanjay Vidyarthi argues that Inchcape is "not at the mercy of any one macro cycle", as when one market is down another is usually performing well. He views these "asynchronous cycles" as a positive, "particularly when the market share opportunity is layered on top". 

A key growth opportunity comes from taking more of the value chain. Management acknowledges that the business currently underserves the last 10-15 years of a vehicle's life. That's a problem given this part of the cycle is higher-margin and accounts for three-quarters of profit from the vehicle lifetime value. 

Analysts at Berenberg think Inchcape can deliver incremental profits of £50mn in the medium term by focusing more on this area. Meanwhile, digital headway is being made through investment in proprietary technology and the company is also rolling out artificial intelligence solutions to more of its services. 

Underpinning all future growth are strong relationships with the OEMs. These cover a range of operators, from long-standing partners including Toyota and Jaguar Land Rover (both of which Inchcape has partnered with for over 50 years) to newer ones such as BYD, Great Wall Motor and Changan. Distribution deals with this Chinese trio highlight that Inchcape has its eye on the ball when it comes to electric vehicles. 

Resilient interims

Recent trading has been encouraging despite car sector headwinds. Last week, the company reported a steady set of interims backed up by strong cash generation; free cash flow rose by a fifth to £226mn and the cash flow conversion rate came in at 76 per cent. 

For the six months to 30 June, revenue from continuing operations (ie distribution) was up 4 per cent at £4.73bn. On a constant currency basis, the uplift was 8 per cent, split between organic growth and the impact of acquisitions. 

Revenue growth of a fifth in Asia Pacific and 16 per cent in Europe and Africa was offset by a 16 per cent decline in the Americas, where “many markets at historic lows” meant lower volumes. But there were market share gains in plenty of regions and a “resilient” share performance in the Americas. Margins are expected to improve in the Americas in the second half.

Adjusted operating profit nudged up 1 per cent to £299mn, while statutory pre-tax profits climbed by a tenth to £195mn. There were positive signs on cost control, with overheads down and the ratio of adjusted net operating expenses to revenue falling from 11.4 per cent to 10.9 per cent. 

The balance sheet is also in a decent condition, providing firepower for future acquisitions. Leverage was down to 0.7 times at the half-year stage, comfortably under the target ceiling of one times, and this is expected to reduce further (note that this metric excludes some fairly hefty lease liabilities). Meanwhile, two-thirds of corporate debt, excluding the revolving credit facility, is at fixed rates and is not due to be repaid for at least three years. 

A re-rating opportunity 

Inchcape trades on 10 times forward consensus earnings, a 17 per cent discount to its five-year average. That is too low for a business that has made significant strategic progress and boasts strong cash generation and return on capital characteristics. A few things need to slot into place for a re-rating to occur – most crucially the demand environment – but we agree with Panmure Liberum that the valuation "does not reflect the ROCE capability". 

Over at Peel Hunt, analyst Andrew Nussey expects "a material re-rating of the equity", with bolt-on M&A helping to offset the dilutive impact on earnings in 2025 from the UK retail disposal and FX headwinds.

Management forecasts “moderated growth” for the full year and a “return to high levels of growth” in the medium to long term. While there are short-term market headwinds at play, this opportunity should not be missed.