Sector sentiment remains low and the new car market continues to decline. We believe the sector valuation has priced in a lot of this risk but update our forecasts to reflect the more difficult trading environment, applying a c.10% -15% downgrade to earnings across the sector. Balance sheet strength across the sector is generally robust, and in our view, we are likely to see further consolidation activity once recovery is in sight as smaller operators become more distressed. Dividend yields are attractive at current valuation and FCF yields are generally attractive despite high levels of capex.
Sector thoughts. Market conditions remain difficult going into 2018, with no clear sign of recovery yet. However, we think this is controlled from a residual point of view with well-balanced supply as the new car market finds its natural point of demand. We are also conscious that sterling remains weak, and note the recent strength in European new registrations (September ACEA data is currently +3.7% YTD).
Market Dynamics. Weak sterling, an uncertain UK consumer, the first interest rate rise in a decade, cost pressures and scrutiny of new car financing are not helping. There are clear supply constraints caused partly by sterling but also a recovery in Europe which is pulling supply away from the UK. We believe the operating models of the dealers today is superior to that of 2007/8 with more secure balance sheets, better systems in place and more disciplined growth.
Forecast Assumptions: We apply EPS downgrades to our already below consensus forecasts of 10-16% across the board. This is based on an assumed 6.0% decline in the new car market in 2018E with a further 3.0% decline in 2019E. We assume some margin pressure builds and operating costs increase across the sector. We are more comfortable with the used car market given some supply constraints coming through and evidence of robust residual values. We have not assumed any margin improvements driven by what we expect to be harder residual values.
Valuation. The sector trades at an average P/E of 7.7x in 2018E falling to 7.0x in 2019E, on an EV/EBITDA basis the sector is trading at an average of 4.9x falling to 4.5x in 2019E. Valuations remain at historically low levels reflecting the ongoing uncertainties, but share prices are close to property values in most cases, with strong balance sheets on offer and good free cash flow generation as the heavy capital expenditure of recent years tails off.
Outlook. We think these earnings downgrades have been priced in at current share price levels. We continue to believe that the comparison to 2008 is overdone with most companies having better balance sheets and systems, and also benefiting from shorter buying cycles via PCP, giving greater visibility on earnings. We expect the difficult trading conditions to continue and do not expect a recovery in 2018E but believe at current valuations shares represent significant long term value.
