There is very little 5 Strikes action, so Richard takes the opportunity to slide Inchcape onto the front burner. Over the last eight years, the company has sharpened its focus on motor vehicle distribution. Deciding what to focus on is the basis of good strategy.
Since my last article only two shares have published annual reports and passed my minimum quality filter. Both failed to achieve less than three strikes.
Since the strikes against them give me too much to worry about, I won’t be investigating them for at least a year until they publish their next annual reports.
Just for the record, they are:
- Walker Crips, a broker and financial adviser ( – CROCI – Growth – ROCE)
- Rank, a physical and digital casino and bingo hall operator ( – CROCI – Growth – ROCE – Shares)
(See this article for descriptions of each strike. The minimum quality filter described in that article has been modified. This is the new version).
Kainos moves to the back burner
Despite my enthusiasm for Kainos, I have put the software company on the back burner.
Its dependence on the Workday ecosystem and the emerging threat/opportunity of Artificial Intelligence (AI) have combined to shake my confidence.
Although I had already identified these risks, I thought I might be able to live with them. Then, on 2 September, news that aggressive pricing is reducing the value of contracts in Kainos’ Workday services division provoked more doubts.
Workday is Human Resources software, which Kainos deploys, tests, and optimises for organisations.
Although Kainos expects Workday services to return to growth, I wonder whether AI is part of the explanation and the ramifications are more serious.
Kainos itself is using AI to deploy Workday. It says AI reduces deployment time by 80%.
In isolation, this is good. But maybe rivals are discovering the benefits of AI too, enabling them to undercut each other.
Ultimately automation through AI may enable Kainos’ customers to do more of this work themselves.
Next 15 joins it
My interest in Next 15 is also diminishing.
Next 15 is a data-led “growth consultancy”. AI might be a concern here too, but the trigger for my loss of confidence is the findings of a strategic review announced in last week’s half-year results.
Next 15 has grown by acquiring boutique marketing and data consultancies. Hitherto’s policy has been to operate these businesses autonomously.
Now the company wants to provide more integrated solutions, which requires it to more closely integrate the businesses, without “compromising its decentralised heritage.”
To me, this looks like a contradiction. Although the company says it will achieve integration by simplifying the group’s structure, a decentralised structure is simple. More coordination may require more complexity.
There’s space on the front burner of the stove now. And one of the companies I am simmering there is Inchcape.
Inchcape on the front burner
Inchcape is a storied distributor and retailer of motor vehicles, but its business model has shifted decisively from retail to distribution over the last eight years.
This May, the company declared the transformation complete, with the disposal of its UK car dealerships. Inchcape accompanied news of the disposal with a lot of information about its business model so it is a good time to get to know the business.
In addition to SharePad and annual reports, my source for this article is a presentation: In The Driving Seat: Our Distribution Model [PDF], also available as a webcast handily broken down into four sections here, and transcribed here (top marks for providing a transcription).
Inchcape distributes motor vehicles for manufacturers in geographical markets that are too small for the manufacturers to get directly involved in.
It has exclusive rights to distribute vehicles and parts for 60 manufacturers in 40 geographical markets. In 2016, it had 20 manufacturer partners.
This makes it the leading independent distributor, albeit with room to increase its 3% share of the addressable market (by volume of cars).
Source: Inchcape presentation, May 2024
Most manufacturers outsource distribution in smaller markets, although Tesla is a notable exception.
Some of Inchcape’s brands, including some of the countries, are pretty obscure from my vantage point. Inchcape’s half-year results reported four new distribution contracts:
- Ford (Estonia)
- JAC Trucks (Colombia)
- Changan (Caribbean)
- Forland (Ecuador)
You probably know about Ford, JAC, Changan and Forland are Chinese manufacturers.
Inchcape manages the brand in the territory. It determines how many vehicles are needed, and arranges shipping and storage. It also advertises the brand and supplies retailers with vehicles, parts, finance and insurance products, and an IT platform.
Inchcape says manufacturers need its local knowledge in sometimes complicated markets and value its data-led approach to brand management, pricing, and management of the retail network.
Being the largest independent distributor gives Inchcape scale advantages. It can grow by representing existing partners in more of its 40 territories and new partners in existing territories. The cost of developing IT platforms is spread across many markets.
The easiest way to expand into new territories is through acquisition. These acquisitions and the disposal of retail businesses mean the contribution of distribution to total revenue increased from 40% in 2016 to 80% in 2023 (before the disposal of UK retail).
The pace of acquisitions has been reassuringly restrained though:
In only two of the last eight years has acquisition spending been greater than free cash flow, and marginally so. Those years were followed by modest spending.
The promise of the distribution focus is higher profitability and more growth.
Turnover growth has been erratic in recent years due to the pandemic. A contraction is forecast in 2025 reflecting the disposal of UK retail and a moderation of trading after two strong years. The company has, nevertheless, grown as it has transformed.
The promise of more profitability is enticing because Inchcape earned good returns even when it incorporated more retail.
I have charted the reported profit margin and return on capital employed (ROCE) without any adjustments to present a worst-case scenario. When we get into the weeds we may find justifiable adjustments and higher returns.
In six of the last eight years Return on Capital has been well above 10%, my benchmark for quality. The only year when the company lost money on an unadjusted basis was the first year of the pandemic when often we could not drive anywhere – including car dealerships.
The segmental reports in Inchcape’s annual reports tell us how much revenue and adjusted profit the company has made in its distribution and retail divisions. From this, we can derive their profit margins, which illustrates why Inchape has invested in distribution and sold off retail assets.
Source: Inchcape annual reports
Although there is a lot going on during this period, profit margins in distribution are, in more normal years, around 6%, compared to 2% in retail.
Inchcape also describes the distribution business as cash-generative, which is corroborated by SharePad. Apparently, Inchcape has achieved free cash conversion of more than 100% in each of the last five years.
To my mind, Inchcape’s pitch is quite attractive. A gradual transformation from a position of strength.
For it to turn into an investment though, we have to consider the risks.
High in my mind are financial risks. Inchcape takes ownership of vehicles while they are in transit and storage. This can be many months, which exposes it to financial risks.
Inchcape finances stock by borrowing against it. It pays for stock in the major currencies of the manufacturers, (US dollar, Renminbi, Japanese Yen, and Euro) but receives payment from retailers in local currency.
I don’t even recognise the names of many of those currencies!
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Contact Richard Beddard by email: richard@beddard.net, Twitter: @RichardBeddard, web: beddard.net
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