We recently researched ARB Corporation (ASX:ARB). The Company has since released their full year results for financial year 2018 (FY18). Is recent share price weakness now a buying opportunity?
ARB reported an underlying FY18 net profit of $54.0m, which was in line with consensus estimates. Having said that, it did not exceed market expectations. Because of this, the shares have been sold down since the full year result. A closer inspection of the result suggests that the strong fundamentals underpinning ARB remain in place.
The shares are currently trading on a 1-year forward P/E multiple of ~25x. This is not excessive given ARB’s strong track record and historically premium rating. We therefore consider that ARB still warrants consideration as an investment opportunity.
Overview of ARB
ARB designs, manufactures and distributes the largest range of accessories for four-wheel drive (4WD) utilities, 4WD Sport Utilities (SUVs) and light commercial vehicles in Australia. The Company has manufacturing plants in Australia and Thailand, with sales, warehousing and fitting facilities across Australia.
The Company has operations across three segments:
i) Australian Aftermarket (the largest contributor to sales),
ii) The rapidly-growing export market and
iii) Original Equipment Manufacturers (OEM).
Sales of new 4WD utilities and SUVs are a key driver of demand for ARB’s products. As a portion of new vehicles sold, 4WD utilities and SUVs have increased from 34.9% of new vehicles sold in 2013, to 43.2% in 2017. The 4WD market continues to experience solid growth underpinned by new vehicle releases. This includes the Toyota Tacoma and the Ford Ranger.
Key Factors Underpinning the Company Fundamentals
The Potential for Margin Expansion
EBIT margin in FY18 was flat, at 17.6%, reflecting investment in new products and distribution. In addition, investment in two new stores, which opened late in FY18 made no contribution to FY18 profit.
Group EBIT margin over the last four years has largely been between 17-18%. Accordingly, while the market may have been disappointed that operating leverage remains elusive, the short-term investment being undertaken by the Company have strategic medium-to-longer term benefits to the business. These are expected to result in an expansion in EBIT margin over the next several years.
In particular, ARB’s export markets are strengthening. Also, the Company’s initiatives around new product development have improved sales growth. This in turn should lead to margin expansion. Further, the Company’s Thailand operations support potential for group margin expansion, as manufacturing costs are lower due to lower labour costs. In addition, distribution/shipping costs are lower, as the Thailand site is a ‘Free Zone’ with tax and duty incentives for exports. It also acts as a natural hedge against exchange rate fluctuations.
Strong Sales Outlook
ARB delivered double-digit revenue growth, with a pipeline suggesting this trend will continue in at least the short term. Whilst Company commentary indicated that severe drought in eastern states may be impacting demand in the Australian market, the level of demand overall remains strong. This is both in both Australia and export markets, underpinned by new products and improved distribution.
Supportive domestic market conditions, underpinned by buoyant East Coast infrastructure and construction activity, are being reflected in strong volumes for new 4×4 vehicles. Export markets (which account for 28% of group revenue) are seeing growth in all key regions. They are expected to benefit from expanded distribution while the weakening Australian dollar should be a positive demand driver.
Clearly-Articulated Growth Strategy
ARB’s growth strategy included product development and the rollout of new stores in Australia.
Product development enables ARB to gain more scale and maintain market share. A number of recently-released new products (i.e. LINK, Tailgate Assist and Jack) also supports an existing strong sales order book. Further, ARB undertakes a meaningful portion of Research & Development (R&D) expenditure. This ensures a healthy pipeline of new products for both existing vehicles and newly-released vehicles.
The Company’s strategy for new store openings is to target locations around Australia where the ARB product is under-represented. There are currently 63 ARB stores in Australia. Recent and future store rollouts have included a new store format, which has been well received by customers.
Balance Sheet Supports Growth Initiatives & Capital Management Options
One concerning feature of the FY18 result was weakness in operating cashflow. This was driven by inventory build-up that mainly occurred in the first half. Despite this, the Company remains in a net cash position. This ensures that the Company remains well placed to fund and react to acquisition opportunities and/or capital investments. In particular, the expansion in the production capacity in Thailand.
Charting view of ARB
Our previous comments on the ARB noted that “a failure to rally here might see the share price come back a bit further towards support near $19.50.” The shares have now done that for now it looks like they are right on support. If they hold here, then we can be comfortable that the share price is unlikely to head lower. Otherwise the next support level is down near $18. If investors which to purchase the stock here on support, then they need to make sure that any stop losses take into account the possibility of a short term dip to $18.
Michael Gable is managing director of Fairmont Equities.
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