G.U.D. Holdings (ASX:GUD) recently issued a trading update and highlighted continued strong demand for its automotive products. While improving revenue growth trends are indeed a positive for the Company, we examine the extent to which some mitigating factors may influence investor sentiment towards GUD.
About G.U.D. Holdings
GUD is the largest aftermarket automotive parts suppliers in Australia. They are also the leading supplier of a comprehensive range of water-related products via its Davey Water Products business. The Automotive division is the main earnings driver of business, accounting for over 95% of group earnings.
The Company’s portfolio of automotive aftermarket companies includes long-standing brands like Ryco, Wesfil, and Goss. In recent times, GUD has grown this portfolio with the acquisition of strong brands such as Narva, Projecta, AA Gaskets, Injectronics, and Disk Brakes Australia (DBA).
Key Fundamental Drivers
Strong Demand is Pushing Organic Growth Above Trend
GUD recently highlighted continued strong demand for its automotive products. Third quarter year-to-date (YTD) organic sales were up 15% versus a year ago. Organic growth is presently elevated, with GUD maintaining a higher inventory level to support ongoing demand.
The reported rate of organic growth is above trend. Since FY17, organic revenue growth has averaged around 5-6%. The only negative result reported was in 2H20 (as a result of COVID-19 factors which reduced revenue growth). The Company expects trading conditions in the automotive aftermarket could remain elevated for 24-36 months.
Cost Pressure is Mitigating Operating Leverage
GUD’s operating leverage from favourable trading conditions may not be as strong as the 1H21 results indicated. The Company reported EBIT margin expansion of 160 basis points to 26.6% in 1H21. This was on the back of robust sales volumes across all business units, selective price increases and cost management discipline, despite some unfavourable mix changes, and incremental freight costs.
Cost inflation now appears to be slightly above levels indicated at the 1H21 result in February. This is driven by freight costs and supplier price increase requests. Cost pressure may continue in FY22, noting supplier price rise requests are currently under negotiation. GUD may look to offset some of these cost pressures through price rises over the medium term.
However, while the strong trading environment indicates that price increases should be passed through successfully, it is unlikely to be straight-forward. This is given its customers are also expanding their private label offerings. Further, the Company has commented that the pricing environment remains relatively tight. As such, they do not consider that there will be much price inflation in the short-term.
Davey Business Continues to Underperform
For at least a couple of years, the Company’s Water business (Davey) has been considered non-core. While the Company expected domestic sales to remain robust and export activities to normalise, year-on-year sales growth of +4% reported in the May trading update is only slightly ahead of the rate of sales growth in recent periods. COVID-19 lockdowns continue to impact the rate at which production can be ramped up to meet sales backlog. In addition, there are associated incremental costs (shift penalties, outwards/export air freight, partial factory closure) which are impacting margin.
Divestment of the business does not sound likely over the near term. Further, the lack of progress on a sale of the Davey business has been a long-standing source of frustration for the market. This is especially given the capital being poured into Davey, which is a lower-growth business than the high-returning Automotive business.
Further Acquisitions Targeted – But an Equity Raising May Be Needed
Acquisitions are a key contributor to GUD’s earnings growth profile, with recent acquisitions expected to account for around half of EBIT growth in FY22. The Company has a demonstrated track record in successfully integrating acquisitions and extracting synergies.
The Company continues to look for additional bolt-on acquisition opportunities, noting that there is “no shortage of aftermarket acquisition opportunities”. Other categories of interest include more 4WD exposure, suspension, transmission, and lubricants. The 4WD market is attractive and expected to grow faster than GUD’s existing markets. This is given the ongoing trend of consumer preferences for SUVs and 4WDs. As at calendar year 2020, SUVs accounted for 52% of overall vehicle sales, and has steadily grown from 45% in calendar year 2018.
However, a key risk associated with pursuing further acquisitions is the potential for a further equity raising. The latter may be undertaken in order either to reduce gearing levels (which is expected to rise above the target gearing range of 1.8x to 2.0x), or fund further acquisitions (especially larger-scale ones).
We maintain a cautious view on GUD due to:
i. The elevated gearing level, which raises the overhang of a further equity raising to fund acquisitions and/or bring the gearing back within the target range,
ii. The unlikelihood of a sale of the Davey business (which would re-focus the market on the Company’s strategy to become entirely an Automotive company and improve the already-defensive earnings profile) and
iii. Weakening operating leverage, with increasing cost pressure mitigating strong organic growth rates.
With the GUD having previously bounced off $11 and been sold down near $13.50, the share price is therefore trading in a clear range. Recent weakness from the last couple of weeks suggests that momentum here is to the downside. We are therefore likely to see lower levels from here in GUD’s share price.
Michael Gable is managing director of Fairmont Equities.
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