|Shares Out. (in M):||157||P/E||27.7||19.5|
|Market Cap (in M):||6,411||P/FCF||23.83||17.08|
|Net Debt (in M):||645||EBIT||394||540|
This is a simple enough thesis. Currently the market is giving a chance to invest in fantastic business that is in a duopoly market where it is vastly underperforming its closest peer due to lack of attention. CDK Global (“CDK”) was spun from ADP in September 2014 (they were a sleepy subsidiary inside of a sleepy company - aka the ugly stepchild of the forgotten family). CDK exhibits classic spin dynamics – under-covered and under-loved. CDK is significantly under-earning its nearest competitor – Reynolds & Reynolds (“REY”) (REY has an EBITDA margin of 51.7% versus CDK’s EBITDA margin of 21%). CDK’s business is a tremendously FCF generative business whose true profitability is being masked by spin dynamics coupled with a bloated cost structure. Now that CDK is spun from ADP it will focus on increasing margins and returning cash flow to shareholders. CDK’s stock will be driven upwards by three main points: 1) topline growth driven by secular tailwinds from underinvestment / increased shift of spend towards digital marketing, 2) significant margin expansion, and 3) substantial FCF generation that can be used to repurchase stock.
Based on a 17x forward FCF (~6% FCF yield) multiple on 2018 FYE FCF (note CDK is a June 30th FYE, we are halfway through FYE 2015) plus dividends (2.5 years of dividends assuming no dividend increase) results in a $65 price target or 58% above the current price (representing an IRR of 20%). Even if topline doesn’t expand and CDK just shows half of REY’s margin improvement it would be trading at 13x earnings – which is wildly low for a business of this caliber. Additionally – should CDK convert to SaaS it will benefit from improved topline growth, superior economics, and accordingly likely a higher multiple.
CDK provides information technology and digital marketing/advertising solutions to the automotive retail industry. It is the operating system that runs auto dealerships (pre-sales advertising, sales, financing, parts supply, insurance, and repair and maintenance of vehicles). CDK earns money by selling their software (currently via licenses) to dealerships on a 3-5 year term (with annual pricing escalators), they also sell dealers: equipment (servers, etc.), web services (marketing, web site management, etc.), and volume based products (like financing request or VIN registration). CDK makes money as long as the dealership is open and also has upside optionality from increasing car sales (this is particularly more meaningful in Europe and Asia where volumes are set to grow). CDK serves 26,000 retail locations and automotive manufacturers in approximately 100 countries. CDK operates in an oligopoly market with CDK at 40% market share and private competitor REY at 30% market share (the balance being with a handful of smaller competitors). REY was acquired by UCS in 2006 for $2.8B or ~20x EV/trailing EBITDA and 29x EV/trailing FCF. CDK has three business segments: 1) Automotive Retail Solutions North American, 2) Automotive Retail Solutions International, and 3) Digital Marketing.
CDK has a remarkably resilient business – during the global economic downturn, CDK’s North America organic revenue declined by 4% between FYE 2009 and FYE 2010, while U.S. car sales volumes declined 21% from CY 2008 to 2009 and 760 dealerships closed (a 3.6% decline nationally). AutoNation tried to disintermediate REY & CDK in 2008 by partnering with Microsoft; Microsoft spent a few years working on this and finally gave up. AutoNation is now a CDK customer (Sonic Automotive tried something similar to no avail). The DMS industry is one of the most resilient industries. Some of REY products still run on DOS! I cannot stress enough how sticky the DMS customer base is - this is a cow that can be milked for literally decades upon decades. Dealers themselves are as close to luddites as we can find in the modern business world:
CDK generates higher FCF than net income due to relatively low capital expenditure requirements (averages around 2% to 3% of sales) versus depreciation and amortization (they are amortizing intangibles associated with past acquisitions and their investment in software upgrades). Some customers have been with CDK for 20+ years – being with REY or CDK is viewed as a cost of doing business. After REY’s buyout, REY’s management underinvested in their product and service resulting in CDK taking market share.
CDK is run by a group of ADP veterans. The CEO is Steven Anenen (61 years old), who is a 39 year ADP veteran and has served as president of ADP dealer services since 2004. CDK executives are incentivized against wide range of criteria: 15% weighting towards revenue growth, 20% weighting to operating income growth, 35% division financial performance (which is a mix of net operating income, client retention and sales targets), and 30% strategic objectives (improve market share, focus on rolling out new products, and building a solid leadership pipeline). In 2014 the CEO made a base salary of $475,004 and a cash bonus of $391,020 with over $1M in stock incentive related grants and options. Going forward the target mix is 28% of pay is the base salary, 20% in annual incentive payments (a mix of cash and stock), and 52% in long-term incentive compensation. The executive team had options issued to them with exercise prices ranging from $40.28 up to $79.31 (all above the current price). The CEO has exercisable options for 57,250 shares (another 45,750 shares that are currently not exercisable) and owns an additional 55,447 shares outright. So all in at current prices – the CEO has $6.3M on the line and each $5 he increases the stock by increases his net worth by ~ $800K.
At the current price of $40.86 the market is not giving CDK any credit for realistic margin expansion or topline growth. REY clearly laid out the playbook when they increased margins from 20% to 51.7% shortly after their LBO. All of my primary diligence led me to believe that CDK will easily be able to increase to a minimum of 30% EBIT margins and more realistically 40%. CDK is currently vastly overstaffed with older and highly paid employees, additionally CDK was previously not run in a lean and profit motivated fashion. Merely reducing headcount by 10% can increase CDK’s margins by 5% (assuming lower than market pay). In Q1’15 alone CDK was able to increase margins 170bps YoY (adjusted for spin expenses), indicating how easy it will be for CDK to increase margins.
The market is currently only pricing in that CDK will improve margins to the low 20s (this can be achieved with minimal headcount reduction). If CDK grows at the midrange of management’s guidance and makes minimal EBIT margin improvements (still substantial discounts to REY) that alone justifies and even exceeds the current price. This also assumes no increase in buybacks and no increase in dividends which based on management commentary is almost guaranteed. It seems silly that the market is giving no credit to the fact that the company can: grow annually, achieve higher margins (as indicated by actual results and management guidance), and use FCF for any purpose other than sitting idle on the balance sheet.
CDK will grow from: 1) simple price increases, 2) higher international volumes, 3) continued North American market share wins, and 4) continued increase in digital automotive spend. On the margin side, management has already stated they can easily achieve 100bps of margin improvement annually. In speaking with industry contacts it appears obvious that they will be able to greatly exceed this measure (more detail later on). Suffice to say the downside is baked in and you are getting the upside for free.
Most Compelling Primary Research:
o “There is no reason why CDK can’t get to north of 30% EBIT margins. REY could have easily boosted its EBIT margins: if they would have shut down their generations series (upgrade to software) it would have added 3%-5% the EBIT margin and then their web products which they were giving away for free so it was a total cost center, this would have added another 3% - 5%. Without trying you could have boosted margins by 10% out of the gate to nearly 30% - and this is before even addressing overstaffing. UCS did all this post buyout and look at the margins now.”
o “I tried to buy the business from ADP prior to the spin. I worked to put together a syndicate and ADP wouldn’t sell since they knew it was undervalued. So I bought a bunch of the shares in CDK when they started trading. I think it is so easy for CDK to rapidly increase margins – they will be able to get to 40% with ease. They will win some folks from REY defectors like they have historically but the industry is so sticky that they are more likely to benefit from scaling revenues and cutting headcount. I think it’s a no brainer.”
o “Both REY and CDK are hard to use but CDK is more user friendly. CDK is way more advanced in their digital offerings then REY is. I have used CDK for 20+ years and wouldn’t think of switching. CDK is a great business. On the DMS side CDK is way overstaffed, I have multiple relationship managers, which is unneeded, these are all $150k/year guys who are all in their late 50s – they are just milking it. If CDK gets serious about increasing margins they will remove the duplication to just one $50k/year employee to manage the relationship.”
o “Working at REY is pretty much how I envision Azkaban. REY, in recent years, has put a ton of emphasis on marketing and sales at the expense of product development and support. In short, they lie to customers to sell a product that does not function as advertised while not providing the technical support team with enough manpower or documentation to adequately assist the customer.”
o “The owner and president are so out of touch with what the market is doing and they cannot understand that their image in the marketplace is horrible and preventing business increases for the company.”
o “CDK will be able to easily cut costs. There is a huge portion of the salesforce that is around 55+ years old, makes a hefty six figure salary, and is reasonably superfluous. Management will start cutting the fat as they work to substantially reduce the employee base – the head of Cobalt retired post spin solely for this reason. The mentality at CDK has changed since being public and folks now actually care about returns and financial metrics – pre-spin it was la-la land where no one really was incented to achieve high returns since it was hidden in ADP.”
CDK Will Experience Solid Topline Growth
· The recession resulted in underinvestment in dealer information services systems. North American new vehicle sales in 2014 are expected to return to pre-recessionary volumes (after declining to a low of 11.9 million in 2009), according to IHS. The global economic downturn created a healthier, right-sized retail structure that benefits both automotive retailers and OEMs. Increased dealer profitability enables them to invest in their businesses – this is badly needed (some systems are still DOS based) and the industry transitions from analog to digital it will result in a dramatic uptick for companies like CDK.
· Continued consolidation in the North American dealer segment will result in more dealers switching over to enterprise grade solutions like CDK (CDK will win versus REY in a bake off due to positive industry sentiment and a willingness to invest in improving the technology) and CDK has 7 of the 10 largest dealers in the U.S.
· Emerging market countries will continue to grow; new vehicle sales in China in 2014 are expected to be 8.9% higher than in 2013, according to IHS. New vehicle sales volume in China has eclipsed that of the United States and Japan combined, with 21.4 million new vehicles sold in China in 2013. New vehicle sales growth in China is anticipated to continue at a 7.1% CAGR to 28.0 million in 2017. OEMs continue to invest in China and OEMs have more control over international dealers.
· Digital marketing will become increasingly important. According to a 2013 Google study, 95% of U.S. vehicle buyers now use the internet before purchasing a vehicle. According to a 2013 Polk Automotive Buyer Influence Study, automotive retailers allocated 27% of their advertising spend to digital media while 75% of automotive buyers utilized digital media in their vehicle research. The automotive retail industry’s allocation of advertising spend to digital media continues to lag behind consumer shopping behavior and preferences – this will change over time. By 2017, eMarketer forecasts that U.S. digital automotive advertising spend will reach $9.3 billion, representing a 15.7% CAGR from 2013 spend.
CDK Will Experience Margin Expansion
· CDK has 2x the employees as REY (2x the sales does not require 2x the employees) – CDK is clearly overstaffed. REY was taken private in 2006, and at the time had a similar margin structure to CDK’s today. REY was able to boost its EBITDA margins to over 50% (nearly 60% at peak) by turning over a relatively expensive ($110,000/yr average salary) workforce and cutting other costs.
· When speaking with industry folks they saw no reason why REY and CDK should have different margins. They think that CDK has lots of fat to trim – CDK’s management hinted to this on their first conference call, saying they can increase margins without too much effort (they made a point to highlight that margin expansion is a main priority).
· CDK is spending a ton on their web development property. Ever since they acquired Cobalt (acquired in 2010 for $400M – Cobalt is the core behind the digital marketing arm) they have been way overstaffed. As they start to roll out their cloud hosted products and cut headcount they will be able to drastically bring down costs and push up margins. There are 9,000+ employees at CDK and a large proportion are labor related to software development. As they roll out their cloud products they will be able to drastically reduce this.
o A 10% reduction in headcount at $100,000/yr would boost EBIT margins by 5% and save CDK $90M or $0.57 per share annually. Headcount will likely be cut more and salaries are likely higher implying greater savings.
· CDK is currently underpricing competitors – industry sources have hinted to as much as 20% below REY which is clearly impacting margins and frankly is unneeded given REY’s bad reputation in the dealer community for service and technology.
· CDK is still in the ramp phase on their international business which was hit by the global recession (especially in Europe) currently this business is earning 14% EBIT margins which is nearly half what they are earning in North America (there is no structural reason for this). As volumes rebound this will move up dramatically.
· CDK is significantly under earning on their Digital Marketing business as they are earning a 7% EBIT margin. Normal digital marketing businesses like Conversant (formerly ValueClick) can earn EBIT margins in the 30% range.
· Management has publicly stated they can easily deliver 100bps of margin expansion annually. They were likely drastically under promising as their equity was being struck around the time of the spin and they wanted to talk down the potential. CDK will have a formal analyst day where they greatly expand on how easy it will be for them to expand their margins. They likely have significant fat to cut as is typical of a spin (beyond the tech spend and bloated employee count mentioned above).
o On the Q1’15 earnings call CDK’s management made it clear that margin expansion was a priority: “Clearly, we have lots to do over the next several months, but I want to assure you that margin expansion is and will continue to be a priority for us in this organization.” - Steven J. Anenen, CEO.
CDK Will Generate Substantial FCF:
· CDK generates substantial FCF each year – in the past three years it has averaged ~ $200M per year.
· Management has committed to maintaining a Debt/EBITDA ratio of at a minimum 2x (REY at the extreme is closer to 8x). As CDK grows FCF it will be able to take on an additional ~ $1B in debt to repurchase shares.
· Management will use excess FCF to repurchase stock – they already initiated a $0.48/share annual dividend.
· In my model I assume that 60% of FCF goes to repurchases (at prices that rise 10% annually).
CDK will rapidly expand margins as they cut costs and increase prices, additionally they will be able to modestly grow topline revenue. At present CDK trades at 11x 2018 FYE FCF which is absurdly low for this high quality of a business. As management executes and jumps over the one foot hurdles ahead of it they will rapidly grow FCF and earnings and be able to repurchase substantial amounts of stock (36% of the current market cap by 2018 FYE by my math). CDK will earn $3.73 in 2018 FCF and will be able to trade at 17x FCF with dividends results in a $65 price target or 58% above the recent price (when I ran a DCF I arrived at a similar conclusion). CDK has additional upside via its eventual SaaS conversion (discussions with industry professionals and dealers lead me to believe that this will eventually happen but is not likely anytime soon).
CDK’s margins fail to expand
CDK’s margins will start to naturally expand as Digital Marketing & Automotive Retail Solutions International grows topline coupled management aggressively cutting costs (headcount, corporate waste, etc.). REY gave CDK an easy playbook, CDK is already executing with 170bps improvement YoY in Q1’15.
CDK’s management is not aggressive or is a poor capital allocator
Both Sachem Head Capital Management (a Pershing Square spin) with a 9.8% stake and Fir Tree Partners with an 8.8% stake have recognized CDK’s value. Having two activists with meaningful positions will help ensure that management behaves properly and aggressively expands margins. Additionally – CDK is a ripe target for PE funds as they can leverage them far beyond 2x (REY is 8x).
With 7 of the top 10 dealerships in the U.S. CDK will benefit from dealer consolidation as larger dealer groups consolidate the industry and merge acquired branches onto the dominant DMS – CDK.
With eager activists around the table controlling ~ 18% and a new spinco eager to make its mark CDK will start to rapidly outperform as it cuts costs and executes on some surprisingly low hanging fruit.
|Entry||01/09/2015 10:28 AM|
Thanks for a great write-up. Given the large spread between CDK's current and potential normalized metrics (int'l margins, digital marketing margins, headcount, employee comp, etc), I'm curious to know which assumptions you are using on topline growth, headcount cuts, etc. to arrive at your 2018 EBIT margins and FCF estimate. Would you mind posting your model via Dropbox or at least providing your key operating assumptions so that we can re-derive your 2018 FCF?
|Subject||I talked with CDK Investor Relations|
|Entry||01/09/2015 11:59 AM|
CDK IR says that Reynolds has high margins because it is being run for cash and has substantially contracted its revenues/market share over the years. That market share was taken by CDK, which was being run normally.
The management culture at ADP, according to IR, is to find a bit of sales and margin improvement each year. So, while I am eager to accept the idea that a CDK has room for margin improvement, I don't understand the potential source of that improvement (other than firing people simply because they are expensive - independent of whether they are worth it).
I think a lot of people would like to better understand the argument around margins given that Reynolds was contracting (to the benefit of CDK's market share) while generating fat margins, and so may not really be comparable. It's a QUALITY business, thanks again for the write up.
|Subject||Re: I talked with CDK Investor Relations|
|Entry||01/09/2015 04:46 PM|
I agree thathat Reynolds margins are not sustainable at > 50%. I don't think CDK can get to that level. Even at a big discount to that say 30% you have an easy path to success. In my minds the easy expansion areas are: 1) headcount (as you say), 2) Cobalt which is earning way lower margins then it should be earning compare it to any normal lead Gen or digital marketing business and it looks ugly in comparison, and 3) international is not doing so hot and as that reverts to a more normiced environment it will lift margins as well.
So I think there are multiple levers to margin improvement.
|Subject||Re: Model assumptions|
|Entry||01/09/2015 04:50 PM|
cmg90 - I will get back to you on what makes the most sense. I am traveling over the next few days so it might take a couple days but I will get back to you.
|Subject||Re: Exercise Price|
|Entry||01/09/2015 07:23 PM|
My understanding is they don't since some of the expiration dates are a decade from now. So that timing makes it look less egregious on the face of it. If I am being foolish someone please school me appropriately. Plus there is no footnote referencing any needed adjustment for ADP shares. So I think it is safe.
|Entry||01/12/2015 10:30 AM|
I think there is no question that there is 1,000-1,500 bps of add'l margin that CDK could easily get, without impacting its "growth focus" one iota.
1. Too many heads - they simply have too many people. If you speak to folks in the industry it becomes clear that CDK is run like an old line car company - lots of middle management layers that add limited value, bloated sales and support effort.
2. Prices are too low - CDK consistently prices their products 5-10% below R&R. For a company that argues they are an industry innovation leader and that their closest (only) competitor isn't investing in their products, it doesn't make much sense to price products cheap to R&R. Either you should price in-line or at a premium to R&R, or your "innovation" effort isn't driving differentiated products. Also, given the duopoly structure of the industry, I tend to think that if CDK improves pricing discipline then R&R will just raise prices further...which gives CDK more of a pricing umbrella.
3. High cost heads - this takes longer to fix, but CDK generally has higher average head costs, as the write-up discusses.
The CDK IR team's response seems disingenuous to me. When you talk to people in the industry, there aren’t massive differentiations between CDK and R&R’s products, and R&R gets adequate marks on customer service/support. Where R&R does not do well is on the perception of contract/price flexibility (the Bob Brockman effect). I have rarely encountered a well run embedded, duopolistic enterprise software company where customers are “happy” on price (Vertafore / Applied Systems etc).
Also, CDK is not addressing a limitless market. There is a finite number of customers in the US and CDK knows them all. You could basically get rid of the sales force for existing customers and let the support guy act as sales and service (which I think is how R&R does it). It’s not like there is white space for the sales stuff to attack. So, they end up spinning their wheels attacking R&R’s customer base. And while CDK is winning net customers from R&R, they also lose customers to R&R. New customers are lower margin given price concessions and ramp-up costs. It would be a lot better for everyone if CDK focused on getting price from its base rather than stealing a few customers from R&R.
I agree the major question with this investment is how quickly will CDK act to close the margin gap vs. R&R (to some degree). Is the CEO a true believer in the “innovation is going to change the auto buying experience, and we need to invest accordingly story”, or is he going to roll over to the activists? I think the answer is somewhere in the middle – not going to see margins expand like they did at R&R but also going to get more than 100bps / year.
At current prices, you are paying ~1x of EBITDA more vs. high quality, vertically focused enterprise software peers which trade at ~14x (note: be careful to back out capitalized software which some companies like TRAK use a lot of) – in my mind this is a low price to pay for the massively valuable option that comes with the potential for 20% of margin improvement in a very, very high quality software business. And you get balance sheet optionality here. Also, the margin opportunity provides a great floor – private equity would love to buy this at $35.
|Subject||Re: We agree|
|Entry||01/14/2015 01:34 PM|
can869 - a few questions:
1) What gives you confidence that CDK management will soon attack the SG&A line and cut headcount to grow margins? They have only guided to 50-100bps EBIT margin improvement per year (which as you mention is likely highly conservative, even based on revenue leveraging alone), but specifically, they have not called out the selling/marketing cost line as an area for improvement. I understand that it is now a public company and they cannot just come out and say they are going to slash heads on their first conference call, but why are you confident the CEO will aggressively rationalize some of the ~9,000 employees? He is pumping the market share growth agenda which would lead one to believe that he's not reducing the sales force anytime soon.
2) Do you have a sense for how many of the 9,000 employees CDK can cut and still achieve the recent ~7% revenue growth for the next few years? It seems like this is the biggest point of debate between the Street and the bulls. The write-up mentions 10% headcount cut at $100,000/yr generates 5% EBIT margin expansion. Have you spoken to any industry experts for evidence that they could let go of 1,000 sales people and still achieve hsd growth?
Thanks in advance.
|Subject||Re: Re: We agree|
|Entry||01/14/2015 04:32 PM|
1. I think CDK's management team was legitimately caught off guard by the rapid and fervent interest that it is being given by Wall Street. 50-100bps / year of margin was how they've done things in recent years at ADP and was the initial "bid" from a new CEO who has been at ADP for 30+ years but I don't think is a seasoned public CEO (and had financial incentives to talk down the story initially). My sense is that the management team is now scrambling to more directly address the activists' pitch. The CEO for the first time has the opportuntiy to make a lot of money for himself and actually more fully investigate the margin potential in the business. And, given the traction that activists are getting in today's market, I don't think he can/will ignore them completely. I don't think he is going to run the private equity software playbook in the public markets, but he'll do something.
2. What is magic about 7% growth? Would the market prefer 50bps of margin expansion and 7% growth / year or a move to 35% margins and 5% growth thereafter over ~3-4 years? I personally don't appreciate the 7% growth that much given that it is mostly coming from digital marketing which is a structurally lower margin business. I'd rather see them focus on the software side of the house, sell add-on products and raise prices so that the software business grew consistently at 5%. I can't quantitatively say what a 1,000 person sales reduction would do to growth, but I do believe that R&R is achieving similar penetration of new add-on products to its DMS customers with a massively smaller sales effort (even though they are losing some business to CDK).
|Subject||Re: Re: Re: We agree|
|Entry||01/14/2015 04:43 PM|
Thanks for the quick reply. I completely agree with both points -- management definitely felt rushed to meet the spin deadline and is still scrambling to get the business stood up on its own without ADP, hence the lack of IR returning investor calls. These activist agendas do tend to get traction (albeit sometimes it's up to a year later post-spin depending on how quickly management gets the PF business ready to operate without the parent). I have a call in to IR on Friday - will report back with any new findings but I like the opportunity.
|Subject||Re: New/Used car prices|
|Entry||01/23/2015 10:51 AM|
First off - I am surprised there was no chatter on the buyback announcement. I thought that was great news and indicated that management was acting in a good manner.
In the heirarchy of dealership profitability it ranks as follows (most profitable to least)
2. Used Cars
3. New Cars
So yes used cars can be an important portion of dealer profitability, but it varies widely. Some dealers really promote used cars and are essentially two dealerships in one – new and used. Others only sell a few used cars per year. The auction system is the main way new car dealerships dispose of trade-ins. But they make a nice little margin on this too, if prices fell, the margins would probably stay roughly the same (since dealers treat it as a spread game), which means profit in absolute dollars would fall. With regards to the DMS side of things, CDK would only be very indirectly affected by a change in used car prices, and probably not at all. Keep in mind these systems are only a small part of the dealers expenses, they are on long term contracts, and they are a must have for delaers to run their businesses (this is not something dealers can turn on and off when the economy changes). Dealers’ margins don’t change that much (in the grand scheme of things) in good times or bad because they have such a diversified portfolio …. when new car sales are down, used cars sales and repairs are up; etc. the only real factor would be number of dealerships (which dipped in 2008-2010). The number of delaerships does impact CDK’s revenues. Given that we recently went through a big dip in dealer count its unlikely this will happen again making the dealer base pretty stable now.
In my opinion the biggest threat to the DMS space is a change in the franchise laws so that OEM’s can sell directly to consumers using their own systems (e.g., Tesla). This is unlikely given the political power of NADA (dealership association) but if this were to happen the closed loop system has no need for DMS since closed loop dealerships are not tied into the auction network. This is a whole different part of the ecosystem. Different systems, etc.