|Shares Out. (in M):||135||P/E||20||16|
|Market Cap (in $M):||8,944||P/FCF||19||16|
|Net Debt (in $M):||1,706||EBIT||611||768|
CDK Global Inc. (CDK) is a sustainably high quality business which can be purchased at a fair value. A trailing P/E of 30 may be anathema to some. However, it is necessary to consider the nature of CDK’s business and its future. Growth and margin improvement along with share buybacks offer a compelling investment return. A 15% annual return is possible to fiscal year 2021 when applying a multiple of 20 on free cash flow.
CDK is a high quality business
CDK is the leader in the automotive Dealer Management Systems (“DMS”) market. 70% of revenue is “Retail Solutions North America” (DMS), with pre-tax margins of 40%. 15% of revenue is “Advertising North America”, which delivers online digital marketing solutions to dealerships and OEMs, at a 15% pre-tax margin. The international dealer management software segment is 15% of revenue and earns a 25% pre-tax margin.
CDK sells mission critical software on a subscription basis via long term contracts (80% of revenue from 3-5 year contracts). The customer base is diversified, with average client tenure of 20 years. The business is very sticky because it is a relatively small cost component for an auto dealer and it would be a huge, disruptive undertaking to swap out the software, which underpins the dealership’s various areas of operation. The industry is oligopolistic, with CDK at 40% share and privately-held peer, Reynolds and Reynolds (R&R), at 30% share. CDK has been increasing its share among the large auto dealerships (3+ locations). Net income and free cash flow have been consistently and increasingly positive since the business was spun off from ADP in 2014. Capital spending runs less than 3% of sales, enabling substantial free cash flow generation. Returns on total capital have ranged in the mid-teens and exceed 100% annually when excluding goodwill.
CDK is likely to benefit from the tax bill
90% of pre-tax profits are generated in North America. Accordingly, CDK expects its effective tax rate to decrease from a previous 33% to 26% in fiscal 2019 as result of the corporate tax cut. CDK should be able to capture this tax savings on an ongoing basis because of its competitive position, highlighted by 40% market share and 40% gross margins. This stands in contrast to other price competitive industries in which tax savings may be fleeting as price competition increases. Further, car dealerships with tax savings will be in better position to pay for CDK’s software and consumers will have more money in their pockets to buy cars.
Ability to increase leverage
Given the characteristics of an oligopolistic industry structure, the recurring revenue from long term contracts and because it is a consistently cash generative business, CDK could substantially increase the debt on its balance sheet. The fact that revenue declined less than 6% in the auto-meltdown of 2008-10 is a testament to the resiliency of the business. Currently, total debt to EBITDA is 3.4 with EBIT coverage of 7 times interest. Debt could easily be doubled while maintaining adequate coverage. These funds would be available for share buybacks and dividends.
A currently modest debt burden makes CDK a candidate for a private equity buyout, especially with activist investor, Elliott Management Corp., which owns 8.6% of CDK, involved. CDK’s peer, Reynolds & Reynolds, was taken private in 2006, with the buyers able to substantially increase margins. Elliott referenced, in its June 8, 2016 letter, that it had received inquiries “from a number of other Wall Street participants, including private equity buyers, strategic partners, investment banks and other financing sources, that called us to express interest in CDK.”
Levers CDK can pull to produce a higher stock price
Buybacks and dividends: ample free cash flow and a stable business enable buybacks and special dividends. Management plans to return $750 million to $1 billion to shareholders each of the calendar years 2018 and 2019. This equates to 16% to 22% of current market capitalization.
Margin improvement: In 2016, when CDK’s adjusted EBITDA margins were 23%, Elliott wrote two letters to management laying out plans to optimize business operations and drive shareholder value. CDK has largely followed this plan and margins have been improving as it implements its “business transformation plan”, which includes the streamlining of installations, training and invoicing, more standardized pricing and software offerings, reduction in facility footprint and vendor consolidation. CDK’s North American operations adjusted EBITDA margins have reached 35% after allocating corporate costs. In terms of potential, Elliott points to adjusted EBITDA margins of 55% achieved by Reynolds & Reynolds’ North American operations. CDK’s guidance for fiscal 2018 is revenue growth of 3% to 4% and adjusted EBITDA margins at the high end of a 35% to 36% range, exiting the fiscal year with a margin rate of 36% to 38%. CDK’s restructuring, along with its superior scale, should enable it to continue to move (adjusted) EBITDA margins toward Reynolds and Reynolds overall 50% level. CDK margins will also be boosted as the $250 million of total costs that are associated with the business transformation plan will cease after fiscal 2019.
Revenue growth: We expect CDK to sustain at least 4% revenue growth. Historically CDK has grown at or above that rate. Growth is driven mostly by increasing revenue per site, as more product features are incorporated. CDK has lost some North American customers over the past year among the 1-2 location dealerships. The number of 3+ dealership customers has been growing, as CDK continues to take share. To better retain its 1-2 dealer customers, CDK is acquiring Auto/Mate, in a deal it expects to close the first half of 2018. Auto/Mate, one of the industry’s first dealership management systems, was developed by Wang Laboratories in the 1970s. It has a customer base of over 1,350 dealerships nationwide, with many clients using the system since the 1970s. CDK believes this acquisition will solve its small dealer problem.
The second CDK segment is North American Advertising, which enables digital advertising by OEMs and dealerships on websites. There is some lumpiness and churn in this business as customers go in and out of exclusivity terms. This segment has shown minimal growth and profit contribution. CDK recently signed two endorsements with Nissan which it believes will positively impact 2019 segment revenues.
CDK’s international business has not been growing, both in terms of customer sites and revenue per site. A new international head has been brought in and CDK says it wants this business to grow at a rate above that of the overall company. While not incorporated in our expected revenue growth, I do think the international segment offers some improvement potential.
We assume total CDK revenue increases at the mid-point of fiscal 2018 guidance (3.5%), then 4% annually and that adjusted margins will be in the guided 36% to 38% go-forward range. Incorporating share buybacks as per guidance in F18-19 and then continuing them at a rate less than FCF, CDK offers 15% annual return potential should projected FCF per share be accorded a multiple of 20. We believe a multiple of 20 is reasonable for a highly dependable cash generative company such as CDK.
Over the longer-term, if automated cars are organized as fleets offered on demand, there would be need for fewer auto dealerships.
Antitrust suits have been filed against CDK and Reynolds and Reynolds over the past year by at least four dealerships and four competing vendors. In December 2017, one of the largest US dealerships, Cox Automotive, filed an 11-count lawsuit against CDK for anti-competitive business practices. It is alleged that CDK and Reynolds agreed not to compete with each other in the dealership data integration market. There is risk of both a fine and a subsequently more competitive environment for CDK.
The aforementioned litigation could disrupt CDK’s acquisition of Auto/Mate, currently in the FTC’s second review process, and which CDK expects to close “in the coming months”. CDK has said it is this acquisition which will stem the share loss among small dealerships. If customer sites continue to decline, achievement of 4% revenue growth and further margin expansion may not be possible.
Activist pressured margin improvement and deployment of free cash flow toward buybacks.
Potential for private equity acquisition