The lower margins of the Digital Marketing Solutions segment concern me somewhat. Digital Marketing Solutions EBIT margins were 7% in the latest period (FY 2014), which is down from 9% in 2013. Low margins frequently suggest that a segment is either highly competitive or low value add. Low margins also provide less cushion during economic downturns. The Digital Marketing Solutions segment is by its very nature, the segment that is most susceptible to industry and general economic cycles. According to the Form 10, the margin decline in 2014 was driven by both expenditures to support new contract rollout (admittedly I don’t know what this means but I think it is related to website management) and higher advertising costs. High advertising costs is a bit surprising because I would have thought that there would be more scale in this business as revenue grew $63mm in the same period. The majority of the revenue increase was driven by an increase in website management revenue. In summary, I think there is more to learn about the economics of this segment. I know that it is cyclical but I do not quite understand what is driving margins and how scalable this portion of the business is. I am comforted somewhat by the fact this is a smaller part of the business (<20% of revenue) and that it accelerates financial performance during times of economic boom.
The Auto dealership software industry is much more fragmented than one would think.
As previously discussed, there are a few large players: CDK Global, Dealertrack and Reynolds & Reynolds are the 800-pound gorillas. But there are also a bunch of smaller players that include Auto/Soft, AutoMate, Incadea, Dominion Dealer Solutions and a few others. Incadea operates primarily in international markets and Dealertrack recently acquired Incadea, making DealerTrack an even larger competitor. Fragmentation represents both a risk and an opportunity.
A fragmented competitive landscape is a risk because the persistence and entrance of smaller players drives down industry pricing. These smaller players usually gain market share by offering lower pricing than their larger rivals. For example, a DMS system from a provider like Auto/Mate can cost several thousand dollars less per month than a comparable system from CDK or R&R. While CDK and R&R still dominate, money talks and lower pricing from these rivals can impact their pricing and ultimately operating margins. However, fragmentation is an opportunity here as well. Fragmented industries are often ripe for consolidation. Increasing consolidation can help sustain or drive pricing as smaller competitors that hurt overall pricing are acquired by larger players. We’re starting to see some evidence of this with the recent news regarding DealerTrack and Incadea. Additional consolidation is good for CDK, especially if they are one of the acquirers. Note however, that I don’t expect CDK to be acquired or make a transformative acquisition in the next 2 years because this would likely trigger tax consequences that alter the tax- free spin from ADP.
Increasing consolidation of franchised dealership groups drives DMS pricing down
As of early 2013, there were 17,600 franchised dealership groups and 37,000 used vehicle dealerships in the US. The downturn has driven consolidation of dealerships but there is still a tremendous amount of fragmentation. Over the last several years, we have begun to see ever larger dealership groups form and buy out smaller dealership groups. Some of these are Lithia Motors (LAD), AutoNation (AN) and Penske (PAG)). Even Warren Buffett recently got into the game by buying the fifth largest dealership group in the country called Van Tuyl Group (privately owned). This increasing consolidation among dealership groups is likely to be a negative for CDK and other DMS providers. As dealership groups merge and grow larger, the pricing power shifts in their favor and they are likely to try to extract price concessions from their DMS providers. I haven’t necessarily seen any evidence of price degradation but put it on the radar as a long-term risk if dealership consolidation continues.
New model of direct to consumer sales may limit usage of DMS software
I only need to mention one company here and that is Tesla. Tesla is taking a very different approach to auto sales than any of its automotive competitors. Tesla is eschewing the franchised dealership model in favor of direct to consumer sales. In this new model, Tesla likely does not need to license DMS software. They likely have proprietary software to manage their sales, financing, etc. While I believe that selling cars in this way is likely much more efficient and cost effective, I see it as highly unlikely that larger players like Toyota or GM decide to change their current dealership model in a meaningful way. And even if they do, they cannot eliminate any of their existing dealerships. State franchise laws are very strict and would prevent them from doing so. In summary, I see the risk from the transition to a new sales model in the near to intermediate term as very low, but I did think it was worth highlighting to acknowledge the breadth of risks that are out there.
Management
At a high level, the management team (including the CEO) is a group of ADP veterans that has a wealth of industry experience and has made good capital allocation decisions.
CEO Steve Anenen has been with ADP and CDK for 39 years. He has been at the helm of CDK since 2004 (10 years) and has managed exceptional growth of the base business while making sound acquisitions such as Cobalt, which is now CDK’s Digital Marketing Solutions Business. Anenen has seen many parts of the business and I generally believe that this experience will be valuable to the newly public company.
Many of the other management team members including the CFO and the division heads also have a wealth of experience with CDK and ADP. Chairman Leslie Brun has extensive financial, management and advisory experience that makes him particularly well suited to the role. From corporate governance perspective, CDK gets a gold star for keeping the CEO and Chairman roles separated.
The important thing I like to look at with spinoffs is how much skin management has in the game (in other words, how much of CDK Global’s equity will owned by management). A management team that is overpaid with equity that significantly dilutes the common shareholder’s ownership is not a good thing, but a management that owns a substantial equity stake, has interests that are better aligned to shareholder interests. There is a fine balance between the two, but in summary, we do want management to be owners of the company in a fairly meaningful way.
In the case of CDK, management owns very little of the new company on a pro forma basis. Even if we include additional shares that would be acquired upon the exercise of additional outstanding stock options, the management team would own close to a half million shares in aggregate. While this may sound like a lot, it is well less than 1% of the total outstanding shares. I believe that management’s ownership of the company will grow over time but I wish it were somewhat higher at the get go to ensure that management interests and shareholder interests are well aligned.
Having said that, there are a few things that I like about management compensation at first blush:
Minimum stock ownership guidelines are a key aspect of CDK’s compensation policy. The policy requires that the CEO hold minimum equity ownership in CDK of three times base salary (= ~$1.5mm for 2014) and executive officers hold at least one times base salary. This ensures that management has at least some skin in the game, but this amount of ownership is still relatively low. As of this writing, management satisfied these requirements.
~50% of CEO compensation and ~37% of other executive compensation is comprised of long-term incentive comp like stock options and Stock Awards. I like compensation that is based on long-term objectives. It motivates management to make decisions that are good for the long term.
Capital Allocation
In mid –November, management declared a dividend of 12 cents per share, which results in a dividend yield of ~1.0% (at current stock price = ~$46). I like the move by management to initiate a dividend. The declaration of a dividend represents a fixed quarterly expenditure ($77mm per year in aggregate in FY 2015) and demonstrates confidence in the business by the management team and a capital allocation policy that is shareholder friendly. I expect continued increases in the dividend as former parent ADP was well known for. Additionally, the Free Cash Flow payout ratio of ~33% represents an amount that is appropriate and provides sufficient cushion relative to annual FCF of approximately ~$230mm (excluding one time separation costs).
Prudent acquisitions that add value are also a way that I qualitatively evaluate management’s strategy. CDK has made 30 acquisitions since 2000 that have ranged from smaller tuck in to more transformative. Two key acquisitions have included: the acquisition of Kerridge Computer in 2005 which formed the foundation for CDK’s International DMS platform and the acquisition of Cobalt which is the basis for CDK’s digital marketing solutions business. Both of these acquisitions have proved to be integral to the current business and generally make logical sense for the company. I don’t have specific information on purchase prices and other tuck in acquisitions, so it is difficult to say if management has been prudent with all acquisitions, but at a high level, I can say that acquisitions have been additive and logical.
A key component of CDK’s business strategy going forward is completing acquisitions that support or complement its existing technology. We will need to continue to evaluate the quality and prudence of acquisitions going forward.
Valuation
Now we come to the million-dollar question – what’s it worth? Before we go there, let me recap. There are a lot of things that I like about CDK: an experienced management team that is working in the shareholder’s interest, the recurring revenue stream of DMS software, the relative resistance to recession due to mission critical nature of the software, high switching costs, slow pace of change in enterprise technology and high operating leverage. There are some risks/watch outs to be aware of: industry cyclicality could have some impact to the revenue stream, low margins and susceptibility to cyclicality of Digital Marketing Solutions, fragmentation of DMS providers and increasing consolidation of franchised dealership groups. In totality, I would say that the positives far outweigh the risks. And with the risks, there are fairly strong mitigants. So what’s this all worth to us at Scuttlebutt?
Based on a Discounted Cash Flow Analysis, we get to an intrinsic value of ~$42 per share. When the stock was trading around $25 to $27 per share post debut, it was a healthy discount to fair value. However, at a current share price of ~$46, the value proposition is difficult to justify.
There is an important point that I need to make on the origin of the intrinsic value. The intrinsic value of ~$42 is predicated on a reasonable level of margin improvement driven by two key factors. First, I believe that the business is not productive as it can be today when you compare it to peers like R&R that generate operating margins of 42%-44%. However, I believe that R&R may generate those excess margins at the expense of its product and service levels. Thus, my model assumes that CDK can improve margins in its three key segments to competitive levels, but still well below R&R. Second, CDK should be benefit from operating leverage as it grows the top line, thus improving margins naturally.
Sachem Head Capital Management and Fir Tree Partners, which now own ~18.5% of CDK between the two funds have driven the price of the stock up significantly since the debut. I should note that Vanguard and Blackrock, the mutual fund companies, also own large positions of ~6.1% and 6.9% respectively, but neither is known to be activist in any way.
The question is whether or not these hedge funds will continue to buy and if this will continue to drive the price of the stock up. I would call these speculative drivers of price (not value) and could not recommend an investment on the basis of an increase in price due to these drivers. However, these funds may try to drive value– by recommending strategies and acquisitions to management that can drive margins, Free Cash Flow or strengthen competitive advantages. These are the drivers of value that we at Scuttlebutt can get behind. There is another school of thought that there may be a push for consolidation in the industry. I view large scale or transformative consolidation for CDK as unlikely in the near term given that there would be tax implications with doing so. I think that they will be more focused on tuck-in acquisitions in the near term. However, based on the universe of information out there, it is difficult to ascertain precisely what these funds are proposing to CDK management.
My recommendation is to wait out until the stock trades at fair value or a discount to it. I believe that market volatility should provide more reasonable purchase price opportunities. I would be willing to pick up more shares at what I deem to be fair value because the business is a gem and can deliver decent returns (for what I view as relatively low risk) even at fair value, but I will wait until the shares trade at more reasonable levels. Patience is the name of the game. I think Charlie Munger, Buffett’s right hand man at Berkshire Hathaway, called it “sitting on your ass” investing. In other words, sitting on your ass until the right investment or right price materializes.
Disclosure: I am currently long CDK. I am not an investment advisor and this article presents my personal views. While I have conducted a fair bit of research to write this, you should also do your own research and come to your own conclusions.
