ARB Corporation (ASX: ARB) is an Australian based manufacturer, developer, distributor and retailer of car components and accessories. They primary sell 4WD components and accessories such as canopies, bullbars and warn winches amongst many other things. ARB’s primary markets are large 4WDs such as the Toyota Land Cruiser and the Nissan Patrol, used by recreational drivers, mining companies, aid agencies and military customers. The company is an Australian success story, growing from a small operation where the company’s founder Tony Brown made bullbars and roof racks in his Melbourne home’s driveway to what is now a $2.5 billion company with more than 1500 staff and over $460 million in revenue. You can read more about ARB on their website.
Today, the biggest part of the business is the Australian Aftermarket business accounting for 70% of revenue. Exports account for 33% of sales and sales to OEMs account for the rest. Exports as a percentage of sales are increasing as this segment has grown faster than the Australian business in recent years. ARB designs and manufactures their products in Australia and Thailand. The company’s core competitive advantage is the ARB brand (well known amongst 4WD enthusiasts) and their design and manufacturing capability. ARB products are known amongst 4WD enthusiasts for their high quality and durability, but they are also known for being expensive.
ARB has a very strong balance sheet with $41.6 million in cash and no debt. This is nothing new, ARB has had a net cash balance sheet for many years now. The company is chaired by Roger Brown (Tony Brown’s brother) who has been involved with the company since it was still a private company.
ARB has gone from strength to strength growing organically and by acquisition. Financially, the company performed exceedingly well over the past decade with revenue increased from $228 million in 2010 to $465 million in 2020. Dividends increased from 19.5 cents per share in 2010 (excluding the large special dividend in 2010 of 40 cents per share) to 39.5 cents per share in 2020. Earnings per share increased from 46.3 cents per share in 2010 to 71.8 cents in 2020. Free cash flow increased from $33 million in 2010 to $73.5 million in 2020. This performance is reflected in the stock price with the share price increasing from $7.18 ten years ago to $32.09 in 2020. According to Sharesight this represents an 18.12% p.a compounded return. $10,000 invested in ARB in 2010 would now be worth $44k plus you would have received $8200 in dividends. It’s safe to say that early investors in this company have done well – but investing is a forward-looking exercise and we must research what the likely returns would be if we invested today.
A Closer Look Under ARB’s Bonnet
Despite the enviable financial performance over the past decade, in recent years the growth rate of the business has slowed down. For example, in 2020 revenue increased by just 4.8% compared to 2019 and net profit after tax only increased 0.3% (in part due to adverse currency changes of the AUD relative to the Thai Baht). Even if we go back to the pre-COVID numbers, in 2019 ARB’s revenue and profit increased by just 5% compared to 2018 numbers. These figures aren’t bad by any means, but they do indicate that ARB is not growing at quite the same rate they have in the past. On top of this ARB’s return on capital employed (ROCE) has consistently decreased (I have calculated return on capital employed as operating income / total assets minus current liabilities).
ROCE decreased from 36% in 2008 to 19% in 2020. In fact ROCE has declined every year since 2010 when ROCE reached the high-water mark of 40%. The fact that this has occurred for an entire decade indicates that this is likely structural rather than temporary. This could be for a number of reasons including:
- The ROCE ARB generated in earlier years was unsustainably high;
- ARB is a much larger company these days and generating high returns from larger absolute amounts of capital employed may be more difficult;
- Increased competition. For example, the ever-present competition from (often inferior) low-priced Asian private label equivalents of ARB products may have made it more difficult for ARB to charge high prices for its products;
- Increased manufacturing costs;
- Increased Selling, General and Administrative expenses. For example, operating margins decreased from 19% to 14% since 2011 while gross margins remained around 53% indicating SG&A expenses have increased;
- Other reasons.
I haven’t looked in-depth into why ROCE has so consistently declined, although I suspect this erosion represents a case of ROCE reverting to the mean. The graphs below show this trend very well. Note that the growth rate in earnings per share is slightly lower than the growth in revenue.
This is a good place to emphasise the importance of using ROCE (or other similar metric such as Return on Invested Capital) when analysing a company. If you had just looked at a graph of the revenue and EPS numbers you would think everything is going fine when in fact an important change is taking place within the business whereby more and more capital needs to be employed in the business to generate the same absolute return.
Of course, while the decline in ROCE is something to watch, I should also mention that the current 19% ROCE is still very good by most standards. The question will be whether ARB can reverse this trend and maintain ROCE around 19%. Continued erosion in ROCE over the years combined with slower growth (which could in part be caused by lower ROCE) could result in a very unfavourable outcome for shareholders. The strong balance sheet ensures it won’t kill the company but it could mean losses for shareholders if the expectations built into the share price are not met.
At present prices ARB has a free cash flow yield of 3%. If we presume that ARB can grow at 5-6% in the long term, the current share price implies long term returns of around 8-9%. I like the business; I like the management and I really like the balance sheet but at present prices with the free cash flow yield at such low levels I think I can find better risk -reward opportunities. With potential continued declines in ROCE there is a risk that growth rates may slow further. ARB is a nice business but not at these prices. Of course, the share price could go up from here (on expectations of continued booms in sales), but I prefer to base my decisions on the fundamentals of the business over the long term.