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By George Whitehouse – Clime Asset Management

Founded by Anthony Brown in 1976 after a four-wheel drive expedition to Cape York, ARB Corporation Limited (ASX:ARP) designs, manufactures and distributes 4WD accessories in Australia and internationally. The business was listed on the ASX in 1987 and today is managed by Anthony’s brothers, Roger and Andrew Brown who together own around 15% of the business. Managers with their own wealth invested in the business tend to approach their roles quite differently to those with options packages and an exit strategy.

ARB has significant expertise in product innovation, marketing, exporting, distribution network expansion and the capture of production efficiencies. This has made ARP one of the best long term small-cap investments on the Australian market.

ARB distributes its products throughout Australia from state sales offices with attached warehouses. These state sales offices distribute to ARB stores, independent 4WD specialists and new vehicle dealers throughout each state.

There are now 35 ARB branded stores established in Australia. Thirteen of these are company owned and the other twenty two stores are franchises. ARB has been able to find niche export markets around the world and the local distribution footprint can spread further with management noting a local saturation point of around 50 stores. Management has a track record of conservatively and consistently growing the business.

The business has encountered numerous challenges in the last decade including a crumbling Australian manufacturing sector, rising fuel costs changing consumers vehicle choices, spikes in steel prices and a general lack of skilled labor as the mining boom attracted staff crimping production capability.

ARB has responded by chasing market growth wherever it could be found, from suburban Australia to American 4WD enthusiasts, the mining industry and aid agencies. ARB when faced with a skilled labor shortage at its Melbourne factory opened a factory in Thailand, where labor has is plentiful and cheap.

ARB’s ability to create new products and roll them out to consumer’s as new 4WD models come onto the market is unsurpassed. However innovations can be copied.

A key to ARB’s success is its pricing power. Unlike other automotive parts businesses that market their products to original equipment manufacturers (OEM), ARB’s largest customer base is individual vehicle owners known as the ‘aftermarket’. This market consists of 4WD enthusiasts that are generally passionate, preferring the best product even if it is more expensive.

The vast majority of ARB’s products are brand name products that are marketed by their reputation for quality rather than commodity products marketed by specifications. For example you would not want to be 150km along the Birdsville Track and a bit of your kit breaks leaving you stranded thinking about the few dollars you saved by purchasing a cheaper bull bar. Serious 4WD enthusiasts know this very well. OEM sales now represent around 8.5% of ARB’s total sales.

Exports are the second largest part of ARB’s business. Representing 30% of ARB’s total sales. Exports to the company’s customers in North America and South America are made via ARB’s US subsidiary, Air Locker Inc, while exports to the rest of the world are made from the head office in Victoria.

Approximately 40% of all products sold by ARB are manufactured by ARB. The company has two major manufacturing plants: one in Kilsyth, Victoria and one in Rayong, Thailand. The ability to utilise manufacturing capacity in both countries is working well for ARB and its customers around the world. ARB’s strategy is to gradually expand the smaller plant in Thailand whilst maintaining the larger Australian plant.

ARB’s competitive advantage lies in its ability to innovate with new quality products, its speed to market and distribution footprint in growth markets.

ARB’s main growth strategies can be summarised as follows:

• Increasing output from the company’s manufacturing plants as demand requires.

• Fast tracking the stgelopment of new products.

• Further expanding ARB’s store network throughout Australia, particularly in areas where 4WD vehicle sales are strong.

• Establishing larger and more efficient warehousing and sales facilities especially in Perth.

• Expanding the recently established ARB Off Road business which distributes ARB’s product to the Thai market via existing resellers, ARB has a good reputation in Thailand and, with a large market available, the company is confident this business will generate profitable long term growth.

• Ensuring Kingsley Enterprises has new products to supply its existing customers both locally and overseas.

• Providing the resources required to allow Thule Car Rack Systems to grow within the Australian market.

• Selectively acquiring new products or businesses if suitable opportunities arise.

Major Influences on ARB’s business;

– New vehicle sales worldwide. The global economic crisis caused new vehicle sales to fall dramatically in many markets, resulting in weaker demand for ARB’s products. It is difficult to predict when demand will return to normal, but the company expects to benefit from any upturn, especially in the US. In Australian ARB has recently benefited from the governments stimulus program driving sales of vehicles that were often then equipped with ARB products. This has pulled forward demand into 1H10.   

– Fuel Prices. The oil price is now significantly below the peak price achieved in mid 2008. Consequently, fuel prices have fallen around the world, increasing demand for 4WD vehicles for recreational use. Current fuel prices in Australia, especially for diesel, are providing a favorable market for ARB. One downside of the lower price is the reduced demand for the company’s products in oil producing areas such as the Middle East, Central Asia and Venezuela.

– Steel Prices. Steel is the major raw material input to ARB’s manufacturing process. Prices for steel have been off their peaks and reasonably stable over the past year. Input prices to the steel making process, particularly for iron ore and coking coal, have fallen. However, the future of steel prices still remains uncertain.

– The value of the Australian dollar. Over the past few years ARB’s profitability has become less influenced by movements in the Australian dollar. Establishment of the Thailand manufacturing plant, the purchase of the Thule Car Rack Systems business in Australia and the increasing importation of components from countries such as China have changed ARB’s foreign exchange position.

– Labor availability and cost in Australia. In the past skilled and unskilled labor shortages have seriously affected the company’s performance. In fact it was primarily for this reason that ARB’s manufacturing plant was established in Thailand. Recently the modest increase in the Australian unemployment rate has improved the company’s ability to attract and retain staff.

In the near term ARB should benefit from increased sales resulting from new store openings, increased overseas sales as ARB enters new markets and existing markets recover despite anticipated rises in steel prices.

ARB has strong brands around the world, strong distributors both locally and overseas, a strong balance sheet with no net debt, wonderful cash flow generation and a very capable senior management team with significant ownership in the business leading this analyst to have a cautiously optimistic view of ARB’s future prosperity.

Business Performance & Valuation:

Source: StockVal

The following table outlines some key performance characteristics of the ARB business,

ARB’s business has demonstrated strong cash flow characteristics that have enabled management to declare consistent and growing dividends along with intermittent special dividends illustrating management’s shareholder oriented decisions.

Excluding the years where the business paid a special dividend (2001, 2005 & 2010) the average NROE over the thirteen review and forecast periods is 34.09%.

Over the review and forecast periods the business will generate NPAT of $224.81M and pay fully franked dividends of $148.7M giving us a payout ratio of 66%.

Using the average NROE of 34% as the sustainable return this business can generate (APF) StockVal would have Distributions (D) as 22% and Reinvested (RI) as 12%.

We now have the key inputs StockVal requires to value ARB Corporation,

Using the above inputs and the equity per share StockVal produces the following values,

If an investor is compiling a list of excellent businesses, ARB is up there with the best of them.

An investor who purchased $10,000 of ARB shares in June 1999 would have achieved an annual total return of 20.15% ($62,696) compared to the All Ordinaries Accumulation Index return of 9.85% ($26,816) to December 2009. While ARB’s future performance may be different to its past a successful track records bodes well for investors.   

With a share price over $5 unfortunately this business is not cheap. A sensible investor would also require a margin of safety in the price they pay for even outstanding businesses. However if Mr Market continues to become worried and pessimistic, investors may get an opportunity to become a part owner in this wonderful business on business like terms.

Clime Asset Management uses StockVal.

 

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