Used-car dealer AAA Auto to raise cash for drive into Russia

By bne IntelliNews July 30, 2007

Nicholas Watson in Prague -

Central and Eastern Europe's largest used-car dealer AAA Auto Group is set to continue its expansion across the region with moves into Russia and Serbia planned for 2008. That requires cash, of course, and after considering several financing options, the firm appears to be leaning towards an IPO sometime later this year.

Setting up operations in Russia would be a triumphant return of sorts for AAA Auto's founder and CEO Anthony Denny, who decided to stop doing business there in 1992 after some cars he had been importing from the US were late and his impatient Russian clients sent someone over to Prague to lean on him.

"The cars eventually arrived – there had been some strike at an axel factory in Detroit – and even though these clients called me every three months for the next three years to apologise, I stopped doing anything in Russia and concentrated on the Czech Republic," says today's still youthful-looking, but certainly much-the-wiser, Denny.

Even if the Czech Republic wasn't quite as violent as Russia in the early 1990s, it was still very much the Wild East in terms of the auto market, which was utterly bereft of the vehicles needed to satisfy the new elite who were clambering out of the rubble of communism. After being ripped off a few times importing cars from the US on a commission-basis for the Czech market, Denny decided to start buying and selling used local cars from 1993.

"I decided to have more control and opened up my own site on a 1,000-square-metre (sqm) lot, put in 70 cars and off we went," he says, "Since then, it's never stopped."

It certainly hasn't. By 1996 AAA Auto was selling 100 cars per week, a rate that grew exponentially thereafter until in 2000 Denny set a world record for the number of cars sold on a single lot in a year when he offloaded some 23,000 cars from his Prague dealership. The only way to go was outwards. At the start of this year, AAA Auto had 31 branches spread across five countries – the Czech Republic, Hungary, Poland, Slovakia and Romania. These outlets sold 61,165 cars in 2006, up 22% from the year before, generating revenues of €348.5m, up 29%. Last year's expansion into Hungary and Romania can be seen in the first-quarter figures for this year, which showed group revenues rising 39% to €102m.

"Hungary has been an amazing success without any brand recognition whatsoever," says Denny. "Romania is the Czech Republic in 1994 – the used-car supply is poor and there's not a very sophisticated consumer in terms of the auto market. It will be big in 2009 and 2010, but before then it will be hard work."

Bumps on the road

Despite the impressive numbers, AAA Auto has encountered a few bumps on the road. In 2000, the firm found itself attacked in sections of the Czech press over issues related to the warranties on their cars. With no right of reply to the accusations, Denny regards those attacks as primarily the work of competitors, no doubt smarting at the success of his company. Even so, the episode is illustrative of several problems that the firm continues to encounter as its spreads throughout the region.

The first is that such phenomenal growth inevitably stretches the resources of any firm, particularly in relation to finding qualified and experienced personnel. AAA Auto's business model of owning all the cars on sale is what sets it apart from all its commission-based competitors. But this also means the firm has to spend a huge amount of money, time and energy ensuring that the cars they buy and sell are up to scratch, ie. they haven't been "rejuvenated" or had their odometers wound back – both all-too common problems in this part of the world. Martin Pajer of the auto consultancy Cebia reckons every fourth car imported into the Czech Republic is rejuvenated, with the age that importers quote being at least two years less than the reality.

"The rapid rise up to selling 23,000 cars a year means we were always playing catch-up in terms of trying to hire and train people," says Denny, "We were, to some extent, a victim of our own success."

Another problem that bedevils business in the region is the entrenched interests that exist. For example, Romania is at loggerheads with the EU over a car registration tax it introduced on January 1, which is designed to encourage the importing of new cars and the selling of those cars already existing on the local market. It is surely no coincidence that the current prime minister, Calin Popescu-Tariceanu, is an investor – or was, so he claims – in the dealership that imports Citroen cars to Romania.

The most notorious example of how powerful interests can hold sway over an entire industry is in Russia, where anybody buying a used car has to pay a 25% tax based on the original value of car, making it cheaper in many cases to buy a new vehicle in a car dealerships, many of which are owned by well connected individuals. However, from next year this tax will be abolished, resulting in what Denny expects will be a "massive boom in used-car sales."

It's hard to underestimate the potential of the Russian new and used-car markets. According to PricewaterhouseCoopers, sales of foreign models doubled in 2006 to 280,000 units, while sales of new imported cars in Russia stood at 720,000 units, up 76%. In monetary terms, sales of new imported cars totalled $18.2bn and sales of used imported cars totalled $3.6bn in 2006.

"Already the existing sales volume of 2m units per year has brought the Russian market up to the level of the leading European markets - those like Italy, France and Great Britain," says Stanley Root, head of the PwC's automotive practice. "Russia could become the second-largest automobile market in Europe by 2010.

Root says that today almost all the largest overseas market players are either manufacturing their automobiles in Russia or are in the process of building manufacturing plants there, which in turn means the used-car market will be well supplied. The latest arrival will be Suzuki, which is planning to build a plant in the St Petersburg area with a tentative production capacity of 50,000 units per year.

"All in all, the maximum output capacities of plants operated or planned by overseas automakers is approaching 1m cars per year," says Jochin Legewie, president of the German consultancy CNC. "Clearly, something is up in mother Russia."

That something is a heady combination of a burgeoning middle class, an increase in disposable income, and the rapid development of car loans and car dealership chains. And to take full advantage of this massive opportunity in Russia, Denny says AAA Auto is already in preliminary discussions with several unnamed large local car dealerships about forming a joint venture.

The largest local dealerships in Russia include Rolf Holdings, Aliance Motors, Gema Motors, Incom-Auto and Independence – though the latter is reported to be in talks to sell a majority stake to the UK car dealership Inchcape, which is already present in St Petersburg as well as the Baltic states of Lithuania and Latvia.

Even if AAA Auto doesn't form a joint venture with a local car dealership, the firm is still planning a major foray into Russia by establishing a 40,000-sqm lot in the northern part of Moscow, on the main road that connects to St Petersburg.

Money to grow

Whichever way AAA Auto goes, its headlong drive into Russia will cost serious money. Therefore, the company, which until now has funded its expansion through cash flow and bank loans, is looking into a range of new methods of funding. Denny said he has received interesting offers from several private equity firms undoubtedly attracted to his firm's real estate assets and healthy cash flows, which would allow them to leverage the business.

Denny also says he has received interest from several large international car dealerships. "We speak the same language, share the optimism about the region and their valuations were very nice, but there could be a potential conflict of interest in the direction they want to go in, for example bringing in Chinese cars to Eastern Europe," he says.

The preferred route, it seems, would be an IPO on the Prague and Budapest stock exchanges, with a certain stake sold to a strategic investor. If AAA Auto does carry out an IPO, then it would become only the second used-car dealer in the world to join the stock market. The first was the US network CarMax, shares of which have been traded on the New York Stock Exchange since September 2002.

So what would investors be buying into? As well as Russia, analysts are bullish on the prospects for AAA Auto - as well as the car sales industry generally - in its existing markets, as well as those planned for later years, such as Bulgaria, Turkey and Ukraine.

Underpinning AAA Auto's business is, of course, the sterling rates of growth being put in by the region's economies. The Economist Intelligence Unit expects Euroland to grow around just 2.7% in 2007, compared with predicted 2007 growth rates of 5.3% for the Czech Republic, 6.0% in Poland and 6.7% in Russia.

While an end to this kind of growth would certainly impact the car market, it would probably hurt new car sales first before it impacts, if at all, used-car sales. "The region's macroeconomic indicators over the past three years have been very good and used-car sales have followed that. If the indicators were to turn down, would used-cars sale go down? Well, I wouldn’t like to say they would. We're all riding the boom at the moment, and the new car market is riding it better than we are, so if the economy turns down, our sales might possibly increase as people switch from buying new cars to used cars," says Denny.

The used-car market also fills an important niche in the car market. The Czech investment bank Patria Finance says the buying power of the average household in the CEE region is still such that buying a new car, particularly the prized German and other Western makes, is beyond the reach of many. Thus used-car dealers like AAA Auto will continue to benefit from being suppliers of high-quality, second-hand foreign cars

As well as the rise in people's disposable income and greater access to car loans, the car market promises to be supported by the shortening of the so-called "itch cycle," when people look to change their cars. "We estimate an average car holding period in Europe of 4.6 years," says the bank. "This 'itch' cycle is approximately twice as long as that in the CEE countries."

Patria also reckons that the increasing costs associated with stricter safety and environmental regulation could help the used-car market. The EU's regulations on exhaust emissions - Euro 5 and Euro 6 – will increase the cost of new cars, by as much as €900 for a diesel car if you believe the European Automobile Manufacturers Association.

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