August is reporting season for most automotive company’s 1st half results. Aston Martin and Ferrari reported their respective 1st half 2020 results in early August. On Wednesday of this week, it was finally McLaren’s turn. Aston Martin & Ferrari’s results were very much in line with expectations. Aston is still a train wreck and Ferrari turned in a very solid quarter given the circumstances (Aston Martin & Ferrari’s Q2 2020 Results). Unlike both Aston and Ferrari, which as public companies host presentations and a Q&A session for analyst’s, McLaren, as a private company, simply posts a short overview presentation and a summary of the financial statements on its website (McLaren Investors Center). On the one hand, being private, this is probably more than McLaren is required to do but on the other hand, I do miss listening to what the management team say, and even more so, what they don’t. As I did with the Aston & Ferrari results, instead of just looking at the numbers, I thought it would be more interesting to try and pull apart the story behind the scene.
Good & Lucky
They say is better to be lucky than good, but if you can pull off a bit of both, you can come out in much better shape than expected. More on this in a minute. Back when McLaren reported its Q 1 results, I wrote:
On paper, McLaren had a very solid 2019 with good growth across a number of key P&L metrics. Q1 2020 was exactly the opposite Coming out of 2019, McLaren’s financials looked quite respectable. It had a growing business, the ten-year-old supercar business made money, and as a privately held company, has been able to attract outside investment whenever necessary. On the surface, it was the F1 team that presented the biggest financial challenge and the supercar business looked solid. Then Q1 2020 happened and McLaren’s results imploded. The F1 team is certainly no longer McLaren’s biggest issue. McLaren sold fewer cars and lost more money in Q 1 than Aston Martin. Some of this was by design and some of it not. What caused this, well the “hamster” died in late 2019. The “hamster” in this case, which had spun the wheel that powered the McLaren financial model since 2015, was the Ultimate Series and LT series cars. The model simplistically was that the high profitability from the limited-edition cars would help fund incentives when needed to keep the regular production supercars moving out of dealer’s showrooms. What killed the “hamster”, overwork and exhaustion. Instead of keeping the Ultimate Series cars as a once in every 5+ year’s event, McLaren had started churning them out on an almost annual basis as McLaren had become reliant on the profits. In addition, the last LT car produced, the 600LT was no longer a capped production run and McLaren flooded the market with them. What happened in 2nd half of 2019 broke the model. The last Ultimate Series car launched, the Elva didn’t sell out and McLaren was forced to cut the planned production run from 399 units to 249. The writing was on the wall for the Elva by the way the secondary market was allowed to develop for the Senna. With no restrictions on how long you needed to hold the car for, a significant number of Senna owners flipped the cars shortly after taking delivery. This gut of Sennas on the market depressed values and for the 1st time in memory, a limited edition hypercar was available on the secondary market at or below list. While I do believe the way Ford managed the application process for the GT was atrocious, the one thing they did do right was lock owners into holding their cars for at least two years. At the same time this was happening, in order to move a glut of 600LTs out of showrooms, McLaren was having to provide incentives. So instead of the 600LT being a high profit contributor, it became a drag on the P&L.
To McLaren’s credit, they did realize they had a major problem well prior to the Coronavirus taking its toll. Planned production for 2020 was already reduced heading into this year and McLaren just announced a major restructuring. In addition, capital spending and marketing costs have been cut substantially. The launch of the new Sport Series models has been pushed back to 2021 and the main focus for 2020 is delivering the “hamsters” dying gifts, the Ultimate Series Speedtail & Elva, along with highly profitable 765LTs.
Reducing volumes and drastic cost reduction is where McLaren was good. McLaren had already planned to reduce volumes in the 1st half to flush excess inventory out of the dealer network. McLaren also moved quickly on a restructuring and got the cost base down and in line to where it would more likely need to be moving forward. Budgets were cut across the board with variable spending reduced significantly. Capex was down 25%. Gulf Oil has been brought on-board as a major new sponsor for the F1 Team and as a key partner on the automotive side. Between new sponsors and the sales of a few of the heritage race cars, the financial drag of the F1 Team on the group has been cut in half between 2019 & 2020. The continued improved performance of F1 Team on track, along with Ferrari’s increasingly poor performances, is another potential upside for the year to go. The short-term liquidity issue has been resolved and funding is now in place to carry McLaren into 2021. If I had to guess, probably the best move McLaren has made recently is bringing Paul Walsh on board as Executive Chairman late last year. Prior to joining McLaren, Paul was the Chief Executive of Diageo Plc for 13 years. All the quick moves taken on cost reduction in a crisis are exactly what I would expect to see coming from a highly experienced executive with a background in global consumer products.
Working capital and product mix is where got lucky. As a general business practice, when McLaren ships a car to a dealership, payment from the dealership to McLaren is due in 30 days. However, in general it appears that McLaren has up to 90-day terms with its suppliers. When dealerships reopened, most of the excess inventory had been worked down and McLaren was able to start building and shipping cars again. These newly built cars were being constructed mostly out of parts McLaren had on hand. Net net, McLaren was able to build cars out of parts that had already been paid for or would not need to be paid for until Q3 while collecting payment for these cars in Q2. The net result is working capital in Q 2 was flat vs. the large outflow in Q1.
McLaren has also gotten lucky in terms of the product mix especially for the year to go. The irony here is the over reliance on the Ultimate & Limited Edition series cars that got them into long term trouble is what is saving the business in the year to go. Call it the “hamsters” last dying gift. In the 2nd half of 2020, McLaren is planning on producing roughly 1000 cars. Approximately 75% of these cars will be very high margin Speedtails, Elvas, and 765LTs. This will have a hugely positive benefit to the P&L in the year to go. My rough estimate is the combination of these three has the potential to deliver £360-400 million in sales in the 2nd half. Total sales for automotive has the potential to land in the £600-650 million range which will put it at roughly a 50% decline vs. 2019 in terms of revenue but this revenue will be generated by just 1/3rd the number of cars sold in 2020 vs. 2019. If a few things go well in the second half, McLaren as a group has a chance of recovering to finish the year with EBITDA in the range of £0 to -25 million vs a loss of £115 million in the 1sthalf.
Despite doing a lot of good things right and getting lucky in the 1st half of 2020, McLaren has a number of major underlining challenges. McLaren is still sitting on a massive pile of debt, a large amount of which was generated buying unhealthy growth via dealer incentives. The timing on the rapid ramp up of car production was tied closely to an increase in complaints on McLaren’s build quality and reliability. Its been a lose lose, as McLaren now has a work to do on rebuilding its reputation alongside a very difficult debt situation to manage. While the majority to the debt, $250 million and £370 million of 5-yr Senior Secured Notes, doesn’t come due until July 2022, McLaren may need a further capital infusion to get it through 2021. On top of this there is the not so minor issue of £600 million in un-amortized new product development costs that will need to taken to the P&L at some point. In the investors overview presentation, McLaren mentioned that while the order bank for the 765LT was full for H2 2020, it only had strong orders going into H1 2021. This would indicate that all 765 units of the 765LT have not been sold globally yet and that Limited Edition fatigue remains even among McLaren’s best customers.
With a new hybrid Sport Series model coming in 2021 followed by a new Super Series model in 2022/23, the base business should be secure. However, once Elva production wraps up in 2021, the next Ultimate Series McLaren is not slated to appear until 2025. With roughly £600 million in un-amortized new product development costs and about the same amount in debt that will need to be either paid down or restructured in this period, McLaren is going to need to pull some new levers to fill the missing Ultimate Series revenue and profit gap. I know McLaren has been hosting conference calls with a number of their best customers to get their ideas and feedback (I have not been involved and am not privy to any of the discussions) on different ideas. My guess is the profit gap is going to be filled by a range of different activities. I would expect that the long rumored battery pack upgrades for the P1 will be announced in the near future along with a performance upgrade pack for the Senna before 2025. I would then expect similar “must have” upgrades to be launched for both the P1 and Senna GTRs. Alongside these activities, I would not be surprised if McLaren started some sort of “Classic” service and update program now that early 12Cs are a decade old. This program could then be extended to other models once they hit the 10-year mark in terms of age. While I certainly wasn’t happy to hear that the 765LT production run would have over 50% more units than the 675LT, given the higher margins on the LT cars, production numbers are more likely to expand than contract at this point. Also as we just saw with the 620R in 570/600 Sport Series, I don’t think the LT will be the final model in series going forward. That place will now be filled with an even more hard core and limited production “R” version. Net net, I would not be surprised to see a 785 R announced in late 2021 or early 2022. The remaining gap will be filled with very limited special MSO model runs for special customers similar in nature to the MSO HS.
Right now, McLaren is doing a highly commendable job of navigating in a challenging environment through a combination of making the right (good) decisions and getting a bit lucky in terms of available portfolio. The odious mess of a hangover that underlines the business is all related to sins in the past that management is taking steps to address. The financial situation, while currently stable, remains precarious and the room for error in executing the current strategy is tiny. If the aspirin works McLaren can restore the brand’s reputation with a combination of reduced production numbers and great new models, while significantly reducing the dependency on dealer incentives to move cars off the showroom floor, McLaren should be in a much healthier position in a couple of years. The turnaround in the fortunes of the F1 Team could also not come at a better time. The F1 Team should be a net profit contributor to the group in 2021.
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