Four wheels good, two wheels better

published 17 August 2018

909-bikes-634 — Geraint Thomas on the road to victory in the Tour de France last month

This year's Tour de France was once again won by a Briton, for the sixth time in seven races. Quelle surprise! There was one unexpected twist: Geraint Thomas beat Chris Froome, who was widely expected to defend his title and join the elite group of cyclists who have won a record five Tours. Nonetheless, the fact that UK riders under the well-funded, well-organised Team Sky have dominated the race in recent years will seem remarkable to anybody who remembers that the best finish a British cyclist had previously managed was fourth place.

Critics may say that Team Sky's success is making the Tour predictable some have called for a salary cap to reduce the ability of the top teams to sign up the strongest squad members to support their stars (races such as the Tour are highly tactical team efforts). Yet the reality is that it has once again been a great spectacle to watch as it winds its way through the Alps and Pyrenees, including my own home town of Chteaulin.

Inspiring scenery, combined with the legacy of legendary stars such as Fausto Coppi, Jacques Anquetil, Eddy Merckx, Bernard Hinault and Miguel Indurin, explains why major cycling events such as the Tour de France, the Giro d'Italia and the Vuelta a Espaa remain such popular spectator sports in these European countries. They are, after all, free three-week shows that reach the most remote rural areas, while also being broadcast around the world. As such, they represent an outstanding marketing opportunity for the companies that sponsor the teams and also a showcase for the global cycling industry.

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Cycling is a sector overlooked by many investors perhaps that's because, unless you're a cyclist yourself, bikes can seem old-fashioned, or commoditised, or incapable of real innovation (compared with, say, an electric car). Yet it's a sizeable business: the global cycling industry had a turnover of $55bn in 2017, according to Persistence Market Research. That's expected to rise to around $80bn globally in 2026, powered by a combination of market expansion (eg, rising demand in emerging markets, notably Asia) and technological evolution.

Established markets such as Europe haven't been growing significantly: around 20 million bikes are sold each year in Europe, a figure that's remained roughly level over the past two decades. The UK accounts for around three million sales each year, with a total market value of £1bn, according to Mintel, a market research agency. And despite the recent boom in British competitive cycling, the typical Briton is not yet a demon on two wheels.

Neither are Britons notably big spenders the average British buyer pays around £450 for their bikes, half of the average budget in the famously bicycle-powered Netherlands. Still, committed riders both here and overseas do not hesitate to invest thousands of pounds in their bikes. They would disagree with Lance Armstrong the man who won the Tour de France seven times and was subsequently stripped of all those victories for doping offences who claimed that "it is not about the bike".

Disc brakes are slowly replacing traditional lever brakes they made an appearance in the Tour de France for the first time this year after the Union Cycliste Internationale, the governing body for the sport, changed the regulations to permit them. Gears can be shifted electronically at the push of a button and an electric motor can give you a push as well if you need (licitly or illicitly there have been cases of professional cyclists caught with electric motors hidden inside their bikes during competitions).

Official statistics tentatively point to rising cycle use in the UK: 3.5 billion miles cycled in 2016, 23% above 2006, according to the Department of Transport (with the figure in London doubling). Improvements in electronic-assisted bikes (e-bikes) will surely help attract users who were previously put off by not wanting to arrive at the office looking as if they'd done an especially gruelling hike in the mountains. Hence sales of e-bike are increasing by 20% a year and now represent 10% of bicycles sold in Europe.

Other innovations may also help to expand the market. Bike-sharing companies such as the Chinese firms Ofo and Mobike have raised hundreds of millions of dollars from venture-capital firms to fund their services, which involve filling cities around the world including many European capitals with GPS-enabled rental bikes that can be unlocked and paid for with a smartphone app and left wherever the user wants (no need to find a docking station).

In some cases this may mean putting the bike together from lots of imported components higher import duties on finished bikes from China than on individual parts help to protect this element of the process from global competition. After Raleigh shut its Nottingham factory in 2003 and moved its production line to Taiwan, production in Britain has declined to just 0.6% of European production half of which is manufactured by Brompton, the specialist in folding commuter bikes.

Similarly to the consolidation of the carmakers, many bike brands are now owned by a handful of large firms. These include the Dutch businesses Accell (LaPierre, Raleigh) and Pon (Gazelle, Focus, Cervlo); Taiwan's Giant (which also makes the frames for several of the other brands) and Merida (part-owner of Specialized as well as its own brand); India's Hero (which sells to Halfords, Tesco and Argos); the Canadian group Dorel (Cannondale, Schwinn); US-based Trek (Trek, Bontrager) and Grimaldi Industri (whose Cycleurope division owns several brands including Bianchi, which was established in 1885 and is the oldest bicycle marque still in existence). Many of these firms have plants around the world for example, Giant operates in the Netherlands as well as in China and Taiwan.

Pon offered €845M or €33 per share to buy Accell last year, a deal that would have created the largest manufacturer, but the bid was rejected: for now, Giant and Hero are the leaders, both producing around five million bikes per year. Despite the size of the market and the degree of consolidation, this is not an especially cosy high-margin oligopoly. Competitive pressures have been high and margins have been squeezed.

Even Giant (Taipei: 9921), which should benefit from selling bikes under its own brand and manufacturing parts for other brands, has seen its share price fall to a six-year low, after two successive years of falling revenues and three years of shrinking profits (although first-half revenues picked up this year). A price-to-earnings (p/e) ratio of 21 times 2018 estimates looks too high in these circumstances. Profits at Merida (Taipei: 9914) have also fallen rather like Vincenzo Nibali, the star rider of its racing team, on the slopes the Alpes d'Huez last month and operating cash flow has turned negative. It trades on 24 times 2018 estimates.

Accell (Amsterdam: Accel) lost a contract to supply US retailer Dick's Sporting Goods last year, with Dorel taking its place after almost 18 years. The firm still managed to record flat revenues for the first half of 2018, but its operating profit margin of 4% is thin. The business is trading at a forecast p/e ratio of 14 lower than its Taiwanese peers but still not especially compelling. The share price is now 45% down from the rejected bid from Pon last year suggesting events worked out better for the controlling Pon family than for investors in Accell.

A far cheaper play is Britain's Tandem (LSE: TND), which owns brands such as Dawes and Claud Butler. It generated just £37m of revenues which is tiny in comparison with the £1bn-plus the big players produce but a good return on capital employed of more than 13%. The firm is highly dependent on the UK market, making it riskier than a global player, but on a p/e ratio of under four and a yield of 3%, it may be worth a look.

The firm, often referred to as the Ikea of sports, is privately owned by founder Michel Leclercq and other members of the Mulliez family of retail billionaires. XXL (Oslo: XXL), a fast-growing sports retailer that is now expanding beyond Scandinavia, announced disappointing margins during the first quarter of the year. The shares have fallen sharply, but still trade on a forecast p/e ratio of 13. Overall, competitive pressures mean that this part of the cycling supply chain does not look appealing.

A more interesting part of the industry involves those firms whose names are less well-known to the general public, but highly significant to the dedicated cyclist: the high-end makers of components such as gears, brakes and drivetrains (known collectively as groupsets). Non-cyclists tend to overlook how much it costs to maintain a bike and the desire to upgrade each time there is a technological leap.

Shimano (Tokyo: 7309) is the market leader in groupsets, with an estimated market share of around 50% (its main competitors are the privately owned Campagnolo and SRAM). The company had an operating margin of over 19% last year and healthy operating cash flows. It's not cheap, on a p/e ratio of around 29 times forecast earnings for 2018, but it's nicely entrenched in an attractive niche. It's certainly a stock to watch for a buying opportunity.

Frederic is an investment analyst. He started his career at JP Morgan in Paris. He has more than ten years of experience investing in private equity and also worked with the 3i debt management team investing in private debt. He is an ACCA member and a CFA charterholder. He graduated from Edhec Business School.