Carsales.com 29 May 12

Zooming into the Fat Prophets portfolio

Today we introduce a new company to the Fat Prophets portfolio. Carsales.com has been on our radar for quite a while and the recent pullback in price has been enough to encourage us that the risk to reward equation has become favourable for this growing niche online leader. Therefore, we recommend Carsales.com as a buy to Fat Prophets members around $5.45.

Carsales has sported impressive growth since its inception and upon listing on the ASX in 2009 we were very interested in this speedily growing asset-light business. Concerns about valuation kept us at bay however, due to early valuation multiples trading at an altitude that would have many experienced mountain climbers reaching for their POISK oxygen cylinders.

While the company continues to trade at a premium to the broader market its superior growth profile, prospects and competitive position certainly warrant the premium. Indeed, trading on around 18x June 2012 and 16x June 2013 consensus earnings estimates, the stock looks enticing and we want a slice.

Carsales.com has attained the leading position in online automotive advertising in the Australian market. The company is truly dominant, with some 75% of all time spent looking at automotive classified websites in Australia spent on one of the Carsales owned portfolio of websites.

Investment thesis

There are a number of factors we like about Carsales. They benefit from a durable competitive advantage known as the ‘network effect’ (more on this below), the business model is asset-light with high returns on equity, they possess pricing power and are cashed up with strong continuing free cash flow. The steady stream of cash flow gives them the flexibility to undertake capital management, buying back shares and a solid dividend.

We have discussed before that it is desirable to find a company with a sustainable competitive advantage, often also called an ‘economic moat’.

The term (generally credited to Warren Buffet) refers to a business with the ability to maintain a competitive advantage over competitors. Just as in medieval times, moats protected castles from invaders; economic moats shield companies from competition, allowing them to benefit from excess economic returns over a longer period than would otherwise be expected. We believe Carsales has just such an economic moat, allowing it to benefit from higher margins – Carsales has fat EBITDA margins of 55%.

Just as technology evolved in warfare, providing attackers with methods to try to crack castle defences it is likely over time that a company's economic moat will be eroded, particularly because the high margins and return on equity are attractive targets for competitors seeking a piece of the pie.

In the meantime, however, investors can benefit from those excess economic returns generating a great deal of intrinsic value for the company, with its stock price following suit.  Many legendary investors use this criterion as a filter when looking for investment candidates. The problem is there are simply not many companies who possess a moat.

There is a range of sources for an economic moat for a company. These include low cost producer status or scale advantages or high customer switching costs. Certain intangible assets such as intellectual property (patents, copyrights) may lead to an economic moat, or even brand strength, a classic Warren Buffet example being the purchase of Coca Cola stock.

In the case of Carsales, dominance in their niche is the moat. Also known as the ‘network effect’, it is possibly the handiest advantage to have in the online space. When a business benefits from the network effect, its products or services become more valuable as more people use them. This creates a barrier of entry for competitors, as it is a virtuous cycle. History shows that companies that benefit from the network effect are extremely difficult to dislodge from their leadership position. Often the only way it occurs is when some disruptive technology develops.

Think of the telephone, when very few people had phones there was not much point in having one yourself, but as the number grew, it pretty much became a necessity. Carsales crushes their major competitors on every key metric related to their business as can be seen from the traffic comparisons below.

In the fast growing mobile space, the same dominance is present.

Carsales is an asset-light business model. After all, what they really do is provide listings in a vertical niche. If it was not for the network effect we discussed above, the barrier to entry would actually be low. Some servers and a legion of skilled programmers can go a long way. Therefore, thanks to the network effect they have a business model that requires no significant inventory, nor hugely costly manufacturing plants or mine sites.

As a result, they have a massively profitable business with high returns on equity and assets. We estimate that return on equity will remain above 50% and return on assets over 40% over the next few years.

Another nice aspect of Carsales is that the founder, Greg Roebuck is still running the business with the superb results in recent years demonstrating he is on top of his game and has gathered a strong winning team around him to execute on their business plan. In 2009, Mr Roebuck was named Ernst & Young Australian Entrepreneur of the Year in recognition of his outstanding success.

The breach of the 50 day moving average is suggestive of near term momentum to favour the downside. The confluence of support is located at the $5.02/5.11 region, which is made up of the technically important 200 day moving average and horizontal support level (blue line).

 

With reference to the weekly chart, prices reached the 127.2% Fibonacci extension of $5.84, and has subsequently rotated lower. Firm support is located at the 39 week moving average of $5.07, which is in line with our previously identified region between $5.02/5.11 on the daily chart.

Financial growth

We have talked a lot about how much we like the business but we also want a company to ‘show us the money’ and Carsales certainly does not disappoint on this front. The bar charts from the company’s half-yearly presentation show how the company has levered up rapid revenue growth of 29% over the past five years into a 40% compound growth rate in EBITDA. The bottom line also steamed along with NPAT compound growth of 40.6% for the full year results from 2007 to 2011.

In the first half of 2012, Carsales continued to chug along with operating revenue up 22% to $87.4 million, operating cash flow up 26% to $29.7 million and EPS up 20% to 14.1 cents. The interim dividend was boosted 20% to 11.3 cents per share.

The different operating segments all did quite well, with rapid growth in Display advertising revenues (+49%), followed by Dealer & Data Services up 24% and the only disappointing area that of Private car listings, but still an increase of 7%. Management stated this was a sector wide weakness and they maintained their market share in the area.

The company is also experiencing higher growth in the non-automotive verticals, such as bikes, industry and caravan versus automotive, most likely due to less mature markets in these spaces for online classifieds. Members should note that Auto is one of the big three, after Real Estate and Employment for online classifieds.

In terms of outlook, management does not give quantitative guidance, but generally expects that revenue and NPAT will continue to grow at a rate similar to the first half assuming stable market conditions. The recent unwinding of the stake in New Zealand online retailer Torpedo7 is not expected to have any impact on Carsales' prospects. 

Summary

With the recent pullback in price, a premium domestic online player is now available at a price relative to growth that we feel offers an attractive risk to reward proposal. We like the business model, high returns on capital, cash flows, earnings and dividend growth along with management.

Therefore we recommend Carsales.com as a buy to Fat Prophets members around $5.45.

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