Should Carsales buy Cars.com?
It would be a big bite, but Carsales.com might just be able to manage a takeover of a top three US automotive classifieds business.
Regrets, I've had a few. A fair proportion of my investing regrets have come because I've refused to pay up for high quality businesses that have then become even more successful. It's why I wrote Good things happen to great businesses.
Sometimes a great company looks ‘ex growth'. That's broker-speak for when a company appears to have run out of growth options.
For example, back in 2011 plumbing supplies company Reece (ASX: REH) looked ‘ex-growth'. Revenues and earnings had been flat for several years and the business looked mature. I considered the stock at $20 – it was trading around 18 times earnings – and couldn't bring myself to recommend it.
That proved a mistake. Within a few years a recovery in housing construction had kicked in and Reece had acquired Actrol. As we said in Reece: Three reasons last year – when we upgraded to Buy at $34 – Actrol has the potential to drive growth for years to come.
While acquisitions are tricky to get right, they can provide significant upside. So it pays to remember that potential acquisitions can turbo-charge a high-quality company's growth.
Carsales.com (ASX: CAR) seems a little like Reece in this respect. It sports a high price – 25 times earnings – given it might struggle to deliver double-digit earnings growth over the medium to long term.
But new Carsales managing director Cameron McIntyre said on the 2017 results conference call that the company was ‘acquisitive'. He then said ‘we like to plant acorns to grow into oak trees', so he might have been implying that any acquisitions might be on the small side.
We presume, though, that McIntyre is aware of the May 2017 listing of US company Cars.com (NYSE: CARS). Cars.com is one of the leading online classified companies for the US automotive industry. Incidentally, in the US Cars.com competes with market leader www.autotrader.com, owned by Cox Automotive, which now owns Carsales' Australian competitor www.carsguide.com.au.
Carsales could be interested in buying Cars.com for two main reasons. For one, the US company is cheaper. Cars.com trades on an enterprise value to earnings before interest, tax, depreciation and amortisation (EV/EBITDA) multiple of 11 times next year's earnings. Carsales trades on 17 times, so in theory the Australian company could benefit from ‘multiple arbitrage' if it bought Cars.com.
More importantly, Cars.com operates a business model that Carsales might consider old-fashioned. Cars.com makes most of its revenue from selling online advertising subscription packages to about 20,000 car dealers across the US. These packages allow dealers to showcase their vehicles on its site.
That's so last year
However, the subscription-based model is one that Australian online classifieds businesses have moved away from. In Australia Carsales charges its dealer customers for leads from potential car buyers, rather than subscriptions (although notably its South Korean operation is based on a subscription model). Real estate classifieds group REA Group (ASX: REA) also moved to a pay-per-listing model some time ago.
There might be significant upside for Carsales to shift Cars.com's business model over time.
Although it might not be simple as that. The US automotive classifieds market is more competitive than in Australia – which also helps explain the difference in valuation between Carsales and Cars.com. Not only does Cars.com compete with www.autotrader.com and a host of other free or cheap sites, but upstart player www.cargurus.com has also been taking market share.
Then there's that Cars.com would be a very significant acquisition. We estimate that Carsales.com would need to pay an enterprise value of close to $4.0bn in Australian dollar terms to acquire Cars.com (assuming a takeover price of US$35 a share – it's around US$27 currently).
As Carsales' market capitalisation is $3.3bn, it would be a big bite. There are ways around it – Carsales could enter a joint venture with a partner to acquire Cars.com for example. A one-for-three entitlement issue at $12.50 a share might be enough to fund Carsales' equity stake in that case.
All this is speculation, of course. Carsales may well have run the numbers on Cars.com and decided it would be too risky to go head-to-head with larger competitors in the world's biggest car market.
But it does show that high-quality companies that Australian investors consider mature might still have growth potential, including by acquisition. You shouldn't underestimate how a great business can create value for its shareholders.
For now, we'll wait and see. While Carsales appears outwardly more interested in Latin America at present, it's possible North America is in its sights. And, to use another term popular with the brokers, any acquisition of Cars.com would be truly ‘transformational'.
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