ValueLine: Carsales.com

PORTFOLIO POINT: It has a strong return on assets and its intrinsic value is rising, but there is one box Carsales.com does not tick.
Ever noticed that the biggest and best online businesses are lists? Lists of websites, lists of houses, lists of flights, lists of jobs, lists of hotel rooms '¦ even lists of people!

The business of curating and providing lists can be an extremely lucrative one because there is no need for a warehouse or a manufacturing plant. Nor is there a need for inventory and there is potentially very little maintenance spending required.

But because anyone with access to a server and knowledge of a programming language can imitate the business model, what is needed to be successful is a sustainable competitive advantage. More about that in a moment.

Last year nearly one million cars were sold in Australia; this year the figure is expected to be even higher. Of Australia’s adult population of 19.3 million, 5.3% buy a new car every year. Excluding January sales (when everyone is on holidays) and June sales (with end of financial year run-outs) about 85,000 new cars are sold each month.

That’s a lot of new cars being bought, and one suspects that just as many second hand-cars being sold too. One company leveraged to this industry without having to buy stock, lease a showroom or pay the wages of mechanics is Carsales.com (CRZ).

After a decade of business under private ownership, Carsales.com was floated at $3.50 a share in September 2009 in one of the most highly anticipated listings of the year. As is often the case with such floats, very few retail investors were able to get an allocation.

Today Carsales (CRZ) is Australia’s largest online list of cars, with about 205,000 units available for sale as of June this year.

For the year to June 2010, Carsales reported a profit of $43.2 million, which was $16.8 million less than listed car dealership Automotive Holdings (AHE). Automotive Holdings reported a profit of $60 million but required $1 billion of assets and $376 million of equity to produce it.

By way of comparison, Carsales required just $114 million of assets and $89 million of equity. Automotive Holdings generated a return on assets of 6.5%; Carsales’ figure was 39%.

If they were your assets, which return would you prefer?

For every dollar of sales, Automotive Holdings generates earnings before interest, tax, depreciation and amortisation (EBITDA) of 3.8¢. Carsales generates EBITDA of 52¢ from every dollar of sales.

If you could own one of these businesses, which would you prefer?

Carsales dominates Australia’s online lists of cars, capturing roughly half the market. Its next nearest competitor is the Newscorp-owned Carsguide with 93,000 cars for sale at mid-August, followed by the Trading Post with 69,000 cars.

For the full year to June 2010, Carsales’ revenues increased by 28%, with operating costs rising by less than 12% and net profits increasing by over 41%.

One of the keys to sustaining this kind of performance is a competitive advantage and while many conventional reports cite brands and systems as sources of competitive advantage, Carsales’s advantage comes from what is known as the network effect.

This is arguably one of the strongest sources of competitive advantage and it is evident when the value of a service increases for both new and current users as more people begin to use that good or service.

-The ValueLine portfolio, as at October 5, 2010
Company	Purchase/ June 30 price	Price today	Est value**	Margin of safety	Shares owned	Invested ($)	Capital value ($)	Divs rec	Total return
JB Hi-Fi	19.07	20.4	24.44	14.1%	845	$16,106	$17,230	$0.33	8.70%
Cochlear	74.32	70.06	52.89	-35.5%	102	$7,574	$7,140	$1.05	-4.32%
CSL	32.58	32.88	31.05	4.8%	163	$5,323	$5,372	$0.45	2.30%
Woolworths	27.02	29.61	26.98	-0.8%	206	$5,554	$6,086	$0.00	9.59%
Reece	24.20	22.71	20.8	-15.6%	236	$5,723	$5,371	$0.00	-6.16%
Platinum Asset Mgt	4.68	4.93	4.95	17.5%	854	$3,996	$4,210	$0.00	5.34%
Matrix Engineering	3.42	4.98	6.02	17.3%	2,047	$7,001	$10,194	$0.00	45.61%
CommBank	48.64	51.03	51.19	12.4%	215	$10,458	$10,971	$1.70	8.41%
Cash						$50,267	$50,267	$846.97	1.68%
Total return ($) 2011						$112,003	$117,689		5.08%
Return on invested ($) 2011						$61,736	$66,574		7.84%
All Ordinaries (pts) 2011						4324.8	4638.7		7.26%
Total return ($) 2010									12.79%
Return on invested ($) 2010									27.59%
All Ordinaries (pts) 2010									9.69%
* Latest intrinsic value update August 31, 2010

Think about it like this.

As more people list their cars/jobs/properties on a website, more people visit that website because it has the more cars listed. As more people visit the website, it justifies more people listing their cars there and this virtuous circle continues to work in favour of the dominant site, until an unbridgeable moat exists between Carsales.com and the other brands.

In an effort to break the cycle, one of Carsales’ competitors offered vendors the opportunity to list their cars for free but even that failed to put a dent the growth trajectory of Australia’s leading car classifieds website.

Carsales enjoys the same benefits of the network effect as Seek (SEK) does in job ads, REA Group (REA) does in real estate and Wotif (WTF) does in accommodation. This network effect is as visible and obvious as it is entrenched for Carsales.com and investors looking to buy a wonderful business would be hard-pressed to find many more attractive (for more of Roger’s thoughts on web-based businesses, click here).

Now the reality is that Carsales’ largest shareholder, PBL Media, owns 49% of the company and at some point that stake will be sold. But investors fearing the overhang should be less concerned by who buys and sells the shares and more concerned with whether the intrinsic value of the company is rising or not.

Carsales’ intrinsic value is rising. My forecasts suggest intrinsic value will rise 19% for each of the next three years and, let me assure you, there are few companies that can even promise that.

But a rising intrinsic value is just one of the characteristics the ValueLine portfolio seeks. The other is a discount to today’s intrinsic value. And that is the only test that Carsales.com. does not pass.

Carsales.com is an A1 business with a strong competitive advantage that is generating excellent returns on assets but, according to my calculations, its intrinsic value is $3.77. If we compare this to yesterday’s closing price of $4.72, it is approximately 25% overvalued.

In 2012, my estimated intrinsic value for Carsales rises to $4.65 and in 2012 to $5.24, but disciplined value investors need to make sure that everything lines up perfectly to pursue a successful investment strategy.

Carsales is not currently trading at a discount but it is a great business to keep in mind, should the market temporarily change its mind.

Roger Montgomery is an independent analyst and author of Value.able, available exclusively at rogermontgomery.com.