What's driving carsales.com?

Last week’s share price rise of carsales.com Limited (ASX:CRZ) lifted its market value by about $300 million in just a few days. This price rise followed a rather sparsely worded ASX announcement that outlined a $126 million investment by the company. The investment was into a newly formed online car sales business in South Korea that is presented as the current market leader in that country.

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Whilst the investment by CRZ may be exciting, its description in the ASX release was poor and shortly I will explain why I think this is so.

However, let me be very clear – this should not diminish an investor’s view of CRZ as it has been a company that has consistently exhibited excellent financial performance. Indeed its historic profitability, measured by normalised return on equity (NROE) has recently averaged over 70%. This is an extraordinary metric. Further, its profit growth has exceeded 20% per annum compound for a few years now and its shareholders have been appropriately rewarded.

In my view, CRZ deserves the premium rating that it commands. However, I prefer to explain this rating in terms of its required return and derived multiple of equity (intrinsic value) rather than multiple of earnings (price earnings). The former is derived from historical and expected performance. The latter is really a thumb suck.

CRZ acquires 49.9% of SKENCARSALES

To understand my disillusionment with the recent CRZ announcement let us assume that you, the reader, is an owner of CRZ and I am the manager of the business. You rely on me to tell you what is happening in your business because you are not on the Board.

Would you be satisfied if I suddenly announced that I have outlaid $126 million of your money, mainly through borrowings, to purchase a minority stake in a new South Korean business? Would you accept my statement that the new business is expected to be EBITDA positive but I am not going to tell you by how much? Further, would you be confused if I told you the acquisition will be EPS positive this financial year even though we do not know what the date of acquisition will be?

I suspect that you may want a bit more information from me, and especially so because people are constantly hassling you to buy your CRZ shares. You may ask me to present the balance sheet of this new venture. You would probably like to know whether the $126 million is backed by any tangible assets or whether this company has any debt.  From this you may be able to determine if CRZ is likely to receive distributions at some point or is the assumption that CRZ is going to receive management fees for sharing its expertise?

I think you get the drift. The announcement just didn’t outline enough for a rational and/or reasonable person to make a sensible investment decision regarding CRZ shares. The fact that the share price exploded up appears to have nothing to do with rational investment behaviour. Rather, it represents massive speculation based on the belief that CRZ has done well in the past and so everything it does in the future will be as good. I am sure many people thought that of Don Bradman when he walked onto the field to play his last test innings.

So before I turn to deriving a valuation of CRZ, can I please (again) ask companies to be open and clear in their announcements. If an announcement is not clear then it creates the potential for massive speculation and insider trading. Neither of these are desirable outcomes.

Recent profit performance

CRZ produced another strong half year report in the six months to December 31. Whilst profit growth on the previous corresponding period was about 20% there appeared to be no profit growth on the preceding six months to June 30, 2013. Revenue, profit and cash flow were all lower so maybe the business has a June half bias in its Australian operations. These dominate the Group’s reported profit. This observation is a little troubling to me and particularly given the lofty share valuation.

The December results showed a continued improvement in margins and this was possibly enhanced by the emergence of $2 million of reported profits from CRZ’s Brazilian investment. CRZ has a number of overseas investments through its 22.9% interest in ICarAsia. However, whilst the investment has revalued in the market the underlying businesses across Thailand, Malaysia, Indonesia and China have yet to achieve a profit.

What is CRZ worth?

Successful internet-based companies are hard to value. However intrinsic valuation, based on an assessment of sustainable return on equity, derived from observations of performance and with a realistic view of sustainability, is an investor’s best guide.

To derive value my first appraisal is through the StocksInValue dashboard that shows five years performance. From this I can see an excellent average NROE of 77%. I note that NROE has risen over the five years from a starting performance of 43%. This is a good track record.

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The performance of CRZ over the last five years can be observed as follows. As equity is retained in the business the profit rises. Indeed the growth in equity is nearly precisely matched by the growth in profit. Further, we can see that the profit is very real as the five years of operating cash flows exceeds the five years of reported profit. Dividends have lifted consistently through the period and unlike many other internet companies CRZ is a solid dividend payer.

My next review is of the forecast of future intrinsic value. Here we must derive two inputs. First the sustainable NROE (the profitability) and second the required return (RR) for this stock.

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The NROE has been observable as excellent over recent years and it is currently expected to remain high by market analysts. At this point I will accept this analysis but I must note that the recent investments by CRZ are introducing debt into the company with a very uncertain return profile. I have accepted NROE at 84%.  For RR I have derived a low risk premium at 12.7% that is a function of the high quality financials. However, this RR will be under review if CRZ does not drive profit quickly from its offshore ventures. Time in the internet market place is of the essence because competitive threats are constant.

You can see that the recent price surge has taken CRZ well above value (about $8.62 as at 30 June 2014) and so I suspect that it is based on speculative elements in the market – so called “noise”. The alternative view would be that some market participants know more about the recent investment than that which was disclosed. 

John Abernethy is the Chief Investment Officer at Clime Asset Management, one of Australia’s top performing equity fund managers. To find out more about Clime Asset Management, visit their website at www.clime.com.au.

Clime Growth Portfolio Statistics

Return since June 30, 2013: 8.66%

Returns since Inception (April 19, 2012): 27.80%

Average Yield: 5.74%

Start Value: $141,128.64

Current Value: $153,354.47

Dividends accrued since June 30, 2013: $4,396.74