Carsales: Interim result 2019

Carsales.com's result wasn't wonderful, we'll grant you - the 5% decline in the share price told you that. But there were at least two reassuring aspects to the numbers delivered yesterday.

The first was that people are still buying used cars. We were worried the weakness in new car sales might hit used car sales too but that hasn't happened - at least not yet. Dealer revenue rose 8% in the first half of 2019 with about 2% of that due to volume growth, which is consistent with recent experience.

In fact management indicated that used car sales have been resilient in past downturns - both in Brazil during that company's recent recession and in Australia during the global financial crisis. Partly it's because car buyers switch from new to used vehicles in tougher times, apparently.

The second reassuring aspect to the result was the performance of Carsales' international businesses. South Korean division SK Encar saw revenue increase by 20% and earnings before interest, tax, depreciation and amortisation (EBITDA) rise by 22%. It's a good start and goes some way towards justifying the hefty price paid for the remaining 50% of SK Encar a year ago (Carsales now owns 100%).

In the spotlight

The other star on Carsales' international stage was Brazilian business Webmotors, of which the company owns 30%. Here the numbers were even better, with revenue and EBITDA rising 31% and 54% respectively. But, as we lamented last year, that will only make the remaining 70% more expensive to acquire down the track.

So that's the good news. But the market seems to have been particularly disappointed by the weak points of the result.

The first issue was a decline in display advertising, which fell 16%. As we suspected in November, this is where the weakness in new car sales - and finance and insurance advertising - is hitting Carsales. Manufacturers are cutting ad spend as sales fall, while banks and insurers also pulled back on marketing as the Royal Commission laid bare their sins.

It's also become harder to get vehicle loans, or at least the size of loan originally applied for. This affected Carsales' finance business in the half, with EBITDA falling 72% to around breakeven. As a result, management wrote down the value of Stratton by $48m; it's an acknowledgement the 2014 acquisition hasn't lived up to expectations.

All this meant that underlying net profit fell 2% to $60m in the first half of 2019, which was worse than the market was expecting. While revenues jumped 17% to $235m, that was due to the consolidation of SK Encar for the period. Excluding Encar, revenues rose 3%.

High margins

Management expects the second half to be better, although it's seasonally stronger anyway. It's forecasting that display advertising will improve and, while that may be right, this is clearly a more variable revenue stream than recent history would indicate. The high margins generated on display ads mean any further weakness would be painful.

We've flagged that there could be some cyclical weakness in Carsales' earnings over the next year or two but the slump in display advertising whacked everyone in the face with that possibility. If used car sales weakened there would be additional earnings downside.

Yesterday's guidance implied a profit downgrade for 2019. Management now says net profit growth will be moderate in the second half, which to our minds suggests the full-year result could be essentially flat (given the small decline in profit in the first half).

While the market has already incorporated some of these risks, we're going to increase our margin of safety. We're lowering our Buy price from $12.00 to $11.00, which implies a prospective PER of 20 on flat earnings this year. HOLD.

Note: Our Model Growth and Model Income portfolios own shares in Carsales.

Note: The Intelligent Investor Equity Growth Fund owns shares in Carsales.