Carsales goes for a spin

Carsales' share price fell as much as 10% on Friday after the release of the company's annual general meeting presentation, before closing down 4%, but it wasn't immediately clear what the market was so concerned about.

Lead volumes were 'slightly softer than anticpated ... due to market conditions', but that's hardly a surprise with a weak economy and the federal election. There was also confirmation that the decision by some car makers to stop dealers listing new vehicles for sale had 'had an impact on new car lead volume', but that's been bubbling away for a little while (see 14 Oct 13 (Buy – $10.42)), so shouldn't have come as a great shock. And the company did say it was comfortable with consensus forecasts for 2014.

But the market was obviously onto something and what it was became clear after Friday's close, when the company clarified that the particular consensus it was happy with was the one for earnings before interest, tax and depreciation and amortisation, which it calculated to be $142m.

Assuming depreciation and amortisation of $3m, in line with the past couple of years, net interest of about $3m on the $39m of net debt with which the company finished 2013 and a tax rate of 30% would give about 40 cents of earnings per share, compared to the analyst range of 40.4 – 42.4 cents and consensus of 41.6 cents.

We're not sure why the EBITDA consensus differed from the EPS consensus, perhaps there are different analysts included, but one way or another it looks to us like an EPS guidance downgrade of about 4%. It also smells like a bit of a fudge. So it's understandable the market has responded badly.

Chink in the armour

The recent furore about new car listings has probably been slightly overdone, but it does highlight a chink in Carsales' armour – at least as compared to REA Group. Its customers might be similarly weak, but they trade a commodity that is controlled by a relatively small group of powerful players; it'd be like REA Group dealing with properties all built by a handful of companies (and with lives of only 10-20 years or so). The fact they're not means REA Group can rule the roost in a way that Carsales can't match. But that's no doubt partly why it's on a PER of 39 instead of 26.

Subaru, Holden, VW, Nissan, Honda and Suzuki have apparently used their clout to prevent dealers from listing new cars, although Subaru has recently had a change of heart. It's a genuine threat, but it needs to be seen in context, because new cars only accounted for 14% of dealer enquiries in the second half of 2013, and the dealer channel only accounted for 45% of revenue.

Carsales also said it had 'a number of solutions in progress to address this issue' (presumably including the generic 'new cars for sale' category we mentioned on 14 Oct 13) and was confident that it would not lose significant volume as a result of these moves. As chief executive Greg Roebuck put it: 'We have consumers that want to buy cars'.

Buyers and sellers

Its audience is, indeed, Carsales' main strength. While the likes of Gumtree and Carsguide have plenty of sellers (respectively claiming about 150,000 and 110,000 total cars for sale at the moment compared to about 230,000 for Carsales), they only do so because they charge next to nothing. To execute a trade you need a buyer as well as a seller, and Carsales has plenty of both. This is what enables it to generate more leads than its competitors, to charge more, and to generate much more revenue.

The ACCC's Public Competition Assessment of Carsales' blocked proposal to buy Trading Post, released in June 2013, is well worth reading for those interested, but some of the main data the ACCC looked at is reproduced in Table 2.

'I don't think our threat is from the domestic players,' The Australian quoted Roebuck as saying on Friday. 'It will come from Google, eBay and Facebook.' We'd agree, but the risk shouldn't be overstated. It's easy to imagine that Google can and will munch up every internet business in existence, but the auto dealer classifieds market needs a variety of software support tools, and these in turn require expertise and understanding of the used car market. Even someone like Google couldn't just knock them up in a few months.

A would-be competitor would also have to wear losses for a few years to build a presence in the market. The likes of Google are easily big enough to do that, of course, but they'd have no guarantee of success and it might not be worth their while for a relatively small market that might be seriously damaged by their onslaught.

All this gives us confidence in Carsales' long-term prospects. However, the shares are not cheap, with a prospective price-earnings ratio of about 26 and a prospective free cash flow yield of about 3.5%. Given the downgrade and the uncertainty regarding new listings we think a slightly greater margin of safety would be appropriate for a purchase, so we're trimming our price guides to Sell above $15 (from $16) and Buy below $10 (from $11), prompting a downgrade to HOLD.

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