The hidden value in Carsales

When we first looked at Australia's most popular portal for buying and selling cars (and boats and bikes) in the float of September 2009 (see Carsales.com's luxurious price tag (No View – $3.50)) it was priced on a prospective price-earnings ratio of 22.

By the time of Carsales cleans up the yard (No View – $4.86) on 24 Oct 2011, that multiple was 20. Now it's back up to 26 and the share price has risen 163% since listing. Isn't this party already over?

It may seem that way, and yes, the music is pumping. But there's enough to suggest it may get louder still. In the year to June 2012, Carsales accounted for 80% of the hours spent on Australian automotive classifieds websites. Page impressions on its mobile websites and apps are about three times that of its next three competitors (Telstra, Fairfax Media and News Corp) combined.

Buyers and sellers both benefit from dealing with the industry's biggest player, helping to solidify its dominant position. Carsales gets the best industry data to enhance product offers and improve the user experience. And the bigger it gets, the more reason customers have to use it. This is a monopoly business with huge network effects. That's a statement more easily justified now than four years ago.

Breathtaking financials

The financials are simply breathtaking. In the year to June 2012, earnings before interest and tax margins were 53%. And the return on capital was over 100%. Carsales doesn't require any capital to grow, allowing all of its earnings to be distributed to shareholders.

This means that over the past three years the company has been able to pay out 88% of its earnings as dividends – at the same time as increasing those earnings by an average of 33% a year and increasing its net cash position by the equivalent of nearly five months' profit. Even long-lived analysts marvel at these figures.

For these reasons, the PER is a blunt, ineffective tool. The contrast between the high PER and the dividend yield makes the point. Carsales offers a fully franked dividend yield of about 3.0% for the current year. For a high growth business with a dominant market position, that's very attractive given the 4.0% average dividend yield of the All Ordinaries Index.

Moreover, free cash flow has been tracking even higher than ordinary dividends. That's the reason for the company's growing cash pile and a 6-cent special dividend paid last year. On this year's forecast free cash flow of 33 cents, the stock yields 3.6%. Ultimately, that cash will need to be paid out or put to (very) good use.

So here's the pitch: long-term growth in the high single digits would deliver a total return of 10% a year. In the current low-growth environment, that's attractive enough, but Carsales has a high chance of eclipsing that.

Earnings per share have grown at a compound rate of 33% over the past three years and analysts are forecasting growth in the high teens for this year and next.

Growth will almost certainly slow from these levels as the migration of the auto classifieds market from print to online nears its completion (we estimate that the process is already about three-quarters complete), but there are plenty of reasons to expect healthy growth to continue.

Ultimately, for example, we'd expect the online auto classifieds market to be significantly larger than its erstwhile print equivalent, because it adds so much more value.

At Carsales, private sellers get help valuing their car, the opportunity to load up to 15 photos to help sell it, the ability to edit their ad as many times as they like and a weekly ad performance email. Dealers get more 'leads' from interested buyers, enabling quicker sales and greater returns on their investment in inventory.

Pricing power

These features, plus the network effects, give Carsales significant pricing power. Until recently, the company has chosen not to use it and kept prices low to enhance its competitive position. But in February, for the first time in more than five years, it raised the price that dealers pay for 'leads'.

It's a sign of things to come. A personal listing on the main carsales.com.au website costs just $60. Compared to the value of most car sales, that's peanuts. Price increases are easily justified with improved functionality and anyway, what sensible seller wouldn't pay an extra $20 to be on the site with the most traffic, and therefore the best chance of a sale?

Carsales is also increasingly generating revenue beyond its traditional classifieds business. Carmakers know that people in the market for a second-hand car might be tempted to buy a new one and Carsales gives them the ability to reach these people right at the point of purchase. No wonder revenue from display advertising grew 28% in the latest half to 27% of total revenue. As Carsales develops its editorial content, display advertising revenue should continue to rise.

Revenue from dealer and data services is also growing strongly, up 20% in the latest half. This division offers tools to help dealers buy and price their inventory, and assistance with things like video production to help them sell it.

Last and probably least, for the time being at any rate, is Carsales' expansion into other product categories and regions. The company's online auction/classifieds site quicksales.com.au, for example, passed 1 million individual sale listings during the 2012 financial year.

Overseas, the company hopes to partner with a business in an immature market 'where perhaps there's an argument about who's number 1 or 2 or even number 3 and add value to that business and grow it to a clear market leader position'. No deals have been done as yet and the signs are they won't be unless it's a very good opportunity. In the meantime Carsales appears committed to returning excess cash to shareholders.

So is this a case of backing up the, erm, car? Not without full consideration of the risks. Carsales may look impregnable now but what might Google or Facebook come up with to compete with it? Who knows, but it's a consideration.

A similarly nebulous risk is posed by the company's relationship with Pentana Solutions, the technology provider to automotive dealerships from which Carsales was spawned in the late 1990s. Under a contract that runs until March 2015, Pentana supplies (according to the 2012 annual report) 'data for the exclusive use of carsales.com Ltd in return for a fixed annual payment, plus a percentage of revenues generated through Pentana Solutions'.

What makes this relationship unusual is that Carsales chairman Wal Pisciotta and chief executive Greg Roebuck also own shares in Pentana and sit on the board. Pisciotta is also chairman of Pentana.

The data provided by Pentana includes 'live dealer inventory data' (according to the 2009 prospectus) and presumably feeds directly into dealer and data services revenues. But it also quite likely contributes to Carsales' overall competitive advantages. How much so the company appears unwilling to say, although we will continue to chase management about it.

We'd assess this relationship as a relatively small risk. The limited disclosure (particularly when the contract was renegotiated in March 2010) suggests a minor commercial significance and it's surely in Pisciotta and Roebuck's interests to maintain the status quo.

As the migration from print to online nears its completion, Carsales' earnings will also increasingly be affected by the cyclicality of the underlying car market. However, in all but the most dire scenarios we'd expect earnings growth to continue, albeit at lower levels.

Margin of safety

From a share price perspective, probably the greatest risk is that investors see the slowing growth and settle on paying a lower multiple for the stock, despite the attractive dividend yield. This could undoubtedly happen, but it doesn't make sense to ignore an attractive situation simply because it might get more attractive in the short term.

The best way to deal with these risks is to require a decent margin of safety and to start with a relatively small portfolio weighting. The margin of safety is provided by growth prospects that we'd put comfortably higher than the high single digits we suggested earlier as our base requirement. And we're going to start off with a recommended portfolio limit of 3%.

A price fall and/or clarification of the nature of the relationship with Pentana may result in a higher portfolio limit and a possible upgrade to an outright Buy. Until that happy day, Carsales.com is a LONG TERM BUY.

Note: We're also buying 900 shares for our model Growth portfolio and 600 shares for our Income portfolio at $9.21 for $8,289.00 and $5,526.00 respectively.