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Morningstar | Carsales.com Remains Undervalued Following Market Over-reaction to 1H Result

We have maintained our fair value estimate for narrow-moat-rated Carsales.com at AUD 14.50 per share following its weak first-half result. At the current market price of AUD 11.52, we continue to believe the shares are undervalued and that the market is underestimating the potential of the international businesses and the resilience of the core Australian businesses. The market price implies a fiscal 2019 price/earnings ratio of 22, versus 27 at our fair value, and a dividend yield of 3.9%, or 5.6% including franking credits.

We think the market valuation is overlooking three key positive attributes of the company currently. First, the international portfolio of businesses is growing nicely and as expected. On an underlying basis, the portfolio increased revenue by 21% and still has massive growth potential. Revenue from international businesses comprised 20% of group revenue in the first half, up from 13% in the previous corresponding period, with international EBITDA increasing to 15% of the group from 9%. This is an encouraging trend which we expect to continue and underpin earnings-growth rates for the group.

Second, we think the market is also overlooking the domestic portfolio of adjacent businesses, such as the finance and tyresales.com businesses. Although finance profits collapsed in the first-half, this reflects operating leverage to some degree which means a reversal in profits is likely to be equally as impactful. Importantly, Carsales.com’s competitive position in Australian online automotive classified advertising remains extremely strong and will continue to generate an increasing number of finance leads. The company’s diversification into adjacent areas including tyresales.com creates exposure to a huge market and leverages the strong core business. Although tyresales.com is still relatively small, management claim revenue growth remains very strong.

Third, the strength of the competitive position, and associated network effect, in the core online automotive classified advertising business should not be underestimated. Carsales.com has dominated this segment for many years despite attempts by much larger competitors, such as Facebook and eBay, to disrupt its position. The company is sensibly increasing switching costs and economies of scale via diversification which should at least maintain existing competitive position and economic moat. Key performance indicators such as audience size and inventory remained strong in the first half.

The 5% share price fall following the result was an over-reaction by the market to largely known areas of weakness. The softest parts of the group are display advertising, comprising about 13% of group EBITDA, and finance and related services, comprising about 2% of group EBITDA. However, despite management flagging weakness within the display business at the Annual General Meeting last November and in the finance business last December, the market still seemed surprised by the relative underperformance in these noncore businesses.

We don’t believe Carsales is facing structural problems by any means and consider weakness to be cyclical and fixable. The weakest area of the company appears to be the finance business, which experienced a 72% fall in EBITDA. This was driven by a combination of a weak real estate market, and the associated wealth effect, credit tightening following the Royal Commission into the financial services sector, and weak new cars. However, the depreciating nature of cars means we expect new car sales and the finance business to eventually recover.

Issues with the display business appear largely related to new car sales weakness, but management also took some of the blame for poor execution. We expect new employees and strategies, and an eventual recovery in new car sales to improve display revenue. Importantly, Carsales remains the leading automotive platform in Australia which appeals to automotive manufacturers and financial services advertisers.

Like its online classified peers, Carsales.com operates a capital-light business model that generates good cash flows and which enables relatively low financial leverage and sustainable dividends. In the first half, cash conversion (operating less investing cash flow/statutory NPAT) was strong due to the noncash impairment of the finance business, with operating cash flow growth also strong. Net debt was reasonably stable over the half and was AUD 396 million as at Dec. 31, 2018. Debt metrics remain comfortable, with net debt/EBITDA of 2.1 and the EBIT/interest cover of 14, and we expect these metrics to steadily improve over the coming years.