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Morningstar | Carsales.com Sensibly Sells Problematic Stratton Investment; Fair Value Maintained at AUD 14.50

We are pleased, but not particularly surprised, that narrow-moat Carsales.com has decided to sell its 50.1% shareholding in Stratton Finance. The company bought its Stratton shareholding in 2014 for AUD 60 million but the business has faced several challenges recently; including regulatory change, competition, and weak new cars sales caused by falling real estate prices and the associated wealth effect. The Stratton investment was impaired last December to about AUD 12 million, an immaterial value relative to Carsales.com’s market capitalisation of AUD 3.4 billion, and we expect Stratton to comprise less than 1% of group EBITDA in fiscal 2019.

Carsales.com’s decision to expand into auto finance broking had the potential to create revenue synergies by leveraging the large audience of car buyers. However, we were critical of this strategy because we felt the company expanded too far into the highly competitive finance sector, to a point where it lacked a competitive advantage. We viewed this as poor strategy and capital allocation because companies should aim to strengthen, not weaken, their economic moats. Stratton’s competitive position is reflected in its EBITDA margin of just 5% in fiscal 2018, versus Carsales.com’s online advertising EBITDA margin of 76%.

Carsales.com effectively pre-announced its fiscal 2019 financial results, considering there are only two weeks left of the financial year, with management expecting underlying NPAT of AUD 130 million to AUD 132 million, versus our prior forecast of AUD 129 million. We’ve updated our forecast to the high-end AUD 132 million, although we maintain our fair value estimate of AUD 14.50 per share. Because Stratton is yet to be sold, we retained its earnings in our forecasts. Carsales.com’s share price has increased by about 30% since the start of 2019 since investor fears about the effects of weak new car sales subsided, but at the current market price of AUD 13.77 the stock remains slightly undervalued.

We don’t believe the poor performance of the Stratton investment reflects particularly badly on management’s ability to allocate capital. Apart from the fact that the Stratton investment was made under the previous chief executive officer, Carsales.com takes a cautious approach to investments, which are usually small and reduce the impact of failures. Although the investments in Stratton and iCar Asia have been disappointing, other investments have been more encouraging, and on balance we think the firm's track record is good. Importantly, the decision to sell Stratton and exit a poorly performing business, give management more time, and redirect resources toward strengthening the economic moat of the group.

Ironically, the sale of Stratton may mean Carsales.com becomes more active in the finance segment. This is because the ownership of Stratton meant Carsales.com was partly in competition with its car-dealer customers and potential website advertisers in the auto finance sector. The sale of Stratton will therefore enable Carsales.com to participate in the auto finance sector in different ways without straying too far from its core business or diluting its economic moat. For example, the company may help dealers leverage Carsales.com’s data, audience, and technology to source auto finance business more effectively. This is a more logical role for Carsales.com to have in the auto finance value chain than owning a broker outright.

Although Carsales.com is being hit by weak new car sales, we expect this will ease. The depreciating nature of cars means new car purchases are likely to be deferred rather than canceled outright, and the current weakness is likely to be cyclical. Real estate prices and credit tightening appear to be the main cause of weak new car sales but there is early evidence we may have seen the worst of the real estate price falls. The recent interest rate cut, and likely possibility of further cuts, by the Reserve Bank of Australia should act as a stimulus for the real estate and automotive markets. The Liberal party’s victory in the Australian federal election also removes threats posed by the Labor party, such as the removal of negative gearing, capital gains tax discount, and franking credits for some investors. The Australian Prudential Regulatory Authority’s plan to remove the 7% serviceability buffer on mortgages should also increase the availability of credit.