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Morningstar | Credit Crunch Unlikely to Impact Carsales.com as Much as the Share Price Implies

Narrow-moat-rated Carsales.com remains undervalued following three months of share price weakness. The stock has been impacted by several factors including a deterioration in technology stock investor sentiment, tighter lending standards following the Financial Services Royal Commission, and the negative wealth effect from falling real estate prices. However, despite the 30% share price fall since August, we maintain our fair value estimate at AUD 14.50 implying the market price of AUD 11.36 offers value. We forecast an 11% EPS CAGR over the next decade, versus 18% over the past nine years, driven by an 8.5% revenue CAGR, combined with profit margin expansion. Our fair value implies a fiscal 2019 price/earnings ratio of 26, versus 15 for the S&P/ASX 200 index, and a dividend yield of 3.3%, or 4.7% including franking credits.

We expect Carsales’ narrow economic moat and associated network effect to protect its market share and profit margins from short-term challenges. The company owns the dominant automotive trading platform in Australia and continues to strengthen its competitive position and customer switching costs by developing associated services. Despite competitive threats from platforms such as Facebook and Gumtree, Carsales has consistently maintained its leading market position and we forecast this to continue. In fiscal 2019, we expect the Australian platform to comprise around 70% of group EBITDA which should experience very little impact from tighter lending standards.

Carsales’ finance division is the weakest business currently with divisional EBITDA falling at a CAGR of 20% over the past two years. The decision to diversify into financial services in fiscal 2015 was somewhat surprising considering the company lacks a competitive advantage in the sector. However, most car purchases require third party finance and Carsales has a strong ability to generate automotive finance leads which can be monetised.

We’re not too concerned about the finance division’s earnings weakness and weak competitive position considering it only comprises around 2% of group NPAT and we view challenges as largely cyclical. In the long term, we expect the company to generate an increasing number of finance leads which should support divisional revenue growth. The decision to impair the Stratton Finance business, which comprises the bulk of the finance division, by AUD 48 million last month reflects short-term challenges but is non-cash and immaterial for a company with a market capitalisation of AUD 3 billion. Management has also maintained fiscal 2019 earnings guidance for the rest of the company of "moderate growth weighted towards the second-half" versus our 9% EPS growth forecast which is in line with the average over the past five years.

We expect real estate price weakness is the main cause of the decline in new car sales in Australia for the past eight consecutive months, but we anticipate the impact on Carsales to be less than for the car dealerships. ASX-listed dealer groups including Automotive Holdings Group, A.P. Eagers, Autosports Group, and Motorcycle Holdings have reported weaker sales and their share prices are down 50% on average over the past year. However, Carsales has more in common with automotive afterparts supplier Bapcor, than the dealers by being exposed to the total automotive pool of around 15 million passenger vehicles rather than new car sales of around 1.2 million. Also, the dealers have far greater exposure to automotive financing and in particular the Australian Securities and Investments Commission’s recent decision to ban flex commissions. In the long run, we expect cyclical uptick in car sales following current deferral of purchases, due to the depreciating nature of the asset, rather than a structural decline in the market size.