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Is Carsales Driving To The Middle Of Nowhere?

Australia | Feb 01 2022

This story features CARSALES.COM LIMITED. For more info SHARE ANALYSIS: CAR

As digital disruption mounts in the auto industry, analysts want to know how will respond – a roadmap please!

-The brand proposition
-Carsales’ Achilles heel
-US regulatory trends
-But wait, there’s more disruption
-Near-term outlook – brokers have their say

By Sarah Mills

A lack of guidance from the company at its December investor day and management’s lack of clarity on the long-term outlook has brokers second-guessing.

Separate views are emerging on the future of Carsales ((CAR)) as brokers try to nut out the impact of impending disruption on the company.

Theoretically, as a first-mover holding a virtually unassailable leading position in the market and in the mind of the consumer, Carsales enjoys a considerable brand moat (which we discuss below) if not an economic moat.

This typically protects classifieds companies from standard competitive onslaughts but rarely from serious disruption, and Carsales is being subjected to disruption on several fronts given its exposure to the transitioning automobile industry.

Carsales is one of Australia’s four large high-quality platform operators, the others being Domain Holdings, REA Group and Seek.

Morningstar notes all have narrow economic moats, asset-light business models and strong cash generation. All enjoy first-mover status, a No-1 brand position, and No-1 market position, which combined ensure the company is likely to continue to be trapped in a virtuous business cycle – in a static world that is.

But Carsales differs from its online platform peers in that 80% of its revenue is generated from car dealers, whose agency model market is set to be disrupted by digital retailing (manufacturers selling direct to the consumer from websites). This is a serious threat.

It also faces disruption from the autonomous driving technology and ride-share concepts. 

There is also some concern about the company’s short-term prospects as brokers try to estimate a post-covid trajectory for the company.

Morningstar and JP Morgan both posted sector reviews in January in a bid to assess the company’s post-pandemic prospects in a higher interest-rate environment, and the company’s future in a rapidly changing digital world. 

This research provides the basis for this article, which examines the pros and cons for Carsales: Basically, whether the virtuous cycle will prevail over impending disruption. Short-term prospects are addressed at the end.

The brand moat

Carsales is Australia’s largest aggregator of online automotive classified advertising.

Morningstar points out the company enjoys considerable first-mover advantage: Carsales’ websites capture 80% of all time spent online looking for a motor vehicle in Australia, generating more than three times the page impressions of all competitors combined. 

This yields two benefits: 

-It is the first stop for buyers because it has the largest inventory, and sellers want the largest audience. This in turn creates a virtuous cycle giving it an almost unshakeable position.
-It has established itself as the No.1 provider of online car sales in Australia in the mind of consumer, which, readers familiar with The 22 Immutable Laws of Marketing will know means that it is nearly impossible for competitors to unseat it (the brand moat). Think here of the billions of dollars Pepsi spent to try and unseat Coke and countless similar examples.

Its leadership position in a strong cash-flow industry also makes Carsales a defensive play in economic downturns and periods of heightened uncertainty. 

The Fairfax comparison

This was a position held by Fairfax back in the golden days of print. News Corp launched repeated assaults against the giant (established in 1831), but was unable to make a scratch – until digital disruption that is.

Fairfax led in nearly every online sales segment from real estate to employment, further creating brand stickiness – something Carsales lacks. Interestingly, News Corp performed well in auto, which even then was a different animal, reinforcing the role dealerships play in the market.

Fairfax also consolidated its position (became super-glue sticky) by creating quality journalistic content, providing another reason to buy the paper – the one-stop shop. Carsales lacks this add-on as well.

Fairfax also had a strong economic moat – the print industry was capital intensive requiring printing presses, specialised skills, massive distribution channels and operational excellence – a deadline could never be ignored. And still it fell.

In contrast, Carsales has a weak economic moat.

Fairfax succumbed to disruption primarily due to its own ineptitude, prejudices and inability to pivot in a changing world. In contrast, Carsales has a reasonable track record of innovation, and that weak economic moat means it’s more nimble.

But the company’s December investor day left analysts unconvinced that management has a clear path forward.

The Achilles' Heel

Under business-as-usual circumstance, Carsales' economic moat may have been narrow but its leading market position and brand moat should have proven unassailable.

This position was further buttressed by a deep dealer relationship.

Morningstar notes dealers originally established Carsales to share pricing and car inventory data and still use it to calculate market value and price new inventory.

But what was once a shield has now become the company’s Achilles heel.

Morningstar estimates that 80% of the company’s group earnings (EBITDA) is derived from automotive related advertising. Should manufacturers sell direct to the public, this is the most serious threat.  

This threat is exacerbated by intense competition from minnows and whales, who will be seeking to exploit this weakness in the company’s armour during a brief period of vulnerability. Carsales will need to move fast, strategically and decisively.

Dealerships are already facing an existential threat as buyers increasingly opt to purchase online. 

According to The Future of Customer Engagement and Experience (FCEE), research shows that 46% of consumers prefer to search for and purchase cars online than visit dealerships.

Add to that the threat of digital retailing and Carsales' captive 80% revenue from dealerships looks a lot less solid than it did yesterday.

While theoretically, this offers a ripe opportunity for manufacturers to ramp up their digital retailing efforts, in reality this threat does not appear imminent given the regulatory change required is unlikely to happen overnight.

Regulatory trends in the United States

In the US, for example, most States prohibit auto manufacturers from selling direct to the consumer. 

But US regulators are broadly revisiting anti-trust laws for the digital era, which could shift in either direction depending on the industry. 

To date, only digitally native companies such as Tesla have circumvented the laws prohibiting sales to consumers, suggesting electric vehicles may enjoy different treatment to traditional cars – and the wording of many of the new State bills suggest this will be the case.

In 2020, United States’ Automotive News reports that at least 10 states have introduced bills in the US allowing manufacturers to either sell directly online or buy dealerships (generally on the proviso the manufacturer has no franchised dealership relationships in the area).

This has thrown the cat amongst the pigeons and brokers are seeking a stronger strategic response in Australia from Carsales.

That Australia does not have its own auto manufacturing in Australia could provide some protection, given the distance between the manufacturer and purchaser is usually much further than in other countries.

Autonomous vehicles and ride-share disruption and competition

Morningstar notes that large fleets of autonomous vehicles could cut private vehicle ownership, but doesn’t perceive this to be a near-term threat. 

The analyst notes the lack of human drivers suggests lower operating costs, but in reality ride-share costs are already low and don’t have the costs of autonomous driving technology. 

Morningstar expects autonomous vehicles are more likely to disrupt the taxi and ride-share market before private vehicles.

Some analysts are concerned that behemoths such as Google may target the Australian classified space, but, given the immutable laws of markets/marketing mentioned above, most would consider the fastest and cheapest way to do this would be through acquisitions (which would need to be linked to a much higher strategy).

There are also anti-trust regulations to consider here, at a time when global regulators are threatening big tech’s ambitions.

Many other options

Carsales could form strategic relationships with (and offer bulk discounts to) auto-manufacturers to shore up the new-car market, thereby protecting the broader website market – manufacturers will still need to use non-proprietary distribution channels to advertise.

The company may find it also has many other options. Australia’s major platform retailers could, for example, form a joint portal a-la Fairfax to increase stickiness. 

The company could acquire smaller competitors but this could prove expensive. 

Offshore expansion is an option to grow revenue (the company recently purchased Trading Interactive) but this is a less-convincing long-term strategy in the face of global disruption.

Morningstar notes Carsales is in excellent financial condition. Previously debt free, the Trader Interactive Acquisition has moved the company from being debt free to an interest coverage ratio of 29x, and may increase with further acquisitions but strong cash flows and low expenses (the weak economic moat is a benefit here) means debt can be paid down swiftly. (Although a failure to replicate the Australian experience would dilute returns).

There are many more options – analysts just want some strong strategic guidance on how the company intends to navigate the looming headwinds.

Near-term outlook

The company also has its share of short-term challenges, as the global economy recovers after the pandemic and interest rates rise.

JP Morgan reviews the Australian classifieds market and notes new and used car markets remain tight but considers Carsales' premium to be unwarranted given high execution risk on the company’s new projects, that hold little room for error.

JP Morgan doubts industry constraints will ease until late 2022/early 2023, the company having stated supply chain issues will be tight until at least the second half of 2022.

The analyst believes recent market excitement about adjacencies to be unwarranted, and says the December investor briefing’s estimations of total addressable market disappointed, especially in the digital retailing segment.

Most concerning to the analyst is the company’s aversion to supply long-term targets, suggesting it is less than certain of its strategy.

Nor does JP Morgan appreciate the impending shift in the traditional auto sales model as dealers change their modus operandi and new digital retailers enter the Australia market.

Brokers note listings recovered in the December half as unprecedented demand battled with covid supply constraints, but they expect total listings may retreat once covid subsides.

The broker makes no major changes to near-term earnings, but downgrades to Underweight and cuts the target price -5% to $20.60.

Morningstar is feeling bullish near-term

Morningstar views Carsales from a completely different perspective to JP Morgan, believing the print/TV-to-digital migration still has a long way to play out.

Morningstar believes the company is the most attractively priced Australian online advertising platform and a good defensive play should technology stocks continue to topple.

The analyst says the company is in a prime position to attract a disproportionate share of the lucrative car advertising sales from traditional scattered print and TV media, noting the company’s highly engaged, targeted audience.

Morningstar also notes the market continues to migrate online and the company’s site now allows buyers to filter through a particular car segment, further sharpening advertisers sights.

The analyst believes this trend should buttress the company from disruption headwinds at least for the next few years.

Morningstar expects operating margins should rise and revenue should post a compound annual growth rate of 9%. 

Morningstar notes ESG risks are low and estimates fair value at $21. 

Brokers have their say

Elsewhere in the FNArena universe, Ord Minnett whilelabels JP Morgan research and has thus downgraded the stock to Lighten from Hold, while shifting the target price to $20.60 from $22.

Goldman Sachs agrees with JP Morgan believing domestic targets unveiled at the company's investor day disappointed consensus, although this broker commends the company’s disclosure. Goldman Sachs holds a Neutral rating alongside a $26.70 target price.

UBS believes Carsales' chances in offshore markets are good although it too remains cautious about potential changes to the revenue model. UBS holds a Buy rating and increased the target price to $27 from $25.50 in December.

Credit Suisse Holds a Neutral rating and $25.80 target price. Jarden is Underweight with a $24.50 target. Morgans is on Hold with a $25.80 target.

The FNArena consensus price target currently sits at $24.60, suggesting 11.6% upside with a prospective dividend yield of 2.5%-2.9% on top. FNArena's consensus target is calculated from targets set by Credit Suisse, Ord Minnett, UBS, Morgans and Macquarie.

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