How many cars do you own? One, two? Maybe even three?
It’s not uncommon for US households to own up to three cars. But how many cars do you think people in places like South American own?
Take Juan Garcia for example. Like every other city goer in Mexico City, Juan pays his taxes, works extremely hard to provide for his family. Oh yeah, and he owns multiple cars to drive on different days of the week.
And he’s just one of many who various cars in Mexico City.
For Aussie auto classified company, Carsales.com (ASX:CAR), it’s a huge opportunity. I’ll get to who they are and what they do in a moment. But first let’s explore why Carsales is so eager to jump into Latin America.
A Huge Online Auto Opportunity
How can people in developing regions like South American own multiple cars?
Well for one, a large majority of Latin America’s population live in urban areas.
In his book, ‘Latin America’s Emerging Middle Class’, Jeff Dyton-Johnson writes that since 2010, 80% of LATAM’s population has lived in urban areas.
“Latin America is the most urbanised region in the developing world. Nearly 80 per cent of its population, or 470 million people, lived in urban areas in 2010, and there are fifty-one cities with populations over 1 million; overall car ownership and car use in Latin America are therefore higher than would be expected based on population and GDP per capita levels.”
Thus people need cars to take their kids to school and drive to work. However, large population concentrations in Latin American cities are causing big problems for policy makers.
Not only are roads congested, air quality is significantly poorer.
Urban planners simply cannot keep up with the amount of new cars hitting the road. Thus, policy makers are trying methods to limit the amount of cars on the road at any one time.
In 1989, Mexico City enforced restrictions on travel in central city areas based on the last two digits of your number plate.
For example, cars with number plates ending in 5 or 6 could not drive on Monday’s. Number plates ending in 7 or 8 couldn’t drive in the city on Tuesday’s.
This vehicle restriction model was quickly followed by nine other cities in LA. For example, in Sao Paulo, Brazil, vehicles with number plates ending in 1 and 2 couldn’t drive on Mondays, and so on.
Yet, city goers in LATAM have found an easy way around these restrictions.
The second reason why Juan and other have multiple cars is to have one for different days of the week.
But not only are car sales and registrations growing significantly, so too are internet penetration rates across LATAM.
Countries like Brazil and Mexico have internet penetration levels below 60%. Both countries don’t even appear in the top 50 based on internet penetration. But these penetration levels are growing, in some areas by double digits.
The combination of growing auto sales and internet users in LATAM is one reason why Carsales.com Ltd (ASX:CAR) is so eager to get into the region.
Carsales is Australia’s best known auto classified company. They also own interests in similar businesses in South Korea, Chile, Brazil, Argentina and Mexico, among others.
Earlier this year in 2017, Carsales acquired 100% of DeMotores, an auto classified website in Argentina, Colombia and Chile.
“The inclusion of DeMotores with Carsales’ existing investments in Brazil, Mexico and Chile makes us the number one online automotive classifieds network operating across the Latin American region,” said Carsales director, Paul Barlow.
“This investment further capitalises on our work rolling out a Spanish language version of our world-class technology in Mexico and Chile and helps us continue to benefit from economies of scale in Latin America.”
Question is, will Carsales be an investment worth holdings over the next few years as they grow their international business?
As their name suggests, Carsales offers a market place for car buyers and sellers to meet. Over the years, Carsales has increased their scope, creating a market place for boats, motorbikes, caravans, trucks, farm machinery, construction vehicles and tyre sales.
For the moment, let’s just stick with cars. Say you have a car you want to offload. Rather than going to a dealer and getting a far lower price than you would have hoped, you can chuck it up on Carsales.com.
You can get far more eyes on your car, hopefully someone willing to pay a pretty penny for your model and make.
Of course Carsales isn’t doing this for free. Carsales online advertising fee structure is as follows:
- $0 – $14,000
- $15,000 – $19,000
- $20,000 – $29,000
- Over $30,000
But it’s not just you or me that put up ads to sell our cars. Dealers are a huge part of Carsales Online Advertising division.
In their 2017 annual report, Carsales noted that around 29,864 dealers around the world used their network. And this is only one division of Carsales overall operations.
They also have their international business, which I touched on briefly before. It’s more or less the same deal, but international. However instead of owning their international businesses outright, Carsales has varying stakes, as shown below.
Carsales provides the same online advertising in Argentina, Brazil, Chile, Colombia, Mexico and South Korea. Going forward, Carsales’ execs expect their international division to contribute the lion share of growth.
The company’s third division is Data, Research and Services business. This includes RedBook, a valuations and comparison information portal, along with LiveMarket, DataMotive and DataMotive Business Intelligence.
Dealers, importers, manufacturers and insurance companies make up the majority of customers for this division. They use Carsales’ data and analytics to either better target their market or increase sales of particular car models.
The last division is their Finance and Related Services businesses. Through subsidiaries like Stratton Finance Pty, Carsales offers financing for cars, boats and other leisure items.
Now let’s check out the numbers under the hood. First, let’s take a look at Carsales most recent financial figures. Then we’ll take a broad look at their historical financials.
As you can see, Carsales isn’t cheap statistically.
Investors are paying 29-times earnings, 12-times book value and 27-times free cash flow for the stock.
Why pay so much?
Well, investors believe future earnings will more than reward their investment. Thanks to leverage, the company generates more than a 40% return on equity (ROE).
This means for every shareholder dollar in 2017, Carsales was able to generate an additional 40.7 cents. The company’s return on invested capital (ROIC) is also quite high at 24.5%.
Carsales pays out around 81% of their earnings as dividends. To me this is far too much. If the company can continue to generate 24.5% on invested capital (equity plus debt), surely they should reduce their payout ratio to 50% or even lower.
At 81%, Carsales is potentially growing earnings by 4.6% annually (0.245*(1-0.81)). But at a payout ratio of 50%, Carsales could potentially grow earnings by 12.3% annually.
It would be a 166% improvement on their current earnings potential going forward.
Who knows, maybe Carsales will decrease their payout ratio in the future. However, that seems unlikely as the company has paid out close to 80% of earnings for the past five years. Such a drop in dividends could spook investors, causing a selloff.
In terms of segments, Carsales Online Adverting Services make up the lion share of revenues (72%) and earnings before interest, tax depreciation and amortisation (EBITDA) (80%). Their Data and Research division contributes around 11% to total revenues and 13% to EBITDA.
International, their growth division, contributes 2.2% of revenues and currently makes a 93,000 loss for the business. Finance and Related Services makes up the remainder 15% of revenues and 5.9% of EBITDA.
Now let’s take a look at Carsales 10-year financial history.
*Note some of the figures might be inconsistent with the table above because Bloomberg classifies earnings, revenues, etc. differently.
Something to note is Carsales debt-to-equity ratio (D/E). From 2008-17 D/E has increased from 51% to over 90%. While that seems high, the company currently covers interest payments more than 22-times over.
Take a look at their debt schedule below.
As you can see in 2-5 years’ time, Carsales will have obligations of $193.9 million. Yet such a payment shouldn’t be a problem as the company generates more than A$120 million in operational cash flow annually.
In 2017, Carsales generated A$124.8 million in cash from operations. To maintain their physical assets and keep the company going, Carsales only had to spend A$2.9 million. Meaning Carsales only spent 2.3% of cash generated from operations to keep the cogs turning.
Safe to say the company is a cash flow generating machine.
Not only can they more than meet obligations and maintain physical assets, they spit out more than A$120 million in free cash flow as well.
Clearly, Carsales has an amazing business model, with a service and products that are in hot demand. It’s no wonder why investors have bid the stock up to 30-times earnings.
If you know Warren Buffett, you’ll know what a moat is. He talks extensively about finding and understanding a company’s competitive advantage, or moat as he calls it.
And easy way to tell if a business has a moat is to look at their ROIC. If their ROIC is high, then it’s likely they have a moat – a characteristic that generates more sales each year.
As you can see above, Carsales has a very high ROIC and has maintained it for a number of years. But what is it that makes them better than the rest?
I would argue it’s their network.
A large part of Carsales business is to connect buyers and seller. Yes, they help buyers obtain financing and yes they sell resources like data and analytical platforms. But a vast majority of sales comes from online advertising – someone wanting to sell their car and willing to pay to put it up on Carsales.com.
Essentially, when Aussies think of selling their car online, Carsales is one of the first, if not the first name they think of. To maintain this moat, Carsales simply has to reduce the friction of buying and selling a car online, while improving the experience.
Take a look at the stats below.
It’s clear that Carsales is a market leader in their industry. But how can we know for sure that Carsales will maintain their dominance in Australia and grow their networks overseas?
This is what Buffett means when he wants to know how durable a moat is. We need to know what Carsales will look like 5-10 years from now.
Will they jump into more businesses, increasing their scope and services around vehicles? Or will they stay relatively the same, continuing to grow fast than their competitors?
Of course you might have your own answers. But to me, it’s likely that Carsales will continue to operating in the same way, maybe branching into their finance business a little more.
While new up-starts might come into the market due to the high margins on offer, as long as Carsales can continue to grow their network and increase user engagement, they should be able to fight off any competitor that comes along.
If Carsales had the strongest moat in the world, it still would be worth an unlimited price. So how much should you pay for a company like Carsales?
Before we can come up with an estimated value for Carsales, we need to make some very simple assumptions.
Over the last 10-years Carsales has grown FCF every single year (except 2015 when FCF declined 1%). Over the same period, FCF has grown by 21.8% on a compounded annual basis. That already is pretty impressive.
However this includes periods were Carsales was experiences hyper normal growth. It’s very unlikely that Carsales will continue to grow FCF at more than 20% annually.
Thus, let’s assume FCF will grow by 15% over the next five years. Yet, this might be still slightly optimistic. But at 15% annually, Carsales could generate FCF totalling A$815 million over the next five years.
Discounted at 10%, the present value (PV) of these future cash flows would be A$693 million. Now here comes the tricky part.
We need to estimate a terminal value for the stock. This is the value we believe the business will be worth, or what investors will be willing to pay for Carsales on the 6th year (2024).
As you can imagine, trying to predict a value for a company five years out is no easy task. But let’s assumed investors will pay 15-times FCF for the business.
That means on the 6th year, Carsales would have a terminal value of $3.2 billion, or $1.97 billion in PV terms.
Adding this figure to the total sum of PV cash flows, we have estimated that Carsales has an intrinsic value of $2.66 billion, far below their current market cap of $3.3 billion.
Like I said above, Carsales isn’t a cheap company.
Alternative, we can calculate terminal value by estimating FCF growth into the future. For example, say were thought Carsales could grow FCF, on average, by 4% into perpetuity, then the company could have a terminal value of $2.88 billion, in PV terms.
Adding the sum of future PV cash flows, we’ve estimated Carsales has an intrinsic value of about $2.88 billion, still far too low to warrant an investment.
You might take a more optimistic view on Carsales. The company will likely experience growth from their Latin American businesses. They’ve got a footprint in Asia, trying to expand there. What’s more the business isn’t all that expensive to scale either.
Yet, even for its benefits and profitability, based on conservative measures, Carsales is a bit too expensive at its current price. I suggest you watch it from afar and make a move when the price drops significantly.
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