This week’s company has been on our radar for a long time. We’ve admired its growth since it went public in 2009, but its price tag has been too rich for us. That is, until now.

After two years of sporting nose-bleed multiples, Carsales.com.au (ASX:CRZ) is finally selling at a price we find attractive. The price to earnings multiple, which at one point hit oxygen mask heights of around 50, is now closer to 19.

The business

Carsales dominate the online automotive classified advertising business. By any metric Carsales totally crush its three main competitors and that dominance is getting stronger. With 80% of all time spent looking at automotive classifieds websites around Australia done on a Carsales owned site, its competitors are falling further behind.

Dominance is wonderful, but by itself is no guarantee of profitable business. Here at The Motley Fool we prefer our companies to have an economic moat. We look for a competitive advantage that will keep our companies ahead of its hungry competition.

Carsales’ dominance is its moat. In the online space, the network effect is one the strongest competitive advantages a company can have. The more people who use a site or service the more valuable it becomes. This creates a positive feedback loop which propels companies to greater heights, while virtually excluding competitors.

Show me the money

A competitive advantage is great, but we still need to see the money.

Carsales has grown revenue at a compound rate of 35% p.a. for 5 years. Profitability has grown even faster, with a compound annual growth rate of 49%. In the recently reported 2011 financial year, revenue was up 26% to $153m. Earnings once again grew faster and were up 35% to $58m. On a per share basis earnings grew at 34%.

Profitability has grown faster than revenue thanks to expanding margins. Net margins have almost doubled over the last 5 years from 20.5% to 38%. That margin expansion is an excellent sign of a strong business with plenty of leverage.

A second sign of business strength is pricing power. If a company is able to raise its prices while maintaining its market share, then it has a strong business and dedicated customers. Carsales have pricing power in spades. In the last year they were able to raise prices for classified ads by up to 20% while not merely maintaining market share, but growing it.

Carsales is an asset-light business that has terrific returns on equity. Due to its low capital requirements and high return on funds, they return a substantial amount of earnings to shareholders via dividends and share buybacks. Its high payout ratio delivers investors an attractive 4.2% fully franked trailing yield.

Cashed up

Carsales pristine balance sheet now sports a healthy $33m is cash and no debt after repaying $19m in debt in early 2010. With operations churning out $60m in cash over the last year, management are fortunate to be faced with the issue of capital management. On top of increasing dividends and further buybacks, management have stated they are looking for acquisitions.

Risks down the road

High margins and return on capital attract competitors like flies to a picnic. While the network effect is strong, every moat can be crossed, especially when the reward on the other side is so valuable. Traditional media like Fairfax and its Drive.com.au site will fight hard to retain and regain what was once a business they dominated.

Foolish Bottom Line

Carsales dominate its niche and with the network effect in full swing they should continue to deliver high returns on capital. With margins expanding and last year’s price increase highlighting its pricing power, Carsales will throw off a lot of cash to defend its moat.

With a share price that’s around the same as it was 21 months ago, Carsales has finally grown into its price. The price/earnings to growth (PEG) ratio is now under 1, which is historically an attractive point to begin accumulating shares in a growth company.

At around $4.70 Carsales trades at a small discount to my calculated value and has an attractive risk/reward profile.

Dean Morel is The Motley Fool’s Australian Investment Analyst. Dean has no position in carsales.com.au or any other company mentioned in this article. The Motley Fool has a fast and furious disclosure policy.

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