A Special Report

The Motley Fool’s Top Stock for 2015

Our top stock for 2015 is rarity in today’s ASX: A fast-growing and highly profitable company trading at a reasonable valuation. It’s also a sexy tech stock. That’s one rare combination!

Between the growth prospects, international expansion opportunities, and the under-the-radar status (and did we mention the fully franked dividend?), it’s our firm belief that shareholders in Carsales (ASX: CAR) are likely to be rewarded over time. Simply read on for all the details on Carsales, our top pick for 2015!

Carsales.com (ASX: CAR)

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Company snapshot (data as of May 28, 2015)

Market cap: $2.6 billion

Recent share price: $10.47

Cash/debt: $34 million / $345 million

P/E: 25.5

Why Buy?

  • A dominant player with a long runway ahead
  • Cash is king, and Carsales produces a welter of it
  • Its Australian fortress is strong, and overseas expansion is promising

Those of us over a certain age (and to be fair, even those of us a little younger) can remember a time before the internet.

A time when the 6pm Sunday news was the highest rating television program of the week, when the closest you got to ‘immediate’ news was the hourly AM radio bulletin, and when newspapers were tomorrow’s — rather than today’s – fish and chip wrappers.

There is almost no way to describe the impact of the world wide web that doesn’t understate the effect it has had on many, many facets of business and our lives. News is now immediate — and even the ‘news’ websites are often scooped by the ultra-real time tweets from around the world. There’s little you can’t find out by checking Wikipedia, and the internet has truly democratised information — allowing anyone with a computer or smartphone to be fully informed.

It’s even been one of the great enablers of The Motley Fool, and more importantly the ability for individual investors to gain low-cost access to buy and sell shares, as well as free and immediate access to company announcements and annual reports.

Those obvious and invaluable social benefits have come at a cost for many businesses. That’s because the newspapers and television stations that were once the main — and almost only — source of reliable news and entertainment are now in the fight of their lives.

This fight is, in part, being taken to the newspapers by businesses that have attacked (and already largely won) the battle for the ‘rivers of gold’ — the classified advertising that was the financial engine underpinning the ‘front’ of the paper.

That dynamic — as well as the potential for international growth — is the reason we’re recommending Carsales.com (ASX:CAR) as our top stock pick for 2015.

Carsales climbs to the top…

If you wanted to buy a second-hand motor vehicle, be it a car, truck or bike, potential buyers would head to their local newsagent and pick up a copy of the weekly ‘Trading Post‘ newspaper.

In fact, if you were looking for anything second-hand, from stamps, to furniture, whitegoods to sporting goods, musical instruments, computer parts, pets and just about anything else, there was really nowhere else to turn to.

The Trading Post was yesterday’s poor cousin of today’s eBay or Gumtree as a marketplace. Enter the internet, and the Trading Post was left behind. As eBay rose to prominence, the Trading Post lost most of its business, and its early attempts at digitising itself were dismal.

I remember comparing the Trading Post website’s car section in its early days with Carsales.com, and quite frankly that was the last time I ever clapped eyes on the Trading Post. Carsales.com had nailed the presentation, ease of use and friendly layout, even at that early stage, which we have come to expect from market leading ‘list’ websites. Costs for sellers were extremely competitive compared to listing in the Trading Post at the time, when you could be expected to ring up the newspaper once a week to get your ad re-listed, if you hadn’t sold your vehicle in the first week.

Carsales.com was offering a one-time cost of $30 for a standard ad for a motor vehicle, and your ad remained live until you had sold your car. That was around the same weekly cost in the Trading Post paper.

These days it costs $65 until sold for a standard ad on Carsales.com, although sellers can upgrade to premium for $115 and even PremiumPlus.

The comparison between the old Trading Post newspaper and Carsales.com digital site is probably unfair, but that’s progress. It’s a bit like comparing a horse-drawn cart to a motor vehicle.

And not only did Carsales.com steal the Trading Post‘s second-hand car business, but it also took most of the mainstream newspapers’ new car advertising as well. In the pre-digital age, consumers shopping for a new car were likely to buy the weekend papers and scour the motor vehicle classifieds for the best new car deals, before ringing a few dealers to get more details, and possibly then going to look at a car in person.

Sydney car buyers may well remember driving down Parramatta Road, stopping at just about every car yard to have a browse of the cars available. That was a whole day task for many people, and there was no guarantee you’d find the car you wanted. That same story was repeated right around the country.

Now web users and car buyers can search for second-hand and brand-new cars all in the one place – in the comfort of whatever place you choose, whether it’s at home, in a café or even on the road, in many different mediums including on your computer, laptop, tablet or mobile and all for free!

The Carsales story reaches back to the early years of online commerce. From registering the (almost eponymous) www.carsales.com.au domain name in 1997 and earnings its first revenues the following year, the company has been in the vanguard of online classifieds ever since.

Carsales remained unlisted until its debut on the ASX in 2009, by which time its bevy of automotive and related classified websites included cars, motorbikes, horses, farms, trucks… and the list goes on. It also owned the Red Book car information website.

Shares at the time were being offered at $3.50 — 22 times historical profits of $37 million earned from revenue of $115 million.

New Rivers of Gold

Now fast forward almost 5 years, and Carsales is on track to generate $300 million in revenue and bank more than $100 million in profits in the 2015 financial year. If you’re playing along at home, that’s a net profit margin of a staggering 30%.

Carsales is now a company housing four broad businesses.

Its strong suite of Australian classified websites — cars, bikes, trucks, caravan and camping,  boats and tyres — is its fortress business, with a dominant position in automotive sales. This business is continuing to see continued growth in all areas — new car listings, used car listings and display advertising, which is continuing to grow revenues at around 8%.

That growth, while not the stellar result of years past, is particularly impressive, given Carsales already has an overwhelmingly dominant position in its market, and it has had some vehicle manufacturers convince dealers to remove their vehicles from online classifieds sites. Carsales retains significant pricing power in this market, and benefits from wonderful network effects — buyers go to the sites where the most sellers are. More buyers attract more sellers, and more sellers attract even more buyers. The process is very difficult to reverse for Carsales’ competitors, especially once the dominant player hits a critical mass.

The power of network effects can be difficult to overstate. Consider the difficulty Google (Nasdaq: GOOG) has had in stealing users away from Facebook (Nasdaq: FB) with its own Google+ social media platform. In many ways, Google’s platform is better, and given the entrenched nature of Google in other areas and the ability it has to cross promote and leverage off existing functionality, you would think that Facebook would be in real trouble. The problem for Google is that everyone who uses social media is on Facebook — Google+ may be better in every respect, but if there is no one else using it, there isn’t much reason to join!

Carsales’ second ‘pillar’ is provided by its ‘services’ businesses. These units include the Red Book vehicle information site, Car Facts, which provides vehicle history, and its Media Motive and Data Motive businesses which are online advertising and sales agency businesses. These businesses are natural fits for Carsales, and broadens the company’s reach across more of the automotive and online classifieds markets.

The third part of the company is its investments in international automotive classifieds websites, and this is a key part of our investment thesis. Carsales has taken strategic stakes in ASX-listed iCar Asia (ASX:ICQ), 49.9% of South Korea’s SKENCARSALES and the Brazilian WebMotors. iCar describes itself “own(ing) and operat(ing) ASEAN’s No. 1 network of automotive portals”. iCar owns classifieds sites in Malaysia, Thailand and Indonesia. It is experiencing impressive growth in listings and audience, but is still in the early stages of its evolution and is still delivering losses. WebMotors is already positively contributing to Carsales’ results, with the company booking a $4.6m after-tax profit in the last financial year.

The fourth ‘pillar’ is the company’s investments in Tyresales.com.au and 50.1% share of Stratton Finance. Stratton was acquired in July 2014 and is performing strongly so far, with the ‘fourth pillar’ generating $28.4 million in sales in the last half.

If this is starting to sound just like the Seek (ASX: SEK) strategy, you’re on the right track. Both businesses — as well as real-estate focussed peer, REA Group (ASX:REA) — are at an important inflexion point in their evolution. Having wrested the Australian classified business from the newspaper incumbents, they’ve become the overwhelming market leader. Of course, as your share of the market grows, you face (logically) a slower growth future, simply because there is less of the market available to win.

For instance, just ask the big banks — they’ve seen off the non-bank lenders and have acquired a good chunk of the second-tier players, and are now looking to wealth management and other areas to try to find growth! The one key exception is ANZ (ASX:ANZ), which is looking overseas for growth…

That’s a nice segue back to Carsales and Seek. Feeling like increasingly larger fish in a small pond, both companies have realised that not only will growth be increasingly hard to come by in Australia, but also that their expertise, infrastructure and success in Australia can be exported overseas.

Add in the opportunity to invest in markets whose internet penetration echoes that of Australia in the mid-1990s and that are quickly industrialising, and Carsales is seeing plenty of opportunity.

Cash Flow is More Like Cash Gush!

We’re big fans of the folding stuff at The Motley Fool. The cynic will tell you that cash is worth what it says on the front of the note, while reported profit is whatever the accountant (and auditor!) says it is.

That’s true to some extent, and explains why we look past just reported earnings. In this case, though both earnings and cashflows are growing nicely!

To wit: in the last financial year, Carsales turned in profit growth of 14% and operating cashflow that increased 11%. The very nature of Carsales business is that its costs are largely fixed, meaning each new customer will add revenues but almost no costs.

The result of that is the aforementioned 30% net profit margins, and gross margins of more than 80%. Yes, eighty percent! Of course, that represents the result of 17 years of business here in Australia and, as mentioned, iCar Asia is still unprofitable. But that’s the opportunity for investors and the appeal of Asian and South American expansion for Carsales.

Of course, we’re not writing Australia off, either! As we mentioned above, it delivered an impressive 8% revenue growth in the last financial half. Those are attractive economics, and we still think Carsales can compound its revenue growth in the high single digits for years to come.

Risks and When We’d Sell

A significant part of the Carsales story thus far has been its growth at the expense of traditional media. That tailwind will be significantly reduced now that the transformation is essentially complete. The inevitability of slowing growth doesn’t concern us — we think there is sufficient growth left to justify the current valuation. However if growth slows sooner or more significantly than what we expect, the argument for value could be seriously undermined.

Expanding into other countries always carries risk, and many an Australian business has failed to emulate its domestic success overseas. We think Carsales’ approach to buy meaningful stakes in local incumbents is the right move — allowing it to leverage off the local first mover advantage and save a costly and highly uncertain battle for market share. These foreign companies can also take advantage of the experience and existing technology of Carsales. Nonetheless, foreign expansion is never easy and we’ll be monitoring its progress closely.

While competition is a risk for all businesses, the online classified space is somewhat binary and as such competition deserves a special mention. The network effects previously mentioned provide a potent moat, though if this is breached there is little prize for coming second in this industry. This is perfectly illustrated by the success (or lack thereof) of Carsales’ largest Australian competitors, CarsGuide and Drive — owned by News Limited (ASX: NWS) and Fairfax (ASX: FXJ) respectively. Competitors certainly have their work cut out for them, but with the kind of margins Carsales is delivering, they will be fiercely fighting for dominance.

Interestingly, competitors like the two mentioned above are the perfect competitors for Carsales.com. They are fairly weak, but they do exist, so Carsales.com doesn’t have to worry about the corporate policeman scrutinising every move it makes, like it would if Carsales.com was a monopoly business.

Finally, with most of the business’ revenue coming from dealers, Carsales is susceptible to any industry boycott. As mentioned above, this potential came into play late last year when certain dealer groups tried to do exactly that, but the failure to have any meaningful impact shows just how difficult it is to ignore the market gatekeeper. Nonetheless, Carsales will need to ensure it keeps its major customers onside, or at least not upset them too much.

The Foolish Bottom Line

Carsales is a classic example of the internet’s ability to disaggregate previous business models (e.g. newspapers) into their component parts. Free of the ‘cross-subsidisation’, the resultant powerhouse businesses are free to display their very attractive economics to the world… and investors!

And taking that model to the world — well at least Asia and South America — is a very attractive way to leverage those economics. Like all businesses, Carsales isn’t free of risk, and a trailing P/E of around 25 times shows the market has high hopes for the company. We share those hopes and expect that it will justify our faith through ongoing, long-term growth. Foolish investors, start your engines for a story that will last well beyond 2015…

An important announcement from The Motley Fool Australia (including my $100,000 commitment to dividend stocks!)

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Last updated: 28 May 2015

This report was prepared by Scott Phillips and Catherine Baab-Muguira, and authorised by Bruce Jackson. This report contains general investment advice only (under AFSL 400691).  Please refer to our Financial Services Guide (FSG) for more information.  Employees and contractors of The Motley Fool, may have an interest in any shares mentioned in this free report. These interests can change at any time. The Motley Fool has a clear and concise disclosure policy.

Any and all advice contained in the above content is general advice that has not taken into account your personal circumstances. Before you act on the general advice we provide, please consider whether it is appropriate for your personal or individual circumstances. Please refer to our Financial Services Guide for more information or email us at [email protected] to request a copy.

Please remember that investments can go up and down. Past performance is not necessarily indicative of future returns.

All returns cited are hypothetical and based on the percentage change between the stock price at the time of recommendation and the current or sell price (if the position has been closed) at the time of publication. Brokerage, taxes and any other associated costs are not taken into account. Please remember that investments can go up and down. Past performance is not necessarily indicative of future returns. Performance figures are not intended to be a forecast and The Motley Fool does not guarantee the performance of, or returns on any investment. All figures are accurate as of 28 May 2015. Any and all advice contained in the above content is general advice that has not taken into account your personal circumstances.