Could Carsales’ Dominance Be Under Pressure?

By Roger Montgomery | More Articles by Roger Montgomery

It won’t surprise you to know that the automotive industry is in an incredible state of flux. Online sellers like Carsales have disrupted the once-stable car retailing business. Now it looks like these recent industry disruptors are about to see their own business model disrupted. 

At the half-way point for 2016, new vehicle sales have risen 3.4 per cent to 598,140 units, which means annual sales could hit a record 1.2 million for the full year. Just two years ago Australian new car sales topped 1.1 million.

  • Sales grew fastest in the ACT – up up 12.7 per cent to 2,133
  • Ahead of Victoria – up 5 per cent to 34,262
  • South Australia – up 4.5 per cent to 7,613
  • NT – up 4.3 per cent to 1,240
  • NSW – up 3.2 per cent to 43,449
  • Queensland was even at 27,270
  • While Tasmania (1,853) and WA (10,749) both went backwards nearly 7 per cent.

But despite total new vehicle sales exceeding population growth even amid a weakening Australian dollar, there is very little that is stable about how cars are being sold and who is selling them.

One company that has typically enjoyed the benefits of selling cars, without having to buy the stock, or pay for mechanics or a showroom, has been Carsales (ASX: CAR). Carsales is Australia’s largest online list of cars with approximately 221,000 units available for sale at June this year.

In the first half of 2016, Carsales reported after tax profits of $76.9 million. Meanwhile the car dealerships AP Eagers (ASX: APE) and Automotive Holdings (ASX: AHG), which also includes a logistics business, reported first half 2016 profits of circa $50.1 million and $48.2 million respectively. The comparison is important because one car seller requires no physical property, plant and equipment, such as car lots and service centres, to conduct its businesses and the others do.

The heavy reliance on assets has a direct impact on profitability. In 2015, Carsales reported full year profit of $95 million on total assets of $404 million and equity of $186 million. Automotive Holdings reported a profit of $88 million but required two billion dollars of assets and $672 million of equity to produce it. Similarly, AP Eagers’ 2015 full year profit was $91.7 million on $1.4 billion of assets and $591 million of equity. This data is shown in Figure 1.

27072016_Figure1

While it’s not strictly correct to compare after tax profits to total assets, Automotive Holdings generated a return on assets of 4.44 per cent, and AP Eagers 6.55 per cent, while Carsales generated a 23.5 per cent return on assets. If they were your assets, which return would you prefer?

27072016_Figure2

Similarly, for every dollar of sales, Automotive Holdings generated earnings before interest, tax, depreciation and amortisation (EBITDA) of 4.11 cents, AP Eagers 5 cents and Carsales 49.5 cents. Which business would you prefer to own?

Carsales’s next nearest competitor is Ebay’s Gumtree with 176,017 vehicles, followed by the Newscorp-owned Carsguide with 110,987 and Trading Post with 20,252 vehicles.

Carsales’ advantage has come from what is known as the network effect. The network effect is a strong source of competitive advantage and it is evident when the value of a service increases for both new and current users as more people use that good or service.

Think about it this way: as more people list cars on a website, more people visit that website because there is more to see. As the site attracts more eyeballs and unique visitors, it justifies more cars being listed and the virtuous circle continues to work in favour of the dominant site. Sometimes an unbridgeable moat is created between Carsales and the other brands. Even when competitors offer car vendors the opportunity to list their cars for free (Carsguide did this in 2010), it fails to put a dent (pun intended) in the growth of the dominant site.

But the network effect may not be a permanent source of competitive advantage and there are many operators vying for some of the profits currently accruing to Carsales.

New car inventories on carsales.com have declined considerably in recent months. While listings are seasonally weaker at the financial year end, the fall in 2H16 was particularly strong. Revenue from new car enquiries comprises circa five per cent of Carsales’ core domestic revenues, so the weakness in new car inventories will not meaningfully impact earnings directly. It’s also important to note that while inventories are a good proxy for profitability, the true driver of profitability is turnover which we won’t know until the full year results.

But while new car enquires do not directly contribute meaningfully to Carsales’ profits, the decisions by suppliers (the OEMs) can meaningfully impact its profits through channel restrictions on dealers and display advertising, so it must be monitored closely.

The evolutionary patterns in many industries are anything but a straight line. A piano accordion is a better analogy to describe the periods of consolidation of money and market power, followed by fragmentation, spin-offs and wind-ups.

Enquiries to dealers for used cars is far more lucrative for Carsales than new car listings. And while dealer used car inventories are softer than at the start of 2016, the website still appears to play an important role in dealer sales.

AP Eagers recently provided more detail about its apparent used car disrupter, Carzoos, at its AGM.

Over 2.2 million used cars change hands each year and AP Eagers will put small stores in shopping malls staffed with iPad-armed ‘buddies’ who will purchase and sell customers’ used cars in a streamlined, no-haggle environment. Without the unregulated risks of the peer-to-peer used car market, and with a no-questions-asked seven-day return policy and a price based on the historical average negotiated sale price, the concept could disrupt the existing used car market.

AP Eagers’ trade-in inventory and buying power is a powerful barrier to entry for anyone other than an established dealership network. The ability to provide additional comfort including extended warranties could also serve to make offerings like Carzoos a preferred avenue for used car buyers.

Of course not all used cars will be available through one dealership network and presumably some brands will continue to dominate in the reselling of their own badges and models. It is, however, not outside the realms of possibility that Carsales’ network effect is beginning to be unstitched. And, with the share price at 26 times next year’s earnings, the development of alternative used car selling models is worth watching closely.

Roger Montgomery

About Roger Montgomery

Roger Montgomery is the Chief Investment Officer of Montgomery Investment Management, montinvest.com, and author of blog.rogermontgomery.com. Alan Kohler has referred to Roger as "one of the nations smartest and most successful value investors".

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