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A Top Growth Share From The Motley Fool (Auto Trader)

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A Top Growth Share

Auto Trader

With its dominant market position, the UK’s largest digital automotive marketplace has fuelled consistently high sales growth and astounding margins… let’s go for a drive!

Credit: Getty Images.

Dear fellow investor,

You may have noticed that we serve up our fair share of well-worn Warren Buffett quotes here at The Motley Fool.

You’ll probably already be familiar with most of his famous catchphrases – “Be fearful when others are greedy, greedy when others are fearful” and such. But one little-known piece of Buffett wisdom is far from folksy, and may surprise you. It’s also a quality that I’ve noticed in this impressive growth stock.

When asked in 2000 what attracted him to American Express (NYSE: AXP)– a long-time holding of Buffett’s – the “Oracle of Omaha” gave some insight that may at first seem counterintuitive.

One thing he noticed was that the company was more expensive in the fees it charged merchants – in fact, American Express was growing its market share despite raising its prices more than rivals such as Diners Club. This was a signal to Buffett of the company’s unique competitive advantage – it enjoyed enormous success despite merchants’ love-hate relationship with it.

In my mind, Auto Trader (LSE: AUTO) fits into the same mould. Auto Trader is far and away the UK’s leading vehicle advertising portal. It has one of the best brands in the UK car industry (90% brand awareness in the UK according to the company), and like online property portal Rightmove (LSE: RMV), enjoys significant network effects from being by far the largest company of its type.

But Auto Trader isn’t universally popular with car dealers – browsing online car dealership forums demonstrates that there’s a love-hate relationship between Auto Trader and its main customers, the fragmented UK dealership industry.

The price of Auto Trader’s advertisement packages are several times more expensive than smaller rivals like CarGurus and Pistonheads. And for a small car-dealership, Auto Trader’s packages can represent a significant chunk of a firm’s costs.

But for every angry dealer who begrudges Auto Trader its fees, there are a great many more who wouldn’t be without it and consider the service essential to their operation. Like American Express, it might not be universally popular with those who fork out for its fees – but Auto Trader’s sheer popularity among consumers makes it worth the price, and drives the company’s success.

Investment thesis

Today, brings together the UK’s largest and most engaged audience of car buyers, and the biggest pool of car dealers, creating the UK’s leading car marketplace. More than 75% of all time spent on automotive classified sites is spent on Auto Trader — the company boasts by far the largest choice of used cars available in the UK, with hundreds of thousands of vehicles listed on the site.

Auto Trader makes most of its money through advertising subscription packages sold to car dealerships, allowing large and small dealers to list new and used cars on its website. Over time, Auto Trader has developed more and more valuable tools to help dealers sell their cars more effectively – some rely almost exclusively on Auto Trader to generate sales. And I believe Auto Trader is a prime example of the power of the network effect in action: as more cars are listed on its portal, more consumers flock to it, which widens the company’s already substantial competitive advantage, gives it even more pricing power with dealers, and drives further revenue and profit growth.

Over the three years from fiscal year 2017 to 2019 the company notched an impressive 12.3% increase in sales and improved operating profits by a full 16.3% as operating margins increased to an incredible 68.6%. That’s been achieved by keeping costs low, reinvesting back in advertising to cement its dominant position, and steadily increasing the value (not just the price) of its advertising packages. By making its service more and more effective through constant feature upgrades and experimentation, Auto Trader has been able to sell more premium packages and tools to car dealerships, nearly doubling revenue per retailer from £996 in 2012 to £1,951 in the first half of fiscal 2020.

While new car transactions are notoriously cyclical, used car transactions (in which Auto Trader specialises) tend to be much less so, and depend much more on the overall population of cars in circulation. After a boom in new car sales between 2012 and 2016, the number of cars in the UK reached a record high level of 35 million in 2019 – management expects this greater car population to keep changing hands, as drivers seek to upgrade or replace their vehicles in the years ahead. Used car transactions typically fluctuate from year to year, but looking at the bigger picture, I believe Auto Trader is in an excellent position to succeed over the course of this cycle, and the many more to follow.

I’m also impressed by Auto Trader’s ambitions beyond the lucrative used car market. Management recognises that its market-leading brand makes it a powerful player in the new car market as well as the used sector, with 1.5 million unique visitors to its site each month seeking out new cars – a market which should grow over time as Auto Trader invests in building awareness of its 30,000+ new-car listings. Marketing budgets spent by the likes of BMW, Mercedes and Ford on advertising new cars represents a massive potential market for Auto Trader, and management sees high potential to move into this sector in the years ahead.

Looking further ahead, Auto Trader is also testing the waters with initiatives that could lead the company to directly handling used car transactions online. Auto Trader’s brand in the UK is far more trusted than that of individual car dealers, and as online transactions become the norm more and more elsewhere in our lives, it’s not unreasonable to think that Auto Trader could facilitate transactions for these leads online.

The company has already dipped a toe into these waters with its dealer-focused online wholesale auction site and is rolling out features to help consumers feel comfortable purchasing cars online. It may take some time, but if Auto Trader can use its dominant market position and trusted brand name to take a direct cut of the nearly 8 million used car sales that occur annually, we could be looking at a potentially very lucrative new business line.

Financials and valuation

Fiscal year 2015 2016 2017 2018 2019
Revenue (£m) 256 282 311 330 355
Operating profit (£m) 136 169 202 221 243
Net income (£m) 10 127 155 171 197
Net debt (£m) 518 385 370 355 321

Source: Auto Trader.

As you can see, revenues have risen considerably since 2015, and operating margins have continued to climb – in fact by 2019 they had risen to an astonishingly high level of 68%. I suspect margins could have a little room to grow further, as higher revenues flow directly to Auto Trader’s bottom line.

One key attraction to Auto Trader’s highly scalable business model is that the capital required to be reinvested in the business is extremely low. (Less than £3m a year, just 1% of sales, has typically been reinvested in capital expenditure.) This means that Auto Trader can afford to take generous measures to reward shareholders – in 2019 alone it returned a whopping £151.1m to shareholders in dividends and buybacks.

This hasn’t come at the expense of its balance sheet health though, as its net debt to EBITDA ratio had fallen to just 1.1x as of March 2020. This has reduced interest payments to under £7m annually. I see no reason why its debt couldn’t be paid off completely over time, allowing for more share buybacks, which increase the ownership stake of existing shareholders.

Today, Auto Trader is trading on a fairly undemanding valuation of 19x consensus earnings for the year to March 2021. I believe this could prove an attractive valuation given Auto Trader’s growth potential, highly profitable business model and opportunities for further capital returns to shareholders.

Auto Trader has responded to the Covid-19 pandemic by waiving listing fees for April 2020 advertising packages and has deferred all March payments, which management believes will lead to an operating loss of £6m-£7m in April. This offer may have to be extended more than once but considering the company generated £243m in operating profit in 2019, the bill is more than digestible for Auto Trader and doesn’t impact my long-term thesis.

The company has also raised £200m in additional capital by issuing shares representing roughly 5% of the pre-existing share count. Between this additional cash and existing £100m+ headroom on the company’s lending facilities, I believe it should have no problem withstanding the Covid-19 pandemic even if it extends the fee-free advertising to customers for a longer period of time. This additional cash on hand provides both a short-term backstop in case the pandemic continues for an extended period and should give the company greater firepower to press its advantage over smaller, less cash-rich competitors by investing in new tools for customers or increased marketing campaigns once economic life returns to normal.

Risks and when I’d sell

My positive view on Auto Trader is also shared by my fellow analysts on the team at Motley Fool Share Advisor, where we’ve rated Auto Trader as a ‘Buy’ for members who are seeking growth opportunities for their portfolios with at a minimum 3-year time-horizon. This has been a good recommendation for the service, but it is not intended to be representative. Not all recommendations have performed so well, and some have fallen in value.

I’m still happy to accept the risk that if the UK and global economies entered a recession, consumer spending would likely fall, and car buyers might delay their purchases of vehicles. While used car listings should be less vulnerable to adverse economic conditions, a depressed period for UK car dealerships would probably mean fewer car listings on Auto Trader’s website, and lower profits for the company.

As the Covid-19 pandemic has brought most non-essential economic activity to a screeching halt, some of Auto Trader’s customers may not survive if the outbreak lasts for a significant period of time. But we do believe economic activity will eventually bounce back and when it does, existing or new dealers will be there to sell consumers cars and Auto Trader will be there to help connect them. Investors should also be aware that as management has moved to bolster the company’s balance sheet over the past few weeks, they have guided that the 2020 final dividend payout is unlikely to go ahead if the current market conditions persist – which I believe would be a prudent move to conserve cash to cope during this period of short-term uncertainty and can always be returned to shareholders in 2021 if it is not needed.

It’s possible that management’s ambitious growth projects could backfire, such as expanding further into new car retailing and exploring handling used car transactions directly through its website. Not only would this reduce focus on the core business, it would reduce the number of potential avenues for Auto Trader to expand. To a degree, we’re trusting management to pursue these new opportunities sensibly.

Perhaps the biggest risk to Auto Trader though is that it loses its dominant market-leading position. This is much less likely than the above risk factors in my view, because it enjoys such a strong share of mind among consumers. It is an area where Facebook and eBay have tried to enter, but with much less success than Auto Trader. But it’s worth being mindful that Auto Trader’s success relies on it remaining the most effective and valuable service for buying and selling cars in the UK – losing that status would put a significant dent in Auto Trader’s prospects and profits.

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To your investing,

Ian Pierce, Analyst
Motley Fool UK.

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This report was last updated on 06/06/2020.

Disclosure: Neither Ian Pierce nor The Motley Fool UK own any of the shares mentioned. The Motley Fool UK has recommended Auto Trader and Rightmove shares.


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