Finally, fear has returned to the markets and I can once again think about going shopping.
Whilst it’s true to say that markets are still lofty, we can never predict its future movement – as such softly accumulating at these levels is not a bad idea.
Over the past week I have used 1/4 of my dry powder to add to current positions to my portfolio, I also have a fair few companies on my watchlist.
A company I have had my eye on for a while is AutoTrader Group PLC, a classically boring company that holds a near monopoly over car sales listings in the UK.
Trading at a P/E of 21 at the time of writing even after a 25% haircut from the market, it may appear over-valued at first glance but given it has returned to levels last seen in November 2019, it’s worth a closer look.
AutoTrader Group Plc is an online only company that offers a digital marketplace for individuals and businesses to buy and sell new or used cars online.
Traditionally a printed publication shipped out to all parts of the UK, the management has been able to effectively transition the business to an online-only model which has effectively removed costs from the business.
AutoTrader Group Plc generates revenue through charging private sellers and car retailers to list cars on their website.
As a business perspective investor, the first thing I like to do when considering a potential investment is to take a step back and to consider the underlying dynamics of a company.
I usually try to answer the following questions which usually hint towards the existence or lack of economic moat.
Does this company have to compete fiercely with competitors?
If this company raised prices by say 5%, would people switch to a competitor or stay put?
Can this company pass on any supply side cost increases to customers?
After asking these questions and investigating the likely responses, I concluded that AutoTrader Group Plc possesses a wide economic moat.
But where does this moat come from?
The moat is derived from two sources.
Firstly a network effect stemming from their dominance of online car advertising in the UK with 85% of all adverts being posted on their platform.
Secondly, the moat is entrenched further by AutoTrader’s heavy investment in data services which means it provides buyers and sellers with unmatched information on selling prices and vehicle history. Such a large database of information and sales history forms an intangible asset difficult for competitors to replicate. This data-trove was further bolstered by AutoTrader’s 2019 acquisition of vehicle data company Keeresources Ltd. The utilization of this data creates an unrivaled user experience both informing and empowering consumers.
For example, the listing below lets the buyer know that the listed car is priced fairly but is £513 above the market average. I believe only AuoTrader would have a database of selling prices large enough to present such information accurately, further widening it’s moat.
The effects of the moat are clear: Sellers want to sell on AutoTrader because it attracts the most eyeballs and buyers want to search for cars on AutoTrader.co.uk because it attracts the most listings. The price paid for advertisements doesn’t really come in to the equation.
Whilst it is my view that the best moats can be identified easily by glancing over a business and thinking about it rationally, many readers like this perspective backed up by the numbers, so let’s look.
My favorite measures for the existence of an economic moat are gross and operating margin.
Although not always true, the existence of high gross margin figures and high operating margin figures usually indicates the existence of an economic moat (I tend to look for >80% and >20% respectively).
This is because it indicates that a company may not have to cut its margins in order to compete.
I wasn’t able to find costs of sales figures for AutoTrader, but operating margin figures against revenue displayed below shows that AutoTrader shows all the signs of a ‘moaty’ business. As revenue has increased so has operating margin indicating increased efficiency and the success in growing revenue without cutting prices.
These are the best types of businesses – ones where new revenue flowing through the business increasingly trickles through to the bottom line.
We can also turn to the company’s Capital Expenditure figures just to ensure that there isn’t any income statement manipulation going on.
Sometimes, it’s possible for companies to display very high operating margins by capitalising normal business expenses thus removing them from the income statement.
With Capex consistently under 2% of operating profit, we can confirm that this is not a risk.
Utilization of free cash flow
One sign that AutoTrader Group PLC may not merit its 22P/E ratio is that it appears management may be running out of ideas to put capital to good use.
A key indicator of this is the increased allocation of capital to share repurchases and dividend payments.
As evidenced in the graph below, in 2018 a concerning 78% of the £189m generated in free cash-flow was eaten up by share repurchases and dividend payments.
Whilst buying back shares and paying dividends rewards investors, one would expect more allocation of resources to growth opportunities given how the market is currently pricing AutoTrader Group PLC’s stock.
Let me emphasize, I am a lover of share repurchases as they increase an investor’s ownership stake in a company.
In fact, I have applauded Next PLCs buybacks on several occasions.
BUT a company buying back shares at a P/E <15 is different to a company buying back shares at a P/E of >20.
To me, share repurchases should be reserved for mature companies trading at reasonable valuations not for companies that grew EPS by 10% in the previous year.
Considering these figures with the very small capital expenditure spend, it may be the case that growth is running out and thus 22 p/e is a price not worth paying.
Looking into my crystal ball – a fair value estimate
Ultimately, a company is worth all of it’s future cash flows discounted back to today’s value considering the time value of money.
Considering the future growth paths for AutoTrader Group PLC, I will conservatively estimate earnings growth of 12% over the next 3 years dropping to 10% over years 4-6 then reducing to a normal growth rate of 3.5% into perpetuity.
The basis of these estimates are previous organic growth, analyst estimates and an assumption of a 2% per year reduction in the share count (2.6% between ’16-’17, 2.8% between ’17-’18, 2% between ’18-’19).
I will use a discount rate of 9% reflecting the relative safety of earnings and the record low risk free rate in the UK.
As I am happy that there is no earnings manipulation happening, I used EPS as the basis of my calculation.
The calculation resulted in a Fair Value Estimate for Autotrader Group PLC of £3.98 per share.
As such precise calculations are intrinsically flawed as they rely on human judgement, I like to assign a fair-value range to stocks in order to include a margin of error of the exact calculation.
Giving a 5% margin for error on either end, a fair value range for AutoTrader Group PLC would be between £3.78 and £4.18 a share.
Quality businesses such as AutoTrader are usually tough to buy at around fair value. As such, even though AutoTrader Group PLC’s shares appear to be around 12% over-valued, this is based on conservative estimates and it may be worth opening a very small position at these levels.
I have passed up several opportunities in the past for being ‘over-valued’ based on discounted cash-flow and dividend models and most have gone on to materially outperform. Experience tells me that high-quality cash generative businesses tend to remain ‘over-valued’ on traditional measures.
I sometimes refer to this as a ‘wide moat premium’
FrugalStudent Verdict: HOLD (Add lightly at £4.18, add heavily under £3.78)