CAR: Compounding quality via international expansion

Everyone likes the idea of investing in a quality business. In fact, you have to wonder why you would invest in any other kind of business. Even better than a quality company, is a quality company that is able to compound its returns over long periods of time. Investors who target these types of companies are looking to buy and then hold the investment for a long period and let their returns compound over time as the company grows its business.

I have written a number of articles about quality compounder stocks, analysing stocks that are consistent with the Quality Compounder screen as presented by Stockopedia contributor Roland Head in his article Building a screen to find Compounding Quality stocks. Following the recent reporting season a couple of new stocks have come into the screen when applied to the ASX and NZX. These include carsales.com (ASX:CAR) and Idp Education (ASX:IEL).

Carsales.com needs little introduction. As the name suggests, it is a website for the buying and selling of cars. But there is a bit more to it. They operate across four main geographies. Australia, USA, Brazil and Korea. Over 50% of their revenue is now derived outside Australia. In each of its markets they are the number one marketplace in the space where they compete. In the US, they do not list cars, but rather trucks, RVs, powersports and equipment. The Australian market also covers those along with boats.

Market position

Source: carsales.com, Full Year Results Presentation - Year ended 30 June 2023, 14/8/2023

The business derives revenue in a number of ways. First is through vendors paying to advertise, both dealers and private sellers. The majority of revenue comes from dealers. Next is selling advertising on the site, and there are also a number of ancillary services that are provided.

Albert Einstein said, “Compound interest is the eighth wonder of the world; he who understands it, earns it, he who doesn’t pays it.” Carsales have increased their revenue at a compound annual growth rate of 15% over the last 16 years. Something compounding at 15% doubles in value every five years. Consequently Carsales have grown their revenue from $100 million in 2007 to $942 million pro-forma today (this assumes the full amount from the US and Brazil businesses in which they became majority holders part way through the year is included).

Source: carsales.com, Full Year Results Presentation - Year ended 30 June 2023, 14/8/2023

Carsales have been growing revenue in a number of ways. These include:

• Acquisitions - they moved from 49% to full ownership of Trader Interactive (US) and 40% to 70% ownership of webmotors (Brazil), during FY23. They are also looking at expanding into other underpenetrated international markets.

• Increasing penetration into their established markets

• Improving efficiencies, for example implementing Australian ad serving technology in the US business led to a 25% increase in daily revenue from advertising.

Sometimes revenue growth due to acquisitions may not lead to growth in EPS, which ultimately is the metric that determines the returns available to shareholders. Carsales’ growth has included acquisitions, but they also grew EPS at a compound rate of 8.1% over the last 10 years, meaning that EPS has more than doubled.

These are impressive rates of growth, but to determine the quality of the business we need to survey the profitability as well as the balance sheet. The profitability metrics are very strong. The average operating margin over the last five years has been 54.3%. Net profit margins have averaged 38.4% over the same period. Returns on capital employed are also impressive with a long term average of 21.4%. The profits are also being turned into cash with a strong level of cash generation.

As for the balance sheet, debt is low with a debt to assets ratio of 26% and interest cover is 18 times meaning that there is plenty of leeway to cover debt servicing costs.

The table below shows all of the criteria for the quality compounding screen. As can be seen, CAR exceeds all thresholds, often by large margins.

* includes an abnormal gain.

The operating margin TTM of 95% as reported in Stockopedia includes a one-off gain associated with moving to majority ownership of the US and Brazil businesses. This is not a situation that is likely to be repeated, however it does reflect very prudent investment decisions in the past. If that gain and other one- off costs were to be removed, the operating margin would be 48%, still a very strong result. Likewise the net margin TTM of 82.6% drops to a still very respectable 35.6%.

The most recent results, released on 14 August, impressed the market which has responded by sending the share price 20% higher since. All the key markets where they operate experienced double digit earnings and revenue growth. Analysts responded by upgrading their future EPS expectations resulting in a Momentum Rank of 99.

As is the case with most of these quality compounding stocks, they are rarely cheap. The market is well aware of the favourable characteristics and prices the stock accordingly. CAR trades on a forecast PE ratio of 33 and has a Value Rank of only 21. Advocates of the compounding quality investment approach generally have the view that over the long-term it will be the growth in the underlying value of the business that is the biggest determinant of return rather than the price paid. An investment of $10,000 in CAR 10 years ago would resulted in total profit and dividends of $21,000 to date.

The key question is can they continue to compound growth at a similar rate. It will not be easy. Given the law of large numbers and their already dominant positions in their main markets, but there are still opportunities to capture a greater share of the value pie in their existing businesses as well as the possibility of replicating their success in other underpenetrated markets. A lot will hinge on their ability to expand profitably in overseas markets.

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