|Shares Out. (in M):||925||P/E||0||0|
|Market Cap (in $M):||5,938||P/FCF||0||0|
|Net Debt (in $M):||380||EBIT||0||0|
|Borrow Cost:||Available 0-15% cost|
We believe that shorting Auto Trader (UK listed, £4.8bn market cap) gives us an asymmetric risk/reward profile: increasing competition from US giants Ebay and CarGurus will make it more difficult to pass further price increases to auto dealers and a stock-based pricing model makes the business more vulnerable to end market swings and competitive pressures. Consensus is expecting revenue growth at a high single digit rate and EBITDA margins of 70%+. We believe that growth will slow and that margins are at risk, in turn we expect the stock to de-rate from the current 19x forward EV/EBITDA multiple.
Business Description and underlying economics
Auto Trader Group plc is the UK’s largest digital automotive marketplace, the overall 12th biggest website in the UK, with a consumer audience that is 3x larger than its nearest competitor and ca 55m cross platform visits each month.
The business was born in 1977 when entrepreneur John Madejski launched a small classified advertising magazine in the UK. After circa two decades of print-based advertising, the company launched its first website in 1996. In 2007, the website generated revenues that matched the print-based business and in 2013, the company became 100% digital. The business was listed on the London Stock Exchange in March 2015.
Today, Auto Trader is a wonderful business that benefits from strong competitive advantages, generates EBITDA margins in excess of 70% and ROIC of 50%+ and is highly cash generative.
Auto Trader has been able to generate these results thanks to its dominant competitive position and scalable business model. The business does not require significant amount of capital expenditure nor marketing spend. The business has a tremendous operating leverage that allows the company to turn a £1 of marginal revenue almost entirely in operating profit.
This is vastly a result of Auto Trader’s competitive position and relevance in its industry. The company is by far the number one in UK’s digital automotive marketplace, 3x larger than its closest competitor: auto dealers generate most of their leads that turn into sales on Autotrade.co.uk. In terms of market structure, online marketplaces quite often show a winner-takes-all pattern, with a player dominating the market and few and not relevant competitors. That is a result of strong network effects: the value of a website increases as more people use it. More cars attract more customers, which in turn attract more dealers and more cars in a virtuous circle.
Auto Trader reached this enviable position moving far in advance compared to competitors and thanks to a pre-existing strong brand in the automotive marketplace.
In essence, the business appears to exhibit desirable characteristics as a “quality” investment. Leading market position, protected by competitive advantages such as network effects and brand awareness, superior economics with apparent sustainable growth, leading margins and returns on invested capital.
Auto Trader generated £1,695 in Average Revenue Per Retailer in 2018, an increase of £149 in the year (+9.6%). In 2017 the increase was £162. The company uses three levers to generate growth in ARPR: stock, price and product. In 2018 growth was largely a function of product growth, supported by a 3% underlying price rise and modest levels of stock growth.
Dealer Finance had a very successful product take up: the product allows dealers to pay to advertise their finance offers on each of their full-page advert views. And 1h ’19 the company announced that over 5000 retailers opted in, representing 70% of all eligible retailers. To us, that suggests room for growth from dealer finance is relatively limited.
Consensus points towards further pass price increases and successful delivery of new products as the in recent past: we believe that the assumption derives partly from recency bias and dismisses the presence of competitive threats.
In terms of stock, neither we nor the market are expecting a meaningful positive contribution and Auto Trader openly talks about an anticipated stock headwind:
Therefore, Auto Trader has to deliver on product and price increases. We saw that the market is expecting ARPR growth underpinned by product contribution but that recent history may not be repeatable as Dealer Financing has already saturated the market and other products lack of innovative appeal. We are taking the risk that Auto is indeed successful with its new product delivery. Auto classifies as “product” also its “premium” offering, that allows dealers to increase their prominence: live chat, more pictures, videos, priority listing on mobile and desktop etc. We believe that these products are more cyclical than the base product and more sensitive to end markets swings and dealers’ financial health. As we can see from physical car stock trends above, we believe it’s risky to make the assumption that premium products are going to penetrate the market as much as dealer financing.
On the other hand, further price increases are not going to be easily digested by dealers in the face of mounting competition: a stock-based pricing model allows dealers to tune Auto Trader down and competitors offer a potential interesting alternative.
A stock-based pricing model means that dealers pay per number of cars advertised on Auto Trader:
A large % of customers-dealers (ca 60%) advertise less than 30 cars on the website. Customers that advertise more than 100 cars, though, account for the largest part of the number of cars listed on Auto Trader.
The point is, however, that if dealers want to decrease their spend on Auto Trader, they can do so.
Rightmove vs Auto Trader? Subscription revenues vs a stock-based pricing model and competitive threats
Auto Trader is often compared to another leading UK business: Rightmove Plc, UK’s largest property portal, which has shown resilience in the face of competition even when other competitors (OnTheMarket, Zoopla) accelerated marketing spend. The two companies share several similarities: both are leaders in their own verticals (auto and property), both are 100% online and 100% UK and both are asset-light businesses generating 70%+ EBITDA margins with high returns on invested capital.
A key distinction however is that Rightmove works with a subscription model while Auto Trader, as noted above, works with a stock-based model. That in turn makes Rightmove much more resilient to end market swings and competitive pressures. Real Estate agents (customers of RMV) either subscribe and are able to advertise their properties on Rightmove.co.uk or they don’t. The vast majority of them choose to do so, as Rightmove is the largest provider of leads and the best way to reach house buyers. The business benefits from the same network effects that we described for Auto Trader. As an example, even if Zoopla spent on marketing twice as much in six years as Rightmove spent in ten, it was not able to challenge Rightmove’s leadership. When OnTheMarket entered the scene in 2015, Rightmove’s sales increased by 15%: the business did not slow down because of competition. We would argue that part of that is explained by its subscription model, which implicitly doesn’t give Agents much flexibility to reduce or increase their spend on Rightmove.
On the other hand, auto dealers can decide to modify the number of cars they advertise on Auto Trader according to numerous different factors. Most plausibly, the decision will be a result of how much will be the cost endured by the dealer vs how much will it yield in terms of generated sales.
So average revenue per retailer in 1H ’19 was £1,826 per month or £21,912 a year. We can estimate this represents a high single digit to low double digit cost on an average dealer’s gross margin.
Importantly, we believe that the entrance of competitors with a freemium model will give dealers the opportunity to diversify their marketing efforts and cherry pick cars to advertise in each platform.
CarGurus has been successful penetrating the US market and recently acquired Pistonheads in the UK: they offer a freemium model, a way to quickly acquire inventory. Retailers have no incentive to hold back stock: they have another route to market for free. Then CARG will generate revenues through premium products like preferred ranking or other products. But from a consumer point of view, there is an alternative website to Auto Trader with a large and growing choice of stock. CarGurus is also particularly consumer oriented and ranks search results by appeal of a “deal” vs an estimated fair price. This compares to Auto Trader’s results ranked by default by how much a dealer is paying them. In addition CARG shows how many days a car has been on the website, which again may be a useful information for a prospective car buyer.
In essence, we believe that the combination of a freemium model, which brings inventory, and consumer orientation which brings traffic, may distort some traffic from Autotrader.co.uk to CarGurus. This in turn will make it more difficult to pass price increases to auto dealers and we think that the market is not discounting this scenario.
What is the business worth? Why is the market wrong?
Auto Trader is trading close to the top of its valuation range of the last 18 months at 23x PE and 19x EV/EBIT. The business has been able to deliver on product innovation and monetization and that has caused its re-rating from mid-2018. We remain skeptical of the optimism notwithstanding the increased threats from competitors: eBay signed an agreement to acquire Motors.co.uk in October 2018 and CarGurus acquired PistonHeads in early December 2018.
We believe that even if eventually Auto Trader comes out as the winner in the longer term, its model is inherently more sensitive to competitive pressures compared to comparable businesses (Rightmove). Ebay and CarGurus have deep pockets and online marketplace expertise and Auto Trader will find it more difficult to meet market expectations in terms of ARPR growth: as the market starts to acknowledge the changing competitive environment and the implied fundamental risks, we believe it will be reflected in the valuation of the business.
If we compare it to Rightmove, a more defensible and predictable business, the spread between the two multiples it’s at trough levels in the last two years. We believe this is unjustified and expect it to go back at least to its historical mean. Taking everything into account we believe that, until competitive pressures ease and we can see more stability, Auto Trader should trade between a business like Rightmove and more competitive online businesses like price comparison websites. Moneysupermarkets and GoCompare in the UK trade respectively at 14x EV/EBITDA and 12x, while Rightmove trades at 21x. At the moment, Auto trades at ca 19x on consensus estimates. Furthermore, given that on a DCF basis most of the value relies on the long term growth rate that we’re willing to apply:we are less certain about trends in automotive utilization in the distant future. If we wanted to assume an increase of car sharing and ride sharing, autonomous cars and taxis etc. we would need to price in a lower level of car transactions and car ownership and in turn a lower level of terminal growth compared to other online-based businesses.
Margin compression and de-rating