Description

Summary: 

Jumpman23 wrote a short thesis on the stock in September 2019 with lots of background to the business. Since then, annualized total return on the stock has been 4.3%. Disappointing for a business of this quality but still better than both the FTSE100 and 250 indices over the same period. This is the first buy write-up on Auto Trader in VIC. 

The story is simple: I believe management has to clear relatively low growth hurdles in Average Revenue per Retailer compared to what has been delivered since the 2015 IPO for the stock to deliver low to mid-teen IRRs in coming years. However, if the aspiration of becoming a more transactional marketplace by facilitating more of the car buying transaction digitally becomes a reality, AUTO’s current take of the UK’s car revenue pool could materially increase from the ~2.7% level they achieve today, significantly improving the return profile of the shares at current levels. 

This business has successfully navigated a print-to-digital transformation; the global financial crisis; Brexit; COVID and a constant stream of competing classified marketplaces while growing and consolidating operating margins at around 70% and converting half of its revenues into FCF consistently. The ill-timed acquisition of Autorama in early 2022, which presents some integration and business challenges; and the fear of a recession create a decent opportunity for anyone looking to upgrade their portfolio today. 

Background

Auto Trader (AUTO) is the ultimate classifieds marketplace, a small but critical element of the industry’s P&L that enables the functioning of the UK used and (incrementally) new car market.

They have been around since 1977, but the magazine that made them famous was last printed in 2013. It is one of the few successful print-to-digital transformation stories globally.

Today, AUTO is the place where people go to by default (~35m monthly visitors, 10x its nearest Gumtree’s, #2) when they want to buy a car in the UK (once every 3.5 years, on average). 

It is therefore the place where car dealers advertise their cars: AUTOs share of audience (# of monthly visits vs. closest peers); share of time spent on auto classified websites; and brand awareness have helped create powerful network effects. 

Source: FY23 results presentation 

As a result, AUTO average stock on display represents over 70% of UK monthly used car transactions consistently over time. Its core marketplace business has no need for hard assets and over half of revenues convert into free cash flow.

Source: SMMT, AUTO

Total used car transactions are resilient in recessions: total sales were down a cumulative 10% between 2007 and 2009; down 15% in 2020 and have since mostly recovered to the 20-year average of ~600k/month. 

With the exception of COVID, used cars are rapidly depreciating assets. Car dealers invest large amounts of working capital into their forecourts (as opposed to estate agents for example) and have an incentive to turn their inventory fast (mostly to remain in business, as profit margins are meagre at around 1%). As owners of the asset, they can be as aggressive as they need in price. This is helpful for AUTO in all environments, but even more useful in recessions. Higher interest rates have made ancillary (and highly profitable) finance products less attractive for buyers, which I would expect should focus dealers on completing sales as quickly as possible in the near future.  

AUTO’s stock on display could see a normalization in this scenario, and the stock lever (one of three price levers) should contribute more to absolute Average Revenue per Retailer growth in coming years (compared to 0% in FY23 for example) 

AUTO offers different packages to dealers, and about a third of them use some form of premium package today (compared to less than a tenth at the time of the IPO)

If AUTO didn’t exist, someone would be trying to invent it. In fact, many have tried and keep trying. This is not surprising given the very attractive economics of AUTO’s business. However, displacing dominant marketplaces is incredibly hard, expensive and usually impossible, except in the event of unforced errors by management or if they fail to adapt to radical transformation of their underlying markets. 

Source: 2018 CMD

Shareholders in AUTO are mostly safe: management ranks highly in the classified marketplace universe, and thanks to their focus on permanently expanding their “moat”, minor and major tweaks to the car buying experience (both new and used) have been added to AUTOs core offer to buyers and sellers, increasing the attractiveness of the platform for both groups. 

They have had no shame in adopting competitor’s own enhancements and making them their own: dealer reviews and price ratings are cases in point; or making bolt-on acquisitions that improve data gathering, processing and analytics, which have helped AUTO become a key source of data for dealers, the ONS, the Bank of England, motor insurers, manufacturers, lenders, etc. 

They have also delivered on their strategic objectives over time. Below is the scorecard they presented at the recent CMD in September 2022: 

Source: 2022 CMD

The playground

There are around £190bn worth of New and used car transactions in the UK each year. Gross profit for the industry during the last five years has been around £11.6bn/year (~6.5% margin). Operating costs are around £10.2bn (people ~57.5%; rent ~15%; vehicle costs ~7.5%, Marketing ~7.5%, energy/fuel ~7.5% and IT ~2.5%)

Thinking about the future dynamics of the market, with OEMs already making changes to their sales and distribution models, a portion of the ~2.5 million annual new car transactions will change in structure, with more interaction between OEMs and customers directly, and probably more uniform pricing strategies through coordinated regional sales agent networks. 

Still, as pointed by AUTO in their most recent results, some new entrants to the UK market in the EV space such as BYD have still chosen a traditional franchise model from launch. Changes in the new car space could benefit AUTO, as franchisees becoming disintermediated by OEMs may refocus efforts on the used car market, for example and OEMs wanting to reach customers directly will need effective advertising channels: AUTOs ~2.6 million monthly app users remain an untapped source of potential leads. 

In addition, assuming car owners in the UK continue changing vehicles every 3.5 to 4 years, the structure of 7.3 million used car transactions should not change much. The heterogeneity of the used car ecosystem will remain a feature and continue benefitting the incumbent marketplace, particularly as the top end of the dealer market has become more fragmented than 5 years ago, as noted by AUTO in their most recent call as well.

AUTO’s main source of revenues (81% of total) come from Retailers (Average Revenue per Retailer * # of retailers) which represent ca. 20bps of the industry’s revenues and ~60bps of AUTOs estimate of the transactions they intermediate in the used car market (~£69bn)

Average Revenue Per Retailer (ARPR) has grown at 8.5% CAGR since IPO including COVID, with total Revenue growing at 7.8% (which includes Home Trader, Consumer Services and Manufacturing and Agency revenues) and operating profit at 12.5%. Dealer numbers in the UK have been relatively flat in the last few years at around 16,000 (14,000 of which are AUTOs customers) 

Price, Stock, Product are the three key levers management can pull to grow Retailer revenues. Price increases by 3% on average each year, and product by around 5%. Stock has contributed around 1% on average since IPO but 0% since 2019. COVID did not help as there was a shortage of used cars and they were selling faster than usual. See chart below. 

Source: AUTO

Dealers get good value for their money, and retention rates of products adopted are above 80% on average. 

AUTO’s strategy anticipates things that should remain constant and those that may change in the marketplace. They have gradually positioned the core platform to get closer to the end transaction over time. COVID lockdowns offered an opportunity to test product initiatives that dealers would have typically been reluctant to try, such as reservations, market extensions, and even car delivery. They decided to go for more thanks to encouraging early results. 

Importantly, AUTO is not looking to become the next Carvana/Cazoo/Auto1, even though the future product suite could enable a number of their dealer customers to offer a Carvana-like experience to buyers, without changing their asset light core business model and while focusing on maintaining their core marketplace dominance intact. 

Source: 2022 CMD

AUTO expects digital retailing products will help them expand their current natural TAM (retailers’ marketing budgets of around £1bn) into retailers’ other cost pools (about £7.5bn of directly targeted costs)

Source: 2022 CMD

As this happens, AUTO should be able to capture a higher share of the revenue pool, as demonstrated by other transactional marketplaces: 

Source: 2022 CMD

Potentially doubling their current revenue per vehicle (~£110) while maintaining similar operating margins (70%), which implies doubling their current £75/vehicle op. profit in coming years. 

Source: 2022 CMD

History shows AUTOs ability to undertake significant transformations (print to digital, digital from desktop to mobile, and now digital retailing) even if they’re gradual. 

The important thing, however, is that the core business should continue growing and remain highly profitable even if the current opportunity set did not develop as envisioned by management today. 

Modus operandi

AUTO came to market after a period of PE ownership, with a relatively levered balance sheet. They had completed the print-to-digital transformation and operating margins were on an upward trend. From the outset, management defined a capital allocation policy consisting of: debt repayments to keep leverage below 2x, 1/3rd of free cash going to pay a dividend and the remainder to be used for share repurchases. Between IPO and FY2020 they had repurchased 8% of outstanding shares (at a cost of £353m, or £4.3/share on average), reduced debt by £445 million and distributed £280m in dividends. 

When COVID hit, AUTO’s management reacted fast: offering their product to retailers for free and implementing a discount during lockdowns, a significant investment in goodwill with retailers (there is significant friction in a relationship like this where one player has and exerts significant pricing power) that further cemented their #1 position in the market. 

In addition, management decided to raise £200m of equity in April 2020. They cleared the remaining debt outstanding and ended with about £100m in cash to face the COVID storm. In hindsight, they were too conservative, but the circumstances warranted bold action. 

In early 2022 they bought Autorama, for which they’ll end up paying close to £200m. This is a stain in management’s track record in my view, as they overpaid (>8x revenues, more on this below) The transaction opens the door to the new car leasing D2C market and if it scales, the business could generate decent incremental profits. 

Other than bolt-on deals, the business has limited capital needs. CAPEX has been around 1.5% of sales in the last few years and even with Autorama and the digital journey, investments should not go above 3% sustainably in the longer term. 

The main cost remains people, with around 1,200 employees after the Autorama deal (around 14% of total revenues); marketing is ~6% of sales and other costs plus depreciation around 10%. 

The business is ran conservatively, management like to keep net cash at hand for flexibility and prudence. They will make small deals when opportunities arise that can enhance their core offer and will continue allocating capital as they have until now. 

Autorama

AUTO acquired Autorama in March 2022, a marketplace for connecting OEMs and lease funding companies with individual consumers directly on their leasing of a new vehicle. 

Autorama was looking for additional VC funding. They were launched in 2004 and have been building a presence in the van leasing business since 2006, and had last raised capital in late 2019 with the idea of sacrificing profitability to accelerate unit sales and adoption of their service. COVID hit, new car sales collapsed over 2020 and 2021 and funding required a new push. AUTO original thesis was that they could provide the support they needed to rapidly gain scale. 

The business sold ~20% more vehicles in 2021 than 2019, which in the face of lower overall new car sales in the market indicates greater penetration and market share gains, but an expected recovery in 2022 did not materialize and they sold less than 7k units. 

It’s possible that with AUTOs help they can accelerate unit sales once new vehicle supply returns to normal levels. 

Pre-COVID, Autorama was growing into a 150k unit market and had around 10% market share.

AUTO’s management expect unit economics to scale to £1,100 per car sold at ~25% op. margins = £275 margin per car sold as presented in the CMD. 

AUTO paid £150m in cash and £50m in shares, which were deliverd last week. To justify the price tag, operating margins need to increase to ~25% on ~58k vehicles sold and £1,100/vehicle in the next few years. This is a big ask in my view given the starting point.  

Considering it took Autorama 19 years to get to their current situation, it’s right to ask whether AUTO could have done this themselves organically, at what cost and over which time frame. In hindsight, they paid up massively to accelerate their market position in new cars. Management acknowledges this. 

The business is not yet fully integrated into AUTO, and their end market has been slow to recover. It will operate at a small loss in the next couple of years, and I assume Autorama it reaches breakeven and stays around those levels in the medium term in my base case. 

Valuation considerations

In October 2022 AUTO sold Carzone.ie, their Irish classifieds marketplace. 

AUTO is now 100% focused on the UK as they exited South Africa and the Netherlands in the early 2000s. 

Carzone is Ireland’s #1 car marketplace, with ~35,000 listings and around 1 million monthly visits (~64% share of the 55,000 monthly used car sales in Ireland and >2x the # of visits of the nearest competitor carsireland.ie)

The business generated £4.9m in revenues and £1.3m in op. profit in FY22 (March year-end) representing ca. 1.1% and 0.4% of AUTO’s revenues and op. profits respectively. It had around 558 dealership customers (4% of AUTO’s total) and 4% of the full-time employee base. 

AUTO sold it for £26.1 million (€30 million) in cash. A tiny figure compared to AUTO’s >£5.4bn current market cap. Still, the transaction provides insight into what a private and informed private buyer is willing to pay for a dominant marketplace. 

The price represents ~20x EBIT for a business with 26.5% op. margins (vs. AUTOs 70%) The new owners, Mediahuis Ireland, will be able to consolidate the #1 and #2 marketplaces (they already own carsireland.ie), which should help improve marketing efficiency and margins. 

At a similar multiple, AUTO is worth at least £6.3bn, 17% above current levels. Management has guided for high-single digit ARPR growth in the medium term, in line with what they have delivered since IPO. However, the current share price implies ~3% ARPR growth in the medium to long term. This is too negative in my view. 

From a starting 4.5% FY24 FCF yield, growing ARPR at an undemanding 5% delivers ~5% FCF per 4hare growth. Buybacks and dividends of ~3% of current market cap turn this into ~13% IRR over the medium term. This is decent if not spectacular. A higher ARPR growth, more in line with management guidance of high-single digits in the medium term would increase your potential IRR nicely. A successful integration and scaling of Autorama further improves the return potential, as does a successful rollout of their digital journey strategy. 

For reference, the stock has delivered 13% annualized returns since IPO. 

I believe the absolute downside is limited. A recession is certainly a risk ahead, but for context, AUTOs sales declined only 2% in their 2008/09 fiscal year, a time when they were still undergoing the transition from print to digital. 

Each recession is different and today a larger number of car owners have taken out personal loans to pay for them; penetration of leasing is much higher and the last couple of years have been very strong for used car prices. AUTO believes cars are the last thing people will give up (their data shows that people are looking to own more cars, with demand still very strong for used vehicles and the average price now at £18k). Owners are still sitting on positive equity on their cars so the best they can do is use that to change their vehicles and lock in an attractive monthly payment. A scenario of a spike in repossessions is not their base case. 

Even if the worst came to pass, what may happen is cars (either from forecourts if dealers go bust, or from owners if they fall back on their PCP payments) would be taken off AUTO temporarily, until they find their way back through the wholesale channel into new dealers still in business. The AUTO ad remains a very high ROI proposition for dealers (as % of gross profit on the car sold)

Catalyst

Evidence of Digital Journey delivery; normalization of stock levels on display; normalization of new car sales and acceleration of Autorama's unit sales.