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.

Last update: 08/10/2021 | By Ian Pierce, Analyst, Motley Fool UK.

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, autotrader.co.uk 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, 7X larger than that of the closest competitor, 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 four years from fiscal year 2017 to 2020 the company notched a stable growth in sales and improved operating profits as operating margins increased to an incredible 69%. 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 but dropped to 32.7 million in mid-2021. 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 over 2,000 retailers (100% increase in FY2021) paying for its new car product – a market that should grow over time as Auto Trader invests in building awareness of its 47,000 new-car listings. Marketing budgets spent by the likes of BMW, Mercedes and Ford on advertising new cars represent a massive potential market for Auto Trader, and management sees high potential to move into this sector in the years ahead.

The pandemic has led to an acceleration in online buying behaviours across all industries, and automotive is no exception. Auto Trader aims to change how the UK shops for cars by providing the best online car buying experience, enabling all retailers to sell online. The large volume of data and the insight derived from it enhance consumers’ search experience. Auto Trader research shows that 61% of consumers think buying online is more appealing. Consumers start to believe that online model will make comparing cars easier, avoid haggling and help in the research and understanding of ancillary products.

Management believes that a seamless blend of online and offline experience is what tomorrow’s consumers demand. In response to lockdown, Auto Trader launched click and collect or home delivery service. They also offered Guaranteed Part-Exchange (GPX) product that provides greater certainty on the value of their existing car and the avoidance of haggling. They have recently launched a new product, Market Extension, that allows retailers to sell outside their local area, a key product for the increasing number of retailers looking to sell online.

Market research shows that electric vehicles (EV) sales set to overtake internal combustion engines by 2025. Auto Trader has implemented new search filters for electric vehicles including battery range and charge time to unlock valuable opportunities in EV. They will continue to deliver new features to improve price transparency on their platform to build trust for consumers.

Financials and valuation

Source: Auto Trader.

As you can see, revenues have risen considerably from 2017 to 2020, and operating margins have continued to climb to an astonishingly high level of 69% in 2020. However, revenue generated in FY 2021 was significantly impacted since they offered free advertising to retailers through four months of the year and provided a 25% discount in June as they reopened from the first lockdown. Operating profit also decreased by 38% and profit margins shrank to 61%. In the year ahead, management expects to deliver revenue and operating profit margins more or less in line with FY 2020 levels.

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. (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. Despite the challenging FY 2021, the board managed to increase dividend to 5 pence per share (FY2020: 2.4 pence per share).

The balance sheet is healthy as the company has completed 5% of equity financing at 400 pence to raise £182.9m net of fees incurred on 3 April 2020. As of 31 March 2021, the Group had net cash of £10.3m (31 March 2020: net debt of £282.4m). Leverage, defined as the ratio of net bank debt to EBITDA, decreased to zero (2020: 1.0x).

The board resumes its prior capital allocation policy which was suspended for a year due to COVID-19. Auto Trader will continue to invest in the business enabling it to grow whilst returning around one-third of net income to shareholders in the form of dividends. Having reduced its debt position, any surplus cash following these activities will be used to continue the share buyback programme.

On 31 July 2020, the Group acquired AutoConvert (legally named BlueOwl Network Limited) for the consideration of £18.2m. AutoConvert is a finance, insurance and compliance software platform with integrated customer relationship management systems for the automotive sector.

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.

Although COVID-19 is currently having little impact on the operational performance for new fiscal year, as seen in other countries, we cannot yet be sure that COVID-19 will not reappear as a significant negative factor in Auto’s future financial performance.

There have been significant declines in new and used car markets since Mar 2021 as a result of lockdown restrictions. The semiconductor issues will continue to impact the new supply of new cars, Electric Vehicles in particular. In fact, the average time the British hold their car increases from 3.5 years to 4.2 years that Auto’s top line will be negatively affected by reduced number of transactions.

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To your investing,

Ian Pierce, Analyst
Motley Fool UK.

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Footnotes:

This report was last updated on 08/10/2021 by Hayes Chan, CFA.

Disclosure: Hayes Chan, CFA, Ian Pierce and The Motley Fool UK don’t own any of the shares mentioned. The Motley Fool UK has recommended Auto Trader and Rightmove shares.