CAR Group: Great company, bad price

On occasion, a ridiculously high purchase price for a given stock will cause a splendid business to become a poor investment – if not permanently, at least for a painfully long period.

                                                                                      Warren Buffett’s 2018 letter to shareholders

In the current market, there are quite a few candidates that you could put in the ‘great company, bad price’ basket.

But I’ll highlight Car Group (ASX: CAR) because it is a really great company trading at what I think is a really bad price for long-term investors to pay.

Let's first look at why it's a great company. Then I'll show you why the current market price is a poor one...

CAR has above-average growth prospects. While already having a dominant position in the Australian market, it recently bought into the US and Brazilian markets where growth prospects are also good. It has a leading position in Korea too.

CAR is one of the largest online marketplaces for vehicle sales (both auto and non-auto) in the world. The beauty of the business is that it is very capital light. The core asset is a technology platform that matches buyers and sellers.

It holds no physical inventory, it doesn’t manufacture anything, nor does it have to worry about logistics or supply chains. It simply takes a fee for the services it provides.

That’s why CAR consistently generated very high returns on equity in its early years. What’s more, it did so using very little debt.

Expensive acquisitions

But that began to change in 2021 with the acquisition of a 51% stake in the US business Trader Interactive. The acquisition came with a near $600 million equity capital raising. Then, in FY23, CAR purchased the remaining stake in Trader Interactive, as well as another 40% stake in the Brazilian operations, Webmotors, taking its stake to 70%.

Those purchases required a $1.670 billion equity capital raising.

So, the company’s total equity capital went from around $300 million at 1 July 2020 to around $3 billion at 31 December.

Equity capital consists of ‘contributed equity’, which comes from things like capital raisings and dividend reinvestment plans, and ‘retained earnings’, which are profits retained by the business for future growth. 

(There is also a ‘reserves’ component which adjusts for things like the impact of foreign exchange movements. But for the purposes of business analysis, you want to focus on contributed equity and retained earnings.)

CAR’s contributed equity increased from around $150 million in July 2020 to $2.455 billion by 31 December 2023. Over the same time, retained earnings increased from around $200 million to $694 million. But all that increase came as a result of an accounting uplift. When CAR increased its stake in Trader Interactive and Webmotors, it paid a higher price than it did previously. The difference between the old and the new price – nearly $500 million – went onto its bottom line in FY23 and into ‘retained earnings’.

So really, all of CAR’s equity capital growth has come from capital raisings to fund acquisitions.

There’s nothing inherently wrong with this. But what you want to see is those acquisitions paying off and generating a good return on the new issued equity.

Here’s where it gets interesting.

Deteriorating profitability

There is no doubt CAR has increased earnings per share (EPS) strongly following these acquisitions.

In FY20, EPS came in around 50 cents. Consensus forecasts for FY24 suggest EPS will be around 85 cents. That’s 70% growth in four years, or about 17.5% per year.

While that looks good on the surface, it conceals a problem.

Here’s another way of looking at it…

In FY20, book value (another term for equity) per share was around $1.20. So the EPS return on book value (effectively, return on equity) was just over 40% (50c/$1.20). That’s a very profitable business.

But by FY24, book value per share had grown to an (estimated) $8.44. The forecast EPS return on book value is, therefore, around 10% (85c/$8.44).

In other words, CAR’s profitability – thanks to these acquisitions – has declined from 40% to 10%.

The underlying business isn't the problem. The reason for the deterioration is that CAR paid a very hefty price for the prospect of long-term growth from the large US and Brazilian markets.

At the time of the acquisitions, they said the valuation was on an EV/EBITDA multiple of around 21 times.

EV is enterprise value, and consists of the debt and equity value of the business. EBITDA is effectively operational earnings. It stands for earnings before interest, tax, depreciation and amortization. Given the lack of tangible assets in the business, depreciation and amortization is a minimal expense. However, interest and taxes are real expenses.

Clearly, it looks like CAR paid a lot for these acquisitions. It no doubt did so in the expectation that in the long term it would pay off. And it could well do so.

But the reality is that profitability has declined massively over the past few years. And while consensus earnings forecasts suggest ROE will get back to around 13% by FY26, it’s still well down on where it was pre-acquisitions.

I want to stress the point that the underlying business is sound. CAR generates revenues and profits using almost no tangible capital. That means most of the profit it throws off is free cashflow, available for dividend payments, growth initiatives or capital management.

But the presence of over $4 billion in intangible assets on the balance sheet (with around $3 billion of that being Goodwill) tells you something. It’s where the purchase price of the US and Brazilian acquisitions reside, where it will remain as a way of measuring future profitability.

So over the past few years, CAR has gone from being a highly profitable business to one somewhat weighed down by inflated purchase prices.

A company with a 40% ROE should trade at a much higher multiple of book value than a company with a ROE of 13%. And while book value is much greater than it was four years ago, that growth has come from new equity raisings, rather than retained earnings.

In fact, CAR doesn’t retain a great deal of its earnings. It pays out 80% of profits as a dividend.(But don't worry, it's a growth company!)

This growth isn’t coming from reinvested earnings. It’s coming from good prospects in new markets…purchased in the past few years for a very full price.

With this in mind, CAR trades at nearly 40 times FY24 forecast earnings, and around 34 times FY25 forecast earnings.

I could be wrong, but to me, this looks like a high price to pay for a company where profitability has been diminished by paying a high price for acquisitions. In Buffett’s words, this could cause a splendid business to become a poor investment for a painfully long period.

This is the type of analysis I undertake for clients in my service, The Fat Tail Investment Advisory. You can try the service by clicking HERE…it comes with a 30-day money-back guarantee.

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