Companies that dominate their markets are highly sought-after by investors. This is because they often make huge profits that can be relied on year after year and can deliver exceptionally good returns to their owners. Auto Trader (AUTO), the owner and operator of the UK’s largest automotive marketplace, seems to fit this description. But how long can it keep on growing its profits?
The business
If you were going to create the ideal business to invest in then you would probably base it around a product or a service that is very difficult to compete with. One of the best ways to do this is to create something that your customers become reliant on and can’t do without and which increases the more people buy and use it. This is known in financial jargon as a network effect and, as we shall see, Auto Trader is a great example of it.
Auto Trader has been in business since 1977. It started out as a printed publication, but is now an internet business. Most of its revenue is derived from the UK, mainly through its website autotrader.co.uk. It also has a very small business in Ireland.
Auto Trader exists to make it easier for its customers to buy and sell cars. It does so by offering a range of products and services to help sellers get the best price they can for their stock of cars – to maximise their profits – and to turn them into cash as fast as possible. Auto Trader is selling itself as an indispensable partner that its customers must have in order for them to survive and prosper in a fiercely competitive UK car market.
The company earns its money from the following sources:
- Trade customers. This is by far the company’s biggest source of revenue. Its customers are professional retailers who buy and sell vehicles to make a profit. They include franchised dealerships, car supermarkets and independent retailers. Auto Trader makes money from charging them a stock advertising charge on a per-car basis. Retailers with large amounts of stock can get a discount on the standard charge. More money can then be earned by upselling value-added services that help sellers become better engaged with sellers or to source their cars better.
- Home traders. These are smaller buyers and sellers of cars who trade from home. They tend to buy advertising and other products on a pay-as-they-go basis.
- Consumer services. This represents revenue from individuals who advertise their cars on autotrader.co.uk. It also includes income from businesses that provide services to car buyers such as finance, insurance and vehicle checking. These service providers tend to pay Auto Trader a flat rate.
- Manufacturers and display advertising. Revenue from adverts for things such as new cars.
All Auto Trader’s revenue growth has come from its trade customers. Back in 2012, it accounted for 74 per cent of total revenues. Today it is just over 84 per cent as it has grown rapidly whereas revenues from other sources are largely unchanged.
Revenue from car retailers has almost doubled since 2012 despite the number of forecourts trading with Auto Trader staying at around or just above the 13,000 level.
Auto Trader has been very good at squeezing more money out of its customers. This is shown by the impressive growth in the average revenue per retailer (ARPR) per month, which has gone from £996 in 2012 to £1,951 as of September 2019.
This growth in ARPR can be a classic hallmark of business strength and market dominance. It would not have been able to do this if its customers could get the same products and services cheaper elsewhere. In many ways, what Auto Trader has done with its ARPR figures is very similar to what Rightmove (RMV) – another dominant advertising and services business – has done with its estate agency customers.
Shareholders are generally happy when they own a slice of a business that appears to have this type of pricing power. However, they need to be careful that the business concerned is not exploiting its customers and ripping them off.
High prices and big profits will attract the interest of competitors and new industry entrants. Not so long ago, funeral services provider Dignity (DTY) was held up as a business with bulletproof market dominance and an enviable ability to keep increasing its prices every year. It turned out not to be true as competitors entered its market and took a big slice of its fat profit margins by offering customers lower prices.
When you come across a company such as Rightmove or Auto Trader you need to try to find out the source of its revenue per customer growth and try to work out if it is sustainable.
Auto Trader has been quite helpful in this regard by telling readers of its annual report how its change in ARPR from year to year has come about. It breaks the explanation down into three bits: price increases, volume changes (the stock of cars being advertised) and products (are customers buying more valued-added products?).
Good businesses will always be aware of their customers’ ability to pay for their products. Car dealers operate on quite modest gross profit margins (estimated at around 15 per cent by Auto Trader in 2018), which will vary from car to car and even thinner operating margins, which suggests that their ability to cope with higher costs is not that great.
But Auto Trader has always said that it believes it has a big opportunity to make more money as its customers’ advertising costs continue to move from offline to online. It believes that there is enough retailer gross margin or costs to take from other sources and give it to Auto Trader. There is also a strong case for arguing that if retailers look at profit earned per forecourt selling space then spending more money to move stock faster could well be money well spent.
If Auto Trader’s ARPR figures are anything to go by then these claims look reasonable. While there is evidence of significant pricing power, the gains in recent years have also come from selling more products to customers.
Auto Trader is sitting on a very valuable asset. The data and knowledge it has about the UK car market means that it has been able to provide its customers with a range of valuable services better than any of its competitors.
The aim of these products is to help retailers buy and sell cars faster and for better prices. When this is backed by huge levels of customer engagement relative to that offered by its competitors then its offer is very attractive to retailers – why would they go anywhere else? The strength of this data asset has recently been enhanced by the acquisition of KeeResources, which provides software, data and digital services and has expertise in areas such as fleet management.
Valued-added services range from providing local marketplace knowledge on cars, listing cars with finance and monthly costs, text chat, which allows buyers to directly contact the sellers, and more prominent advertising on autotrader.co.uk. More of Auto Trader’s customers are buying these products, with 21 per cent of them taking an advanced or premium product as of September 2019 compared with 15 per cent a year earlier.
The real strength of Auto Trader’s business in recent years is that competition has not taken lots of business away from it. If anything, the evidence suggests that Auto Trader is more than holding its own and is actually getting stronger.
It has by far the strongest brand and offers the highest level of customer engagement, with more than 50m page views per month on autotrader.co.uk and a greater than 75 per cent market share based on website minutes viewed in the UK, according to ComScore (ebay Motors is the next biggest with 11 per cent). As of September 2019, Auto Trader had just over 13,300 forecourts advertising on its website, with an average of 481,000 cars listed per month.
This type of scale and dominance has been hard earned by giving customers what they want over the years. This success has generated more success because Auto Trader has become so entrenched in the ecosystem of the UK car retail market that most retailers cannot afford not to be on the platform (as seems to be the case with Rightmove in property). This is the network effect in action – the more businesses that use Auto Trader, the more useful and valuable it becomes. 80 per cent of UK car retailers are currently using it. This is a formidable economic moat.
Impressive profitability and operational gearing
From a revenue generation point of view, Auto Trader has performed very well. It has arguably done even better when it comes to its profitability and free cash flow generation.
Auto Trader: Key financial performance measures
Year (£m) | 2013 | 2014 | 2015 | 2016 | 2017 | 2018 | 2019 | TTM |
Revenue | 218.9 | 237.7 | 255.9 | 281.6 | 311.4 | 330.1 | 355.1 | 365 |
Op Profit | 105.5 | 121.3 | 138.2 | 168.8 | 202.7 | 221.3 | 242.8 | 254.2 |
Inv Capital | 385.8 | 442.1 | 362 | 367.5 | 337.7 | 365.3 | 386.9 | 432.8 |
FCF | 80.8 | 69.3 | 57.9 | 148.8 | 166.8 | 177.1 | 204.3 | 181 |
Capex | 16.7 | 16.3 | 9.1 | 3.1 | 3.7 | 2.9 | 2.3 | 2.4 |
Profit after tax | 20.3 | 25.3 | 41.2 | 128.6 | 154.7 | 171.1 | 197.7 | 208.3 |
Ratios: | 2013 | 2014 | 2015 | 2016 | 2017 | 2018 | 2019 | TTM |
Op margin | 48.2% | 51.0% | 54.0% | 59.9% | 65.1% | 67.0% | 68.4% | 69.6% |
ROCE | 27.3% | 27.4% | 38.2% | 45.9% | 60.0% | 60.6% | 62.8% | 58.7% |
FCF margin | 36.9% | 29.2% | 22.6% | 52.8% | 53.6% | 53.7% | 57.5% | 49.6% |
FCF conv | 398.0% | 273.9% | 140.5% | 115.7% | 107.8% | 103.5% | 103.3% | 86.9% |
Capex to Sales | 7.6% | 6.9% | 3.6% | 1.1% | 1.2% | 0.9% | 0.6% | 0.7% |
Sources: Annual reports, Investors Chronicle
Back in 2013, Auto Trader was making just over £100m of annual operating profits with an operating margin of 48 per cent. In the 12 months to September 2019 they had increased to £254m, with margins of nearly 70 per cent. Return on capital employed (ROCE) is currently sitting around 60 per cent, with free cash flow margins of nearly 50 per cent. You won’t find many businesses listed on the London Stock Exchange that can churn out numbers like this.
If you take a closer look at the business performance, you cannot help but be impressed by it.
Auto Trader: Revenues, costs and operating profit
Year (£m) | 2013 | 2014 | 2015 | 2016 | 2017 | 2018 | 2019 | TTM |
Revenue | 218.9 | 237.7 | 255.9 | 281.6 | 311.4 | 330.1 | 355.1 | 365 |
Costs: | ||||||||
People | 55.5 | 55.1 | 51.7 | 51.5 | 49.5 | 54.8 | 56.4 | 56.1 |
Marketing | 13.2 | 15.2 | 15.4 | 15.7 | 16 | 16.3 | 17.6 | 17.6 |
Other | 29.5 | 31.3 | 32.2 | 32.5 | 30.7 | 28.7 | 29.4 | 29.4 |
Depreciation & Amortisation | 15.2 | 14.8 | 12.5 | 10.6 | 8 | 9 | 8.9 | 7.7 |
Share based payments | 5.9 | 2.5 | 4.5 | |||||
Total Costs: | 113.4 | 116.4 | 117.7 | 112.8 | 108.7 | 108.8 | 112.3 | 110.8 |
Operating profit | 105.5 | 121.3 | 138.2 | 168.8 | 202.7 | 221.3 | 242.8 | 254.2 |
Changes £m | 2014 | 2015 | 2016 | 2017 | 2018 | 2019 | 2014-TTM | |
Increase in revenue | 18.8 | 18.2 | 25.7 | 29.8 | 18.7 | 25 | 146.1 | |
Increase in costs | 3 | 1.3 | -4.9 | -4.1 | 0.1 | 3.5 | -2.6 | |
Increase in profit | 15.8 | 16.9 | 30.6 | 33.9 | 18.6 | 21.5 | 148.7 |
Sources: Annual report, Investors Chronicle
Auto Trader’s revenue growth has come without any increase in costs since 2013 in as good an example of operational gearing as I have probably ever seen. In fact, annual operating costs were nearly £3m lower in the year to September 2019 than they were in 2013. All the increase in revenue has been added to profits. Staff costs are virtually unchanged as the number of staff has been cut from 1,104 to 798, which has produced a remarkable improvement in revenue per employee.
Depreciation and amortisation expenses have fallen as the group’s self-billing software assets are now fully written off.
Where’s the future profits growth going to come from?
Britain’s new and used car markets are going through a bit of a rough patch. This means that the stock of cars for sale is unlikely to grow much and may actually shrink for a while. This provides a bit of headwind for Auto Trader’s revenues as they are heavily linked to the number of cars being advertised on its website.
Modest price increases are likely, while retailers can avoid these by trading up to more advanced and premium products. Therefore expectations for further increases in ARPR are not unreasonable.
New products and services have the potential to keep the profits moving upwards in the years ahead. Auto Trader has set its sights on the new car market as a source of growth. It reckons that there are around 120,000 new cars at any one time that are hidden from potential customers’ eyes by dealers and that it can help to sell them by putting them on autotrader.co.uk. 30,000 new cars were on the site last year and there is scope for this number to increase. Last year, the company made no revenue from this service as it was trialling it, but it will start charging customers for it in the 2019-20 financial year.
Ultimately, Auto Trader believes that there are many things it can do to generate more revenue from the new car market, but these will take some time to make a meaningful difference to revenues and profits. Examples of potential services include customer deposits, online payments, part exchange prices and vehicle delivery.
The company’s joint venture with Cox Automotive UK – Dealer Auction – is already making a contribution to profits and there is scope for this to grow. This is a platform for retailers to view and buy the vehicle stock of leasing companies and large fleets before the vehicles are de-fleeted. This means that buyers and sellers are able to cut out the auction process these cars usually go through. Sellers will be able to sell their vehicles faster and get better prices for them. Buyers will be able to gain access to stock on a single platform that offers lots of data as well as additional services such as financing and delivery.
Auto Trader forecasts
Year (£m) | 2020 | 2021 | 2022 |
Turnover | 373.5 | 400 | 426.5 |
EBITDA | 270.3 | 292.9 | 313.9 |
EBIT | 261.8 | 284.8 | 306.6 |
Pre-tax profit | 253.2 | 276.4 | 299 |
Post-tax profit | 205.5 | 226.6 | 244.2 |
EPS (p) | 22.2 | 24.9 | 27.6 |
Dividend (p) | 7.3 | 8.2 | 9 |
Capex | 2.8 | 3 | 3.3 |
Free cash flow | 211.6 | 240.7 | 258.8 |
Net borrowing | 290.2 | 252.5 | 211.6 |
Source: SharePad
I think Auto Trader is one of the best businesses I have analysed over the years. Despite a tough UK car market, the company’s business model with the benefit of its huge network effects suggests that it can keep on taking a bigger slice of the UK automotive revenue pie while keeping competitors at bay.
Its profitability and free cash flow (FCF) generation is quite remarkable and will not only help grow the value of the business and buy back shares, but also make it less risky. This is a business that used to be heavily indebted – not a brilliant idea given its huge operational gearing – but net debt to Ebitda should go below one times next year and keep on coming down.
It should come as no surprise that investors will have to pay a high valuation for this business. At 578p, the shares trade on a rolling one-year forecast price/earnings (PE) ratio of 23.7 times, which is not cheap but not desperately expensive for a business of this quality with a reasonable growth outlook.
