Auto Trader (AUTO) is a high-quality business – and one of the most profitable businesses on the London stock market. This is reflected in the valuation of its shares, but a proven track record of innovation and growth means they remain an attractive long-term investment.
A dominant business
Auto Trader is the UK’s largest automotive marketplace. Having started out as a printed publication in 1977, it is now primarily an internet business.
It dominates the UK automotive advertising market and accounts for over 75 per cent of all the website minutes spent by the users of all automotive classified sites on a monthly basis.
Despite competition from businesses such as GumTree, eBay, Motors, CarGurus and Pistonheads, Auto Trader has been able to successfully defend and enhance its competitive position over the years.
Auto Trader exists to make it easier for people and businesses to buy and sell cars. It offers a range of products and services to help sellers get the best price they can for their stock of cars and to turn them into cash as fast as possible so that they can maximise the returns of their businesses.
Visitors to the autotrader.co.uk website benefit from Auto Trader’s huge amounts of market data, which can help them find the best vehicle at the right price.
They can search from a selection of nearly 445,000 vehicles and obtain useful information on things such as a vehicle’s key characteristics, its location, reviews, vehicle history, used car valuations as well as loans and finance services.
As well as buying vehicles, consumers can also lease them through Auto Trader and build a leasing agreement online.
Auto Trader generates revenue from four main sources:
Fantastic business economics
Auto Trader has achieved its dominant market position by providing better services than its rivals. It is constantly innovating and creating new value-added services to help its customers.
In doing so, it is selling itself as an indispensable partner to automotive retailers that want to grow their profits in a fiercely competitive car market.
The company’s dominance has created a powerful network effect, which means that the more retailers that use Auto Trader, the more other retailers and consumers use it.
Just as with Rightmove in the UK property market, automotive retailers largely accept that if they are going to succeed and grow their businesses, they cannot afford not to advertise on Auto Trader.
When Auto Trader’s large and growing revenues are combined with a high fixed cost base – people and marketing are the biggest costs – then the result is an outstandingly profitable business.
The core Auto Trader business has operating margins of more than 70 per cent. The company as a whole is great at turning its profits into free cash flow, with free cash flow margins of more than 50 per cent while the return on operating capital employed last year was a whopping 165 per cent.
These numbers are the hallmarks of a great business. When they are combined with continued revenue and profit growth, the long-term returns to shareholders have been very good indeed.
Since Auto Trader's shares listed on the stock exchange back in March 2015, they have returned 189 per cent. By comparison, the FTSE All-Share Index has returned 53 per cent. The shares have also outperformed the UK market on a one-, three- and five-year view.
Getting behind the numbers
High levels of profitability and cash generation are highly sought-after by investors. However, it is important to understand how they come about.
Large profits are often a good sign, but sometimes very profitable and dominant businesses can become complacent. They can take their customers for granted and possibly even charge them too much and open the door for competitors in the process.
Auto Trader’s track record in growing revenues from its core retailer customers suggests that it is doing something right.
The company’s revenues are largely determined by a number of factors.
The first is the number of vehicles that are advertised on its website. This has seen a small decline in recent years.
The second is the prices charged to customers. Auto Trader has an annual pricing event for its packages, and has been very successful in raising prices in most years. The exception was during the Covid-19 pandemic when the company gave big temporary discounts to its customers to help them with their finances.
However, if you look at Auto Trader’s average revenue per retailer (ARPR) per month, it has shown impressive growth and has more than doubled in the past decade.
This performance has been helped by the third key revenue generator – the number of value-added products purchased by customers.
Retailers can buy a standard advertising package which includes basic vehicle referencing data and stock management tools that are accessed through a retailer portal.
If they pay more, they can gain more insight into their market by referencing Auto Trader’s vast data resources and tools to help them maximise selling prices and turn their vehicle stock into cash faster.
Value-added services include vehicle condition and specification adjusted valuations, part-exchange valuations, pricing trends for vehicles, competitor stock analysis, vehicle selling days and the performance of advertising analysis.
In recent years, a growing proportion of Auto Trader’s customers have been buying these value-added services, which accounted for 37 per cent of revenues in the first half of its 2023-24 financial year.
Looking at the breakdown of Auto Trader’s growth in its ARPR, over half of the growth since 2015 has come from additional services, with the rest largely explained by price increases.
This is an encouraging sign that Auto Trader is not exploiting its market dominance too much. It is earning more by giving its customers more. Service levels are also kept high by thousands of software updates to the retailer portal every year.
But can Auto Trader keep on growing?
Well placed to thrive in a changing car market
Auto Trader’s competitive position remains very strong. However, its future prosperity is largely dependent on the health of its retailer customer base.
The UK car market is going through a period of change with the ongoing shift to electric vehicles (EVs) and how manufacturers and retailers sell vehicles. This has implications for how much revenue Auto Trader might be able to earn from its customers going forward.
The biggest change is the decision by some car manufacturers to move to an agency or direct selling model in the UK.
Historically, new cars have been sold through franchised dealerships. Here, the dealership buys stock from the manufacturer at a wholesale price, which gives it a fixed margin – the general consensus is that this is around 15 per cent – in relation to the recommended retail price (RRP). This means that the dealer can offer discounts to the RRP – and flex its margins – in order to sell more cars and earn volume bonuses.
Under the agency model, the manufacturer fixes the selling price of a car so that it is the same across all dealers who sell it. The dealer receives and prepares the car and offers customers showrooms and test drives in exchange for a fixed handling fee.
This model appeals to some manufacturers as more car sales are taking place over the internet. Franchised dealers may not be happy as their margins per vehicle could be lower.
With less money in their pockets, there are fears that some franchised dealers will have less to spend with Auto Trader and therefore put pressure on its profits.
This threat is likely to be minimal. Firstly, it only applies to new cars, which currently account for a small part of Auto Trader’s business when fleet sales are taken into account. Also, not all manufacturers are going down the agency route and will stick with the existing system. New cars will still need to be advertised and this is likely to be done through Auto Trader.
A longer-term threat is the hit to franchised dealer servicing revenues from the shift to EVs, which require less servicing.
These developments could actually end up being positive for Auto Trader as franchised dealers will need to place even more focus on used cars in order to make acceptable profits.
New products to continue to drive profits growth
Auto Trader remains very upbeat on its long-term prospects in the UK market. It is confident that it can continue to offer more value-added services to retailers and drive up ARPR.
For example, it is currently piloting a service called Deal Builder, which allows a customer to put together all the parts of a car purchase online. Initial signs are that this is working well with dealer customers and it could add £90-£120 per year to Auto Trader’s ARPR if it is rolled out across its customer base.
Over the next couple of years, the company will continue to see a drag on its earnings from its Autorama leasing business, which is still loss-making and the deferred acquisition costs are expensed against profits.
Autorama will also slightly dilute the company’s profit margins compared with its recent history. The company is targeting margins in the 20-30 per cent range compared with over 70 per cent from the core AutoTrader business. Overall, profit margins are still expected to be 65 per cent by 2026.
There is also likely to be a temporary and mild hit from the introduction of a digital sales tax.
As a result, earning per share (EPS) growth for the year to March 2024 is only expected to be around 5 per cent to 28.5p. It is then expected to pick up to the 12-13 per cent growth level, hitting 36.3p in 2026, according to the consensus forecasts of City analysts.
Are the shares worth buying now?
The shares of very good and growing companies such as Auto Trader deserve to have high stock market valuations. The problem investors face is that the market already knows that it is a good company and has priced the shares accordingly.
Higher interest rates have brought valuations down so that Auto Trader now trades on a one-year forecast price/earnings (PE) ratio of 22.1 times at a share price of 699p. This compares with the five-year average of 24.2 times. The shares have commanded in excess of 30 times forecast earnings during this time.
If the forecast PE multiple stays as it is now, then Auto Trader's shares could be 802p by the end of March next year (22.1 x 36.3p) which would imply an upside of nearly 15 per cent from the current share price. A trough valuation of around 18 times would give a price of 655p, implying downside of 6.2 per cent.
Earnings growth looks as though it has the potential to drive the share price higher, but big gains are unlikely unless profit forecasts increase considerably.
That said, patient investors looking for steady returns should sleep well owning the shares over the next few years.
