Following the lead of the S&P/ASX200 (ASX:XJO) (Index:^AXJO), shares in Carsales.Com Ltd (ASX: CAR) have dropped sharply today and are now trading below $10. The shares have been trading in a small range between $9.50 and $10.50 for most of 2015 and show no signs of breaking out any-time soon.
There may be several reasons behind the lack of momentum but the most important is probably the fact Carsales will only produce moderate earnings growth this year while still being valued at a significant premium to the rest of the market.
Carsales is the dominant player in the online automotive advertising market in Australia. While new competitors have entered the market more recently, it still has the competitive advantage of attracting the largest audience of buyers and sellers of motor vehicles.
This advantage has given Carsales great pricing power which has allowed it to achieve a return on equity (ROE) of over 50% for the past four years. Carsales has been a great investment over a long period of time and has provided on average, an annual total shareholder return (dividends + capital gains) of over 20% each year over the last five-year period.
The last six months however, have seen the share price underperform the rest of the market by over 7% and it appears investors have become less optimistic since the half year results were released in February.
Management is anticipating revenue to remain solid throughout the second half of FY15 but net profit after tax (NPAT) will only grow more moderately. With shares trading on a price-to-earnings ratio of around 24, investors may expect more than moderate earnings growth from the company.
The underlying fundamentals for Carsales are strong. It still commands excellent pricing power in its core Australian market, while simultaneously creating a growing footprint in overseas markets. Carsales is targeting growth in Asia and Latin America through its investments in iCarAsia, SkenCarsales and Webmotors.
Although they only make a small overall contribution currently, these investments are growing at double-digit rates and should provide substantial growth over the medium term.
While there is no doubt Carsales.com is a quality business, I am inclined to wait for the full year results to be released before jumping in. Economic conditions can impact consumer car sales and while the recent budget may have improved sentiment, the economy is still patchy.
With such a premium to the rest of the market I would like to see a return to higher earnings growth for this to be justified. With that in mind, I will keep a close eye on Carsales and believe this is a stock that should be on growth investors' watchlists.
