Carsales' Stratton splutters

Diversification into ‘adjacent areas', as they're sometimes called, carries risk. At its recent annual meeting, management announced that Carsales' core business, ‘Online Advertising', was performing well. Another double-digit increase in revenue is expected in 2017, partly driven by price increases for its dealer customers.

But Carsales' financial services business, Stratton, has hit a pothole. Management announced that first half revenue and profit would be ‘substantially below' the 2016 result.

Carsales acquired a 50.1% stake in Stratton in 2014. It arranges finance for car buyers through a panel of lenders. Apparently the ‘temporary volume capacity reductions' at a major lender experienced late last financial year – see Carsales: Result 2016 – have turned out to be less temporary than expected.

Carsales' disclosure leaves something to be desired but, after some digging, we've pieced together the story. It appears that an unnamed lender on Stratton's panel – one that accounts for an incredible 40% of the loan book – was having ‘some challenges with ASIC'. We've already seen that ASIC is investigating the car finance and insurance market – see Automotive Holdings: Result 2016 – so the industry seems to be experiencing some regulatory turbulence.

Stratton seems to have received volume bonuses for using this particular lender too. So with the lender's volumes being affected by the ASIC investigation, the downturn in Stratton's revenues has been amplified.

Lender bender

Originally management expected volumes to recover in the first quarter of this financial year but that's no longer the case. It now appears that Stratton was too heavily reliant on one lender and our suspicion is that, if ASIC is investigating that lender, those volumes might not return at all.

To keep things in perspective, Carsales owns just 50% of Stratton, the division is small compared to the core Online Advertising business, and there's no suggestion of wrongdoing by Stratton itself. The combined effect is that, while Stratton's 2017 earnings could be 50% below 2016 levels, this will only knock about 3% off forecast earnings per share. We're now expecting around 48 cents this year, placing the stock on a forecast PER of 22.

Normally we'd consider temporary difficulties at a quality business a good reason to upgrade. Presumably, Stratton will be able to redirect its volumes to other lenders in time. But we have other concerns too, some of which were mentioned in Carsales: Result 2016 (since then the share price has fallen 22%).

Gumtree growing

Chief among our concerns is that Carsales' recent earnings growth has been disappointing. What growth has come has been mainly due to imposing price increases on dealers, a strategy which might end up backfiring. Gumtree has also been aggressive in chasing market share, which we think is limiting pricing power in the private listings market. The last time Carsales increased its standard ad price (from $60 to $65) was in December 2013.

We also believe Carsales has been a beneficiary of the strong housing market in the eastern states. Classifieds businesses are cyclical and will suffer in any downturn. In our opinion Carsales has less pricing power than REA Group, and much less international diversification than Seek, yet it trades on similar multiples to those stocks.

Carsales remains a very high quality business. But with a few problems at its finance division and some evidence of rising competition, we're now looking for a higher margin of safety. We'll look to upgrade the stock should it dip below $10.00, as explained in Carsales recommendation guide a few days ago. HOLD.

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