We know that many acquisitions fail to deliver value. We understand why Warren Buffett says he’s “much more inclined to cry than to smile” when he reads about one company buying another. But in rare cases – like Carsales’ Trader Interactive deal – acquisitions can be a low risk way to grow when entering a new market.
Cheap borrowing sparked a boom in acquisitions in Australia
Low interest rates, bolstered by government and central bank stimulus, have given companies and investors a way to borrow heaps of cheap money.
This has spurred a boom in acquisitions that’s underpinned the recent rally in the stock market. According to JP Morgan, there have been around 80 acquisitions on the ASX200 this year. At an average of A$1.6bn, the total value of acquisitions is well ahead of recent years.
We did not weep when Carsales bought 49% of Trader Interactive in May
In the main, we agree with Mr Buffett’s view that many acquisitions fail to deliver value. We have a preference for companies that can grow earnings under their own steam – by selling more goods and services, to more customers, year after year. We are sceptical of companies that grow mainly by buying other businesses. Buying a profitable business will increase overall earnings, but often fails to create value for shareholders - especially if the buyer pays too high a price.
But we didn’t feel the prickle of tears when Carsales, a core portfolio company, bought 49% of Trader Interactive for A$800m in May. Trader Interactive owns a number of leading online classified advertising websites in the US. Each website has a specialty, from recreational vehicles (campervans), commercial trucks, powersports (jet skis and snowmobiles), to industrial equipment. This was a sizeable acquisition for Carsales, and we took part in a A$600m equity raising that helped fund the deal.
We support the Trader Interactive deal for four reasons.
First, Carsales has not grown earnings mainly by acquisition. In Australia, its largest market, it has grown the number of customers, and adverts placed - and raised prices – year after year. The company is thoughtful about how it allocates free cash flow. It has sensibly reinvested profits into improving its website, and the value the site delivers to customers.
Category-leading websites have a strong competitive advantage
Second, Carsales knows that the category leader in an online classified advertising business has a strong competitive advantage. Category leaders benefit from a virtuous circle. Customers looking to buy a vehicle visit the leading website because that’s where the most for-sale vehicles are. Buyers get to browse the biggest range of models on the category leader’s site. And sellers want to advertise on the site because that’s where the buyers are.
Competitors have found it very difficult to derail this virtuous circle. And this is part of our investment thesis for Carsales: a strong, durable market position.
Because category leaders are so hard to unseat, it makes sense for Carsales to buy the category leader in a new territory.
Buying the leader is arguably less risky than making a big investment in wooing buyers and sellers to a new site with no track record.
Carsales has a proven track record with category leaders in new territories
Third, Carsales has successfully expanded into new countries by acquiring shares in category leaders. Years ago, Carsales used this playbook to enter South Korea, where it bought into Encar, and Brazil buying into Webmotors. Both territories contribute to Carsales’ profits, and Encar makes up over 15% of its pre-tax earnings.
Fourth, Trader Interactive opens up a new territory for future earnings growth, and extends Carsales’ growth runway. And trading in a new territory diversifies Carsales’ earnings base, making it less reliant on the Australian market.
Many an investment banker is burning the midnight oil right now, looking for acquisitions to pitch to ambitious CEOs. Not all of these acquisitions will create value for shareholders. But sometimes an acquisition is the low risk way to grow a business.