Stockwatch: Rate rise risk for this high-flyer

Despite deflationary signs there are examples of how investors are willing to party on, if with selective partners. I recently drew attention to the high valuation of financial services group Hargreaves Lansdown in the FTSE 100 index, and Mid 250-listed Auto Trader Group is in a similar category.

There is a parallel with property website Rightmove - investors regard them both as growth plays par excellence and have chased them up to price/earnings multiples testing 30 times, despite zilch yields. As online businesses strongly positioned, both these firms are beneficiaries of the UK's low interest rate regime, boosting trading activity in cars and houses, also financial deals encouraging consumers. But to what extent are they cyclical, as and when interest rates rise? The stockmarket really does not want to consider that now.

Fat margins affirm high price/sales ratio

Auto Trader publishes the UK's largest car adverts website with an operating margin around the 60% level and rising. Its stock has been a strong performer since floating last March at 235p, closing up 9% on the day as if investors sensed "the next Rightmove". Auto Trader has kept advancing to breach 340p which capitalises the business at £3.4 billion and represents 13.2 times the last annual sales, although Rightmove trades on a whopping price-to-sales ratio (PSR) of 21.5 times.

Similarly ARM Holdings enjoys a PSR near 18 times based on a 34% gross margin, given its leadership in microchips. At the other end of the scale are supermarket shares on PSR's of just 0.25 as wafer-thin margins make it costly to generate sales. So this ratio is very wide-ranging and although Auto Trader's annual revenue growth is a modest 8%, on a margins basis its stock is not wholly out of line. Yet all this may partly reflect investors' desperate search for growth businesses in a deflationary era; those very few stocks enjoying a big premium.

Certainly, Auto Trader has an attractive business model. With a 38-year history, its magazine of used-car adverts was always a strong cash generator, morphed online with more options to help car retailers and buyers alike. It is the established leader relative to more recent entrants webuyanycar.com and eBay Motors, and Auto Trader's relationships with dealers constitute a high barrier to entry for any other media group.

Looking exposed on a P/E valuation

Projections for a newly-floated business can be sketchy, but assuming the recent consensus for a tripling in profit and earnings (helped by lower debt charges after issuing equity) the 12-month forward P/E is near 28 times. So can the business grow anywhere near that rate, sustainably?

Auto Trader has streamlined by selling overseas businesses to focus on the UK and Ireland, enabling it to benefit more directly from a strong UK car market, boosted by low interest rates and attractive financial packages. 2014 saw new car registrations grow 9% to 2.5 million vehicles in context of 32 million cars in the UK and 9.3 million transactions - strong new car sales fuelling the used-car market on two-three year view. Over 50% of consumers now only visit one forecourt before buying a vehicle, most of their research being done online. So the commercial context is strong; for exactly how long, we shall see. It's not unfair to say a P/E in the high twenties, prices the car market for perfection, but you could say the same of houses i.e. Rightmove.

Regarding the extent debt management will transform earnings, the end-March 2015 balance sheet had borrowings down from £1,107 million to £540.7 million (all non-current) versus £21 million cash. Intangible assets weigh heavily at £330 million while trade receivables/payables roughly balance. The income statement shows net finance costs decimating operating profit, from £133 million to £11 million pre-tax, although flotation proceeds are said to have halved debt and "a new term loan facility at a much lower interest rate has been entered into" - notes to the accounts declaring as an interest charge at LIBOR plus a margin of 1.5% to 3.25%. Quite another case of seeing exactly what pans out.

No effective yield support

Despite operating cash conversion up from 79% to 87% on the year, and an objective for "significant shareholder returns", the high stock price means the prospective yield is only about 0.5%. To offer a modestly meaningful yield of say 3% the dividend would need hiking from about 2p to 10p a share; this enhanced also by special dividends to be genuinely "significant". It isn't an issue while Auto Trader is perceived as a growth play, but if those expectations meet a reality check - prompting momentum traders to dump - then the shareholder base will change. Genuine investors will want to see a meaningful yield, partly to help limit downside risk, hence the stock needs to de-rate to establish this. Same applies to Rightmove which yields just over 1%.

Trade valuation was much lower in 2014

Apax Partners assumed ownership via a 49.9% purchase from Guardian Media Group in 2007, often quoted at a total value of £1.35 billion, although this is the "enterprise value" which includes debt. Apax later bought the remaining 50.1% in early 2014 for about £600 million, with overall enterprise value agreed at £1.75 billion. Barely a year on, a flotation price of 235p valued the equity at £2.35 billion. Admittedly, raising £437 million net has been applied to cut debt which should enhance earning power; but the P/E looks high anyway.

Even so, Exane BNP Paribas targets 375p a share, based on EPS of 14.5p for the year to March 2016 (slightly above consensus) implying they reckon a P/E near 29 times is fair. They justify this due to "structural growth opportunities" resulting from Auto Trader's competitive positioning and operational leverage. Numis Securities has similar profit forecasts as company broker. This is not exactly a spread of opinion though.

A play for long/short traders

How ironic, this most sought-after stock cannot rate "investment grade" since it offers no demonstrable margin of safety at current prices. Momentum traders party on, and, indeed, it is tricky to make a convincing case to short because the business shows no signs of weakening. Yet Hargreaves Lansdown stock plunged from 1,550p to 850p in 2014 despite no adverse news flow, showing how stocks that are fundamentally overvalued become increasingly dictated by sentiment. It will be interesting to see how Auto Trader and Rightmove cope with a higher interest rate environment, the chief risk being if rates rise faster than expected.

For more information see: about-us.autotrader.co.uk/investors.