The rush by institutions to get set in the Carsales float last week was reminiscent of a Boxing Day crowd in Pitt Street for the Myer sale. An innovative upfront bookbuild structure saw the issue price set and the institutional component fully sold before the prospectus was lodged.

The first significant float attempted this year is off to a flying start.

Strong support for Carsales is no surprise as the institutions clamouring for access to this raising have done well from previous forays in the internet classifieds sector. Claiming a market share of about 60 per cent, Carsales is in the same league in automotive as Seek in employment and REA Group in real estate. Carsales has more than 150,000 cars listed at any time, double the nearest competitor. It also has a commanding position in boat and motorcycle listings.

However, despite investor enthusiasm, premium pricing means that this is no doorbuster special. Under the Carsales offer, shares worth up to $250 million will be sold to institutional and retail investors, with the issue price of $3.50 per share valuing the company at just over $800 million.

This pricing is approaching nose-bleed territory, pitched at a 2010 PE of 22x and 14.5x EBITDA, a premium of about 50 per cent to the current PE multiple for an average industrial company.

There's little question that Carsales deserves a premium to market multiples as internet classifieds continue to be a hot sector. Over the past three years Carsales has recorded annual profit growth of about 70 per cent. Yet, based on the prospectus forecasts, the pace of growth is slowing. The total volume of car advertisements went backwards over the last year, largely attributable to dealers carrying lower new car inventory during the downturn. For the year to 2010 both revenue and profit growth are expected to be about 20 per cent.

A simple rule of thumb for valuing growth stocks is that if the PE ratio is half of the medium-term growth rate, the stock is a bargain. If the PE ratio and the growth rate are in line, like this one, then the stock would be regarded as fairly, but fully, priced.

On this basis investors will see good capital growth from Carsales only if the company can sustain growth at 2010 levels over the medium term. The conventional wisdom is that a continued structural shift towards internet classifieds will take care of this.

A further factor supporting the outlook for Carsales is the so-called virtuous cycle that sees a snowballing of both customers and inventory as the market leading position of a classifieds website becomes more apparent and widely recognised. As a purchaser, why waste time on the No.2 site in the category if almost all of the inventory is available at the leading website? And if virtually all of the eyeballs are being drawn to the leading website there is little incentive for advertisers to go elsewhere.

In an industry where there is little scope for sustained product differentiation other than through the quantity of listings, this dynamic serves to build and protect the market position of the industry leader in every key internet classified category.

The virtuous cycle is all important. As for Seek and REA Group, it is all that stands between the current premium valuation of Carsales and a savagely lower market rating. Without it, competitive forces would put a quick stop to the fast growth and high margins achieved by the industry leaders as there are no other barriers to entry.

And yet the ability of the virtuous cycle to withstand assault from a well-funded and patient competitor is largely untested. Internet classifieds is a young industry and it is only in the past few years that barely profitable niche businesses have transformed into emergent advertising powerhouses. Carsales recorded EBITDA of less than $9 million in 2006 but is set to exceed $55 million in 2010 with an EBITDA margin of about 50 per cent. Continued…