Description

Shares in CarGurus (“CARG”) are dislocated due to a combination of macro headwinds and business model shifts which are affecting near term results. We believe CARG shares were overly penalized due to near term earnings volatility combined with a stock which used to be a darling for growth investors and will likely attract value investors in the near term, but seems to be an orphan stock at present. At current valuation, the market is pricing in an overly bearish set of outcomes. We see over 100% upside over the next 2 years with limited downside.

Background
CARG has been written twice on VIC, the latest was written in January 2021, just days after CARG completed its acquisition of CarOffer – a marketplace that enables dealers to buy and sell vehicles wholesale. This turned out to be a major development for the company, partially responsible for the latest stock dislocation. Please refer to these prior write ups for better background of CarGurus. I’m trying to keep this one short and sweet.

CARG was founded in 2006 in the US with the aim of becoming the largest destination for consumers shopping for 2nd hand cars. Management introduced a proprietary algorithm enabling consumers to get a fair price indication for each car offered, therefore enabling the platform to “score” the fairness of dealers’ offer. The business model was pretty simple - CARG offers a freemium subscription to dealers that need to upgrade to paying status if they want to benefit from all features CARG offers.

Being relatively affordable to other platforms (e.g. Cars.com, AutoTrader) and offering a better consumer experience, CARG quickly disrupted the market to become the #1 platform in the US. From little over 10,000 paying dealers in 2015, CARG has now c. 25k paying dealers with a clear path to 30,000 in the US alone. As the company delivered demonstrable value to dealers, it was able to extract more value from them by consistently raising prices:

The combination of steady increase in paying dealers combined with higher subscription fees led the company to grow massively from less than $100m in sales in 2015 to over $650m in subscription sales projected in 2022. This business exhibits very high gross margins (90%+) and incrementally high margins. Unsurprisingly, EBITDA margins quickly jumped from 0% in 2015 to as high as 34% in 2021, before some issues encountered in 2022 we’ll address below:

The flywheel effects of a marketplace disrupting competitors, exhibiting economies of scale and with a long runway for growth attracted high multiple valuation for the stock. The company went public in late 2017 at c. $30 for a valuation of c. 10x forward sales:

However, since the company closed the CarOffer acquisition in January 2021, the stock halved. While the valuation compression of all growth stocks didn’t help in 2022, the real culprit for the stock performance were Q1 and Q2 2022 results, where the company significantly missed expectations and lowered forward guidance. From April 2022 to date the stock fell nearly 70%:

Understanding CarOffer
Up until 2021, CarGurus had 1 simple business and monetisation model: bring consumer leads to dealers which would ultimately pay CarGurus a monthly subscription fee. This proven and tested model exhibits very high margins and economies of scale. The acquisition of CarOffer introduced a level of complexity that seems to have caught off guard both management and investors. CarOffer enabled CARG to increase its monetisation of the value chain by introducing a transactional model, for both dealers (“Dealer-to-Dealer Wholesale”) as well as retail (“InstantMaxCashOffer”, or “IMCO”):

CARG proven algorithm would define a fair market value of each car (“IMV”) enabling dealers as well as vendors to get cash quotes for the cars to sell and actively bid for 2nd hand cars. The idea seemed a good one as over 90% of 2nd car auctions in the US still occur offline, so the prospects for l.t. Growth seemed very encouraging.

The monetisation model for CarOffer is very different from the listing business and varies whether the client is Wholesale or Retail:
In Wholesale, CARG would charge dealers a buying fee, a selling fee, an inspection fee and a transportation fee. Gross margins per units are targeted in the 30%s
In retail (IMCO), CARG would set a retail price that would enable them to make c. $1k of gross profit per car, or low single digit gross margin:

This business exploded in 2021. In Q1-21 CARG reported $15.6m in sales from CarOffer and zero EBITDA and in Q1-22 it reported $267.3m in sales and over $20m in quarterly EBITDA. The acquisition of CarOffer appeared like a home run.

However, things didn't turn out as expected in 2022 and profitability for this business crumbled:

We’re expecting quarterly sales to fall from $350m in Q2 to little over $100m in Q4 and EBITDA to fall from over $30m in Q4-21 to negative $30m a year later. What happened?
As per CEO comments at Q3-22 results: “These market volume and unit price declines resulted in two disappointing trends: compressed wholesale transaction volumes and sell-through rates within our dealer-to-dealer and Instant Max Cash Offer businesses as well as higher arbitration rates during the third quarter. In addition to these market challenges, we identified operational issues within our CarOffer business, which negatively contributed to an already tough dynamic. Simply put, the processes and operations which worked well in a rising wholesale price environment were not effective enough in a declining price environment”.

In simpler terms, CARG management realized what many before learned the hard way (Zillow, TripAdvisor to name a few): moving from a listing business to a transactional business can be a painful endeavor, especially if market conditions change. CarOffer seems to work very well in an environment where car prices raise but in a falling price environment it doesn’t work well for 2 reasons:
Wholesalers stop buying, expecting further price cuts. This affects revenues with negative operating leverage on CARG fixed cost base
Buyers engage in more arbitration. Arbitration is the process by which CarOffer investigates and resolves claims from buying dealers. In these situations, CarOffer does not control the vehicle and therefore acts as an agent in the transaction. More arbitrations means more transactions being unwound which is like saying that CARG takes more inventory risk, which is obviously a very negative dynamic when prices fall

At a recent Raymond James investor event, the CEO mentioned how CarOffer wasn’t really built for declining prices environments: “The CarOffer business had not built itself during a time of price declines, and so they did not have the right policies in place, the operational rigor, the proper systems, the proper incentives to keep dealer behavior and our operations in check to handle an environment with higher arbitration rates”. The company is prudently taking its time to address the issues and will not exercise its option to buy the outstanding 25% of CarOffer it doesn’t yet own.

We believe that management will either fix the problem or simply move out of the business, not unlike what Zillow did re: home flipping. It either works or it will get quickly wound down. This is a proven and shareholder focus management team.

Valuation considerations
We believe the asymmetry in the investment is very compelling. If CarOffer fails, this is more than priced in the stock. If it gets turned around, the stock is probably worth 2-3x current prices. Downside is limited due to 1) strong cash generation - even in 2022, when the company had to face numerous operational and macro challenges, CARG generated c. $140-150m in FCF for an 8% FCF yield, 2) The company has over $400m in cash, another $400m in liquidity, and no debt outstanding. Cash represents c. 23% of current market capitalization, 3) Valuation downside appears limited at sub 7x current (2023E) EV/EBITDA.

The valuation multiple contracted massively for this business in the last 12 months, from over 5x sales to c. 1x and from 20x+ EBITDA to below 10x:

We set exit EV / EBITDA multiple at 10x, which is likely overly bearish considering the low-capital intensity of the business, its market position and its long runway for growth.
In our base case, we are assuming:
2025 EBITDA margin for marketplace of c. 30%, at the low end of the target range, with LSD top line growth from here
Stabilization of CarOffer business with EBITDA margin in the low teens (was 17% in 2021)
Buyback activity to commence in earnest

Summary Financials and Valuation metrics:

At 10x EV/EBITDA 2025, we see share price in the $30s for 100%+ upside.

Catalyst

Stabilisation of CarOffer

Growth in marketplace

Buybacks