Description

Summary

·         The used car market in general is ripe for digitalization as the process for consumers sucks.  Carvana have started to show in the US that consumers will gravitate towards both buying and selling cars online sight unseen. Thistle produced a great write-up at the end of 2018 on Carvana that was prescient about how the business would evolve: https://valueinvestorsclub.com/idea/CARVANA_CO_CVNA/7557201389#description . I encourage you to read that as well as it discusses the business model and there many things that are applicable to this business.

·         I was unsure about the business model about for a long time. And I don’t invest in companies with management who behave like Carvana so I never really considered being long there and I was actually short at various points which was clearly a mistake.

·         Luckily for me, my conviction is that there is a newly listed European business, at a fraction of the valuation of Carvana, that carries a more compelling business case and a likelihood of structurally higher margins in-time. The stock has declined in a straight line since the IPO pop and now trades below the low end of the initial pricing range.

Auto1 Group is a leading European online used car platform. Auto1 Group started by buying cars from consumer to sell to dealers and are now pivoting to a direct to consumer platform, where they look to both directly buy from and sell to consumers and make a profit from transaction spread and added on services (this is the general direction of the industry). Auto1 have built a very large dealer wholesale business (called AUTO1, sold 2x as many vehicles as Carvana did total via this channel last year, buying cars mostly from consumers but also some from dealers), and are now trying to introduce consumers to the sell-side of this marketplace via the Autohero site (Carvana sold 24x as many retail units as Auto1 in 2020, but they will look to catchup quickly, with the gap closing to around 10x in 2021). Auto1 launched their consumer buying business many years ago, following developments in the UK which had seen the success of WeBuyAnyCar. On both sides of the retail marketplace, Auto1 are a fast follower of proven successes in a different geography (Carvana and WBAC). In the case of WBAC, they were not selling to consumers but rather to BCA, a used car offline marketplace with dominant market share in the UK. In some ways this looks a lot like Auto1 today, who buy 90% of cars from consumers and sell 98% to dealers, but they are pushing hard to change the sell-side of that equation.

 In summary, the core investment thesis:

·         Used car sales carry significant friction and costs for consumers. Consumers also don’t trust the condition of the cars they buy, and so aren’t willing to pay maximum price. People who sell their cars don’t always get the best price, and often face a decent amount of inconvenience.

·         Dealers tend to have limited inventory and geographic reach, as well as inefficient access to consumers

·         Auto1’s solution is to build a consolidated pan-European digital business

·         They interact with dealers and consumers on both sides of their platform, but this is likely to be majority C2C over time.

·         They also aim to refurbish where appropriate to increase resale value, speed, and consumer satisfaction.

·         Their consumer facing business is starting to grow very rapidly

·         Overall group revenue growth is set to accelerate in coming years as this segment matures

·         Company trades at 1.3x forward sales, with likely MSD net margins = around 30x terminal P/E with the potential to 10x or more the sales topline in 10 years

·         In success cases, the earnings power of the company ranges from EUR5-20bln per year at full maturity, compared to the current market cap of around EUR7.5bln.

·         They are currently heavily investing in building out the ecosystem to support this growth with 4x YoY rise in inspected vehicles next year and huge investment in their online B2C presence. As their brand and popularity grows, CAC should moderate.

·         Europe is simultaneously a very large market and a market sufficiently insulated from North America, Asia and Africa to have its own champion.

·         I believe the margin targets set at the time of the IPO were quite conservative, but the stock today does not price those targets or even particularly close to it.

·         Investors underestimate the likelihood that Autohero will succeed – it has huge advantages due to its association with Auto1. They also underestimate how demographic shifts will advantage this business over time with more digital native consumers ageing into the target market.

Business Model

The European used car market ranges between EUR300-600bln per annum (on pure volume basis – this does not include potential add-on services). The original core thesis of Auto1 was to make it easy for consumers to sell into this market and get a good price, while improving the access of dealers who had limited ability to find consumers – consumers generally have to go directly to dealer, brought in by advertising. This core thesis has now transformed into also selling to consumers directly as they believe that they can generate substantial income from added-on services in DTC sales.

Many used cars are not in as good condition as the seller suggests and it is difficult for buyers to ascertain the condition accurately. Buying a used car has traditionally been a risky endeavour for this reason. In a survey by YouGov, 50% of customers said that they were nervous about trips to car dealers, and 50% said that they would pay a premium to avoid this part of the process. Auto1 tries to improve this process by i) knowing the condition before sale through detailed inspection and ii) where needed improving the condition via refurbishment (they currently outsource it mostly but are rapidly moving to build in-house capacity) to give the best experience to the buyer and to obtain the best price. Over time if Auto1 builds a reputation as a trustworthy place to buy a car this will give it a substantial brand advantage. If they do a good job for consumers, then there will be an element of recurring revenue that doesn’t require additional CAC – every 5 years a satisfied customer will come back and sell their existing car to Auto1, and buy another one from them, needing only to pay the net difference between the value of the two cars. It’s critical to satisfy the customer.

It’s key for Auto1 to get the inspection process right and really capture the precise nature of each car it buys so that it can pay the right price and can then in turn provide that information to a buyer, as well as feed their database and optimise their pricing model. If they can do a better job at inspection than a dealer can, then they are going to be able to buy much better than any dealer. Auto1 have an increasingly data driven process. They’ve built their platform to capture all of this information from the inspection and then in turn automate the process of valuation and acquisition as much as possible which gives two advantage – speed and convenience for the seller, and savings on personnel costs. While there are many individual aspects of car condition – mileage, smell, corrosion etc. – cars are fairly universal objects with fairly tight valuation bounds and therefore it is much easier to automatically value a car than say a house. Although to be honest currently it seems the image they present to investors has more automation than the reality based on my work. I think they have some way to go on the pricing model still, and the next gains here will be challenging to achieve.

The European market is highly fragmented in terms of the numbers of dealers (they estimate 200k+ dealers, and for example in Germany the top 10 dealers cover just 8% of B2C transactions, and top 10 dealers across Europe cover just 2% of transactions). In continental Europe there are only 2 listed user car dealerships (both in Scandinavia) whereas there are nearly 10 in the UK and nearly 15 in the US. This lack of competition and fragmentation is a powerful support for the Auto1 thesis.

In Germany, the most mature market B2C, they are currently in the process of building a track record on their own book to start an own-originated consumer finance program – this is the same path Carvana went down a few years ago and it is also being copied by CarMax. It takes a couple of years to complete as you need a fully mature cohort on your own book to start selling them. They also think they have an advantage if a consumer defaults to the point of repossession, as they can simply feed the car back into their ecosystem and sell it on, which is much more efficient than a bank can achieve – most car financing in Europe is currently from regional banks. They believe that over time, they can consistently arbitrage the ABS and car loan markets to generate substantial margin.

Selling or buying a car is generally one of the largest purchases a consumer will make. Therefore, both price and the specific car available will drive the purchase. Branding is unlikely to draw a huge number of customers to buy or sell – the only exception would be if the buyer is concerned about being sold a substandard car and want Auto1 specifically for that reason - but it will probably bring in customers who will look at what’s available and ideally it will eventually make it the first port of call for consumers on both sides of the marketplace - Auto1 could displace classifieds and become the Zillow of used cars in Europe. However, it’s key for Auto1 to be both the low cost provider and to have the widest selection available to actually convert the transaction. Fortunately, scale should be the key driver of both of these factors, and Auto1 is the largest used car platform in Europe. Scale means more cars bought, which means more cars available, which means more cars sold. Scale means a bigger base to spread fixed costs over, a better brand, more supplier power, and more efficient inventory and logistics management. Scale is critical in this business. 

The new Autohero business should grow rapidly. Carvana grew their business initially via their relationship with DriveTime, a dealership group owned by the Garcias. Autohero has an even better partnership – with the Auto1 dealer and consumer sourcing network and their logistics and refurbishment businesses. They have over 400 drop-off points and 150 logistics centres across Europe to supercharge this network, and they are massively investing in their internal capacity with screened plans for 10x on the refurbishment side and logistics plans for 1mln cars. Right now Auto1 can achieve a international transfer for EUR75 which shows their logistics capabilities even at this early stage.

The great thing is that the market is not pricing Autohero at all as a meaningful player in the market, but really they have every advantage in turning this into a dominant DTC business. European auto consumer sell-side is dominated by classifieds, but their businesses are pure online with no logistics, refurbishment or financing capabilities. Investors love these businesses because they have very high quality financial models, which I think is making them complacent about the advantages of Autohero. Classifieds can never vertically integrate, so they can never solve the pain points that make people dislike buying a used car.

Demand is currently offline mostly. But over time, digital native demographics age into the target market, people get more comfortable with online transactions, they see the benefit, the convenience, the trust that can be built in a consumer centric online platform, and over time they gravitate towards the digital model because it’s better. It’s better for the buyer, it’s better for the seller, and it’s a business model that has higher margins and a bigger addressable market. #

Note Auto1 did at time test the African and US markets but withdrew as they felt they could do a better job focusing on the European market specifically. It's unlikely they will ever move beyond Europe except perhaps via acquisition or maybe something like North Africa.

Market size

In their prospectus, they provided estimates for the total addressable user car market, which basically covers the EU, geographically contiguous countries such as Norway, and certain parts of the Balkans and Eastern Europe (they commissioned OC&C for this task, and generally I have found that this report probably plays slightly on the bullish side relative to other sources I reviewed, but not hugely). They found that there were 47mln cars sold in 2019 (they used 2019 due to the covid pandemic affecting 2020), with a total value of EUR600bln. Of this, about 75% went to the end user, of which the vast majority represents consumers. The remainder are for example dealer to dealer sales and intra-corporate sales. Their projections were that this segment is likely to grow around 5% CAGR for the mid-term. This market sizing did not include associated financing, which is a key aspect of their DTC revenue model, and I believe it makes sense to make specific transaction level estimates for this segment.

Moreover they state that online penetration into this market is only around 1% (compared to broader e-commerce penetration of around 15% in Europe - they identify specific categories such as consumer electronics at 37% and apparel at 17% as potential comps. At 20% penetration, there would be EUR130bln in total sales via this channel, not including financing. If Auto1 retained their market share, they would generate >EUR50bln in revenue at these estimates, and likely >EUR10bln in gross profit, depending on their success of getting higher margin financing revenues into the mix. They are the best capitalized platform by some distance in continental Europe, as well as the largest, as so are well placed to re-invest in their business to drive this penetration and achieve this market share. In the case where the online channel became dominant in used cars, you could see this company generating in excess of EUR30bln in gross profit and EUR20bln in net income per year.

Unit economics goals

·         EUR12,500 average sale price

·         Goal for refurb cost is EUR500 over time

·         High teens gross margin on the transaction

·         Additional high margin financing revenues (approx. EUR600 in gross profit per transaction)

·         Gross profit per unit goal of EUR2,300 per car

The key drivers of the bridge from EUR300 (the 2019 level) to EUR2,300 GPU are

·         EUR500 in pricing optimization, (approx. 50% achieved I believe, and still only partially automated)

·         EUR500 in refurb efficiencies as current outsized spend fades and more in brough in-house

·         EUR300 from potential delivery fees – internal merchant transfers cost them EUR75 which is a big advantage vs non-logistic competitor, so potential to sell at very high gross margin for delivery.

·         EUR500 from financing

·         EUR200 from contracts

How much of this is realistic is up for debate but I think most of it is just spreading current costs and investments across a lower base and the bigger question is the attach rates and efficacy of finance and contracts revenue.

In order to achieve the above type of GPU on the loan, Auto1 must essentially originate loans at somewhere like 85-92 cents on the dollar depending on the assumed attach rate, which over a 4 year loan translates to a 200-400bps drop in yield on sale. I think in the long run they can sell these at around a 2% yield on a securitized basis so they will have to originate at 4-6%. This seems very achievable considering where broader used car loans are in Europe (generally 7-8% over this tenor).

Corporate economics goals for 2030 from IPO

·         2-2.5mln cars sold 2030 (although they are soft talking this goal more to like 2027)

·         EUR10k ASP

·         Gross margin low to mid teens

·         Mid to high single digit EBITDA margin

·         = EUR1.5bln EBITDA goal roughly

·         Capex less than EUR100mln

·         = EUR1bln+ FCF attributing full taxation

Valuation & Risk Reward

By 2025 I expect the company to sell in the region of 1.5mln cars. This is more bullish than their official expectations at the time of the IPO, but I think is closer to the real internal expectations of the company based on my conversations with them. As the Autohero business grows as a % of mix, ASP will also grow towards about EUR10k, suggesting in the region of EUR15bln in revenue in 2025 (I can share detailed modelling figures but clearly the direction here is more important than the exact number). This would be about EUR15bln in revenue. At this point I think investors will be highly confident in net margins of 5% or more, and a 30x multiple on terminal net income would lead to a 30+% IRR over the next 5 years. There’s clearly risk on the downside, but I am confident that this will be a profitable endeavour, and at just 1.5x 2021 sales there’s clearly a decent amount of room for margins to disappoint and the stock still to do reasonably well.

The company has expressed a great deal of confidence in selling several million cars per year at around the time frame of a decade from now, a level at which you can make virtually any level of underwriting of unit economics from here and still get a compelling IRR.

Risks

·         Potential VC backed competition

·         Lack of profits, majority of terminal value tied up in new Autohero business

·         Inventory model means liquidity must be carefully managed and exposes potential mark-to-market losses.

·         European market proves to be structurally inferior to US market in C2C, despite superior C2B and B2B and markets and business logic to that effect.

·         Structural change to used car market as EVs rise in terms of percentage of cars sold

·         Long-term car ownership declines due to bikes and public transport

In my view the first 3 risks here are non-issues. Auto1 has so much money and such a dominant position that they will retain their leading position in continental Europe. The second set of 3 risks is just unknowable for me currently although I will watch all these issues over time. I think the potential payoffs are large and make it worth it.

Catalyst

·         Growth accelerates as Autohero ramps up

·         Start originating financing of their own and show good attach rates and early profits