Description

Executive Summary

Business Description

CarGurus is a leading online automotive marketplace that connects buyers and sellers of new and used cars. It is the largest automotive marketplace in the United States, based on the platform’s number of paying dealers 23,659, monthly unique users 38,655,000 and fleet of inventory selection 5.5Mn listings. The company also operates under the CarGurus brand in Canada and the United Kingdom. Since 2015, CarGurus has steadily grown its market share in terms of the number of paying dealers on its platform and has experienced a CAGR of 17% and 188% in its US and international markets, respectively. This growth has also been accompanied by increasing profitability with the company earning a 22% 4-year average ROE, in accordance with recent 2020 year-end guidance profitability figures. CarGurus currently trades on the NASDAQ for $31.85 per share and has a market capitalization of $3.71Bn.

Thesis

CarGurus presents an opportunity to invest in an increasingly profitable company that is gaining market share in a growing, long-term market. Competition amongst online automotive marketplaces is strong, but CarGurus has differentiated itself. Its differentiation stems from the transparency and objectivity of its deal ratings, and from the relevancy of search results to customer search criteria as well as from its subscriber pricing strategy.

Dealers are offered unrivalled access to a massive ready-to-buy audience, and consumers are sure to be treated fairly. This has created the foundation for powerful network effects that the company currently enjoys, and that cannot be easily replicated by competitors. Its business is analogous to a flywheel: as more dealers find their way onto the platform, the greater the value proposition becomes to the consumer, which in turn generates more leads for dealers and enhances their ROI, and encourages more dealers to join the platform, and the cycle continues.

Risks

There are three major risks to consider: (1) inability to recuperate recently cancelled dealer subscribers, (2) their expansion into international marketplaces face intense competition, and (3) synergies between CarOffer and CarGurus may not be realizable.

Valuation

Based on the calculated intrinsic value of the company, CarGurus currently offers returns of at least ~20% in the market today.

Business Description

CarGurus is a global automotive marketplace that connects buyers and sellers of new and used cars. It boasts 46,439,000 monthly unique site users and 30,162 paying dealers worldwide. This compares to their US peers of Cars.com’s 25,349,000 monthly unique users and 18,130 paying dealers, and TrueCar’s 9,505,721 monthly unique users and 14,603 paying dealers. Based on an estimate of 43,000 dealerships in the U.S. by Borrell Associates in 2017[1] CarGurus currently possesses a 70% market share. This is a marked improvement over the estimated 28% that the company held back in 2015. In addition to rapidly capturing paying dealer market share, CarGurus has managed to grow their revenue per subscribing dealer at a CAGR of 10% for the period of 2015 to Q1 2020. The growth in both the company’s subscriber base and revenue per subscriber yields a CAGR of 41% and 103% for revenue and operating income, respectively since 2015 and in accordance with 2020 year-end guidance. Finally, this growth has been accompanied by increasing profitability with the company earning a 22% 4-year average ROE, in accordance with recent 2020 year-end guidance profitability figures.

The company was founded in 2006 by Langley Steinert, the company’s current CEO and Chairman. CarGurus began as an automotive internet blog where consumers could post dealer reviews and inquiries for all things related to cars and car shops. Dealers saw a growing opportunity to buy advertisements on the blog and from there the company pivoted its strategy to connect buyers and dealers through inventory listings. The company underwent an IPO on October 12^th, 2017 at $16 per share.

Business Model

CarGurus’ business model can be summed up as trying to capture as much business from commerce surrounding automotive dealerships profitably possible. The company’s objective is to create the most transparent and trusted automotive marketplace for the consumer. CarGurus achieves transparency by sorting search results based on deal competitiveness, which gives consumers confidence that they are being shown the most relevant search results to their needs. The company also empowers consumers to rate dealerships based on their own experiences. In addition, CarGurus encourages trust in its consumer base through the objectivity of its deal ratings. For example, on CarGurus Great and Good deals comprise only 5% and 15% of total offerings, respectively, whereas on competitor platforms Great and Good deals comprise 20% and 20%-50% of total offerings, respectively[2]. The wide rating distribution for Great and Good deals on competitor platforms infers a lack of objectivity in appraisals.

Another way in which CarGurus differentiates itself is in the optimization of its search strategy. 70% of all search activity is found in the long tail,’ which is where the company places emphasis. Effectively, this means that the company is focused on providing search results that are more relevant to specific search criteria (i.e., 2015 black Honda Accord Aurora Ontario rather than a more generic search for a black Honda Accord) [3].  As a result of their superior offerings, CarGurus has established the largest ready-to-buy consumer audience of any online automotive marketplace in the U.S. and this produces powerful network effects for dealers.

Dealership economics depend on sales volume, gross margin and customer acquisition costs. By providing dealerships with the largest ready-to-buy consumer audience, the highest closing rate for listed inventory, and fair gross profits the company offers a deep value proposition for dealerships[4]. Also, CarGurus operates a freemium pricing strategy where dealers can list their inventory for free and receive anonymized emails from interested customers or pay a subscription fee for access to interested customer contact information and the ability to list the dealership’s own contact information, amongst other features. In addition to the marketplace subscription revenue, the company also generates revenue from auto manufacturers and auto-related brand advertisers. This business model has generated the greatest online selection of new and used vehicle listings with approximately 5.5Mn listings, and the greatest number of unique monthly users 23,659 in the US[5].

Strategic Initiatives and COVID19 Impact

In accordance with their strategic initiative to scale the business internationally, on January 8^th, 2019 CarGurus acquired the online marketplace PistonHeads to establish a foothold in the United Kingdom and compete with the incumbent Auto Trader. At the time of the acquisition, PistonHeads was a 5Mn unique visitor platform with a focus on performance cars and a good reputation amongst dealers. In addition, to further drive customer traffic in the US and aid in generating customer-dealer connections CarGurus purchased Autolist on January 16^th, 2020.

CarGurus market share has rescinded from its peak of 84% in 2019 due to dealer subscription cancellations in response to the COVID-19 pandemic induced turmoil. The pandemic materially impacted the company’s sales figures in the first half of 2020 but has not materially impacted the second half of the year’s figures, as per their latest quarterly filing. In response to the material top-line impact, CarGurus reduced their workforce on April 13^th, 2020 by 13% resulting in a $3,248,000 restructuring charge for severance and a $1,019,000 write-off of capitalized we development costs for international marketplaces. Top-line figures effectively returned to normalcy in the third quarter of 2020, thus leaving the company in a much leaner position to close out the year than it had when the year began.

While the pandemic dampened 2020 first-half sales it has also expedited the process shifting automotive dealership commerce online. With mandated manufacturing shutdowns, a closing of wholesale auctions and an increased consumer demand as a result of moving away from cities and reluctance to use public transportation dealership inventory was incredibly volatile throughout 2020. Historically, sourcing dealership inventory has always been a major pain point within the industry, but this perfect storm created a massive need to shift wholesale vehicle sales online.

At the end of 2020, CarGurus announced its intent to acquire a controlling stake in CarOffer – a marketplace that enables dealers to buy and sell vehicles wholesale, by aggregating buyer interests and matching it with seller interest from thousands of dealers across the country without the burden of timed auctions. CarGurus believes that CarOffer will further deepen their value proposition to dealerships and enable them to participate in the wholesale transaction market. The company also believes that its retail data will be incredibly valuable in wholesale transactions.

On January 14^th, 2021 CarGurus announced it had completed the acquisition of CarOffer at an EV of $275Mn. CarGurus acquired a 51% interest in the company in exchange for $70,125,000 in cash and $70,125,000 in class A common stock. The number of shares of Class A common stock issued to complete this transaction was 3,115,282 in accordance with a $22.51 per share value. CarGurus also retains the right to purchase the remaining equity in CarOffer over the next couple of years.

In addition to the shares and cash paid to acquire CarOffer, CarGurus also established a retention pool in the aggregate amount of $8,000,000 in the form of restricted stock units. $6,000,000 of which was earmarked for certain CarOffer employees following the close of the acquisition, and $2,000,000 of which was earmarked for issuance to future CarOffer employees. Given the lack of disclosure around the conversion of these RSUs to Class A common stock, they were not reflected in the diluted share count and were thus considered to be debt that the company will have to pay off in the future. If the number of RSUs that were to be issued upon the consummation of the acquisition had been disclosed, they would’ve contributed to the diluted share count.

CarOffer presents a significant growth opportunity for CarGurus. Since its inception, CarOffer has experienced a surge in the gross volume of sales transacted over its platform from $42Mm in 2019 to over $350Mn today. CarGurus estimates the North American wholesale total addressable revenue opportunity to be between $7Bn and $8Bn annually[6]. This is a based on CarOffer’s transaction fee-based model, which currently charges both parties a $275 fee for a successful transaction, and an estimated 11Mn to 12Mn cars sold wholesale per year. This seems to be a reasonable approximation given that the National Auto Auction Association claims that its member auctions generate over $107Bn in wholesale revenue annually[7].

Competitive Landscape

Current competitors like Cars.com and Auto Trader were founded by print media companies to combat their eroding classified advertising businesses, and to take advantage of internet growth. These early players effectively produced a carbon copy of their traditional pay-for-placement business model and put it on the internet. This pay-for-placement model ranks search results based on the amount the dealer pays, which forces dealers to aggressively bid for placement in the first few pages of the search results as it is more likely to convert into sales. This, however, inhibits the retail consumer experience by 1) limiting the selection of inventory by disenfranchising smaller players who cannot compete in bidding wars, 2) eliminating transparency on both prices and dealership reviews as these marketplaces have a conflict of interest in criticizing their paying dealers, and 3) search results lacking relevancy to the consumer who is seeking the best deal, and not the highest bidder.

 

CarGurus’ model is not easily replicable by competitors, and there is evidence that it is in fact becoming more difficult to replicate over time. High switching costs exist for companies operating a pay-for-placement model like Cars.com and Auto Trader or operating a successful transaction fee model like TrueCar[1] [2]. Swapping to a freemium business model would be painful as these businesses would have to start giving away leads to incentivize new dealers to join their platform, which would alienate their largest customers who pay dearly for those leads. Although these businesses are in a tough position as they are experiencing declining customer dealer numbers and stagnating average revenue per dealer figures, they are also experiencing improving unique monthly user data. This implies that their placement leads are in fact becoming more valuable to the highest bidder as their sites are drawing more attention. Therefore, it might be suggested that over time these businesses will continue to distance themselves from the network effects currently being enjoyed by CarGurus, as they offer less transparency and relevancy to consumers.

 

CarGurus’ competitive advantage is highlighted by the aforementioned network effects that it currently enjoys, which seem to only grow more powerful with time. The company also benefits from incumbent competitors that are stuck in their ways and are incredibly unlikely to move away from their current business models. These sustained network effects enable CarGurus to continue to gobble up market share, and their recent purchase of CarOffer should deepen their value proposition to dealers as their retail data is leveraged in the wholesale market.

 

Financial Snapshot

The numbers below are presented in thousands, except for share count and per share numbers.

 

 

Although the top line of the business has been impacted as of late by COVID, since having gone public CarGurus has improved its business by practically every metric (subscriber dealers, monthly active users, average annual revenue per subscriber, ROE and profitability). It has a strong balance sheet as illustrated below, but as highlighted below it has a substantial cash position that could be put to more effective use.

 

 

The company has also displayed decent ROIC numbers since having gone public as displayed below.

 

Management and Shareholder Alignment

Almost all of CEO Langley Steinert’s compensation is comprised of equity compensation in the form of RSUs. In 2019, 98% of the CEO’s compensation was in the form of RSUs[1]. The company’s long-term incentive compensation is predominantly comprised of RSUs with a time-based vesting requirement of four years to be settled in Class A common stock.

 

The company also offers management cash invective awards based on business performance goals and individual performance goals. Management could be better aligned with shareholder interests through the use of share awards tied to distinct performance goals instead of time-based vesting awards.

 

A snapshot of major investors and their respective ownership shares can be found in the appendix. CarGurus founder and CEO, Langley Steinert effectively controls the direction of the company via his ownership of Common B shares, which enjoy a 10 to 1 voting ratio compared to the Common A shares. Insiders collectively own 7.8% of the Common A shares outstanding, but 71.1% of the voting rights.

 

Investment Thesis

CarGurus presents an opportunity to invest in an increasingly profitable company that is gaining market share in a growing, long-term market. Competition amongst online automotive marketplaces is strong, but CarGurus has differentiated itself. Its differentiation stems from the transparency and objectivity of its deal ratings, and from the relevancy of search results to customer search criteria as well as in its subscriber pricing strategy. Dealers are offered unrivalled access to a massive ready-to-buy audience, and consumers are sure to be treated fairly. This lays the foundation for powerful network effects that cannot be easily replicated by competitors. Its competitive advantage is analogous to a flywheel: as more dealers find their way onto the platform, the greater the value proposition becomes to the consumer, which in turn generates more leads for dealers and enhances their ROI, and encourages more dealers to join the platform, and the cycle continues.

 

In the short term, there is a strong likelihood that a prolonged pandemic will benefit the company further. Currently, the company is leaner in its operations after reducing its workforce by 13% in April 2020, and the pandemic will only continue to benefit the company[2]. For example, in 2019 the company began allowing eligible consumers to pre-qualify for financing, which is a significant value add to dealerships as it further lowers the customer acquisition costs of doing business[3]. Their recent purchase of CarOffer, which closed on January 14^th of 2021, is a bet that the automotive industry will only further shift online for all players in the market.

 

In the mid-to-long-term, there are still a great many prospects for the company’s continued growth including, but not limited to: (1) further expanding operations internationally, (2) breaking into the automotive insurance business, (3) continued growth with online wholesale auctions, (4) pricing power as evidence by the company’s growing average annual revenue per dealer, and (5) a digital peer-to-peer marketplace.

 

Key Risk

Inability to recover cancelled subscriber dealers

In the first two quarters of 2020, CarGurus experienced a significant decline in subscriber dealer numbers by ~5,331 in response to dealerships being squeezed during the fallout of the pandemic. Although the company believes it has stymied the cancellations there is no guarantee that those dealerships will come back to the platform, and this would represent a significant loss in revenue. The company has noted that it is seeing advertising budgets of dealerships on the rise again, but it will take time before those dealer subscription number fully recover.

 

Stunted growth abroad

In 2019, CarGurus purchased PistonHeads as a means of expanding its operations to the United Kingdom. The online automotive marketplace there is relatively monopolistic as Auto Trader dominates the space. There is a risk that the acquisition will not pan out in CarGurus favour as it faces serious competition from domestic incumbents.

 

The company had to offer their services for free during the fallout of the pandemic in the U.K. in the months of April and May and were forced to do so yet again in the third quarter of 2020. In addition, the company has ceased its operations in the Italian, German and Spanish markets. International success is not guaranteed.

 

Wrong about CarOffer

The company paid what appears to be a fair price for the wholesale auction marketplace CarOffer, and the company is assuming that the two operations will yield significant synergies. There is no guarantee that the acquisition will pan out as expected, and the synergies generated could fall short of expectations.

 

Valuation

The post-merger value of CarGurus was determined by combining the pre-merger values of both CarGurus and CarOffer. The pre-merger value of CarGurus was modelled using a DCF analysis on the company’s FCFF using short- and long-term growth rates of 18% and 2.5%, respectively. Given that the company is currently experiencing a CAGR of 41% and 103% for revenue and operating income, respectively, and a 22% 4-year average ROE this short-term growth rate seemed reasonable. To double-check this assumption, a what-if analysis was performed in Excel using the company’s pre-merger market cap and share count to back into the market’s assumed growth rate. This produced a short-term growth rate of 17% and justifies the original assumption. A standard 9% discount rate was used, and an enterprise value of $2.88Bn was determined for the pre-merger value of CarGurus.

 

The pre-merger value of CarOffer was appraised in a similar manner, but it is more susceptible to assumptions owing to the fact that its financials are largely undisclosed. CarGurus did disclose, however, that CarOffer operates a transaction-based model, and that the company has seen a gross transaction volume (GTV) of $518Mn on their platform over the first three quarters of 2020. It should be highlighted that GTV has grown from $42Mn in the fourth quarter of 2019 to $353Mn in the third quarter of 2020. Extrapolating this growth yields $1Bn in GTV for 2020. This number represents the value of all vehicles that exchanged hands over the platform.

 

CarOffer’s revenues are a function of the number of transactions that occur through its marketplace. These figures have not been disclosed, but a take-rate of GTV can be assumed. For comparison sake, in 2020 companies like Etsy and eBay displayed take-rates between 8.5% and 16.5% of the GTV on their own marketplaces, respectively. To be conservative a take-rate of 12% of GTV was assumed for CarOffer resulting in an estimated $120,000,000 in revenue for the company. This figure, in accordance with the purchase enterprise value of $275Mn for CarOffer, yields an EV/Sales multiple of 2.29x. This is reasonable when the EV/Sales multiples being applied to comparable firms are taken into consideration (refer to the table below).

 

For simplicity sake, CarGurus’ FCFF/Sales multiple was then applied to CarOffer to produce a FCFF estimate for the company. The intrinsic value of CarOffer was then determined under different growth scenarios using H-models. This model as well as the calculations of the company’s implied enterprise values under different growth scenarios are displayed in the appendix. These implied values were then combined with CarGurus’ aforementioned implied enterprise value to determine the value of the combined entity.

 

 

At the current $31.85 per share market price, CarGurus presents an opportunity for 20%-30% returns based on the calculated intrinsic share values above. However, owing to the fact that CarOffer’s intrinsic value is highly susceptible to model assumptions, a second analysis was produced to verify the calculated share prices above.

 

Instead of assuming a take rate, the number of transactions that occur over the platform can be estimated. First, by taking a fraction (~85%) of the average retail price of a used car in 2020 as reported by the NADA[1] we assume that the average wholesale price of a used car in 2020 is $18,029. Dividing the projected $1Bn in GTV by the average wholesale price of a used vehicle produces an estimate for the number of transactions on the platform ~55,468. Finally, applying a $275 transaction fee to both parties of each transaction yields an estimate of $30,507,252 in revenue for CarOffer in 2020 (see appendix). However, this figure doesn’t consider the potential synergies that exist between the two companies. Therefore, adjusting this figure for the number of dealers that CarGurus intends to bring onto the CarOffer platform produces a revised revenue estimate of $319,215,686 (see appendix).

 

Again, for simplicity sake, CarGurus’ FCFF/Sales multiple was applied to CarOffer to produce a FCFF estimate for the company. The intrinsic value of CarOffer was then determined under different growth scenarios using H-models (see appendix). These implied values were then combined with CarGurus’ aforementioned implied enterprise value to determine the value of the combined entity.

 

 

 

This second set of calculations requires more assumptions than the first appraisal, and thus should be considered only to support the previous conclusion that based on the current share price of $31.85, CarGurus is currently underpriced in the market today. This range for the combined entity’s intrinsic value implies an opportunity to make a return of at least 88% in the market today.

Catalyst

CarGurus purchase of CarOffer