Description

The set-up

A quick brain teaser to start off: you’ve got a subscription platform that historically grew revenues at 29% through adding clients (¼ of growth) and expansion within existing clients (¾). You penetrate ⅔ of the potential client base. What’s more, your clients go into a recession and their addressable spend drops by 12% over 3 years. Yet, the platform grew by 4.5% p. a. in that period. What would you assume will be the growth once the addressable spend rebounds and then grows at a GDP-like pace?

8%? 10%? Maybe mid-teens? (keep in mind that your client growth will be materially lower)

Wrong. The platform will keep growing at the pace of the last 3 years: 4.5%. At least the market thinks so.

That’s the current setup in the shares of CarGurus.

Summary

We believe that shares of CarGurus offer a ~40% upside, realizable over next 1.5 years. Moreover, the shares should compound at high teens over the long-term, as CARG leverages its position in a network effect driven industry to increase its share. A normalized 8% FCFE yield, at least an MSD FCF growth, and active buybacks offer ample downside protection.

CarGurus has been written about on VIC this year already but the focus of the writeup differed from ours. The writeup correctly identified the market’s overblown fears about the acquired CarOffer segments as a contributor to the attractive situation. We think those concerns have largely passed, evidenced by a 20% rise since. 

We still think CARG has considerable room to run due to the market’s simplistic expectations around the performance of the core Marketplace segment. The current opportunity is a result of the last two years of disappointing growth. The market got spooked and the sell-side started doing what it does best: extrapolating recent results forward. Sell-side estimates have the core Marketplace segment growing at ~4.5% CAGR for the next 5 years (guess what was the L3Y CAGR). A reverse DCF valuation (with an 11% discount rate and no value assigned to the CarOffer stake) implies a similar growth pace. Turning the discount rate down to 9% implies a mere 2.5% CAGR.

We think those assumptions will prove to be highly pessimistic. We believe that (i) CARG has a durable competitive advantage that results in higher ROI for dealers, (ii) after the situation on the used car market normalizes, CARG will drive a HSD growth in revenue per dealer from upsell, pricing, and new product adoption.

Note: the forecasted financials in the header include only the fully-owned Marketplace segment.

Business Description

CARG operates two segments: a core marketplace segment and CarOffer, where it has a 51% stake. Our thesis focuses on the marketplace segment. For more information about CarOffer, we invite readers to visit the other 2023 writeup. There is a short note with our opinions on CarOffer at the end of the writeup.

The marketplace is a classified – a platform that connects sellers with buyers without facilitating the transaction. The 24,500 dealers subscribed to the platform list their cars on cargurus.com. On the other side of the marketplace sit car buyers. The website has around 27 million monthly unique visitors. They can view details of each car and an assigned “value rating” ranging from great deal to overpriced. Car buyers submit “leads”, contacting the dealer of their interest. The transaction is then handled outside the platform, in the dealership.

The marketplace makes money from subscriptions (90% of revenue) and advertising (10%). CARG offers a basic subscription tier, 2 premium tiers and a freemium tier. Dealers on freemium get contacted only via an anonymized email. Basic tier subscribers can communicate with buyers via phone, email, and in-built chat application. Premium subscribers can display their dealership branding and their listings get a preferential placement on the website. We estimate that 25% of dealers are currently signed up for the 2 premium plans, up from 17% in 2018. Premium dealerships contribute ~45% of the subscription revenue.

Due to the consolidation of financials with CarOffer, we have to estimate the marketplace financials. We know it made $663mm in LTM revenue at a 90% gross margin. Based on the margin profile pre-CarOffer acquisition, we estimate $185mm in EBITDA (28% EBITDA margin) and ~$145mm of FCF (22% FCF margin at ~80% FCF conversion), with all of it coming to equity.

Industry Description

CARG competes in the car listing platform industry – a part of a broader, $8.6bn, car dealership advertising industry. The listing platform industry is a classic classifieds market. Market players compete to create the largest network connecting buyers to sellers. The industry is strongly consolidated, with only 3 major players: Car Gurus (25% share), Cars.com (24% share), and AutoTrader (21% share). Most car dealerships use two car listings platforms.

The industry grew at 6% CAGR since 2016 and should outpace GDP growth by taking share of dealers’ wallets. Car listings platform has three growth drivers: the GDP-like growth of dealership advertising, digital channels continuing to take share of advertising, and listing platforms gaining share of digital spend. Around 65% of dealers’ spend today goes through digital channels, up from 56% in 2018, and 28% in 2015. Expectations are that the share will reach 75% in 5yrs. If car listings platform keep their share of the digital wallet, they can expect a similar 6% growth in the next 5 years.

Covid impact on the industry

The car listings industry was profoundly affected by Covid. Days on market for cars declined from ~70 to ~25 and gross profit per car shot up by 70%. The situation set off two behavioral changes among dealerships. Firstly, dealerships cut their advertising budgets. The demand overhang meant that marketing was no longer necessary to turn cars over quickly. Aggregate dealership marketing expenditures fell by 11% from $9.2 in 2019 to $8.2bn in 2021 according to NADA. Secondly, dealerships stopped optimizing their advertising stack, adopting an “if it ain’t broken, don’t fix it” mentality, as the money kept rolling in. These developments had an adverse impact on CARG’s growth. The first reduced the TAM. The latter slowed down CARG’s momentum in gaining share of dealers wallets.Dealerships recovered their spend by 5% in 2022 and NADA’s 2023 forecast implies a further 10% increase. Going forward, we underwrite a ~2% annual growth till 2029 vs. 3.5% CAGR from 2011 to 2019.

Investment Thesis

Our thesis is two pronged. 

(i) The two-sided market dynamics endow CARG with a durable advantage that will support a superior ROI and drive a healthy ~LSD growth in subscribing dealership count. 

(ii) CARG will drive a MSD to HSD growth in revenue per subscribing dealer coming from utilizing superior ROI to drive price growth, dealerships continuing to switch to premium plans, and new product adoption.

Thesis I: CARG’s Superior Dealer Proposition is More Durable than the Market Assumes Thanks to the Classified Market Dynamics

Classified industries have a strong tendency to trend towards consolidation (for closest comparison, see the case of the UK AutoTrader). Yet, not once have we seen the sell-side bring up the dynamics within classified industries as a key driver for CARG’s results going forward. However, we think that the US car listing market will be no different and will end up as a “winner-takes-most” situation.

CARG is well-positioned to become that winner. CARG delivers more value to customers resulting in higher customer engagement. The superior proposition to customers results in higher ROI to dealers, with the two naturally strengthening each other. Once dealers restart optimizing their marketing spend, CarGurus will be the main benefactor, seeing healthy dealership adds and stealing share of wallet from other car listing platforms.

Customers searching for cars care about (i) inventory depth and (ii) transparency. CARG delivers on both fronts. It has ~2.7 million U. S. vehicle listings. Compare that to Cars.com and Autotrader, which have 2.2 and 1.9 million, thanks to ~33,600 dealerships enrolled (including freemium dealers) vs. ~19,500 on Cars.com and ~23,800 on Autotrader. Additionally, CARG provides higher transparency with its accurate car ratings. Only ~⅓ of cars listed on CarGurus are assigned a “good” or “great value” rating, following a normal distribution. Compare that to Autotrader and Cars.com where ⅔ of cars earn that distinction. Customer surveys indicate that this is an important differentiator for car shoppers. The advantage seems easily replicable. We disagree. Interviews with former employees at Cars.com revealed that the Company tried changing its ranking mechanism but the change was pushed back by the dealers.

Inventory depth and transparency drive higher customer engagement resulting in more connections made and higher conversion rate. CARG has 60% more visitors to its site than Cars.com and AutoTrader and visitors spend twice as much time on CarGurus website. As a result, CarGurus is 3x more likely to be the last site customers visit before purchase – a proxy for the customers conversion rates.

For the dealers, this means that cars get turned faster on CarGurus. Dealer surveys indicate that the difference in inventory turnover is currently around ~20%. Combined with subscription prices ~15% below competitors, dealers get a ~40% higher ROI on CarGurus. That draws more dealers to the platform, reinforcing the advantage for customers. 

We don’t bet against network effects in classified markets. The self-reinforcing cycle will continue increasing connections for dealers, keeping ROI higher on CARG than on other platforms. We are strongly convinced that the ROI advantage will persist and help drive at least a 2.5% subscribing dealership growth over the next five years vs. ~1% assumed by the market.

Thesis II: Superior ROI Will Drive High Single Digit Revenue per Dealer Growth Once Dealer Spend Comes Back Online

“[increasing prices] has been an exercise that was on pause really for 2.5 years post COVID. We have started to do those again, and in earnest, really at any sort of scale in Q1.” - CARG CEO, 

Pre-Covid, CARG grew average revenue per subscribing dealer (ARPSD) at a 24% 3yr CAGR. We estimate that ~7 ppts. came from upsell (dealers switching to higher cost plans), ~12 ppts. from price increases, and the balance from new products (primarily marketing tool suite). Growth in 2020-2022 slowed down to 5.2%, coming only from upsell and new products. The market is extrapolating a ~3.6% growth going forward. No ARPSD reacceleration in 2022, despite recovering dealership marketing expenditures, solidified the market in its assumptions. 

We believe that CARG will deliver a >8% CAGR in ARPSD over the next 6 years. We believe there is room for >4% growth in pricing, ~3.0% growth via upsell, and a >1% growth through add-on products adoption. We think the market is misinterpreting the 2022 situation. The 2022 pause in price taking as intentional. Dealerships were first ramping up marketing services that they cut back on, not increasing spend on those they kept. Moreover, inventory levels remained depressed. It’s harder to drive higher revenue on a smaller number of listings. Management was aware of this dynamic, and erred on the side of caution to not alleviate the dealers, thus pushing them off the platform and weakening the network effect.

The pricing power remains intact. 2023 is already seeing a pick up in price growth, as CARG starts renewing contracts at higher prices, supported by increasing inventory levels at dealerships. Management has disclosed that it is targeting to raise prices during renewals ~20% of dealerships that have been “dramatically underpaying”. Channel checks indicate that pricing for those dealerships is up by >30%. Other dealerships are up for ~2% price increases at renewals. The renewal process could contribute ~4 ppts. to ARPSD growth in 2023 and 6.5 ppts. in 2024.

After 2024, we think there is room for pricing to run further. Given the current 15% gap in pricing vs. comps, if comps continue to raise prices at 2% a year, CARG could raise prices at ~4.7% in 2025-2028 to close the gap. Our base case sees pricing contributing 3.5 ppts. to ARPSD growth in 2025-2028 after 3.5 ppts. in 2023 and 6 ppts. in 2024. 

ARPSD will grow further through upsell. Dealerships on premium plans contribute 47% of subscription revenue and penetration is steadily rising. We estimate that only 17% of dealerships were on premium plans in 2017. Today, that number is 25%. Growth remained robust even through 2020-2022.

2023 will likely see a slow-down, but dealerships are open to adopting higher tiers in a >12 months horizon. The main consideration are inventory levels, which are starting to improve. Management sounded positive on Q1 call regarding upsell, strengthening our conviction. Assuming that 1.5% of the dealer base subscribes to the premium plans in 2024-2028, penetration would reach 31%. Through conversations with dealerships, we have learned that premium subscriptions cost 2.5-3.0x regular ones. At midpoint, upsell could deliver 3 ppts. to ARPSD.

The last growth vector, additional product adoption, can deliver almost 1 ppt. to the ARPSD growth solely from the Digital Deal with Area Boost add-on. Dealers paying for Digital Deal can pre-finance customers for their cars and sell them additional financing products. The Area Boost component enlarges the radius of customers that dealers can tap into (e. g. the dealership’s cars become visible to customers in a 30 mile radius, instead of a 20 mile radius). According to management, Digital Deal leads deliver 2-5x conversion rates of standard email leads and area boost generates more leads. The strong value proposition has led to rapid adoption. After launching in May 2021, Digital Deal was adopted by 11% of dealerships by Q2’23. The strong adoption prompted management to raise digital deal pricing from ~$250 to ~$500. At these prices, Digital Deal produces a ~8% uplift in revenue per dealer.

At a 55% attach rate by 2028, the product would add 0.8 ppts. to annual ARPSD growth.  And that’s assuming the prices aren’t raised further. Other products for dealerships, such as Lead AI, marketing management tool, and targeted ad buying, can provide additional boost to ARPSD, making us confident in the >1 ppt. of ARPSD growth coming from additional products.

To sum up, the three growth vectors should deliver at least ~7.5% ARPSD growth till 2028 – a fact completely missed by the market due to infatuation with short-term results.

A Short Note on CarOffer

We don’t feel comfortable forecasting CarOffer financials. The segment is more like a startup, competing in a segment disrupting a legacy industry. However, we think that there is a plausible case to be made that it will turn to profitability, which makes us confident that it won’t destroy the value created by the marketplace segment. 

The reasons are that (i) the business model seems fixed and (ii) management seems dedicated to preserving shareholder value. The gross margin has improved from 0% to 5% between Q4’22 and Q1’23. Annualized EBITDA loss was only ~8mm. This was a product of management’s moves to (i) dial back volumes (cut retail-to-dealer volumes by 50%), (ii) introduce better inspection controls, and (iii) increase fees (inspection fees up 50%; transportation fees also increased). We feel confident that CarOffer can turn profitable in the coming years.

If CarOffer achieves profitability, it has the potential to generate significant value for shareholders. The wholesale segment can be especially interesting. Its unit economics are better than the retail-to-dealer segment and it has an inherent distribution advantage: access to dealers enrolled at CarGurus' marketplace. The advantage should allow the segment to grow faster and more profitably than competitors.

If CarOffer doesn’t turn profitable, management seems content to hold it at current volumes, which will not dramatically impact the merits of the investment.

Valuation

We value the Marketplace segment on a stand alone basis, given the uncertainty in predicting CarOffer’s results. We have a 2024 price target, supported by an intrinsic valuation.

Our base case 2023/2024 marketplace revenue forecast is ~$685mm/$745mm at 4% yoy/12% yoy growth rates. Growth in 2023 should accelerate toward the latter half of the year, exiting at $185mm in Q4. 2024 will benefit from a full-year inclusion of renewals at higher prices, upsell momentum returning, and car dealerships that churned during Covid returning to the platform. At 29% EBITDA margin and 81% FCF conversion, the marketplace will generate ~$180mm of FCF in 2024. A 12.0x LTM EV / Marketplace FCF multiple, coupled with ongoing share repurchases, and $300mm in current net cash, yields a $25 price target at ~40% upside and a 22% IRR.

Our BotE long-term forecast yields a high-teens to low-twenties IRR over the next 5yrs: 8.5% FCF yield + 9% growth CAGR + 1.5 % from margin improvement. If you prefer a DCF, our assumptions imply a 30% discount to intrinsic value, assuming an 11% discount rate and a 3% terminal growth rate.

The key longer-term assumptions are that (i) CARG dealership count will return to pre-Covid numbers in the next 3 years, then grow at 2% a year, resulting in a 2.5% CAGR (ii) grows at a 7% CAGR till 2028, and (iii) EBITDA margins improve to 31% from 29% as CARG leverages partly-fixed R&D and G&A expenditures.

We view the assumptions as conservative in light of (i) our conviction that the industry will trend to consolidation, supporting faster dealer growth, (ii) upsell and price-taking have historically delivered low-teens growth, and (iii) operating leverage historically being 2x what we underwrite.

Risks and Mitigants

Management scaling up CarOffer after initially favorable results only for the business to deteriorate once again. 

• Mitigated by higher fees and stricter inspection controls. These should ensure the worst case scenario still results in 0% gross margins.

Underpaying dealerships rejecting renewals at higher prices. There are signs of this already happening, causing a ~1.5% customer base churn. 

• Around 40% of the churned dealers return to the platform in the next quarter. We think it’s likely that, over the long-term, only 20% of the “underpaying dealerships” facing >30% price hikes will stay off the platform due to the ROI difference.

Competitors undercutting prices to close the ROI gap.

• Would require a ~30% price reduction, severely hurting competitors’ profitability

• In the long-term, this is a losing strategy in this business. Lower revenue would translate into lower S&M, hurting competitors’ ability to attract car buyers

Dealership advertising expenditures remain depressed. 

• Our view is that, in the long-term, the world returns to normalcy. The situation with car inventories should be similar and dealers will raise advertising expenditures accordingly.

Catalyst

Earnings - We anticipate material outperformance on revenue growth rates

Divestiture of CarOffer - We think that the market is still, to some degree, preoccupied with the CarOffer segment's results (just listen to the questions analysts asked at Q1/Q2'23 earnings calls). A divestiture would sharpen the focus on the Marketplace segment performance