Description

Cars.com (“CARS”) is an undervalued company with several exciting growth opportunities on the horizon after two tough years.  Its subscription-based Dealer Inspire business continues to grow at a robust 20%+ annual rate, the digital marketplace has inflected as its competitive landscape has improved, CARS has launched a compelling OTT product called Fuel and its national advertising business is forecasted to improve to a hsd+ growth rate this year.  Applying a conservative multiple or FCF yield to our 2022 estimates implies a $22 price target, which is more than 65% higher than today’s price.  

Business Description

CARS began publicly trading in May 2017 at $25/share.  The Company was a spin-off of Tegna and the legacy Gannett newspaper assets that sold cars in the classifieds section.  CARS has three business segments: 

1) Digital marketplace.  The Cars.com marketplace is a lead generation source for car buyers to find cars and for dealers to sell cars.  Around 19K dealers list their 4-5M cars for sale and ~20-25M monthly average visitors go to the cars.com website to find cars for sale.  Dealers pay on average $2,000 per month to CARS.  This segment is 70% of revenue, growing at a lsd rate, with 20% EBITDA margins, high incremental margins and is roughly 55-60% of total company EBITDA.  This segment is called “Direct revenue” and also includes the new Fuel product, which sells highly targeted OTT video commercials with ARPD >$10,000/month.  

2) Dealer Inspire.  This business consists of the building and operation of subscription-based, OEM-approved websites for 4,400 dealerships in the US.  This segment is 15% of revenue, growing at a 20%+ rate annually, with 15% EBITDA margins, and is 10% of total company EBITDA.  This piece of business is captured in the “Direct revenue” line, but CARS sporadically discloses enough datapoints to calculate its revenue and EBITDA contribution. 

3) National advertising.  This consists of display advertising on CARS’ marketplace websites as well as search engine optimization (“SEO”) and search engine monetization (“SEM”) programs for dealers, which helps with media spend beyond the CARS platform.  The business serves major OEMs and companies with car-buying related products and services who buy directly from CARS as well as a variety of customers buying programmatically via ad exchanges.  This segment is 15% of revenue, estimated to grow at a low double-digit rate from 2020’s reset level, is very high margin at an estimated 75% EBITDA level, and 30-35% of EBITDA.        

Why It Is Mispriced

Dealer Inspire is a hidden gem 

Prior VIC write-ups emphasized this point when the stock was $8 and it is still true with the stock at $13.  OEMs require their franchised dealers to have a website built and maintained by an approved vendor to standardize website quality.  Dealer Inspire partners with OEMs to design the dealer website template and additional options.  Dealer Inspire and OEMs set dealer pricing which recurs monthly and is frequently included among the many other monthly recurring charges a dealer receives from the OEM.  Dealer Inspire has this “hunting license” for most OEMs and we have heard consistently positive commentary about their product and technology. Average monthly spend of $1,750 is a combination of the website (~$1100-$1300/month) as well as SEM and SEO services sold to dealers that use CARS’ expertise to drive traffic to dealer websites.  Dealer Inspire currently has 4,400 dealer customers, 400 more GM websites ready-to-launch in 2021, and a robust pipeline of other OEM websites.  The addressable market is the 17,000 franchised dealers out there, so there is a significant runway for continued growth.  There are a handful of other competitors, but Dealer Inspire is best-in-class.  

Additionally, the Company has upsell opportunities in this business.  Their Conversations tool is an AI-powered chatbot that adds another $300-$500/month to the ARPD, in addition to the above.  We have heard generally positive commentary about the AI response flows and, funnily enough, that people come into the dealership asking for “Ana,” the chatbot.  Penetration has moved from 25% in 2019 to 27% in 2020.  The Company thinks 35%+ of the dealer base is plausible.  An Online Shopping tool with a monthly cost of $700 has also increased from a penetration rate of 14% in 2019 to 20% in 2020, with the potential to reach 40%+ over time.  Online Shopper enables ecommerce transactions on the dealer websites, with features that allow shoppers to customize vehicles, compare payments, add finance, insurance and aftermarket products, schedule delivery, and check-out online.     

Lastly, Dealer Inspire has a hunting license with all major OEMs except Ford.  Ford and Dealer Inspire signed a digital marketing “endorsed provider” agreement in the 4Q, which may signal a near-term Ford website provider agreement.  Ford has over 3,000 dealerships, so this would be a big win if it happened.  

Dealer Inspire’s implied value is at least ~$4/share, assuming 15% margins as the business grows rapidly.  Note that the Company has suggested that fully scaled margins at Dealer Inspire are in the low 20% level.    

CARS implied valuation excluding DI is well under 7x 2022 EV/EBITDA for a growing business with EBITDA margins greater than 30% and some interesting developments.    

Lead-gen competitive landscape more favorable 

Three large players (CarGurus, Autotrader, and CARS) compete in the lead generation space in auto.  It is frequently a set-it and forget-it arrangement with subscriptions to all three for large

dealers in good times and annual contracts that auto-renew but have no cancellation penalties.  Our calls suggest that pricing and ROI results are usually similar, although CarGurus is a bit lower priced, resulting in a stronger ROI for dealers than CARS.  Autotrader is generally the most expensive with a lower ROI than either CarGurus or CARS, but it is still strong enough that most appear satisfied.       

Prior to two years ago, competition was stiffer.  CarGurus was taking share by undercutting on price.  CarGurus ultimately reached close to full market penetration and so needed to drive growth through pricing instead of volume.  CarGurus raised prices very aggressively, sometimes in a dealer unfriendly way, particularly beginning in 2019.  According to (still-upset) dealers and a former CarGurus’ Dealer Council member that we spoke with, some dealers received letters with as much as 400% price increases with no prior notification and 20 days to pay or be cut off.  Today, dealers say that CarGurus is not far from price parity with CARS.  Notably, despite these aggressive pricing tactics, CarGurus remains #1 in market share, highlighting the necessity of lead gen for dealers. Roughly 80-90% of total auto inventory for sale is listed on CarGurus and 60-70% is listed on CARS and Autotrader.  CARS dealer customer counts have fallen by about 2,600 dealers from 21.5K dealers to 18.9K as CARG market share has grown as illustrated in the chart below.  However, CARS’ dealer counts showed positive growth for the first time in years in December 2019, followed by growth again in March 2020 (at which point covid impacted results).

Three smaller players – TrueCar, CarFax, and Edmunds – also compete in the lead gen space.  Dealers utilize some combination of the three for lead generation but usually as a supplement to the spend on the big three.  TrueCar and Edmunds were not spoken of as well as CarFax.  CarFax is a potential threat and worth watching closely although there is no indication they threaten the CARS improvement story at the moment.  

Additionally, there are a few competitive advantages to CARS’ business model vs. peers.  The CARS domain name, Cars.com, is extremely valuable.  2/3rd+ of traffic is completely organic versus less than 1/4th organic traffic at CarGurus.  CarGurus pays for most of their traffic.  On a per monthly average unique (MAU) metric, both spend $2/person, however, CARS spends $50M per quarter versus CarGurus spend of $80M on similar revenue bases.  As a result, CARS is more profitable/higher margin than CarGurus.  CARS also has excellent content, which is important for SEO.  Our diligence suggests that the CARS marketplace is “the” website consumers go to first to research cars.  This drives customer demand for CARS and ROI because everyone visits this site, and presence on CARS is important for branding.  CARS was an early mover in lead generation (launching in 1998) and is widely regarded as an “of course” site to list dealer inventory.

Marketplace business has inflected in the last six months after two tough years 

Dealer count is an important metric; without a foot in the door, nothing can be sold to a dealer.  CARS faced three challenges in the last two years that impacted dealer count, all of which are now resolved.

#1: 35% of CARS dealers were contracted under an unfavorable affiliate relationship where a sales rep from the legacy Tegna newspaper parent controlled the relationship.  The Company paid to exit these agreements and to take direct control of the dealer customer relationship during 2018/2019.  Sales rep changes are challenging and >20% of affiliate accounts churned on day one.  The Company exited the last affiliate relationship in Q4 2019 and made its last early termination payment in 2Q20.  Affiliate revenue sharing payments, which we believe negatively impacted EBITDA margins by 300-400 bps, have ceased.    

#2: In response to market share losses to CarGurus, the Company embarked on a sales transformation at the end of 2018 with the goal of improving customer service and their sales rep capabilities.  This led to dealer churn in 2019 associated with the sales rep turnover as relationships in this business are important.  About half of the dealer churn in 2019 was the result of affiliate terminations and the other half from the sales rep changes.  Importantly, these efforts started showing improving results shortly after the initial churn and the Company has consistently indicated that retention rates have increased and dealer counts have improved.  Retention rates are currently at an all-time high and CARS has grown dealer counts in four out of the last five quarters.   

#3: Covid has impacted this business significantly.  Lead gen is a set-it-and-forget-it decision in good times but in hard times, dealer marketing spending gets slashed, resulting in lead gen spending cuts.  This was industry wide.  Dealers cut spending or cancelled subscriptions entirely during covid and hundreds of them are still yet to return.  The one quarter with dealer count declines in the last five quarters was covid-related.

Today, the weather is sunnier for CARS.  All three negative drivers have been lapped, setting the stage for strong customer retention and dealer count growth going-forward.  Affiliate payments ended six months ago.  Their “new” sales reps have been in place for over two years now and are doing well – last quarter was the highest dealer retention rate on record at CARS and the Company commented that they added dealers in both January and February.  Additionally, dealer counts immediately post-covid hit an all-time low, so comps ease going-forward.  The Company has commented that they should be able to get back to pre-covid numbers and they will likely grow slowly from there.    

Lead gen spending generally is growing nicely and a rising tide lifts all boats if pricing is rational.  Our diligence suggests that lead gen spending overall grows at the 10%+ rate annually.  The lead gen revenue CAGR from 2015 through 2020 was 8% across CARS, CarGurus, and TrueCar, which includes a covid-depressed 2020 number.  The Borrell Associates growth estimate quoted in CARS’ 10K implies a 9% CAGR through 2023.

Category growth is a result of the following: 

1. Lead gen spend competes with marketing spending where there is zero attributable ROI (i.e. TV, billboard, radio, sponsorship, etc.) versus at least some clear ROI; 

2. Dealers sell more cars when there are more eyeballs on their inventory and lead gen websites have strong network effects;

3. Each marketplace displays cars in a different order, so large dealers want to be represented on as many marketplaces as possible;

4. Dealers get “free” co-op marketing dollars from many OEMs, which are a significant component of their marketing budgets and sometimes are applied to the lead gen vendors for new car marketing.

A rejuvenated CARS combined with healthy category growth sets up well for near-term strength at CARS.  This is apparent when looking at the last two quarters’ results but not yet fully appreciated by the market.  

Fuel is an underappreciated marketing opportunity

Fuel is a targeted OTT video advertising product.  CARS tracks its cars.com visitors (i.e. what they have browsed) and can serve up a targeted video ad to those visitors where it makes sense across the internet (i.e. on a YouTube pre-roll, on another website, on social media, etc).  This offering competes primarily with TV ad spend as it’s effectively a much more targeted TV commercial that viewers are required to watch (viewers cannot skip an OTT ad) and that costs less money.  Fuel pricing is $10K/month with a three-month minimum commitment and is payable through “coopable" dollars. Coopable dollars drive adoption as they must be used or are lost and can be are applied only to specific types of marketing spend, including TV advertising which Fuel seeks to displace.  $10K/month is almost 4x as much as ARPD from the marketplace + DI combined monthly revenue so the opportunity is significant.  Fuel could be a year-round continuous purchase, although it is likely more periodic.  

TV ads are much more expensive typically costing at a minimum $10K/month and are not as targeted.  TV is estimated to be 25% of large franchise auto dealer marketing budgets, so there is a large share of wallet for Fuel to target.  Fuel currently makes sense for 10% of dealerships at CARS today, or 2,000 dealers, with the potential to triple as the Company improves its targeting.  For example, CARS currently can target 2,000 zip codes (one dealer per zip code) but is working on further differentiating buyer preferences within these zip codes (i.e. buyers of luxury versus economy cars) for which it will sell exclusivity.  Assuming a 3-month duration, Fuel is a $60M+ revenue opportunity, and at a 50% EBITDA margin, implies a $30M incremental EBITDA opportunity in the relatively near-term.  Today, based on Company commentary that 65% of ARPD increases in the 4Q came from Fuel, Fuel generates $14-$15M in run-rate revenue and $7-$8M in EBITDA.    

Our diligence work indicates that Fuel is a welcome addition and CARS has cited it as the fastest growing new product in company history.  OTT ad spending is growing at a 25%+ rate per year.  Lithia Motors, which has 180 dealerships, is investing heavily in the product according to our sources.

National advertising improvement 

The national advertising business also suffered in 2019 but the business has stabilized.  Ad agencies forced CARS to shift from selling all their ads directly for a high cost per click to selling some of their ads indirectly using a programmatic exchange for a low cost per click.  For a third of their ad business, CPMs declined from $20-$40 to $2-3 – massive price erosion. Because margins are so high in the national advertising segment, this was also a very substantial hit to EBITDA in 2019.     

The national advertising business has stabilized at around $18-20M/quarter and ad agency growth forecasts for auto ad spending for 2021 are 8-15%.     

Valuation

Our forecast results in a $22 price target using a 10x 2022 EBITDA multiple (using EBITDA ex-SBC).      

CARS has averaged an 11x EBITDA multiple over the last 3 and 5 years and 9x over the last year although the outlook is considerably sunnier than recent history.  EBITDA to FCF conversion has averaged 80% due to low capex needs and limited cash taxes, so a 10x EV/EBITDA multiple implies a 9% FCF yield assumption.  

CarGurus, which is a very comparable company to CARS, is trading at 21x EV/EBITDA and TrueCar at 26x.  While CarGurus is growing somewhat faster this year, CARS has considerably higher EBITDA margins and an 11x multiple gap is illogical.  The TrueCar valuation is even more so as it is expected to decline this year after a big contract loss and has breakeven margins.    

Risks

• Supply chain issues at OEMs continue and dampen advertising spending in 2021

• Lack of used car inventory dampens advertising spending in 2021    

• Google or Amazon enter this market.  Google did launch a small beta program in some markets in November, but this is their third attempt to crack this market and they do not have a dedicated salesforce to easily enable them to grab share

• CarFax steals significant share   

• Difficult traffic comps in 2021 prove indicative of lower leads in 2021.  Management has indicated that the strong traffic numbers in 2020 were due to a “window-shopping” captive audience at home in front of their computers, so the lead comps will be much more favorable than the traffic comps

• Chrome 2022.  Cookie limitations starting in 2022 may inhibit growth from Fuel.  CARS is confident that they can manage around this dynamic

Catalyst

• Continued strength in dealer count, ARPD and revenue 

• Ford agreement announcement 

• Outperformance vs. consensus 

• Consensus upgrade cycle.  In March, an excellent Benchmark analyst upgraded on CARS with an $18 price target.  The other analysts covering the stock reference it as a “show me” story and have not yet given the company credit for its improving dynamics 

• Improvement in relative valuation vs. CARG/TRUE, which are currently trading at 21x and 26x EV/EBITDA

• Continued cash flow generation used to pay down debt.  CARS has averaged $2/share in cash flow generation annually over the last five years

• Take-out potential.  Our sources indicate that CDK offered $28/share to acquire CARS in 2019 and would be more interested in the CARS business today because some overlapping lines of business at CDK have been divested.  We believe Starboard wanted a higher price, scuttling the deal