Description

Situation Background:

Cars.com ("CARS") is one of the leading digital marketplaces for buying and selling cars (~82% used / ~18% new).

CARS is a high-margin internet asset that should experience secular growth as dealer advertising budgets shift to digital.  Revenues are generated primarily by subscription advertising revenues from approximately 21,000 franchise and independent car dealers (80% of revenues).  The dealers pay to list their inventory online; there is a base pricing package and various upselling options for premium placement.  The rest of revenues come from website display advertisements (18% of revenue) that are primarily sold to OEMs and other small adjacencies (2% of revenue) 

Cars was spun out of TEGNA on May 18th; TEGNA primarily owns TV broadcast assets, which typically have very different holder bases than internet assets.  Our historical analysis of spinoffs suggests that selling pressure tends to be more acute in situations where the spinoff is a much different business than the parent.  Another factor is that research analysts covering the parent do not generally publish on the spin if it is in a sector that the analyst does not cover.  In this instance, we have not yet seen anything published by analysts covering the parent (the only firm who has published is an obscure firm named Barrington).  We also believe that misleadingly high headline multiples on consensus combined with general concerns around the auto market have weighed on the stock.

Thesis:

We believe Cars.com is one of the most compelling spin-offs we have seen over the past few years

• Expected returns are very attractive (38% 3yr base case IRR) and we expect the equity to be supported by catalysts

• We expect short-term catalysts from investor discovery and an acceleration of growth as the business laps the issues from the problematic website re-platforming

• We believe the equity will be supported over the intermediate term by the significant step up in cash flows from affiliate agreements rolling off in 2019 & 2020

Misunderstood Valuation: We believe CARS is materially cheaper than it appears at first glance

• CARS shows up on screens as a reasonably priced (10.6x 2017E EBITDA adj. for non-recurring EBITDA) to somewhat expensive asset (22.1x 2018E EPS)

• However, on our estimates, CARS is trading at 5.9x normalized EBITDA and a 13.9% cash flow yield (15.1% if tax reform lowers the tax rate by 10%)

• These valuations are quite low given that this is a unique internet asset with sticky revenues, strong margins, and a secular growth profile

• Below, we lay out the drivers that cause our estimates to materially exceed the consensus view.  For reference, our EV/EBITDA multiple deducts $301mm from the EV to reflect the company’s ongoing tax shield (which we view as an excess asset when calculating pre-tax metrics).  This is further explained in point 5 below

1. Income Statement Projections: We estimate $12.5mm of public co costs and $12.8mm of increased spend on marketing/sales are partially offset by $8.3mm of revenue growth

2. Non-Cash Revenue: We remove the $25.2mm of non-cash revenue that is amortizing into the income statement as a result of the contract with affiliates

3. Affiliate Arrangements: We believe the most misunderstood portion of the CARS thesis is the potential uplift from the expiration of affiliate contracts

• To understand the affiliate arrangements (which constitute ~27% of revenue today), it helps to quickly refresh on the history of Cars.com

• Cars.com was originally part of Classified Ventures, a consortium of media companies including Tribune, Gannett, McClatchy, Graham Holdings, and AH Belo

• Cars.com was sold through the media companies' existing sales force (selling a dealer an advertising package combination of TV, radio, newspaper, and Cars.com)

• Over time, Cars.com began selling directly to consumers in geographies where the consortium did no business

• The direct sales force thus developed a well-established playbook for inheriting legacy clients, increasing market penetration, and upselling premium products

• In 2014, Gannett (now TEGNA) purchased Cars.com from the rest of the Classified Ventures group for an implied price of ~$2.5bn

• We believe that PE buyers would have paid a higher price than Gannett, but the group wanted to sell to a member to preserve the affiliate relationships

• In the purchase agreement, the affiliates received the right to take a 40% commission on their sales of Cars.com (end price to the consumer is the same as direct)

• The six affiliate arrangements expire in October 2019 (4 of 6 arrangements) and June 2020 (2 of 6); we expect a significant uplift in cash flows as a result

• Price: Cars.com will receive 67% more revenue for each sale as they will keep 100% of list price (rather than 60% under the current arrangement).  We expect a revenue increase of ~$90mm as a result of price increases alone

• Volume: The direct sales force has historically been able to penetrate and upsell clients to a far greater degree than the affiliate sales force.  Our diligence suggests there is 20%-40% upside from increased penetration and upselling additional products (we model a 21.2% uplift, or ~$48mm of revenue)

• Margins: Additionally, we believe the incremental affiliate revenues are likely to come through at very high incremental margins based on our work: (1) Sales Force Cost - Our research suggests that ~150 additional sales people are needed to cover affiliate markets ($16.5mm of cost assuming ~$110k per head), (2) Marketing: Diligence suggests the transition will likely come with an incremental ~$10mm of marketing spend, (3) COGS: Incremental COGS should be very low as the technology platform is highly scalable (we estimate a 90% gross margin on incremental revenue), (4) Elimination of Costs (Revenue Affiliate Share): CARS pays its affiliates ~$9mm a year for major account sales it does at a central level

• We estimate incremental EBITDA margins on affiliate revenues of 83.3% (though this is really 76.7% adjusting for the revenue share)

4. Cost Cutting: While 2017 will see increased public company costs (~$12.5mm), we believe there are opportunities to reduce IT spend

• We have been told that one of the major benefits of the recent re-platforming that the company did is the increased flexibility on IT spending

• Industry contacts suggest there could be $20mm of savings from increased cloud utilization, outsourcing more services, and cutting headcount

5. Cash Tax Shield: CARS will receive a significant tax benefit from intangible amortization stemming from Gannett's purchase of Cars.com

• CARS' headline GAAP earnings are depressed by ~$75mm pre-tax due to amortization of acquired intangibles from Gannett's purchase of the rest of Cars.com

• This non-cash charge depresses headline earnings (resulting in an artificially inflated P/E) and we of course ignore this in our cash flow estimate

• Independent of GAAP accounting, the company is receiving a significant tax benefit from the amortization of these purchased intangibles. This dynamic bolsters cash flows by lowering the cash tax rate to ~25%-28% (vs the effective tax rate of 38% for GAAP accounting)

Comps:

Private Transaction Comps: AutoTrader US is the best private transaction comp to CARS (the two companies are the largest players in the marketplace)

• In 2010, Providence Equity Partners bought a 25% stake in AutoTrader US from Cox Enterprises (privately held)

• In 2014, Providence sold the stake back to Cox at a price described as ~6x revenue ($1.8bn for the 25% stake)

• A 6x multiple on our normalized revenue implies the stock is worth ~132% more (without taking into consideration CARS’ unique tax attributes which are worth another ~18% of the market cap)

• Market multiples have certainly increased since 2014, although the perceived growth trajectory for the penetration of digital auto advertising is likely lower now

• Given that Cars.com is a fairly unique business, there are not that many comparable companies (AutoTrader is the only relevant transaction comp we see)

Prior Sales Process: We think the prior sales process (where Gannett purchased the other 73% of Cars.com at an implied $2.5bn valuation) is the most relevant transaction comp

• The $2.5bn price ignores the valuation drag from the ~5.5yr affiliate agreement at the time of the transaction

• The negative PV of these agreements (which are set to run off soon) should have been in the range of ~$300mm based on the excess commissions

• In addition, press reports suggested that there were PE buyers interested at higher valuations (have seen $3bn mentioned)

• Our diligence supports the view that private equity would have paid a higher price than Gannett, but we understand there was a strong preference to sell the business to one of the media parties given the desire to preserve the affiliate relationships (keeps jobs, helps with selling other media products, etc.)

• We suspect the business is worth more in a sale today as revenues have increased by ~25% and market multiples are now meaningfully higher

Public Comps: Cars.com does not have any great public comparables, so we look to a mixture of online auto marketplaces & other digital marketplaces to triangulate

• We would expect public investors to value CARS based on a mix of earnings multiples, cash flow multiples, and EBITDA multiples

• The publicly traded peers below seem to generally trade at EBITDA multiples in the mid-teens and earnings multiples in the low-to-mid 20s

• While pinning down a precise multiple is difficult, we expect CARS to ultimately trade at a modest discount to peer valuations with similar mid-term growth (15-20x cash flow)

• The modest discount reflects higher leverage at CARS and a lower multiple for the CFs from the amortization tax shield (15yr CFs rather than perpetual)

• In addition, there is some risk to CARS' revenue growth given the recent traffic and revenue issues following the re-platforming

• However, CARS could certainly trade at 20x+ should revenue growth accelerate to the mid-term mgmt target of 5%-10% revenue growth

Catalysts:

• Investor Discovery: We believe the core principles of our underlying thesis will become increasingly evident to the market as investors study the business

• Mgmt has been vague around the uplift from affiliate contracts rolling off, and they also have not done much to highlight that cash flows exceed earnings

• We would expect increased disclosure by the company over time to be a positive

• We would also expect a ~$1.7bn market cap equity to attract significant analyst coverage over time, which we would expect to be a net positive

• Revenue Re-Acceleration: Investors studying CARS' recent revenue performance and disclosure around traffic & dealer counts may have concerns around LT-growth

• We believe the issues here were driven by the re-platforming of the website, which was highly mismanaged and led to a material deterioration in search traffic

• The deterioration in search traffic drove a decline in organic dealer count, as savvy dealers would have seen an increase in CARS' cost per lead

• Given CARS' refusal to negotiate on price with most dealers, it appears that some dealers dropped CARS

• As a result dealer count went from organic growth of 4% in 2015 to an organic decline of 4% in 2016

• However, we believe traffic has stabilized and started to grow now that the new platform is up and running (i.e. CARS taking market share back even if comps are not yet positive)

• The rebound in traffic should also get some boost from the increased business investment in 2017 (which we have built into our normalized margins)

• There are some short sellers who have been making a bear pitch on Cars.com.  The short interest is higher than normal here (~18%) and we have observed that many  internet businesses have higher short interest than the rest of the market (a number of L/S funds tend to be significantly overweight internet in their long portfolio and need industry shorts to pair with them).  We have spoken with short sellers and believe the short pitch is shallow and reflects limited diligence

• In effect, the bear argument amounts to “why should a declining internet asset trade at 11x EBITDA?”

• The simple answer is that: 1) we believe the business is not declining and 2) we see the company trading at 6x normalized EBITDA, not 11x.  We saw one quarter of slight revenue growth (with an estimated ~2.8% organic revenue decline) and this was driven by a temporary traffic issue.  Cars.com has years of consistent revenue growth (including CY 2016).  Publicly available data from similarweb.com suggests that CARS has taken significant traffic share since the start of the year (up 2.2% in the comp group of Cars.com, Autotrader, CarGurus, and TrueCar) as the company recovers from the idiosyncratic one-time issue of the website replatform.  The sequential trends are also consistent with improvement on a month-by-month basis through June.  We believe additional spending on marketing will only improve the traffic trends ahead of the much easier comps of H2.  Given these factors, we think shorts may end up surprised by the strength of traffic growth by year end (which we believe will translate to renewed revenue growth in the future)

• Improvement in the revenue trajectory will take time (need to win dealers back, marketing spend is weighted more to the fall than summer, etc), but all of our discussions with dealers suggest CARS has a highly competitive offering that should be able to at least maintain share in a growing space absent poor execution

• Longer-term, revenue is mathematically set to accelerate as the affiliate agreements expire (both from price and also likely in terms of the volume uplift)

• Independent of the pricing uplift, the mix shift to direct should be positive for consolidated revenue growth because wholesale revenues have consistently lagged

• Outperformance on Margins: Mgmt is guiding investors towards medium-term margins of 34%-37%; these margins appear highly conservative

• While some business investment is needed after TEGNA cut too deep to improve margins, we expect material margin improvement over time

• We think the affiliate revenues are likely to come through at very high incremental margins (especially with the mathematical elimination of $9mm in costs)

• Further, incremental margins should be very high given the 80%-90% incremental gross margins

• Additionally, we think there may be potential for cost-cutting in terms of IT spend (as mentioned before)

• Potential Catalyst - Earlier Affiliate Capture: We think it could make sense for mgmt to attempt to re-capture some portion of its affiliates earlier than 2019/2020

• If CARS paid a modest premium to the NPV of the affiliate agreements, they could get direct control over these geographies and start improving results

• Mgmt has also minimum performance requirements as a way to potentially get earlier control

• Potential Catalyst - Tax Reform: CARS stands to benefit from tax reform to a greater degree than other businesses based on the following

• The business is 100% domestic, and therefore should be more levered to lower US corporate tax rates than most public equities

• In addition to benefiting from more tax savings, the tax savings should be more enduring for CARS than for most other public equities

• Capital intensive businesses should see pricing pressure as tax rates decline (given that capital investment is priced to an after-tax ROIC)

• CARS has no invested capital, but instead prices its products based on the ROI to the subscription buyer (tax rates should not negatively affect the economics)

• Potential Catalyst - Sale of the Business: Chairman Scott Forbes has a track record of creating value in online marketplace businesses

• Forbes was Chairman of Orbitz; while he was there, they re-accelerated growth and the business was sold in ~2yrs at a healthy premium

• PE funds would likely find the future affiliate uplift and the potential to consolidate a still-somewhat fragmented industry attractive

• Our historical analysis of spinoffs suggests that spinoffs are 5x as likely to be acquired as the avg public equity in the 5 years following the spin. The decision to spin CARS may have been made in order to maximize tax efficiency, with the plan to ultimately sell the business post-spin. If so, the decision to put Forbes in as Chairman (as well as putting a former senior M&A banker on the board) may have been done to set up for a sale

Risks:

• Market Share: We believe the largest risk is the potential to lose share to existing competitors and new entrants

• Competitors like Car Gurus have been willing to tolerate low margins (and even losses in some cases) in order to build market share.  However, we have heard that Car Gurus is raising prices ahead of a potential IPO, helping to restore rationality to industry pricing

• Given the low barriers to entry and long-term likelihood of consolidation due to material synergies, we expect competition to remain fierce near-term

• Traffic declined meaningfully in 2016, and Q1 showed organic revenue declines (largely due to a decline in dealer count driven by the traffic issues).  The traffic declines appear to be broadly attributable to the botched re-platforming from last year and inadequate relative mktg spend as TEGNA starved the business of investment (rather than from a worse competitive position)

• Mitigant: The company gave guidance for positive traffic growth this year despite weak Q1 numbers as recently as May.  This suggests they are seeing positive momentum (and they have a better understanding of the easy Q4 comp)

• Cyclicality: Auto sales are cyclical, and we appear to be operating above cycle in terms of auto sales

• Mitigant: ~80% of business value comes from used car sales, which have historically been less cyclical

• Mitigant: The subscription model and the mix shift towards digital have historically proved a buffer to an economic downturn

• Dealers have said that cutting their digital advertising would be the last thing they would want to cut, and Cars has managed to hold firm on price in the past

• As evidence, the business grew revenues 3% in 2009 and just 2% of dealers eliminated their CARS subscription (although the penetration opportunity was much greater in 2008-2009)

• Long-Term Auto Risks: We could see a movement away from a dealership-driven auto market and/or a long-term reduction in individual buying demand

• Autonomous driving and increased prevalence of ride-sharing fleets could reduce demand for Cars.com

• Mitigant: These risks appear to be longer term than the investment time horizon (although they certainly could impact the exit multiple)

• We would think Carsales faces similar risks from these long-term trends and it still trades at >20x earnings today

Returns:

We model a base case 3yr IRR of 38%

• Our model assumes an exit price of 18.0x 2020 cash flows, which is an implied 16.0x 2021 cash flows with an exit in mid-2020

• We are modeling sluggish underlying growth through 2020 ex-affiliate relationships to reflect the current state of the autos market

• We do not assume tax reform takes place in our base case

We believe these returns are highly compelling and reflect a lack of understanding of CARS’ underlying financial profile.  We believe there is ample margin of safety (i.e. if marketing spend to re-ignite traffic growth needs to be higher).  Returns could be front-end weighted if investor discovery takes place more quickly and/or the business is acquired.

Disclaimers:

The views expressed herein are for informational purposes only, and are not intended to be, and should not be, relied upon as an investment recommendation in connection with any investment decision for any purpose or for legal, accounting or tax advice.  This information does not constitute an offer to sell, or the solicitation of an offer to buy, any security.  Any forward-looking financial information (“Forward-Looking Information”), including but not limited to, IRRs, EBITDA, cash flow, margins and revenues are presented for the purpose of providing insight into our investment objectives.  The Forward-Looking Information is not a prediction, projection or guarantee of future performance and is based upon assumptions regarding future events and situations that may prove not to be accurate or may not materialize.

The author makes no representation as to the accuracy or correctness of the information contained herein and expressly disclaims any liability to any person from relying on such information.  The information and views contained herein are provided as of the date this summary was posted and present the views of an investment firm that currently holds a long position in the company’s securities.  The author has no obligation to update any of the information provided herein.  The author reserves the right, in light of, among other factors, its ongoing evaluation of the company’s financial condition, business, operations and prospects, the market price of the company’s stock, conditions in the securities markets generally, general economic and industry conditions, its business objectives and other relevant factors, at any time, to decide to purchase, sell, or engage in any other transaction involving, the company’s securities as it deems appropriate.   Past performance is neither indicative nor a guarantee of future results.  There can be no assurance that an investment in the company will be profitable or that the assumptions regarding future events and situations will materialize or prove correct. 

Catalyst

Potentially include: investor discovery, revenue re-acceleration, outperformance on margins, earlier affiliate re-capture, tax reform, and/or sale