CARG - CarGurus: Changing Market Catches Company Off Guard

Summary

• CarGurus, Inc. is playing catch-up in a rapidly changing wholesale market.
• Instant Max Cash took a big hit sequentially as the number of transactions and average selling prices fell.
• Considering macroeconomic factors and not having the processes in place to deal with the changes to Wholesale, CarGurus, Inc. believes its long-term growth trajectory remains in place.

CarGurus, Inc. ( CARG ) hit some headwinds that included the macroeconomic forces all companies are facing, but also operational challenges associated with its weak performance in Wholesale in the quarter. These put a damper on its results, and are likely to continue on for a quarter or two, depending on how long the company takes to make adjustments to the changing marketplace.

While CarGurus' Instant Max Cash Offer business grew exponentially year-over-year, on a sequential basis it plunged 24 percent as a result of a decrease in the number of transactions in the reporting period and lower average selling prices.

Even though some of the numbers were related to a usual slowdown in the third quarter, it was far from being the only factor involved. My expectations are they are going to continue on into the first couple of quarters of 2023 at a minimum, primarily because of rising interest rates, increasing economic uncertainty, and consumers not as confident in the job market as they have been in the recent past.

In this article, we'll look at the latest numbers from CARG's earnings report, the internal challenges it faces in relationship to its wholesale business, the weakness in its Instant Max Cash Offer business, and if the online trend in the industry remains in place.

Recent numbers

Revenue in the third quarter was $226.45 million, up 91 percent year-over-year, but missing by $35.47 million. That compares to revenue in the third quarter of 2021 which came in at $223 million. For the first nine months of 2022, revenue was $1.37 billion, more than double the $612 million in revenue generated in the first nine months of 2021.

Net income in the reporting period was $107 million, or $0.14 per diluted share, compared to net income of $29 million or $0.24 per diluted share in the third quarter of 2021. Net income in the first nine months of 2022 was $35 million, compared to $80 million in the first nine months of 2021.

A big part of that discrepancy comes from the total cost in revenue for the first nine months of 2022 of $848 million, significantly up from the total cost in revenue for the first nine months of 2021 of $135 million.

GAAP operating income in the third quarter of 2022 was $28.7 million, down 28 percent from the $40.1 million in GAAP operating income in the third quarter of 2021.

GAAP consolidated income in the reporting period was $18.8 million compared to $29.3 million in GAAP consolidated income in the third quarter of 2021.

Adjusted EBITDA in the third quarter of 2022 was $38.8 million, down from the $64.9 million in adjusted EBITDA in the third quarter of 2021.

At the end of the third quarter the company held cash and cash equivalents of $404.4 million and another $400 million under its revolving credit facility.

Revenue by segments

Marketplace revenue was $165.3 million, up 3 percent compared to $159.9 million in the third quarter of 2021, and up 1 percent sequentially. The increase in revenue was attributed to revenue coming from its high-margin subscription listing service, led by U.S. dealers using the platform, along with an increase in sales of add-on products.

Wholesale revenue was $47.0 million, up 4 percent compared to $45.2 million in the third quarter of 2021. Driving the increase in revenue in wholesale was higher transportation revenue from its dealer-to-dealer business, as well as sales increases in its Instant Max Cash Offer business.

Product revenue was $214.1 million, up 1,105 percent compared to $17.8 million in the third quarter of 2021. That sales increase in Product revenue was attributed to the expansion of Instant Max Cash Offer to now cover approximately 93 percent of the U.S. population.

But as mentioned earlier, Instant Max Cash Offer lost growth momentum in the third quarter as a result of a drop in average selling prices and a decline in the number of transactions in the reporting period.

Where CarGurus underperformed

Management lowered its guidance significantly in the third quarter, and that was specifically connected to the performance of its Digital Wholesale business. For those that may not know, Instant Max Cash Offer is reported within the Wholesale segment.

Wholesale revenue in the third quarter was down 38 percent because of the weakening market that brought about fewer transactions in its dealer-to-dealer business, along with downward pricing pressure from negotiations.

Most important in the weak Wholesale performance was the company further underperformed because of operational issues within its CarOffer business. What happened was the operations and processes that were effective in a wholesale environment where prices were rising, didn't work well when prices started to fall.

Management said it's going to take some "time to work through our Digital Wholesale operational challenges," suggesting it could be a headwind that last for a while even as the company faces general market weakness in the sector.

Since CARG management didn't see this coming as far as it related to its CarOffer business at that level, the company is now scrambling to solve the problem; something that puts it in a temporary, vulnerable position in my opinion.

I do think there is a silver lining in this situation, and that is the company is quickly learning how it must operate in a market that has been on fire. This provides an opportunity for CarGurus, Inc. to solve a big problem, and once it does, it'll have a much better handle on how to run the business and positive and adverse economic environments. If it can effectively and efficiently deliver in this area, it'll be a much stronger company as a result, increasing confidence with investors and internally.

Headwinds it faces

We know most of the headwinds businesses are facing in the current economic environment, including fears about the length and depth of the recession, an uncertain job market, consumers and businesses prioritizing spending, higher inflation and rising interest rates.

With the impact from COVID-19 receding in the West and markets opening up, it changed the dynamic of the car and vehicle market, which have been in favor of sellers for some time because of lack of supply. Now that supply has caught up with demand and consumers aren't sure about whether or not they'll have a job as more companies are cutting back on headcount, it has turned the market on its head with buyers on in the driver's seat.

One of the things that caught management off guard was the negotiation factor, which drove down prices from prior levels.

Softer demand is a key contributor to the new environment, and that isn't likely to change in the near future.

With the economy likely to remain weak for at least a couple of more quarters, and possibly longer, this is going to continue to weigh on the performance of CARG, even as it works to improve how its processes when prices are falling.

Conclusion

I don't think there's any doubt the sector CarGurus, Inc. competes in is a long-term trend, and over time, assuming it can retain and grow market share, it should be a solid performer for patient investors.

In the near term, I don't see that happening, and it's highly probable it's going to get worse before it gets better, and even its strong segment will probably come under some pressure as the market faces more headwinds.

It's readily apparent CARG management believes that, too, as it dropped its revenue guidance in the fourth quarter from $270 million to $300 million, well below consensus of $468.43 million. And for earnings per share in the fourth quarter, it downwardly adjusted that from expectations of $0.27 per share to a range of $0.13 to $0.16 per share.

Concerning full-year guidance, it lowered that from consensus revenue of $1.87 billion to a range of $1.64 billion to $1.67 billion. And for EPS, it lowered that from $1.23 consensus to a range of $1.02 to $1.05 for full-year 2022.

The bottom line for me concerning CARG is it hasn't faced a situation like this since the market took off in its favor, and now it's having to deal with issues it hasn't had to face before, specifically in its Wholesale segment.

As mentioned earlier, this is a challenge and an opportunity for the company, and if it can come out on the other side of it a better company able to successfully compete in different market conditions, CarGurus, Inc. is going to be a lot stronger and more attractive to investors.

Nonetheless, in the near term there will be challenges from the headwinds, and I think the CarGurus, Inc. share price will remain under pressure, but at the same time offer some good entry points for investors, or attractive prices to lower the cost basis for existing shareholders.

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