CARS - CarGurus Faces Increasingly Negative Economic And Credit Environments

2023-05-11 14:46:44 ET

Summary

• CarGurus, Inc. recently reported its Q1 2023 financial results.
• The firm connects automobile buyers with dealers and other sellers in the U.S., Canada, and the UK.
• While its Q1 results weren't as bad as feared, a softening economy combined with reduced bank lending leaves me cautious.
• For the near term, I'm Neutral (Hold) on CarGurus, Inc.

A Quick Take On CarGurus

CarGurus, Inc. ( CARG ) reported its Q1 2023 financial results on May 9, 2023, beating revenue and EPS consensus estimates.

The firm operates an online marketplace to connect buyers of used automobiles with sellers and dealerships in the United States and internationally.

An important risk to the company's outlook is the combination of a macroeconomic downturn and reduced credit availability as banks reduce their lending activity to lower credit-quality borrowers.

I'm Neutral (Hold) on CarGurus, Inc. stock for the near term until we gain more visibility into the economic and lending environment ahead.

CarGurus Overview

Cambridge, Massachusetts-based CarGurus was founded in 2005 to provide consumers and sellers with an online venue to buy and sell used automobiles.

The firm is headed by Chief Executive Officer, Jason Trevisan, who has been with the company since 2015 and was previously a General Partner at venture capital firm Polaris Partners.

The company's primary offerings include the following:

• Buy and sell automobiles

• Research automobile information

• Obtain financing

CarGurus acquires customers through online marketing, social media and partnerships, and pursues dealer relationships through its direct sales and marketing efforts.

CarGurus' Market & Competition

According to a 2022 market research report by Mordor Intelligence, the U.S. market for used automobiles was estimated at $196 billion in 2021 and is forecast to reach $302 billion by 2027.

This represents a forecast CAGR of 7.51% from 2022 to 2027.

An important driver for this expected growth is a return to normalcy after supply chain shocks as a result of the pandemic and other factors.

However, a rising interest rate environment has reduced automobile affordability for certain consumers, leading to variability in demand and price in recent months.

Major competitive or other industry participants include:

• Cars.com ( CARS )

• CarMax ( KMX )

• TrueCar ( TRUE )

• CarBravo

• AutoNation ( AN )

• AutoTrader.com

• KBB.com

• Edmunds.com

• CarsDirect.com

• CarFinder.com

CarGurus' Recent Financial Trends

• Total revenue by quarter has risen and fallen, as the chart shows here:

• Gross profit margin by quarter has grown materially in recent quarters:

• Selling, G&A expenses as a percentage of total revenue by quarter have also risen sharply in the most recent reporting period:

• Operating income by quarter has been trending lower more recently:

• Operating leverage by quarter has turned positive in the just-finished quarter:

• Earnings per share (Diluted) have remained positive in each of the last three quarters:

(All data in the above charts is GAAP.)

In the past 12 months, CARG's stock price has fallen 11.5% vs. that of TrueCar, Inc.'s ( TRUE ) drop of 27.06%, as the chart indicates below:

For the balance sheet , the firm ended the quarter with $456.7 million in cash and equivalents and no debt.

Over the trailing twelve months, free cash flow ("FCF") was an impressive $222.3 million, of which capital expenditures accounted for $7.1 million. The company paid $55.5 million in stock-based compensation, or SBC, in the last four quarters, the highest figure in the last eleven-quarter period.

Valuation And Other Metrics For CarGurus

Below is a table of relevant capitalization and valuation figures for the company:

(Source - Seeking Alpha)

As a reference, a relevant partial public comparable would be Cars.com (CARS); shown below is a comparison of their primary valuation metrics:

(Source - Seeking Alpha)

Commentary On CarGurus

In its last earnings call ( Source - Seeking Alpha ), covering Q1 2023's results, management highlighted the changes it is making to its options list to enhance its platform to attract, retain and improve the performance of its participating dealers.

The company saw an increase in voluntary dealer cancellations that management believes was due to 'lower inventory levels and margin preservation during a period of economic uncertainty.'

Management also worked to improve the buying process for customers with the addition of its Digital Deal, which enables consumers to "customize their shopping experience" by allowing them to do more online.

Leadership wants to produce a fully end-to-end solution for both sides of its marketplace, and its Digital Deal and other initiatives are additional steps along that path.

Total revenue for Q1 2023 fell 46.1% year-over-year, but the gross profit margin increased 24.6 percentage points.

Management did not disclose any dealer retention rates but said that it produced net positive additions in Q1 outside of its normal annual business review process.

However, SG&A as a percentage of revenue increased 15.3 percentage points year-over-year and operating income dropped 47.2%.

Looking ahead, management only provided guidance for Q2 and not for the full year. It expects total revenue to be $230 million at the midpoint of the range, or a drop of 55% year-over-year.

The company's financial position is very strong, with ample liquidity, no debt, and very impressive free cash flow.

Regarding valuation, my discounted cash flow ("DCF") calculation below indicates the stock may be overpriced, given the assumptions of the DCF:

The St. Louis Federal Reserve's tracking of U.S. used auto and truck prices indicates a materially falling price index in recent months, from a high of around 215 to its current approximation of 183, a drop of nearly 15%, as shown in the chart below:

From management's most recent earnings call, I prepared a chart showing the frequency of key terms mentioned (or not) in the call, as shown below:

I'm most interested in the frequency of potentially negative terms, so management cited "Uncertain" once, "Challeng(es)(ing)" five times, "Macro" three times and "Drop" seven times in various contexts.

The negative terms referred to the upheaval in the used car market in recent periods due first to inventory drop and rising prices, followed by more recent lower prices.

An important risk to the company's outlook is the combination of a macroeconomic downturn and reduced credit availability as banks reduce their lending activity to lower-quality borrowers.

While CarGurus, Inc. has bounced recently due to a better-than-feared Q1 report, given the aforementioned risks, I'm Neutral (Hold) on CARG stock for the near term.

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