CARG - CarGurus: Issues With CarOffer Present An Opportunity

Summary

• Issues at CarOffer have overshadowed CARG's strong core business.
• A slightly more difficult used car market should bode well for CARG.
• CARG has pricing power given the value of its offering.

CarGurus' ( CARG ) results are being muddied by issues at CarOffer, but its core business remains strong and is greatly undervalued. The company has a number of catalysts including fixing the CarOffer business, a tougher car selling environment where dealers lean into advertising, and pricing power.

Company Profile

CARG is an online used and new automobile lead-generation and transaction marketplace.

The company’s platform offers car dealers several tiered subscriptions to list and help sell their vehicle inventory. All dealers can put their inventory on CARG’s site for free, although leads are capped and there is no dealership branding, address, website URL, or phone number displayed on the free tier. Consumers can contact these dealers only through an anonymous, CarGurus?branded email address so the dealer does not receive any of the consumer’s personal contact information.

The company then has three tiers of paid subscriptions (Enhanced, Featured, and Featured Priority) that gives dealers different levels of exposure and features. Listings for all paying dealers include a link to their website, dealership branding and information such as name, address, hours of operation, and map directions to their dealership. Dealers on paid tiers can call and email potential buyers. Most dealers are on the Enhanced subscription plan.

Subscriptions are priced based on a dealer’s inventory size, region, and CARG’s assessment of the ROI it expects to deliver for the dealer. CARG also separately offers digital advertising for both dealerships and auto manufacturers on its own website, other sites, as well as social media.

On the consumer side, the company uses proprietary algorithms to assign used cars on its platform one of five Deal Ratings - Great Deal, Good Deal, Fair Deal, High Priced, or Overpriced – based on similar cars sold in the same region. A car’s Deal Rating is primarily bases on the Instant Market Value ((IMV)) of the vehicles and a Dealer Rating, which is derived from user?generated content from its users’ experiences with dealers. Its IMV, meanwhile, is a proprietary algorithm that assesses the market value of a used vehicle in a local market based on more than 20 ranking signals and more than 100 normalization rules.

In 2021, the company had 79.3 million monthly sessions and 31.6 million average unique users in the U.S., making it the most visited online automotive marketplace. Meanwhile, at the end of Q3 it had 24,700 paying dealerships in the U.S.

CARG also operates in Canada and the U.K. It owns PistonHeads in the U.K., an automotive marketplace, forum, and editorial site geared towards automotive enthusiasts. Paying U.K. dealers who list on the CarGurus platform automatically have their inventory added to the PistonHeads site for greater consumer reach.

CarOffer Acquisition

One of the most interesting things about CARG revolves around its 2021 acquisition of a 51% stake in CarOffer.

When CARG purchased its stake, CarOffer was a young, fast-growing digital wholesale trading platform. It has an instant trade platform, which it calls the Matrix, that allows dealers to transact automatically using rule-based strategies instead of using a more traditional timed-auction process. Dealers can input information on what types of cars they're interested in buying at what price limits.

CARG was also looking to take the technology and apply it to its Instant Max Cash Offer, allowing dealers to not just buy cars wholesale, but to also be able to purchase them directly from consumers.

CarOffer only began operating in Q3 of 2019, and by Q1 of this year under CARG, it had become a profitable, $1 billion revenue run-rate business. That quarter the business saw revenue grow 1,600% to $267 million with adjusted EBITDA of $20 million. $162 million of that revenue came from marrying CarOffer’s technology to its Instant Max Cash Offer.

In Q2, the business once again put up impressive numbers. Revenue grew 506% to $347.3 million, and its adjusted EBITDA rose 51% to $19.1 million.

Then in Q3 the wheels fell off, with revenue down -25% sequentially to $261 million and adjusted EBITDA of -$16 million.

The issue was that in a declining-price used car market, dealers were more apt to reject a vehicle for not being as described and start an arbitration process. CARG would then have to take possession of the vehicle and either rematch it to another dealer at a lower price or send it to auction at a loss.

Management said it needs more rigor with inspections going forward, especially with regard to the inside of vehicles. It also has gotten partners to do scans for frame damage, as well as mechanical inspections and electrical inspections. They also plan to scrutinize a vehicle’s history more thoroughly.

Next the company plans to remove users from the platform that over-arbitrate. It also plans to more quickly get rid of vehicles that are returned.

Notably, CARG has the option to purchase the remainder of CarOffer in two additional steps. In Q3, it decided not to purchase another 25% stake in the company, which would have been based on 7x its trailing 12-month gross profit as of June 30th. That would have valued the entire business over $1 billion, much greater than the $275 million it was valued at when CARG took its 51% stake.

It now has the option to buy the remaining 49% of the company it doesn’t own in the second half of 2024 based off of a multiple of 12x its trailing 12-month adjusted EBITDA.

Opportunities

CARG’s biggest opportunity is fixing the issues with the CarOffer business. The business had performed well until the recent hiccup, but the company needs to be more vigilant with inspections and the vehicles it is procuring for its dealer clients. It looks like it is putting the processes in place, and while they could impact margins a bit, it does look fixable.

While CarOffer adds some volatility to the business, the arbitration issues notwithstanding, it can help transform the company into an all-in-one lead-generation and transaction platform, where buyers can find a car, trade-in their car, and in some cases even get it delivered, all online or partially online. All the while, CARG would just be the middleman, not taking on any buying, selling, or inventory risk. It’s probably the model Carvana ( CVNA ) should have pursued.

The other big opportunity CARG has is to raise prices. A few years ago while researching CARG for the fund I was at, I polled and talked to numerous car dealers. The overarching theme was that CARG was undercharging versus the value they gave to dealers compared to their competitors. I've been told this is still the case.

CARG is not only the #1 visited automotive site in the U.S., but it is also very easy for dealers to see their return on investment from using their service, as CARG feeds leads right to the dealer. Other platforms can be a bit more opaque. That’s why the company has a nice runway to continue to increase its pricing. Its heft in the space also makes it imperative for dealers to be on the site.

CARG’s core marketplace business is also a bit countercyclical. When selling used cars becomes more difficult, dealers generally like to lean into advertising in order to move units. Since cars are depreciating assets, dealers want to get them off their lots as quickly as possible.

Increasing brand awareness is also another long-term opportunity. CARG still draws much of its traffic through algorithmic traffic acquisition spend. The more it can establish its brand and draw people to its platform directly, the less costly it is and the better its margins.

Risks

The biggest near-term risk for CARG is that it is more difficult and takes longer to repair the CarOffer business than expected. This business is also transactional, and thus is more prone to a downturn in the used car market. The good news is that management has said it will take some time to fix it, and that it looks like it is in the consensus numbers for next year.

CARG’s international business has also been a drag, especially in the U.K. The company has really struggled to get a strong foothold in Britain, where Autotrader (AUTO.LN) is the dominant player. It’s made some progress, but it’s been slow and the unit still loses money. I have my doubts it becomes highly successful.

Search algorithm changes from Google (GOOG) ( GOOGL ) is another area of risk. The bulk of CARG’s traffic comes through mobile, and the company long ago figured out how to use local SEO to drive traffic. This is how it became the dominant player in the U.S. The company has maneuvered through numerous search algorithm changes in the past, but it is always a risk.

Valuation

CARG trades at 15x the 2023 EBITDA consensus of $117 million, and 10.5x the 2024 consensus of $169.8 million. Analyst estimates are for consolidated EBITDA, and thus include the full losses for CarOffer, not just the 51% it owns.

Looking just at its core Marketplace business, however, CARG stock is much cheaper. Assuming modest 3% revenue growth and 27.5% EBITDA margins, the core business would generate $187 million in EBITDA in 2023. The core enterprise value is also less, as you would take out the minority interest. That leaves you with an EV/’23 EBITDA multiple of 8.7x for the core business.

Rival Cars.com (CARS) trades at 8.2x 2023 EBITDA, while British firm AutoTrader trades at nearly 15x FY24 (ending in March) estimates.

Conclusion

The core CARG business is strong with plenty of runway to increase prices and grow revenue. Meanwhile, the stock’s valuation has been dragged down by the current issues from its 51% stake in CarOffer. It also tends to be a bit countercyclical, so should perform well in a difficult used car market.

I’d value the core business at around $20-22 per share at a minimum. But I could easily see investors valuing it even higher, as a 15x EBITDA multiple would put the business at around $27.

Meanwhile, despite its struggles, its stake in CarOffer is not worthless. This was a disruptive, fast-growing business before the recent issues that would as a whole have been valued around $1 billion (7x trailing gross profits or 12x trailing EBITDA for the period ending June 30th). At half that value, CARG’s 51% stake is worth ~$2 a share.

I still think once the issues at CarOffer are remedied and the used car market normalizes that this is a good business and that the deal still makes a lot of sense. CARG already has a powerful lead-gen platform, and CarOffer’s technology can really make it a one-stop shop for consumers with a lot less time spent at the dealership.

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