CarGurus: A high quality business

Overview

CarGurus (NASDAQ:CARG) is a leading online automotive marketplace, connecting buyers and sellers of new and used cars. Using proprietary technology and data driven insights, they successfully increase trust and transparency in the automotive search experience which their competitors have yet to do. Operating mainly in the US, CarGurus has begun expanding internationally primarily in the UK and Canada. In an industry unable to recover post trade war fears, CarGurus is a company which has been undervalued despite their continuously impressive financials, acquisitions, and market penetration efforts. While the market may have taken into account a fall in the attractiveness of the overall industry in its price correction, it has failed to take into account the fact that CarGurus is a growth engine carving out a new niche industry for themselves. The three main thesis points supporting my case for CarGurus includes the market penetration capabilities of their freemium model, the impact of a recent acquisition of CarOffer, and the underestimated growth runway and potential growth in international markets.

The business model

CarGurus operates a freemium model — users can sign up to sell their cars on the site for free with limited features, and can be upsold to higher subscription levels, four to be specific in the case of CarGurus. What drives the upsell? CarGurus’ numerous features. Acting as an aid to dealerships, paying subscribers can have their dealership address and location displayed, as well as numerous additional features including a real-time performance marketing suite monitoring impressions and impact, as well as tailored advertising advice and dealership management assistance.

From a consumer standpoint, CarGurus has unique features including an “Instant Market Value” calculator and deal ratings indicating how each car is priced. What CarGurus does is collecting unstructured data regarding each car across their thousands of dealers, standardizing the descriptions of each car to improve user experience, and using millions of data points with past sales to come up with an instant market value of what the car should be valued at. This is something that none of their competitors have done, and using this instant market value, they assign the car a deal rating ranging from a “Great Deal” to “Overpriced”.

Revenue breakdown

CarGurus’ revenue is broken down into 2 main segments — their Marketplace Subscription Revenue and Advertising & other Revenue.

Marketplace Subscription Revenue is driven by paying dealers subscribing to one of four listings packages. The subscription pricing is variable and depends on factors such as dealer inventory, size, region, and estimated return on investment they can expect to generate using the CarGurus platform — this variable model is possible only with their big data capabilities and allows them to maximize their Marketplace Subscription Revenue. Advertising revenue is driven by auto manufacturers displaying advertising on the CarGurus site and is calculated on a cost per thousand impressions basis.

Subscription revenue is the main driver of revenue, accounting for 88% of revenue in their US segment, and overall company revenue is driven by US operations with 94% of all revenue coming from the US. International markets are still nascent and with a relatively recent market entry in the UK and Canada, the proportion of international revenue in total revenue is expected to grow.

CarGurus is an extremely high quality business and this is mainly because of their revenue and the way their revenue is structured and insured against risk. CarGurus’ revenue is:

• Cyclically resistant — the used car industry is one which survives economic downturns.
• Recurring — due to the subscription based model, 89% of all revenue is recurring and is guaranteed year on year.
• Diversified- CarGurus’ top 10 customers account for only 5% of their total revenue, they are not dependent on larger sellers and have a negotiating power advantage over them.

Industry overview

One of the main reasons why CarGurus is such a great business is their ability to continuously grow in an industry that is shrinking. They are currently the leader in the industry, growing their market share by 18% over the past 5 years, currently accounting for 38% of the online automotive industry. In terms of competition, CarGurus competes mainly with AutoTrader in the UK, and Cars.com and TrueCar in the US.

Due to being the only industry player operating using a freemium model, CarGurus has not only the most sellers on their platform, but also the most monthly visitors and this is driven by the network effects created by the freemium model.

Diving a little deeper we can see CarGurus’ dominance and one of our main thesis points come to light. As the only industry competitor with positive revenue growth, leading the industry in gross margins at 93%, and sales and marketing spend at $315m, CarGurus is well poised to not only retain dominance of their current markets but also use their superior margins to fuel their sales and marketing spend and continue their domination. CarGurus is able to outspend their competitors on a dollar to dollar basis in terms of advertising, and that’s really been one of the main driving forces behind their incredible market share gains.

Thesis I: Freemium

Brief overview — the freemium model as previously defined allows users to sign up for free, then upgrade to one of four paid package levels — Standard, Enhanced, Featured, or Featured Priority. The benefits to CarGurus of operating such a model include increased scale and growth driven by the free lure and the possibility of upsell. The freemium model excels at efficient customer acquisition and can be cited as the primary force behind CarGurus’ impressive market penetration, allowing them to capture 93% of all dealers in the US on their platform with 54% of all dealers in the US as paying dealers. An overview of the freemium model and subscription model value proposition to consumers is outlined below.

To put it simply — the freemium model allows more dealers to sign up, which in turn attracts more customers, which in turn attracts even more dealers, creating a network effect. This is what has led to CarGurus acquiring the largest audience of car shoppers in the US and the most consumers.

The freemium model is what has led CarGurus to growing their market share by 18% over the past 5 years and is what will enable them to continue to do so, and will act as a boon with their entry into nascent markets and international territory.

Market concern — “CarGurus’ price transparency is just a “race to the bottom,” with the format forcing dealers to sell at rock-bottom prices” — Navigate 2019 Conference.

The market has assumed that CarGurus’ freemium business model is one which forces prices downwards due to its transparency and equality between listings, only distinguishing between good and bad deals. Dealers are unable to charge higher prices in fear of being labelled as “overpriced” and so prices are naturally kept low. Commentary and industry speakers have highlighted this as being unsustainable for most firms in the industry and for a business that does not have good relationships with dealers due to this business aspect, it will suffer in the long run.

However, CarGurus is the exception and this is shown with CarGurus’ data indicating an improving year on year dealer churn, with dealer churn rates falling 28% from Q4 2016.

Dealer churn rates falling 28% from Q4 2016

Furthermore, ever rising monthly revenue for dealers from selling vehicles have been growing at CAGR between 29% and 42%, depending on the year in which a cohort of dealers joined CarGurus.

Growing monthly revenue by dealership cohort

What we can gather from this aforementioned data is that CarGurus have the greatest inventory turnover as well as the most customers on their platform. It is because of this reason that I believe CarGurus will continue to improve their churn rates, acquire more dealerships, continue increasing cohort revenue and prove the market wrong and assuage market fears, as their value proposition to dealers outweighs the downward pressure on prices of the freemium model.

Thesis II — CarOffer

CarOffer connects wholesale buyers and sellers of cars, and was acquired by CarGurus for a 51% stake at a valuation of $275m. What CarOffer does, can be summed up in a simple analogy — If I have 100 cookies to sell and I can only sell 100 and you can only buy 10, we cannot do business. But, if you have 9 other people each willing to buy 10 cookies each to purchase the other 90 cookies combined, I can sell you my 100 cookies.

CarOffer aggregates individual demand for wholesale cars and matches it to wholesale car sellers using their Buying Matrix platform. This is the important component of their business which CarGurus will be integrating into their platform.

CarOffer value

The acquisition opens CarGurus to the wholesale automotive market with a total addressable market of $7–8bn annually. CarOffer has been historically able to increase dealership turnover by 20–25% Using these figures to do a quick back-of-the-envelope valuation signifies the possible impact of this deal on CarGurus’ clients and one of their KPIs — average annual revenue per subscribing dealer.

If each dealer sells an average of 12 vehicles, at an average price of $22,000, a 20% increase in dealership turnover means an extra $264,000 to each dealer per year, which is a 63% increase to their current average annual revenue per subscribing dealer. At current dealer levels of 30,000, this represents an added revenue potential of $79m, a 14% increase in revenue.

This represents a huge value opportunity for CarGurus to capitalize on, and the market has not reacted to the news in the way in which it should have, primarily because of the market’s fear of the wholesale automotive industry being affected by the closure of brick and mortar stores.

Market fears — The market expects the number of dealership brick and mortar stores halving by 2025. Various industry research has indicated this, and it is true that the wholesale market will be affected by this.

However, it is also important to note that CarGurus is well insured against this. The buying matrix algorithm and CarOffer’s business model is designed with the shift to digital in mind, and this is one of CarGurus’ vision points for the next 5 years.

The above diagram highlights CarGurus’ current strategy to bring the entire car buying process digital. Through launching their new consumer financing service, they are currently in the process of automating more and more parts of the buying process until it is completely possible online. What this means is that despite brick and mortar stores declining, this will be offset by the rise in digital stores and digital dealerships, operating on an inventory basis with no showroom or store. CarGurus is pioneering this, with their competitors nowhere near them, and this is one of the main areas where they will capitalize and CarOffer will be a useful addition to this as a platform with significant digital capabilities already.

Thesis III — High growth runway

CarGurus is still in the high growth phase of their business. Their revenues have been growing at astounding rates, at 60%, 43%, and 30% in 2017, 2018, and 2019 respectively prior to Covid, and they will continue to grow in post-Covid recovery.

By fueling international growth and expansion with a strong US base, CarGurus stands to exponentially grow their number of paying dealers and as a result dramatically increase their current revenues. The international portion of total revenue has been growing, from 1% to 6% of total revenue over the past 5 years, and a large portion of CarGurus’ valuation is based on this expansion growing revenue.

Future growth potential — With 55,000 dealers internationally (in the UK and Canada) and assuming CarGurus can replicate their US market paying dealers penetration rate of 54%, with an annual average revenue per subscribing dealer of $4200, CarGurus stands to make:

55000*0.54*4200 = $124.7M

in annual revenues if they can replicate their US market dominance internationally. This is 4x their current revenue, and with CarGurus having only 6700 paying dealers currently in international markets, their growth prospects remain strong.

$124.7M is a realistic figure, given significant market share gains for CarGurus. As a comparison point their main rival in the UK, AutoTrader who currently only operates in the UK, has annual revenues of $368.9M. Given CarGurus’ international expansion also covers Canada and not just the UK, this projected revenue potential can be viewed as a base case.

Market concern — the main market concern behind CarGurus’ international expansion is their halted efforts in Italy, Germany, and Spain. At the start of Covid, CarGurus halted international expansion in these regions and instead focused on the UK and Canada.

While this may seem negative, in reality this was a well thought out move for the business regardless of the pandemic.

CarGurus’ UK and Canada segments have been growing pre-Covid at CAGRs of 66% and 19% respectively, whereas geographies like Italy, Spain, and Germany exhibited much slower growth. Moreover, the latter countries were the ones to be particularly affected by Covid.

CarGurus’ strategy will pay off, and with their freemium model, product offerings, and focused expansion efforts, they will be able to consolidate market power in new geographies by using their strong US base to support their newer endeavours. Their growth potential is yet to be fully realized, and their growth trajectory seems promising.

Valuation

With all of this future potential, unrealized power, and a high quality business, how much is CarGurus actually worth to investors?

My valuation for CarGurus was done using a discounted cash flow model, by forecasting the income statement, balance sheet, and cash flow statement, creating a revenue projection model and using these to calculate the present value of CarGurus’ future free cash flows, and using an exit multiple method, I came to my final price per stock valuation.

Some of the key metrics for my valuation -

• I used a weighted average cost of capital (WACC) of 8%. This was a conservative figure given Damodaran’s estimated 5.37% WACC for the software entertainment industry which he categorizes CarGurus as part of, as well as my own calculated WACC of 5.06%. While these figures may seem extremely low, it is important to remember that the industry and CarGurus specifically, is a business with a lower innate risk due to the non-cyclicality of the used car market and as a high quality business, a lower WACC is representative.
• I used an EV/EBITDA multiple of 12x which I believed was conservative, given CarGurus current EV/EBITDA multiple of 22x, and assuming the space becomes less attractive over time, I believe my multiple is sensible.

Finally, these next few diagrams represent my valuation for CarGurus in a bear, base, and bull scenario. I do believe that CarGurus is an extremely high quality business, and that is probably why it has been featured in the portfolios of over 31 hedge funds. CarGurus is a company that I would be comfortable holding, and one which I would encourage investors to look into themselves.

Adideb Misra is a Research Analyst for Alternatives at the London School of Economics’ Investment Research Group, reading Economics.

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