2 stocks in investment funds’ portfolios. CarGurus: Car marketplace with 38.9% upside potential

Despite the high level of competition in the market, CarGurus has established itself as one of the most visited automotive websites in the US due to its value offering and systematic development strategy. The company's platform offers car dealers three subscription levels for listing and selling cars. Most dealers use an advanced subscription plan that allows them to call and email potential buyers, as well as post a website link, branding, and additional information.

In 2021, CarGurus acquired a 51% stake in CarOffer, then a young, fast-growing digital car wholesale platform. The platform allows dealers to make transactions to purchase and sale cars online, setting the requirements for vehicles.

CarOffer started operating only in Q3 2019 and already in Q1 2020, under the new parent company’s management, it became a profitable business with TTM revenue of more than $1 billion. Up to Q2 2022, CarOffer had shown an impressive revenue growth rate. However, in the next reporting period, the indicator declined compared to both previous quarter and previous year. Since then, CarOffer's revenue has steadily declined. In Q2 2023, the wholesale segment revenue was $69 million compared to $347 million a year earlier. Due to problems in the wholesale segment, CarGurus stock came under pressure and is now trading several times lower than the spring 2022 levels.

Digital wholesale financials; source: Company Presentation

The problem was caused by the declining prices for used cars, against which dealers tend to reject cars because they do not meet their request, as well as start arbitration processes due to any shortcomings. When a dealer rejects a car, the company needs to offer the vehicle to another dealer at a lower price or send it to auction at a loss.

CarGurus takes measures to overcome the headwinds. The company’s management announced its intention to carry out more thorough inspections of vehicles. It also has engaged partners to inspect the vehicles for frame damage, as well as to test the mechanical condition and electronics. In addition, during the latest conference call, CarGurus’ management highlighted several positive macro data that may indicate an imminent recovery in the used car market. However, it is worth noting that the price dynamics remain predominantly negative.

The dynamics of prices for used cars; source: Company Data

In our opinion, headwinds in the wholesale segment are somewhat overestimated by the market. Despite a significant share of the segment in the revenue structure, it accounts for an insignificant part of the company's profit. Thus, despite a dramatic 53% decline in total revenue in Q2 2023, adjusted EBITDA declined by only 19% YoY, as more than 90% of earnings before interest, taxes, depreciation, and amortization are accounted for by the retail business segment marketplace.

The retail business remains healthy. The number of paid dealers on the platform remains stable. At the same time, the average quarterly revenue per dealer in the US rose to $6,110 from $5,771 a year earlier. Revenue per international dealer increased from $1,533 to $1,601. As a result, quarterly revenue in the segment reached $171 million from $164 million a year earlier. Adjusted EBITDA declined marginally from $42 million to $41 million. However, the firm's management noted that it expects the segment's EBITDA to rise consistently.

Marketplace segment financials; source: Company Presentation

Financial performance

CarGurus trailing 12 months' (TTM) financial performance can be summarized as follows:

• Revenue amounted to $1.18 billion, down 28.4% from the end of the year. The decrease was due to negative dynamics in the wholesale segment.
• Gross profit decreased from $657.6 million to $606.9 million. Gross margin increased from 39.73% to 51.22%, due to a significant reduction in costs in the wholesale segment, as well as due to an increase in the share of a more profitable segment in the revenue structure.
• Adjusted EBITDA was $159.9 million versus $186.7 million for the year. EBITDA margin increased from 11.28% to 13.49%.
• Net income rose from $193.8 million to $298.8 million, driven by interest and other income. Net margin increased from 11.71% to 25.21%.

Dynamics of the company's financial results; source: compiled by author

• Cash from operations amounted to $264.2 million versus $256.1 million at the end of the year. The growth is due to the dynamics of net income.
• Free cash flow increased from $250.2 million to $256.7 million.

Company’s cash flow; Source: compiled by author

CarGurus has a strong balance sheet: the company has no debt, cash equivalents, and short-term investments account for $453.6 million, and net debt is, accordingly, deeply negative. A substantial cash reserve with positive cash flow and a strong balance sheet is a potential catalyst for unlocking business value. In December 2022, CarGurus authorized a $250 million buyback program, under which $144 million is still available to the company.

Stock valuation

Although CarGurus is one of the few players with an efficient business model and positive cash flow in its market, the company trades at a significant discount to peers on the following multiples: EV/Sales — 1.35x, EV/EBITDA — 15.18x, P/Cash flow — 10.71x, P/E — 8.38x, FWD P/E — 15.34x.

Comparable valuation; source: compiled by author

The minimum price target from investment banks set by Piper Sandler is $15 per share, while B. Riley estimates CARG at $28 per share. According to the Wall Street consensus, the stock’s fair market value is $25, implying a 38.9% upside potential.

Price targets of investment banks; source: compiled by author

Key risks

• CarGurus operates in a highly cyclical industry. Although we believe that the expected recession is reflected in the current price, there is a possibility that the deterioration in consumer sentiment will have a greater impact than we think. In this case, the stock may remain under pressure for an extended period.
• Although we believe that headwinds in the wholesale segment are somewhat overrated by the market, a further revenue decline in the segment could put pressure on the company's financials and its stock price for an extended period.
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