CarGurus: Deceleration And Margin Compression Lurk Ahead
Summary
- CarGurus beat Wall Street estimates yet again for the fourth quarter, its second time reporting earnings as a public company since going public last year.
- Revenues grew 49% y/y to $85.3 million in the quarter.
- Operating margins, however, showed a meaningful contraction as product costs and general overhead ticked up.
- CarGurus shares rallied 11% after earnings, fairly valuing the stock at 10x forward revenues.
CarGurus (NASDAQ: CARG), the used-car marketplace platform for auto dealers, has reported yet another fantastic quarter that has the stock up more than 10%. Since going public last October at $16/share (though shares opened on Day 1 trading at nearly twice that price), CarGurus has been met with plenty of enthusiasm by the markets:
The reasons for this enthusiasm are fairly obvious. First, CarGurus has the distinction of having one of the highest gross margins in the market - in FY17, it generated $299.3 million of gross margin dollars on $316.9 million of revenues, indicating a 94.4% gross margin. This means that, on top of CarGurus' rapid top-line growth (49% y/y this quarter), nearly every incremental dollar of it is dropping into the bottom line. This is the driving reason behind investors' high valuation of CarGurus' revenue stream - a company with such high gross margins can benefit uniquely from greater scale.
Second, CarGurus has a dominant position in the used-car marketplace arena. According to comScore, which tracks internet traffic data, CarGurus is the leading used-car research website. This makes car dealers (2/3 of dealers in the U.S. are customers of CarGurus) rather beholden to CarGurus to draw in business. CarGurus has been able to raise prices for its core offerings while selling more premium listings - as evidenced by its "average annual revenue per subscribing dealer" (AARSD) metric, which grew 16% y/y yet again to $12,055 for U.S. dealers.
Soft guidance betraying a high valuation?
That being said, there is reason to believe that the gas in the tank for CarGurus' rally is running low, as the company reaches a critical inflection point in its high valuation.
For FY18, CarGurus is guiding to the following:
- Revenue of $396-$400 million.
- Pro forma operating income of $21-$25 million.
- Pro forma EPS of $0.14-$0.16.
As CarGurus is yet to generate a meaningful profit to support its valuation, a revenue multiplier is generally investors' most reliable yardstick for CarGurus' valuation. As of the close of trading on March 2 (the day after CarGurus' earnings report), CarGurus was valued at a market cap of $4.24 billion; netting out its $138 million of cash and no debt, the company has an enterprise value of $4.10 billion, a 10.3x EV/FY18 revenue multiple.
Of course, we do have to note that CarGurus has a track record so far of guiding conservatively (underpromise, overdeliver), and its FY18 revenue range represents 26% y/y growth at the midpoint - after 60% growth in FY17, this is almost hard to believe. But the fact remains that CarGurus does carry an extremely high valuation as it hits a saturation phase and sees deceleration on its top-line growth.
More than two-thirds of U.S. dealers are already customers. Though the company's international efforts are still nascent and can provide the next leg of growth, at CarGurus' current share price of $36, I can't help but to feel that growth execution is already priced in.
When I last wrote on the company, I had placed a price target of exactly $36 on CarGurus based on 8x EV/FY18 revenues - at the time, before having seen CarGurus' guidance released with Q4 earnings, I was assuming 50% y/y growth in FY18. Since then, with shares having rallied nearly 20% and a new guidance that suggests CarGurus' growth will come in well below 50% y/y, I don't really see a reason to own shares at a double-digit revenue multiple. At this juncture, CarGurus is at best a hold, as shares look fairly valued.
Margin compression another concern
Other than soft guidance, the other concerning factor coming out of CarGurus' earnings was the deterioration in its earnings margin. Yes, it's true that CarGurus beat on the top and bottom lines, but as it approaches the $400 million annual revenue mark, investors are expecting it to turn a profit above the breakeven it's showing now. The value of having such high gross margins is essentially nullified if CarGurus can't keep operating expenses in check.
See below the company's Q4 results:
Figure 1. CarGurus Q4 earnings
Source: CarGurus investor relations
Revenues grew 49% y/y to $90.6 million, beating analyst expectations of $86.2 million (+42% y/y) by a respectable margin. Of course, the beat is impressive in itself, but note that CarGurus is rapidly decelerating from 56% y/y growth last quarter, and 60% growth for the full year. If we believe CarGurus' guidance pointing to 26% growth next year, then we've got a huge series of decelerating quarters ahead of us.
Meanwhile, CarGurus' expenses are rocketing. Product and R&D costs nearly tripled to $8.3 million in the quarter (and doubled in the full year), while general and administrative costs doubled to $8.6 million in the quarter (and nearly doubled in the full year). As a result, CarGurus' operating income in the quarter shrank to a mere $32K, down from $4.6 million in the fourth quarter of last year - despite the huge top-line growth and corresponding gross margin dollar expansion. This indicates that the company went from a GAAP operating margin of 8% in 4Q16 to breakeven (0%) this quarter.
With CarGurus pointing to $21-$25 million in pro forma operating income in FY18 (versus $20.3 million this year), CarGurus is essentially suggesting that it won't see any improvements in operating margin this coming year. Despite the company's impressive growth, some investors are fearing that CarGurus is taking way too long to become profitable - or that it will never be massively profitable at all.
The one positive indicator on the bottom line is the fact that, at the very least, CarGurus showed growth in its free cash flows. It generated positive $5.5 million of FCF this quarter versus a loss in 4Q16, and for the full year, FCF of $18.3 million is up 43% y/y:
Source: CarGurus investor relations
We do have to note, however, that at a $4 billion enterprise value, CarGurus' FCF of $18.3 million isn't nearly enough to support its valuation, especially as it heads into a deceleration phase and the growth on both the top and bottom lines starts to taper down.
Key takeaways
With CarGurus' rally to the high $30s, I'm no longer as enthusiastic on the name as I was previously. At $30 and below, I'm a buyer; at $36, I believe shares to be fully valued.
There's no question that CarGurus operates a high-quality business with a leading market share and defensible moat. But as the company is failing to turn its huge top-line growth into profit expansion, and as revenue growth is expected to cool down this year, CarGurus' 10x forward revenue multiple might be at risk of retreating in the near term.
This article was written by
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