Put CARG On Your Watchlist For International Growth
Summary
- CARG stock price has risen 30%+ since early October and is now looking fully valued.
- Revenue is growing ~28% y/y but international losses are capping and hiding strong US earnings growth.
- The current frothy market is not the time to build substantial positions, particularly in growth companies, but CARG should be on your watchlist and a buy below $34 per share.
"Be fearful when others are greedy." Warren Buffett
The current market confidence and record highs feels fragile to many long term investors. Buying fully valued growth stocks like CarGurus (NASDAQ:CARG) at a time like this is unlikely to be an optimal entry point. Still, CARG is a fast growing company with a strong position in the US and investing in building dominant positions in international markets, so it is worth putting on your watch list for a better entry point. It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.
#1 - Strong market position - "Be the toll-road"
CARG is an online car sales website linking dealerships and other sellers to car buyers. Network dynamics are vital for marketplaces like CARG and a strong leadership position is vital. With sound management a leadership position can be built to an almost impregnable market position, much like Facebook in social media or Google in search. For car sales, CARG is the leader in the US.
Source: Q3 CarGurus Investors Presentation
Visitors to CarGurus website tend to spend more time on their site than competitors, thus indicating a deep engagement. Still there is room for audience growth with only 40% of unique visitors in the United States, not to mention continued growth from users new to car sales websites.
Source: Q3 CarGurus Investors Presentation
#2 - Q3 Earnings - strong growth continues
Earnings for CarGurus continued to show growth in revenue while investing in growth, particularly internationally.
- Revenue grew 26% Y/Y to $150 m for Q3.
- Profits fell to $10.4 m (0.09 a share) from Q3-18 $13.9 m (0.12 a share)
US operations growth continues.
As the market leader CarGurus is now focussing on deeper and more effective support for its clientbase. The company uses metrics such as AARSD (average annual revenue per subscribing dealer) and connections to show the increasing value of the platform. AARSD keeps CARG focussed on what matters most, which is the value to their clients.
Source: Q3 CarGurus Investor Presentation
Sell more things to existing clients.
CarGurus currently gets almost 90% of its income from dealer subscriptions to its online marketplace, with the rest mostly advertising. In the US there is an estimated 43,000 dealers and already 28,600+ are subscribers to CARG. CARG is still adding dealers but is putting more focus on delivering more value both by investing in the brand to develop more organic leads, but also through a greater range of products and services, such as finance and insurance sales. So far this is helping increase AARSD at a higher rate (21%) than leads (16% YTD) and that's faster than unique visitor growth (9% YTD).
International - too small to matter yet, but it will soon.
The US market is still the core of CarGurus with 94% of turnover and all profit as the growth focus starts to shift to international markets. CarGurus have launched in Canada, UK, Germany, Italy and Spain. Combined the future opportunity is bigger than the US with ~55,000 dealers, yet only 6,507 have signed up so far. Growth in the last 12 months has been impressive at almost 100% p.a. If growth continues at this rate, or even slows to ~50% in the coming years, it will quickly become the main driver for growth.
Source: Q3 Investor Presentation
International - has lost $30 m so far in 2019.
International operations lost around $30 m USD for the first 3 quarters of 2019, which is to be expected in the early days, but investors would want to start seeing signs of a positive trend in a few more quarters. At current rates that might not take long, but is not guaranteed.
International - the place to watch.
Fast growth on a small "early adopter" position means far less than being the market leader in an established market. If CarGurus maintains growth at current rates or even at rates above 50% p.a. and starts to head towards break-even on international operations then the stock multiple could be re-rated. Quarterly losses have stabilized (see chart below) whilst growth continues, even outside of the Pistonheads purchase. But a positive earnings trend isn't in evidence yet. It is worth staying tuned though because if losses started declining the stock would be rerated quickly.
Source: Caterer Goodman from CARG data
#3 - Valuation
Valuations under different scenarios.
We look at different outcomes for growth and profit so we can consider what the stock price range, both under best and conservative scenarios.
Historical earnings valuation.
Warren Buffett often argues that only historical earnings truly count, so let's start there. Based on a market capitalization of about $4.3 billion we can look at the PE ratio for 2018 earnings and the last 12 months overall. We then remove the losses for the international division to see what the valuation for the US looks like solo.
Source: Caterer Goodman from CARG data
Note: we have adjusted reported 2018 earnings from $65.2 m to $25.5 m due to the due to a one-off tax benefit of $39.6 million.
Forward PE valuation.
We've forecast a range of outcomes below to see what the valuation looks like under
Source: Caterer Goodman from CARG data
Assumptions and Comments
2019 Fully Year - At the Q3 conference call, CarGurus management set the range for net income for 2019 at $63.6 to $65.6 m. Given the recent trend of exceeding earnings forecasts, our assumption of $64 m could be quite conservative.
2020 - In 2019 revenue grew (27%) whilst net income likely grew from $25.5* m to a forecast $64 m (~150%) despite international losses. (*adjusted for one-off tax benefit). Net income is unlikely to continue at that heady pace, so if we assume that US net income grows by a low end 30% and high end of 60% to see the extreme range of views. We will also put on the positive and negative scenarios for international where losses fall to $10 m or remain roughly unchanged at ~$40 m.
Valuation Bottom-line - A bit too pricey
We believe the forecast earnings for 2019 are most influential now we are passed Q3. A Price to Earnings ratio of 67 is still well above the 35-45 range we think is reasonable for a company with CarGuru's growth profile. We don't believe the 150% net income growth is sustainable and a range of 30-60% is far more likely. But CarGurus only looks attractive value if we assume that the US grows net income at 60% and international operations reduce losses quickly. That much luck is not the definition of "margin of safety".
How CarGurus could justify a higher valuation.
CarGurus great growth so far however shouldn't blind you to some of the risks and imperfections that exist. These include:
- What if sustained profitability doesn't arrive? Management says that it is investing in growth, and we tend to believe them. But it's possible that high rates of marketing spend might be required to maintain market position. There is a vast valuation difference between a company with high consistent margins and one with lower margins. CARG should get there, but hasn't yet demonstrated beyond doubt that it belongs in elite company.
- What if international expansion fails? CarGurus is investing significantly in international growth, which is the right thing to do. Although the signs are good so far, overseas expansion may yet fail. The usual failures are due to cultural, legal, political or market differences but rising anti-American technology firm bias is also rising in European Union.
- What if Tesla's direct sales a sign of things to come? It is easy to overstate the risk here given Tesla's direct sales, even with growth, remain a tiny share of US vehicle sales. Legal challenges to Tesla's direct sales continue in many states. Still, it is not impossible to imagine CarGurus being affected if dealerships decline due to Tesla selling directly and/or membership based self-driving car services.
- Langley Steinert controls 50% of voting stock. Anytime someone has complete control there is a risk that this voting control isn't used wisely. The obvious counter argument is that CarGurus has grown very strongly under the leadership of Mr Steinert, so right not it is a positive. Still, shareholders should keep a clear eye on the decisions and goals that are set by management.
#4 - When to buy? Below $34
We'd argue that given current market conditions and full valuation that those considering a purchase of CARG should either start small or preferably wait. CarGurus has a strong market position producing strong network dynamics, good growth and international opportunities which are currently dragging on profitability, so remains a good long term opportunity. The wider market however is looking frothy and a wobble from a trade deal delay, worsening global growth or profit taking may see a correction like mid year (and hopefully not like December 2018).
Data by YCharts
For CarGurus there appears to be good support at the $30-32 per share range, but with strong growth continuing we often find support lines edge higher over time.
We think only investors looking for growth stocks should consider CarGurus and even then should be patient enough for an entry price of $34 per share.
This article was written by
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.