Cars.com (CARS): A Cheap Enough Stock with a Clear Catalyst and Tons of Rivals
About a week ago, Starboard Value disclosed a 9.9% position in Cars.com (CARS). Starboard Value is an activist hedge fund. It is probably best known for its 294-page presentation on Darden Restaurants (DRI) back in 2014. You can read that presentation here (PDF). Cars.com is a 2017 spin-off from Tegna (TGNA). Tegna is the rump of the old Gannett. It consists mostly of local TV stations. The public company now called Gannett (GCI) was spun-off from Tegna (then known as Gannett) in 2016. It consists mostly of USA Today (a national newspaper in the U.S.) and about 100 local newspapers.
So, in a sense, the public company Cars.com was formed as a break-up of a break-up.
Cars.com is a research website for car shoppers. Publicly traded competitors include CarGurus (CARG) and TrueCar (TRUE). TrueCar went public in 2015. You can read its IPO prospectus here. CarGurus went public in October of this year. You can read its IPO prospectus here. Because Cars.com was a spin-off instead of an IPO, the SEC document it filed is different. You can read Cars.com’s 2017 spinoff document (its S-1) here. The company has yet to file a 10-K. You can read the most recent 10-Q here.
I’m not going to describe what Cars.com does, because you can visit the website or download the app (today, most people use the app) and play the role of customer for yourself. No description I can give you will explain the company better than having you just give the website a whirl.
So, I’m not going to explain Cars.com’s business. What am I going to do?
I’m going to explain why I’m writing to you about the stock.
I’m writing to you about Cars.com stock for 3 reasons:
- An activist hedge fund, Starboard Value, now owns just under 10% of the company
- The stock’s history is that Cars.com was bought by Gannett (then a TV and newspaper company) in 2014 and then Gannett broke into two parts in 2016 (Cars.com went with the TV part) and finally Cars.com was broken off of an already broken-off company. So, there are no long-time owners/analysts/etc. of Cars.com stock and many of the investors who have held the company’s – or its predecessor’s – shares were not originally interested in owning a website.
- Some competitors of Cars.com trade at much higher multiples of sales, earnings, etc. than Cars.com does.
In other words: this is a Joel Greenblatt “You Can Be a Stock Market Genius” type situation. The company is the end result of a fairly recent (2014) acquisition and two very recent (2016 and 2017) spin-offs. Most importantly, the stock appears to be a relative value.
Is it a good business?
Quality
The business model is theoretically a good one. And the company’s current financial results are very solid. A website like this has economics similar to a local TV station. For full-year 2017, management is guiding for an adjusted EBITDA margin of 38% of sales. The business requires minimal tangible capital to run (receivables are the biggest use of capital). I’d estimate the business has – over the last 9 months – produced about $120 million of free cash flow while tying up maybe $60 million of net tangible assets. A triple digit after-tax return on net tangible assets seems certain. It’s really not important to know whether a business has an 80% return on capital, a 160% return on capital, or a 320% return on capital. Once you hit ROC numbers like that – growth is good and you don’t need to retain much capital to fund it. By the numbers, it’s a great business. That’s all you need to know.
Growth
Here’s our first problem. Cars.com isn’t growing. The most recent earnings release had sales down 1% (which is what’s expected for the full year). The number of visitors was up 3%. However, the number of visits was down 1%. This means the people who are visiting the website are doing it less often. Is this a good result or a bad result?
It’s hard to say. Here’s the most remarkable fact you’re going to read about Cars.com. During the first 9 months of this year, Cars.com spent exactly the same amount on marketing as it did over the first 9 months of last year.
Cars.com spent $160 million on marketing during the first 9 months of the year. That annualizes out to about $213 million spent on marketing.
Let’s compare this to some competitors.
2017 increase in Cars.com marketing spend: +0%
2017 increase in TrueCar’s marketing spend: +22%
2017 increase in CarGurus’s marketing spend: +55%
So, is a 1% decline in website traffic and a 1% decline in overall revenue a good or bad result when you increase marketing spend by 0% and your competitors increase it by 22% and 55%?
It sounds good. But, there’s a difference between losing barely any sales in dollars and losing barely any sales in points of market share. Is Cars.com losing market share without losing sales simply because the online car shopping industry is growing so fast?
Let’s compare Cars.com’s sales growth to sales growth at its competitors.
2017 decrease in Cars.com sales: -1%
2017 increase in TrueCar’s sales: +18%
2017 increase in CarGurus’s sales: +65%
It looks like TrueCar and CarGurus are doing better. It looks like they will grow faster than Cars.com and overtake it, thereby achieving the kinds of economies of scale and “winner takes all” victory that the internet is known for.
But, there’s a catch. And again, it’s marketing we need to talk about.
Let’s compare Cars.com’s marketing spending as a percent of sales to its competitors.
Marketing spend at Cars.com: 34% of sales
Marketing spend at TrueCar: 57% of sales
Marketing spend at CarGurus: 74% of sales
Finally, let’s compare the current scale of the 3 companies in terms of sales:
Year-to-date Cars.com sales: $470 million
Year-to-date TrueCar sales: $240 million
Year-to-date CarGurus sales: $226 million
So, Cars.com is about double the size of TrueCar and CarGurus. However, TrueCar and CarGurus spend about the same amount on sales and marketing as Cars.com does. This must mean that while Cars.com is already highly profitable – TrueCar and CarGurus aren’t.
Let’s check 2017 operating profit at the 3 companies.
Year-to-date operating profit at Cars.com: $95 million
Year-to-date operating loss at TrueCar: ($23 million)
Year-to-date operating profit at CarGurus: $15 million
So, Cars.com has about double the sales and 6 times the profits of TrueCar and CarGurus. How do the enterprise values of these 3 companies compare?
Relative Value
As I write this (on Christmas Eve 2017), Cars.com has a market cap of $2.12 billion and about $590 million in net debt. Let’s call the enterprise value $2.7 billion.
TrueCar has a market cap of $1.13 billion and about $196 million in cash (with no debt). Let’s call the enterprise value $930 million.
CarGurus has a market cap of $3.17 billion and about $85 million of cash (again, no debt). Let’s call the enterprise value $3.2 billion.
Using those numbers – which I won’t promise are anything but a quick back of the envelope by me – we get EV/Sales ratios of 4.3 for Cars.com, 2.9 for TrueCar, and 10.3 for CarGurus. Those are annualized numbers where we just assume sales in the fourth quarter will be one-third of sales in the first 9 months of the year. That’s probably unfair to the faster growing companies.
What’s interesting here is that the already highly profitable company – Cars.com – is not trading at a much higher multiple of sales than its much less profitable competitors. These competitors are growing much faster. However, the competitors are buying this growth with very high marketing spending as a percent of sales. Remember: TrueCar grew its sales by 18% year-over-year while growing its marketing spending by 22% and CarGurus grew its sales by 65% year-over-year while growing its marketing spending by 55%. Cars.com shrank its sales by 1% while growing its market spending by 0%. All 3 companies saw rates of sales growth that were close to their rates of marketing spending growth.
Why the Starboard Value Investment Makes Cars.com Interesting
What’s interesting here is that Cars.com is the bigger and more profitable company. However, the market is awarding the highest multiple to the company that is growing its sales the fastest. This company (CarGurus) is probably growing its sales the fastest because it is growing its marketing spending the fastest.
Basically, investors are saying that $1 of sales at CarGurus is worth more than 2 times more than the same $1 of sales at Cars.com (EV/Sales of 10.3 vs. EV/Sales of 4.3) because CarGurus is re-investing more than 2 times more of each $1 of sales in marketing than Cars.com is (marketing as a percent of sales of 74% vs. marketing as a percent of sales of 34%).
In other words, it may not be that investors like CarGurus’s competitive position better than Cars.com’s competitive position. It may just be that investors like CarGurus’s strategy (and management) better than Cars.com’s strategy (and management).
An activist investor can’t fix a poor competitive position. But, an activist investor can shake-up strategy and management.
In fact, while doing my original research on Cars.com (this was months before Starboard’s investment), the only complaint I really came across from investors, analysts, etc. explaining why Cars.com should trade at a lower multiple than its peers was that Cars.com had a less entrepreneurial culture and was a less sales growth oriented company.
Those are issues an activist can address.
Absolute Value
Cars.com is not overpriced on an absolute basis. Media properties often sell for 10 times EBITDA or more. On a leveraged basis (free cash flow divided by market cap) the stock is definitely cheap.
Rivalry
Warren Buffett’s big test of “moat” is how much damage a competitor can do through overzealous rivalry. In other words, how hard is it for a competitor to take ten percent of Coke’s market share if they’re willing to do aggressive – maybe even irrationally aggressive – things?
Some competitors of Cars.com are willing to spend 50% to 75% of sales on marketing while making little or no profit. Several of these competitors have gone public. Many are well-funded with large market caps and plenty of cash – and no debt – on their balance sheet.
Cars.com is facing some dot-com boom type competitors. They’re aggressive. They are seeking scale. And investors are willing to provide them with cheap equity capital (that is, the market will give them a high P/E ratio or even tolerate losses).
Will all this last?
Probably not. At some point, competitors will be less aggressive about marketing. At some point, investors will be less rewarding of growth and more rewarding of earnings in this industry.
But, until that’s the case, competitors of Cars.com may be able to do a ton of damage to the company through extremely intense rivalry – especially in the form of high marketing spending.
Verdict
Cars.com is a relatively cheap stock with a clear catalyst. It isn’t expensive on an absolute basis. And it is already proven. However, the industry is not settled yet. I see signs of intense rivalry. I prefer to invest where competition is getting less intense rather than more intense.
Right now: this just isn’t the industry for me.
The car shopping website industry reminds me a lot of the hotel shopping website industry. I like the growth prospects of both these industries. I like the business model of some of the players in both these industries. And I know that the winner in each of these industries will one day be raking in a lot of cash. But, in both these industries, I’m too afraid of the prospects for ultra-intense rivalry especially in the form of heavy ad spending.
So, I won’t be buying Cars.com today. However, I do recommend that Focused Compounding members look at the stock from a Joel Greenblatt “You Can Be a Stock Market Genius” type perspective. The business model is great. The relative valuation is good. And there’s a clear catalyst in the form of Starboard Value.
I recommend you research the stock and come to your own conclusion.
I plan to research Cars.com more in the future. For now: it’s a pass for me.
P.S. – A Technical Note on “Affiliate Revenue Share”
I told you I wouldn’t waste time describing Cars.com as a business. However, there is one point I want to make. Cars.com has an expense line called “affiliate revenue share”.
The explanation of this expense is: “Affiliate revenue share primarily represents payments made to affiliates for major account customers we service directly that are located in the affiliates’ market territory. Revenue recognized for these sales is recorded as retail revenues.”
That description makes no sense unless you understand that Cars.com used to be owned by a bunch of newspapers who all bought advertising packages from Cars.com at wholesale rates and then re-sold these packages to local car dealers (in the paper’s market area) at marked-up prices. The important thing to note is a bargaining power issue here. These newspapers were – at one point – both owners and customers of Cars.com. That kind of relationship tends to lead to agreements that favor the owner/customer. Once a company with these agreements is freed from the ownership grip of these customers, it’s likely to transition into agreements made when its bargaining power is greater (and its incentives – to maximize profits – are clearer). In other words, Cars.com’s margins might go up.
Some of these agreements expire in the years ahead. And I believe some investors expect Cars.com to get better terms in the future. Once Cars.com is fully disentangled from its previous owners – in other words, once the wholesale agreements expire – Cars.com may be able to either get better pricing on selling wholesale advertising packages through these former owners or Cars.com may just have no agreement and sell directly in these territories.
There is a 2014 article on the economics of Cars.com and its relationship with these newspapers that explains the issue better than I ever could. I strongly recommend you read this article.