Cars.com Is Not In The Growth Race (NYSE:CARS)

Cars.com (NYSE:CARS), one of the strongest participants in the online automotive space, has seen its stock do nothing more than experience aggressive fluctuations since the beginning of 2022 and has been down 20% since 2019. In contrast, the Dow Jones is up more than 15% and 50%, respectively. Now, the company has a relatively cheap forward PE multiple of just 10, but because of CARS’ lack of growth, the stock is likely to underperform the general markets. I think the stock is just a hold.

Cars.com business model and lack of growth

Taking a look at the latest 10-K annual report, CARS’ primary business is, of course, the leader automotive website cars.com. Here, the company has different ways of getting revenues. The first and most important one is through car dealer subscriptions, which provide access to the web page’s traffic of more than 600 million views and impressions from more than 26 million unique monthly active users.

Going deeper, this subscription-based revenue comprehends about 90% of revenues as reported. It also has some advantages that provide a lot of solidity to the business income, but on the contrary, they also make it very difficult to grow. For example, the main advantage is that because cars.com is one of the most important automotive websites in America, many mid- and small-car dealers need their cars for sale to be listed there.

This means the website is somewhat of a vertical software solution for those dealers. Hence, the revenue stream is extremely solid and more resilient to cyclicality because, without cars.com, the dealers would be losing important revenue opportunities.

The other important revenue stream for CARS is advertising revenue. However, it is only about 8% of total revenues and is also referred to in the report as OEM and National. This source of income is way more volatile as it moves following dealers’ inventories. When it is more difficult to sell cars, dealers opt to increase advertising expenditure, while on the contrary case, dealers do tend to diminish marketing expenses, as mentioned in the last earnings call.

On the other side, the main disadvantage I see in the entire business model is that while cars.com is an important website, the competition is quite fierce. Some of the other web alternatives are the widely known CarGurus, TrueCar, and AutoTrader. In many aspects, the platform also competes against CarFax and KBB. This means that, unlike a genuine and authentic vertical software company, cars.com is not a fundamental component for many of its clients to work correctly, but just one must-have amongst others. Cars.com is not Autodesk, Cadence, or Adobe. As I see it, CARS is more like the old local newspaper without a proper brand strength and is more similar to a commodity advertiser.

This lack of complete market dominance means increasing prices is complicated. By looking at metrics like total revenues and the number of dealers, excluding the recent AccuTrade initiative, the revenues per dealer have been relatively stagnant, even compared to 2019. I believe the company cannot raise prices easily because competition and market dynamics don’t allow it.

It is also difficult to get new organic customers because almost everybody who needs to be a client already is. In its recent earnings call, the management was clear on that and that getting a big dealership client would be game-changing for the company, although this is a low-probability scenario.

Since around 90% of the revenues come from this subscription service and just about 8% from advertising, the entire company’s revenues are also stagnant or barely growing, as shown in the last earnings presentation.

The Q2 2024 earnings results

For the current Q2 2024 earnings, CARS’ reported some bitter-sweet results. First, a 6.4% revenue increase, which is ok, but 4% of that was caused by the D2C media acquisition last year. This, together with lower Active Unique Visitors of 26.1 million, compared to last year’s Q2 of 26.9 million, shows the difficulty the company has in growing organically.

On the good news side, the company’s EBITDA increased 10% year-over-year, primarily caused by the D2C acquisition and the advertising revenue that grew 28%, caused by dealers increasing expenditures as their inventories rose. Also, the EBITDA margin expanded by 1.1% due to the operating leverage that the business has in the advertising space. Still, I do not think that EBITDA expansion is a significant long-term trend as it seems to be caused by cyclicality and deceleration in the automotive industry and higher dealer advertising expenses.

The CDK Global outage impacted CARS’ clients, which impacted the AccuTrade growth momentum, following what the management said in the earnings call. Although I don’t think AccuTrade is yet that material since it’s just about 2% of revenues, it is an interesting initiative that the company has to achieve some growth over time. Cars.com acquired the firm in 2022.

The company also reports lower dealer customers than in 2022 but has managed to keep a higher ARPD than in 2022. Unfortunately, even that metric stagnated since last year.

From a financial standpoint, CARS has some minor weaknesses in the balance sheet, like $470 million in long-term debt, giving a 2.2X leverage ratio, which is fairly manageable but something to keep in mind if the business sees some revenue fragility in the future.

The company also has spent $14.4 million buying back common stock since the beginning of the year, almost matching the $16.7 million paid in stock-based compensation.

What would happen with the stock?

Currently, CARS is valued at a forward PE ratio of 10, which is usually considered cheap. Unfortunately, the company is barely growing with the legacy subscription business and has a little component of cyclicality in the advertising segment. While AccuTrade is interesting, it is still not material enough to propel growth in the short to mid-term. The management sees a likely 2-4% revenue growth for the end of this year, but without organic growth ahead, it is quite difficult to get optimistic about a growth acceleration.

Since the business is also pretty solid, with a decent balance sheet with net leverage close to 2 and an adjusted EBITDA margin of around 28%, I don’t envisage a stock decline easily from these cheap valuations. On the contrary, with eventual lower interest rates, the business could see some small margin expansion from lower debt payments likely after 2026 and higher stock valuation multiples.

Valuation

The stock might be close to fairly valued at a current forward PE of 10. For the following valuation framework, providing a small multiple expansion to 12 in the eventual PE ratio due to lower interest rates and the CARS’ inability to grow revenues consistently over time.

Additionally, projecting that AccuTrade does not explode its revenues and the company doesn’t make more acquisitions, I consider that a 2% earnings growth might be conservative but a realistic target for the stock to follow.

The framework also provides a small net share reduction product of the company’s big stock-based compensation while also buying back the stock accordingly. As a result, the company might give a close to 5% CAGR in 2027, which is, in my opinion, not compelling at all if we just compare this to even long-term bond returns at this moment.

Conclusion

While Cars.com is a solid company with a staple-ish business model for its dealer customers, has a decent balance sheet, and a conservative management, the stock is not poised to perform well enough in the long term in my opinion, due to its inability to achieve enough revenue growth sources. Hence, the stock is a hold, and if you can consider deploying the capital better, it could even be a sell.