Could CarGurus Be the Next Top Auto Stock?

Daniel Miller, The Motley Fool

At a time when many Main Street and Wall Street investors are skittish about investing in automakers and auto suppliers amid a new-vehicle sales plateau in the U.S. market, a shroud of darkness has been cast over the broader auto industry. For savvy investors, however, that leaves a few overlooked and intriguing companies that warrant further consideration. CarGurus (NASDAQ: CARG) -- thanks to diverse and high-quality revenue, changing purchasing behaviors, and a multipronged growth story -- should be well positioned despite a plateauing new-vehicle market. Here's a look at what investors need to know about CarGurus, and what could make it the next top auto stock.

CarGurus 101

Let's dig into the basics first: What CarGurus does and how it generates revenue. CarGurus is a global online automotive marketplace connecting buyers and sellers of new and used vehicles using proprietary technology, data analytics, and search algorithms. As of the fourth quarter of 2018, CarGurus was the largest automotive shopping site in the U.S. by unique monthly visitors and total audience.

Graphic showing CarGurus ahead of competitors in monthly visits, unique visitors, mobile users and visits per visitor.

Graphic Source: CarGurus Q4 2018 Business Update, February 2019.

But how exactly does the automotive website generate revenue? From two primary sources: marketplace subscriptions and advertising. Looking first at marketplace subscription revenue, the company essentially offers three types of listing products to its network of dealers: the basic listing (free), enhanced and featured listings (requires a paid subscription, with the price determined by a number of factors), and Dealer Dashboard, which offers a number of insights and analytical tools. Advertising and other revenue is mostly nondealer displayed advertising from auto manufacturers and other auto-related brands sold on a cost-per-thousand-impressions basis.

Basically, the company makes the bulk of its revenue selling products and solutions to dealers connecting with consumers, as well as advertisements for peers looking to purchase vehicles from other peers or dealerships. Now that we better understand how CarGurus operates, what makes it a top auto stock right now?

3 reasons CarGurus is well positioned

One main factor in CarGurus' favor is that while demand for new-vehicle sales in the U.S. is plateauing -- which is hurting major automakers and auto suppliers focused on selling parts to those OEMs -- CarGurus also connects the dots between consumers and dealers for used vehicles, a market expected to challenge or exceed record high sales in 2019. And don't forget the used-car sales market in the U.S. is more than twice as large as the new-vehicle market in units sold. But while there's uncertainty surrounding the used-car industry with a wave of off-lease vehicles hitting the used market and how it will impact pricing, it's generally anticipated that prices will decline from recent highs, making used cars even more compelling compared with new vehicles. That's a development that would hurt CarGurus far less, if at all, than most auto stocks relying on specific brands, only selling new vehicles, or supplying OEMs. Because CarGurus doesn't solely focus on the new-vehicle market, it's less risky than companies that focus only in that market.

Man and woman looking at car buying options online.

Image source: Getty Images.

There's another intriguing aspect that bodes well for CarGurus' investors: The consumer behavior trend is promising. Let's look at a few figures here. Consider that in 2017 total U.S. automotive industry marketing spend was $16 billion for offline spending and $21 billion for online. From 2017 to 2022, online spending is expected to surge from $21 billion to $27 billion, while offline declines from $16 billion to $14 billion. The driving force behind this is simply consumer behavior: In 2005, consumers averaged five dealership visits on average before making a purchase, far more than the 1.6 average dealership visits a decade later in 2015. Simply put, consumers are doing more research online and completing more of their purchase online than ever before, and CarGurus is positioned well for that behavior transition.

A third reason that tends to go overlooked by investors is the quality of CarGurus' revenue. Consider that nearly 90% of CarGurus' revenue generated in 2018 was recurring from its marketplace subscription business. Further, management has improved its retention rate in recent years, keeping a higher percentage of its paying dealers annually. Even better yet, CarGurus' top 10 customers generated only 5% of its 2018 marketplace subscription revenue, which means no massive customer holds any significant leverage, and any individual customer loss won't ruin near-term results. If a picture is worth a thousand words, the following graph helps add more detail.

graphics showing high retention rates.

Graphic Source: CarGurus Q4 2018 Business Update, February 2019.

CarGurus' balance between new- and used-vehicle business, improving online consumer behavior, and revenue spread across many customers, rather than only a handful of massive customers, has the company well positioned now, but the real growth story is how it can expand in the years ahead.

What's down the road?

Let's think of CarGurus' growth story as a virtuous cycle with three key parts: Grow the size and engagement of its consumer base, which helps increase its number of paying U.S. dealers and revenue per dealer, all while perfecting its business model and scale to expand efficiently internationally.

One way for CarGurus to expand its audience and engagement is by solving more consumer needs. For example, it currently offers detailed analyses for consumers researching and comparing new and used vehicles. It also offers peer-to-peer purchase and selling, as well as delivery. That leaves a large opportunity for CarGurus to offer vehicle inspections, which goes hand-in-hand with researching and comparing -- and it could offer financing and/or insurance, as well as warranty products, to go hand-in-hand with purchasing.

It could even open up lanes for consumers to not only sell to peers, as they already do, but to also sell to businesses or dealerships. Management also notes that service and maintenance could be an opportunity for CarGurus -- and don't forget service and maintenance drive big-time profit margins for traditional brick-and-mortar dealerships.

All those previously mentioned opportunities could seriously increase the engagement of CarGurus' consumers and grow its pool of monthly active users, which should easily boost the company's value to dealerships. That's a smooth segue into how the company needs to grow and better monetize its subscribing dealers.

Outside of offering dealers a larger group of consumers to connect with, it needs to develop new products such as dealer displays, in-depth analytical tools, and audience retargeting, to name only a few. So far, management has made progress: During the fourth quarter of 2017, the company sold multiple products to 19% of dealers. After cross-selling and developing new products, the company now sells multiple products to 26% of its dealers as of the fourth quarter of 2018. Selling more products to more dealerships helps drive average annual revenue per subscribing dealer (AARSD), a huge boost to its top line. In fact, over the same fourth-quarter 2017 to 2018 time frame, CarGurus increased its AARSD from $12,055 by 23%, to $14,819.

As CarGurus continues to develop new products and grow its AARSD, its business model becomes more refined and better poised to expand internationally. So far, so good, as its number of international average monthly unique users soared 104% from 2.8 million during the fourth quarter of 2017 to 5.7 million during the fourth quarter of 2018. Further, the number of its 2,548 paying international dealers jumped 55% during the same time frame to 3,938. The U.S. will remain CarGurus' core market, but the international opportunity is a tantalizing growth story for long-term investors.

At a time when Wall Street has left many auto stocks for dead, CarGurus is a compelling business with high-quality and diverse revenue, consumer behaviors shifting toward online platforms and solutions, increasing AARSD, and lucrative potential internationally. If management continues to innovate new ways to engage a larger consumer base and cross-sell more products to dealers, it could become the next top auto stock even as new-vehicle sales plateau in the U.S. market.

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Daniel Miller has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.