Cars.com – Spin-Off Requires Discounting Before Appeal Lures – Seeking Alpha
Cars.com (CARS) has finally become a pure play after its spin-off from parent company Tegna (TGNA). As the former parent and Cars.com do not have much in common, the spin-off should provide a lot of room for an incentivized and ¨freed¨ management team to start creating a lot of value for shareholders.
While Cars.com could certainly welcome a boost to its operational performance, I wonder if the new management team can create much value given Cars.com’s recent struggles even while operating in a true growth industry.
A Quick Look Back In Time
Cars.com has been around for nearly two decades; the online automotive marketplace was founded back in 1998. Media company Gannett (GCI) fully acquired the business in 2014, and the purchase of the remaining 73% stake in Cars.com valued the business at $2.5 billion at the time.
Gannett itself split up the business a year later, the summer of 2015. The newspaper and publishing business continued to operate under its namesake brand, and the broadcasting and internet business (including Cars.com) became Tegna. In September of 2016, Tegna announced that it plans to spin off Cars.com in a transaction that finally took place in May of 2017.
Cars.com describes itself as a two-sided digital marketplace. It allows consumers to make more informed buying decisions, and partners gain access to a larger audience, through which they can reap market share.
These services resulted in revenues of $630 million in 2016. Cars.com remains a relatively modest player given the $30 billion market opportunity. Consumers are attracted to 4.7 million vehicles being listed as inventory on the website, supplied by more than 20,000 dealer partners and consumers. The company claims in its investor presentation that it has the best mobile app, as well as the best brand awareness. This latter claim is backed up by the Millward Brown Brand tracker: Cars.com is beating the likes of Autotrader, KBB, Edmunds and TrueCar, among others.
These websites and their underlying companies play a crucial role in the buying decisions being made by consumers. The number of dealership visits (in order to buy a car) has dropped from 5 times to 1.6 times over the past ten years. Instead 95% of buyers use digital sources when they are shopping for a car, and 20% of them end up at Cars.com.
The business model is heavily geared towards retail customers, where the company generates $463 million in revenues, or 73% of the company´s total sales. Most of this comes from subscription fees (53% of total revenues) and OEM and advertising makes up 18% of total revenues. The wholesale business generates $170 million in revenues, driven by a subscription based model as well.
To sum it up, Cars.com is an interesting business with a recurring revenue model, scale and good cash flow generation. A strong position with regard to data and bright prospects for growth in the wider industry makes business prospects look good.
There are some negative trends at work as well: total traffic fell by 5% in 2016 to 412.3 million visitors, and the number of dealer customers fell slightly as well. Despite this drop in traffic, Cars.com has managed to grow sales by 6% last year – adjusted EBITDA improved to $260 million. The 41.1% margins were up a full point compared to the year before.
The company does not expect to replicate this performance this year. Sales are seen flat to up 2% at best, while EBITDA margins are expected to fall and come in between 38% and 40%.
The cash flow conversion of the business is great however. Organic capital spending amounts to just $10 million per annum, while D&A charges combined run at $83 million. The big gap is occasionally ¨filled¨ in terms of incidental large cash outflows as a result of bolt-on deals. Cars.com in the past has made multiple deals including for DealerRater, Newcars.com and PickupTrucks.com.
Tegna´s investors will receive one share of Cars.com for every three shares in Tegna that they owned before the spin-off took place. In May, Tegna posted its first-quarter results, revealing a diluted share count of 217.6 million shares. That suggests Cars.com will have 72.5 million shares outstanding, valuing equity in the company at $2.03 billion given a per-share value of $28.
Unfortunately Tegna has shifted some debt onto the books of Cars.com, as Tegna will pay itself a $650 million cash dividend from Cars. The company claims that leverage is seen at 2.5 times following this payment, based on $260 million in adjusted EBITDA. This suggests Cars.com will operate with a $650 million net debt load, implying that the entire business is valued at $2.68 billion. This is pretty much the same as the valuation at which Gannett acquired the remainder of the company back in 2014.
As revenues are more or less seen around $640 million, we can estimate adjusted EBITDA at $248 million this year, based on the guidance for margins of 38%-40%. If we subtract $83 million in D&A charges, adjusted EBIT is seen around $165 million. Given the $650 million net debt load, I see interest costs at close to $30 million per annum.
After applying a 35% tax rate, earnings are seen at $88 million after taxes, equivalent to an earnings per share number of $1.20. That values the company at 23 times earnings. While that seems reasonable for a leading player with solid prospects, we have to factor in that traffic to the website is softening, as sales are seen flattish and margins are coming down a bit. On the bright side, the gap between D&A charges and capital spending is huge, so cash flows exceed GAAP earnings power by nearly a dollar per share.
Final Thoughts: Can A Focused Company Unleash Growth Powers?
Cars.com has pretty much been a stagnant business over the past two years, despite the great ambitions. While sales and EBITDA have seen continued improvements, real underlying metrics such as traffic have not.
Leverage is reasonable, but manageable, given the cash flow generation. Yet a 23 times multiple for a company that is not seeing any earnings growth in a growing market seems like a full valuation. This is certainly the case given that the company relies heavily on traffic. An invasion by any large company (Google (NASDAQ:GOOG) (NASDAQ:GOOGL) or Amazon (NASDAQ:AMZN)) might hurt the prospects for Cars.com. This is pretty much the same as what some of these players have done and continue to do for MRO businesses, retailers, or virtually any kind of distribution/traffic business – which is what Cars.com really is.
The company is now valued at 4.2 times sales, which seems a fairly steep multiple if margins indeed are to come under further pressure. TrueCar (NASDAQ:TRUE) is a $1.6 billion peer that trades at 5.8 times sales, yet it is actually growing its sales by 22% year on year in the most recent quarter. In Cars.com´s defense, TrueCar is not posting any profits.
Auto Trader Group PLC (OTC:AUTO) is growing sales by low double digits, but is posting sky-high operating margins of +60%. Based on this incredible combination of rapid growth and very high margins, Auto Trader Group trades at roughly 13 times sales.
So while the relative multiples look reasonable, and Cars.com´s valuation can certainly be defended, certainly if we focus on cash flows instead of earnings, the ¨unleashed¨ management team has to start delivering on growth on all metrics to justify this valuation and create appeal. This includes finding more partners, growing reach and accelerating sales growth momentum as it maintains margins at current levels.
I typically like spin-offs, as a focused management team often has the potential and ability to create a loft of value for investors. As I am still awaiting the typical sell-off in the shares, given that the initial owners of the parent company often become willing or forced sellers, I am patiently waiting for a nice entry point. At levels in the low-twenties I would be willing to pick up a few shares as part of a speculative position.
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.