CarGurus, Inc. (CARG) Earnings Call Transcript

Great. Thanks, everyone, for joining. My name is Rajat Gupta. I'm a member of the JPMorgan automotive equity research team. Very pleased to have with us CEO, Jason Trevisan from CarGurus; and also Kirndeep Singh, Vice President and head of Investor Relations.

I guess we're going to start with Q&A, just go right into it. Maybe Jason, maybe to Kirn, just a more broader macro high-level question. Could you just give us a sense of latest trends you're seeing from a consumer demand perspective? Maybe in the second quarter since you reported earnings? Maybe in early April and into May? Any pockets of weakness or any noticeable trends in your used vehicles or perhaps geographical differences that you're seeing in terms of search metrics or traffic trends?

Sure. Hello, everyone. Thanks for joining. It's nice to be here today. So the auto industry continues to see quite a lot of volatility since COVID, honestly. So it's been a few years now where we've seen volatility in new car production, in inventory levels and in consumer demand and pricing as a result. So all of those are interrelated. I would say most recently, some of the trends that we've seen, perhaps one of the most pronounced in the last 6 months has been the return of production of new cars. And so they were really sidelined for several years because of chip shortage. That's a long lead time for new car production, and so those have now started to come back. As a result, you're seeing new car inventories come back on dealers' lots. At the same time, used inventory has ticked down a bit over the last quarter or so. From a demand perspective, consumer demand has certainly weakened. Recession concerns and higher interest rates are the 2 primary drivers of weakened consumer demand. From a geographic perspective, no, I wouldn't say we've seen much of a difference in terms of demand. You've certainly seen -- we are always seeing geographic disparity in -- where higher demand -- stronger demand is based on the types of cars in the regions of the country. And that's actually one of the things that we think CarOffer, in particular, but also our platform can really help exploit in a good way, which is to help dealers create those arbitrage opportunities in sourcing vehicles or in selling vehicles from a geographic perspective. And then on traffic, no, I wouldn't say there's really any new trends other than consumer demand being down, which, in general, will create a higher cost to acquire traffic for us.

Got it. That's helpful. Maybe just to touch upon, you mentioned affordability like financing. In the previous call, you had highlighted some softening in the consumer financing segment. I mean, obviously, small contribution from a revenue perspective for the company. But if you could share any more color around any approval or credit trends you're seeing across the audience. Perhaps details in what you're seeing with regards to consumer drop-off rates. Do you do monthly payments? Or maybe -- or opposed to like just lenders trying to just stay away or being a little more strict from an approval perspective for the consumer.

Absolutely. So let me just first orient everyone from a P&L perspective. We do have a small revenue stream, as Rajat said, a small revenue stream from, we call it, consumer financing, which is bounties that we get paid from lenders when we prequalify consumers for a loan with them, and then they get qualified and take on that loan through the dealer. And that's also an integral part of an evolution that we have, which is more towards supporting more of the transaction on our site. And so we are increasingly having consumers get prequalified and even fully qualified for financing for a loan. So those are the areas in which we see consumer loan activity. And yes, monthly payments have gone up materially for consumers, and in a lot of cases, 2 or 3x what they were because of interest rates. That has consumers, number one, looking for much less expensive cars. So we've seen a spike in search activity for lower-priced cars among consumers. We've also seen consumers drop out of the funnel or the process after they've seen the rates that they would actually qualify for. Furthermore, we've seen lenders qualify fewer or smaller percentage of applicants. Delinquency rates have gone up the last couple of months, in particular, for auto loans. And so lenders are scrutinizing much more carefully who they actually approve. So yes, I would say almost in all fronts, the auto loan segment is absolutely tighter today than it was even 2 months ago.

Got it, got it. That's helpful color. Just wanted to move away from macro. We can come back to it again later. But just on second quarter, you've given us revenue and EBITDA guidance. With respect to CarOffer, in particular, expected to improve sequentially, slightly breakeven or higher. But if I look at like the Marketplace business, excluding the CarOffer improvement, it seems to be taking a step down from an EBITDA perspective, like just taking midpoints of guidance. Any way to quantify how much of that weakness can be attributed to like dealer cancellations, given ABRs versus just more softness in like some of the macro indicators you highlighted or maybe just on the OEM side, if you could just help unpack that a little bit.

Sure. So just to simplify it to top line and then EBITDA. From a top line perspective, the 2 -- again, oversimplifying, but the 2 areas of revenue for us are marketplace subscription, which are dealers subscribing to our platform and then non-subscription revenue, which is OEM, auto manufacturer advertising and consumer financing. And so in the guide we've given, we've said that softness in automotive advertising and consumer financing, based on what we just talked about, are a headwind that's offsetting subscription revenue growth. Subscription revenue growth is -- subscription is growing. It's growing primarily because we're growing what we call QARSD, which is quarterly average revenue per subscribing dealer. So that's a metric that we've continued to grow for the last many quarters, and that's driven by a number of things. But lately, it's been driven more by us holding firmer on unit pricing with dealers as well as renewing dealers into new packages, higher packages and also adding new products like digital deal, which is a migration to transactions on our platform. So those are the high-level dynamics from a revenue perspective. Really more of the story as it relates to EBITDA and the guide is about expense increase. And so there, we have taken on a new lease this year for a building we're moving into next year, but we're paying sort of double rents this year. That started in Q1 but it only had 2 months in Q1 so we have a full quarter of it in Q2. We have headcount grow over. And then we also have marketing expense, which can fluctuate quarter-to-quarter.

Got it. And just on CarOffer, you guided to sequential improvement, slight improvement in EBITDA there. How much of that is a function of you trying to just maybe shrink the business a little bit, focus more on optimizing operations versus gross margin or just leverage? Just if you could give us a sense of that trajectory. And any more comments you can give us like on future trajectory of that business from a profitability perspective?

Yes. So again, just to level set, CarOffer is our Digital Wholesale platform, a business we acquired a couple of years ago. It has grown very quickly as a business. It's still a young business. And toward the end of 2022, when unit prices in the wholesale industry went from 2 years of growing to starting to decline, we recognized a number of operational inefficiencies and challenges in the business that were not relevant or didn't expose themselves in a rising price environment. And so very quickly, we and the CarOffer team worked together to really scrutinize every aspect of the business operationally to understand what was driving some of this new dealer behavior in a price declining environment and make sure that our platform and our system worked well in both rising and falling price environments. And so Q4 identified and quickly jumped on those issues. Q1, worked very hard to remedy those issues and, frankly, did a better job than we expected to. Both our team and their team have done an outstanding job and getting in front of the operational challenges. Just to give you a sense of where that focus has been, inspections is a great example. If we had -- if you have an inspection process that doesn't catch enough of the issues or most or all of the issues, and you send a car through that ultimately gets arbitrated by the buying dealer, that can trigger a series of dissatisfying events for the buying dealer and the selling dealer and us, frankly. And so really fixing inspections was at the heart of what we did. But it also includes focusing on transportation and actual arbitration itself, on account management, on our policies of the company and systems. And so we've said it's going to take a few quarters to really get that to a point where we feel as if we can be highly predictable about what's going to happen with any cohort of transactions and make sure that we can repeatably scale the business in a very profitable way. So we're in a mode now where we were in Q1 and we remain there in Q2, where we're keeping volumes low. We're making sure that we have absolutely dialed in on all of the KPIs across the business before we start to scale it up again. And so I think that's the mode we're in. You then have the external factor of if wholesale unit prices are rising or falling. And if they're rising, you tend to find dealers more inclined to transact. They want to bring in more inventory to their dealership because they believe prices are rising. And so by the time they recondition that car and go to sell it, it's going to be worth more because it's been an appreciating asset. If they feel that prices are going to decline over the next 4 weeks, then they're going to be much more reluctant to trade in wholesale. Instead, they're going to rely just on their trade-ins. And so that is an external factor that we can't always predict. But we have shared, we think we'll end the year at slightly lower prices per unit than where we are today.

What makes you decide whether when to step back on growth there? Is it the macro? Or just you need to feel more comfortable with the operations? I mean, because there are obviously a huge market share opportunity there for the business. So it's -- it's up to you. Yes.

Yes, yes. So huge market share. I mean today, CarOffer probably has 2% of the wholesale market. Purely online wholesale -- or online has probably less than 10% penetration of overall wholesale and that's up from 0% 3 years ago. So huge runway for growth of digital penetration. CarOffer is one of the top online providers. They have a matrix programmatic buying model that is different and more efficient than a lot of the traditional auction models. And we have customers that are using it for, in some cases, the majority of their wholesale buying or selling. But still very small market share overall. So yes, huge runway. What's tempering the volume today is 100% getting the operations more dialed in than they had been.

Understood. That's helpful. Maybe I just wanted to turn to the audience. Any questions on some of the topics we've discussed so far? There's 1.

Just a question, if you have visibility or see-through to the financial health of your dealers across the entire dealer network, what's the state of their well-being financially, considering this environment? And I know it's a broad -- obviously, dealers of all sizes. So maybe if you could speak to some of the smaller ones versus larger guys.

Okay, sure. So yes, I was going to start with the larger ones, there are 6 or 7 public, so you can see those and most dealers enjoyed extraordinarily -- relatively extraordinarily high margins in the past couple of years and those are starting to be pressured now in ways they hadn't been over the past couple of years. Among smaller dealers, they're commonly cited as some of the hardest hit because they don't have the sophistication from a systems and technology perspective, nor do they have the scale of buying. And so mistakes for them sourcing cars are much more costly to them. We have seen more consolidation. That's a trend that a lot of people have seen. And in some cases, in addition to consolidation, we've also seen a slightly higher rate of closures among some of the smaller dealers than we had in the past. There's around 42,000 to 45,000 dealers in the country. About 2/3 are independents. And so those that have -- those independents that have less than, say, 50 cars make up a high volume of rooftops but they don't make up really that high volume or that higher percentage of total units. So small has been harder than big, and I think there's been probably a lowering tide across the board as well.

How do you increase the quality of inspections without dramatically changing the cost structure of the CarOffer business?

So we -- for our inspections, we have a partner model. So we work with a handful of inspection partners. We are -- we have increased our -- how closely we work with them to also be tighter with how we grade our partners in what they're doing, how we measure and grade their performance at both the vendor as well as the actual individual inspector level. But I would say the step function change has been that we have gone from almost exclusively cosmetic inspection to now electrical, mechanical and frame inspection on certain segments of cars that have a higher propensity for issues there. So we don't do that on 100% but we do that on much more than what we did before. And we -- in order to do that, number one is we've raised the price of our inspections from about $100, about $150. Number two, inspection partners that can do, say, mechanical inspections at scale at that -- at an appropriate price have grown a number from what existed a year or 2 ago, where we were trying to almost create the market for third-party inspectors who can do all those things. Now they're more out there for us to partner with at the right price.

Any other questions? No. Maybe shifting to the pricing discussion, like big topic on the earnings call. You've seen a lot of your competitors make the same moves. Could you -- and maybe you can throw in digital deal in there as well. But just early results from these ABR discussions so far. What dealers -- what concerns the dealers the most? Is it just uncertainty around inventory supply or perhaps just the moderating gross margins from the peakish levels? Separately, what is the key ROI proposition you're pitching to dealers with this new pricing? And are there any underlying industry assumptions also embedded in those discussions?

Sure. So 1 thing to sort of acknowledge about the auto industry is many auto dealers think in terms of monthly budgets. And so the idea that there is comfort in having a fixed monthly price is significant with many auto dealers. Putting that aside, inventory is probably the single biggest driver for many auto dealers in terms of their propensity to spend on marketing. We give them stats around leads per unit, leads per dealer, cost per lead, et cetera. And so that's a big driver. What we ultimately try and get dealers to think in terms of is cost per sale and really ROI. And so because we do not, though, have a full closed-loop attribution model with them, that is often a discussion and it's not a hard and fast number that everybody can point to. But when you look at the, say, cost per lead and then the quality of leads as measured by the conversion rate of those leads, you can get to a cost per sale. And then the dealer knows what they're making on the front end and the back end per sale, so sort of on the gross margin of the metal as well as the F&I and any additional add-ons they have. And from a lot of our research, we know that on average, we are priced below our competitors from a cost per lead perspective. We know that the quality of our leads are exceptionally high. So the -- I think one of the more helpful metrics is that consumers are 3x more likely to use our site last before purchasing a car than any other site. So that gives a proxy for conversion rates. We also track conversion rates from third-party attribution sources so we have a good sense for the conversion rate of leads that we send to dealers. And so volume, price and quality typically results in surveys that we do and research that we do is that we're the strongest ROI. We began, several years ago, pricing quite low in the market in order to gain a seat at the table. We have slowly, I would argue, moved that up over time, but we still feel that we have the most advantaged ROI in the industry. And then I'll go on to digital deal later, but.

Yes, I was going to just ask on that, like how much of that ROI differentiation is due to digital deal or are you already embedding that in that -- in those assumptions yet? Or is that more of.

So everything I just said is on, call it, just our core lead volume. We have been making a multiyear push to bring more of the transaction on our site. Consumers want that and now dealers want that too. The reason consumers want it is because they obviously are much more comfortable doing more things online. But spending 4 or 5 hours in the dealership has never been -- has been a pain point for consumers. So they'd love to take some of that time and move it online. Dealers also are more amenable to that because during COVID, they typically shrunk their sales forces quite a bit. And so their sales teams now can't field or can't manage all of the leads that come in. They're starting to pick and select the ones that they think have the highest propensity to close. So we've been moving a lot of the transaction online. And that -- today, that has manifested itself most clearly in something called Digital Deal, which is something that a dealer can sign up for, and it allows them to have -- to enable all of their inventory with the ability for a consumer to not only get prequalified for financing but to get fully qualified for a loan on that car. The dealer can cross-sell any other F&I products that they would sell that consumer in their dealership on our site. They can get a trade-in valuation on our site if that consumer has a trade-in. So the consumer can then, with tax title registration factored in and everything else I just said, get a penny-perfect deal amount. So we will tell them on our site, you're going to put $4,000 down and this is going to be your monthly payment. They can then set up an appointment with the dealer and they can put down a deposit with the dealer if they'd like to. So consumers who come through that flow of the funnel and go to the dealer are converting at 2 to 5x the rate that our standard leads are converting at. We're selling that as a fixed-price product that dealers can sign up for. And again, that becomes an ROI exercise where we say X percent of your leads are going to be Digital Deal enabled. They convert at, we get more precise than this, but call it 3x the rate of a standard lead. And so therefore, the ROI on this add-on is X and we're charging you Y, and that's still a very strong ROI value prop. So increasingly, we're growing the percent of consumers on our site who are going through that flow and spending an hour in the dealership instead of 5 hours in the dealership. We launched that product, digital deal, 9 months ago. In the first 9 months, we've got about 10% of our dealers have adopted it. And we are framing this as the future, the new normal. This is how consumers want to behave. This is how dealers increasingly want to behave. And so it's, we hope and think, quickly going from early adopter dealers to the norm and the NPS among consumers who use this is extraordinarily high.