Online used-car retailer Vroom targets IPO worth at least $281M

Source: autonews.com

Investment Thesis

Alongside Carvana (CVNA), Vroom (VRM) is an auto e-commerce platform that is transforming the used vehicle industry by offering a better way to buy (and sell) used vehicles. Vroom utilizes a vertically integrated, asset-light approach as the company reinvents all phases of the vehicle buying and selling process, from discovery to delivery and everything in between.

My investment thesis is centered around the following points:

  • E-commerce remains an inexorable secular growth trend that has decades of growth ahead of it, especially as technologies such as virtual reality and augmented reality become more robust. The coronavirus pandemic has accelerated consumers’ use of e-commerce platforms, and the online used-car sales market has experienced these tailwinds too. As the world’s digital transformation proceeds further, more people should buy and sell used-cars on e-commerce platforms like Vroom and Carvana.
  • As you may know, the used-car market in the United States is worth $840 billion, but to date, it remains highly fragmented. Hence, Vroom’s addressable market is ripe for disruption.
  • Since consolidation in the used-car retail market is inevitable, Vroom has a good chance of winning significant market share over the next decade. This would result in substantial revenue (and free cash flow) growth.
  • Now, Vroom could very well be a multi-bagger, but its current valuations are exorbitant. Hence, I rate Vroom neutral at $58.

Today, we will discuss some of the key aspects of Vroom’s business and its market opportunity. Later on, we will analyze the company’s financials, carry out a fair-value estimation exercise, and determine expected returns to formulate an investment decision.

COVID-19 Could Prove To Be The Perfect Storm For Auto E-Commerce

Vroom’s business model is similar to Carvana minus the car-vending machines. Since I already discussed Carvana’s business model in detail in one of my recent notes (shared in the first sentence of this note), I will avoid that discussion today.

In some of the recent articles I’ve read on Vroom, critics have severely criticized the company’s execution. Now, I do acknowledge that Vroom’s total revenues declined to ~$253 million on a YoY basis in the previous quarter, while Carvana’s increased about 13%. However, COVID-19 has actually boosted Vroom’s long-term narrative, which is significantly more important than near-term sales.

Source: Vroom Investor Presentation

According to a survey cited by Vroom in its recent investor presentation, 61% of participants were open to buying a car online, a figure which is almost twice the pre-COVID-19 figure of 32%. The benefit of this shift in consumer behavior to auto e-commerce platforms like Vroom, Carvana, and CarMax (KMX) is quite evident.

Source: Vroom 10Q

During the previous quarter, Vroom managed to sell 74% more vehicles through its platform on a y/y basis. This growth is remarkable, considering the impact of the coronavirus pandemic on consumer spending and Vroom’s inventory and logistics. In the future, I expect these numbers to improve further, and if Vroom’s management executes as well as Carvana did after its IPO, we could be looking at a multi-bagger in the making.

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Source: Vroom Investor Presentation

I have already talked about how large the used-vehicle market is in the United States and how underpenetrated it is with regards to e-commerce (check out that discussion in the Carvana article linked in the first sentence of this note). The point I want to highlight here is that Vroom’s TTM revenue is just $1.125 billion; hence the company has an incredibly long-growth runway (maybe decades).

Now that we have learned about Vroom’s opportunity, let’s shift our focus to the company’s financials to assess performance and liquidity.

Financial Analysis

In August, Vroom reported financials for the first time as a public company, which in fairness were quite underwhelming. The total quarterly revenue declined slightly from $260 million to $253 million. Moreover, gross margins plummeted from $13.85 million to $7.6 million (-45% y/y). Source: YCharts

Now, several analysts have battered the management’s execution during the coronavirus pandemic. However, when I look at the numbers as a long-term investor, I could see improvement in Vroom’s long-term narrative. Among the positives, Vroom’s e-commerce segment revenues slowed down, but they still grew by 45% y/y amidst a global pandemic induced economic recession.

As we saw earlier, more people are open to buying cars online after the COVID-19 pandemic. Thus, in the next few years, Vroom’s revenue base could expand; however, keep in mind that the losses could widen too during the same period. Eventually, Vroom’s operations could become profitable, but that would require good execution by the management team (we will need to wait and watch).

According to estimates from Seeking Alpha, Vroom is expected to grow its revenue to more than $40 billion by 2030 at a CAGR of 43%.

Source: Seeking Alpha

If these estimates were to materialize, Vroom would capture a ~4% share of the U.S. used-car market. Is this possible? Yes. In the recent earnings call, Vroom’s CEO mentioned how the company was in the early phases of opening up its e-commerce platform to traditional dealerships. Such a move would help Vroom increase the inventory on its platform, and that would attract more customers (buyers) to the platform.

The economics of such deals with traditional dealerships are not disclosed at this moment in time. Still, one could expect Vroom to receive significant benefits (read: economies of scale) across its business. In my opinion, the e-commerce platform that wins the majority of traditional dealership revenues will capture the largest chunk of the market (think about Amazon (AMZN) as an example). Personally, I like the moves that Vroom’s management is making in this regard, and long-term trends are in favor for auto e-commerce. Thus, we have some pretty strong bets here (used-car e-commerce revolution via Vroom & Carvana) if we get in at the right price.

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Now let’s take a look at Vroom’s balance sheet to assess its financial stability.

Vroom Cash and Balance sheetSource: YCharts

At the end of last quarter, Vroom had cash and equivalents of ~$650 million ($500 million raised via IPO in June 2020) and financial debt of $110 million. This financial structure looks pretty strong on first viewing; however, Vroom reported a negative TTM EBITDA of -$150 million. Since Vroom’s business operations are losing money, expansion of the revenue base would increase losses for the foreseeable future (we have seen this trend with Carvana in recent years). Hence, investors should prepare for shareholder dilutions, or debt raises in the future.

Vroom’s business operations do not cover the interest expense of $4.3 million adequately, but the company has enough cash after its IPO. However, investors must fully comprehend the risk of insolvency and shareholder dilution before making an investment in Vroom.

What Is Vroom’s Fair Value?

To estimate Vroom’s fair value, I used my proprietary valuation model, with which many of you are already familiar. For those of you who have not yet seen it, here’s what it entails:

  1. In Step 1, we use a traditional DCF model with free cash flow to equity discounted by our (as shareholders) cost of capital.
  2. In Step 2, the model accounts for the effects of the change in shares outstanding.
  3. Normalizing valuation for future growth prospects at the end of the ten years. (3a.) Then, using today’s share price and the projected share price at the end of 10 years, we arrive at a CAGR. If this beats the market by enough of a margin, we invest. If not, we wait for a better entry point.

Before we dive into the valuation, let’s check out some notable assumptions:

Assumption Value
Revenue (FY 2020) $1.3B
Shares outstanding ~119M
Free cash flow margin (long term) 3%

Now, let’s take a look at the results:

Source: L.A. Stevens Valuation Model

I like to perform these valuations without any knowledge of the share price on any given day. I agnostically input assumptions which I believe to be somewhere between conservative and perfectly accurate (as I always want to factor in a margin of safety).

Only once I have inputted the assumptions will I remind myself of the share price and input it into the model, so as to create the two outputs of the model, i.e., over or undervaluation and total projected return.

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As can be seen above, Vroom is priced about at its intrinsic value according to my conservative estimations, but that does not factor in the substantial dilution that’s set to take place for the company over the next ten years.

In light of the rather aggressive dilution that’s pretty much inevitable in my eyes, Vroom is substantially overvalued, and as we will see, this is playing out as well in the total expected return.

So, now, let’s check out the total expected return.

Source: L.A. Stevens Valuation Model

As can be seen above, in light of Vroom’s inevitable dilution (at least in my eyes) as it continues to rapidly grow in an ultra-competitive industry, the returns are lackluster as of today’s pandemic inflated share price.

Closing Remarks

Vroom’s market opportunity is massive, and this gives a long growth runway to the auto e-commerce company. However, management’s execution will dictate the success/failure of Vroom, and presently, they lag Carvana.

Thus, I do not recommend any new investments at $51. However, I would like fresh long-term purchases below $40.

Consumer buying patterns are continuing to transition towards e-commerce, and after COVID-19, more people have become willing to buy a car online. History shows that such a transition will stick, and consumer behavioral patterns related to used-car buying and selling will likely change forever at least to some extent. Such a scenario is beneficial to Vroom and supports the long-term narrative of the company.

Key Takeaway: I rate Vroom a hold at $51.

As always, thanks for reading; remember to follow for more, and happy investing!

Beating the Market: The Time Is Now

There has never been a more important time in stock market history to buy individual stocks at the heart of secular growth trends. Mature market performers/underperformers and index funds simply will not cut it, as we face a decade during which there is absolutely no guarantee the overall markets will rise. 

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Disclosure: I am/we are long AMZN, CVNA. 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.



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