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Vroom & The Risk Conundrum

Psalm Chapter 16 verse 8 states, "I keep my eyes always on the Lord. With him at my right hand, I will not be shaken."


Life is full of challenges, difficulties, and wonderful moments. I find that it is always much more easy to turn to God in times of need, but I always try my best to praise Him during times of joy and peace. To me, the latter part of this statement doesn't mean I won't be shaken during difficulty (emotional effected), but rather, as I get through any difficulty, my belief and commitment to God will remain.


I try to apply these principles to investing through having parameters and strategies in place through financial modeling tools. Investing is very challenging because human perception, which is fickle, drives market sentiment. This often results in pressure for investors to deal with, but through patience and perseverance, getting through market volatility can lead to successful investment returns.


From my perspective, there are two very exciting market opportunities for investors and they involve some of the core economic--generating industries within the U.S. economy - the housing market and automobile vehicle sales. It has taken a little longer, but innovative companies are now poised to disrupt these predominantly physical-based industries through E-commerce. For E-commerce vehicle sales business models, the question becomes, which company or companies are poised to win?


With earnings season for Q2 2021 wrapping up, an assessment of this is timely. First, it is prudent to provide a lay-of-the-land on the competitive landscape. Afterward, the key focal point is on why Carvana Co. (CVNA) has won the initial round of competition, and what it means over the mid-term for investors. As the title of the blog suggests, I will be focused on Vroom, Inc. (VRM) as it is one of the 31 positions in the portfolio.


Competitive Landscape


I will use Vroom's description for this as it provides a good high-level understanding:


The U.S. used vehicle market is highly fragmented, with over 42,000 traditional franchised and independent dealerships nationwide as well as the peer-to-peer market. The players in the used vehicle market can be classified into the following segments:

  • traditional new and used car dealerships;

  • large, national car dealers, such as CarMax and AutoNation, which are expanding into online sales, including “omni-channel” offerings;

  • used car dealers or marketplaces that currently have existing ecommerce businesses or online platforms, such as Carvana;

  • the peer-to-peer market, utilizing sites such as Facebook, Craigslist.com, eBay Motors and Nextdoor.com; and

  • sales by rental car companies directly to consumers of used vehicles which were previously utilized in rental fleets, such as Enterprise Car Sales.

Internet and online automotive sites could change their models to sell used vehicles, such as Google, Amazon, AutoTrader.com, Edmunds.com, KBB.com, Autobytel.com, TrueCar.com, CarGurus and Cars.com. In addition, automobile manufacturers such as General Motors, Ford and Volkswagen could change their sales models to better compete through technology and infrastructure investments. While such enterprises may change their business models and endeavor to compete, the sale of used vehicles through ecommerce presents unique operational and technical challenges.


I would like to caveat here that despite Vroom's opinions regarding the difficulties to replicate the E-commerce model for used vehicles, Shift Technologies (SFT) has emerged as recent competitor that has proven an ability to scale quickly.


I'm not going to provide a lot of assessment of the traditional used car dealerships as they are the most fragmented and vulnerable to disruption, but we do have automotive sites selling used vehicles including TrueCar (TRUE), CarGurus, Inc. (CARG), and Cars (CARS) with dealer partnerships. These peers reflect the most asset-light model and highest current Cash Flow margins. Larger national car dealers including CarMax, Inc. (KMX) and AutoNation, Inc. (AN) will be included to cover omni-channel players, as will the pure E-commerce plays in Carvana, Vroom, and Shift.


Other Internet sites could always get into the business, as could potential automotive OEMs, but these businesses face diversification risks and challenges as a substantial portion of their business operations and capital focus is not in the E-commerce used vehicle arena. In fact, I view the strongest competitive challenges associated among the E-commerce plays, with the next highest threat being from the omni-channel players.


Carvana Has Won For Now


When it comes to who the leader is out of the overall industry peer group, there is no question it is Carvana. If anyone would like to question it, simply take a look at Carvana's Enterprise Value, EV, which stands at $63 billion. Some may think that companies like CarMax or AutoNation would be the largest players, but each respectively sports an EV at $35 and $10 billion.


With CarMax approaching 1.5 million in used vehicle and wholesale unit sales, and AutoNation generating around 30% or so of CarMax's equivalent used vehicle and wholesale Revenue, it's safe to assume that both companies combined are poised to have solid around 2 million or so used vehicle and wholesale units over the last twelve months, LTM. This compares to Carvana's nearly 450,000, reflecting a 23% share of the two. This percentage share was only 7% back in 2018, so Carvana's growth has been exponential versus its omni-channel peers.


Versus smaller E-commerce used vehicle and wholesale pure plays, Carvana has dominated versus Vroom and Shift's respective 85,000 and 22,500 units sold for the LTM. During 2018, Carvana sported a 3 times lead on units sold, and that has since grown to over 4 times today.


Based on Carvana's performance the market has yielded a leading valuation multiple at seven times EV/Revenue. When it comes to Cash Flow which is of the utmost importance, not all peers are created equal. Newcomers for E-commerce pure plays are still looking to scale the business before generating Cash Flow. Omni-channel players including AutoNation and CarMax have generated Cash Flow at 2-4%. Only web-based companies partnering with dealerships have generated the strongest Cash Flow margins at 10-25%.


But the market has focused on Revenue performance and future potential, which makes sense, especially with newer disruptive innovative business models. Over the past 10 years, used vehicle sales have fluctuated from 35 to 40 million per year. This means that the largest players in CarMax and AutoNation reflect around 5% of the market, with Carvana reflecting over 1%.


The market stance is that even though CarMax and AutoNation will likely continue to grow over the next five years, Carvana's exponential rate of growth will continue to drive significantly stronger results. In fact, from my perspective, it looks like all E-commerce pure plays are poised for similar exponential performance, with Carvana challenging for the top Revenue position by 2025 across the board.


Valuation & Outlook


This is the name of the game, and it is here that I want to talk a little bit about Vroom's recent Q2 2012 earnings report and the company. When it comes to E-commerce pure plays, it isn't only about Revenue growth right now. As these companies are not expected to generate Cash Flow over the next four years or so, analysts have lasered in on Gross Margins.


It is to this point that Vroom's Stock Price, SP has been decimated from the pre-earnings position by nearly 35%, the lowest point since going public. Specifically, Piper Sandler has been one of the Wallstreet firms to become highly critical of Vroom's continued investments and growth plans that seemingly continue to depress Gross Margin substantially below that of Carvana.


Vroom's recent sell off has even placed the company's EV/Revenue valuation multiple below that of Shift. As mentioned, Carvana is trading 7 times EV/Revenue, while both Vroom and Shift are trading around 1.4 times. This while Vroom is still generating nearly four times more used vehicle and wholesale unit sales. However, from 2018, Carvana's multiple of used vehicle and wholesale unit sales has increased from below four to over 5 times against Vroom. Conversely, Vroom's over five times unit sales multiple over Shift in 2018 has dropped below four.


Shift's Gross Margin has even surpassed Vroom, albeit just marginally, while continuing to improve. This all sounds like solid justification against Vroom, but the fact remains that Vroom is the second largest E-commerce pure play behind Carvana. Additionally, the next five years will still be challenging for Shift to sustain recent growth trends. And when it comes to capital allocation, Vroom has the strongest Cash position, while generating a lower Cash Burn versus even Carvana, and much lower proportionally than Shift.


It's always challenging to build financial models and think about the next five years out, but it is vital to have a sense of visibility for the future, while considering each quarterly update. From this perspective, I see a compelling opportunity for Vroom as the best investment option between pure plays. Carvana with its premium, will still be the dominant leader, but the return on investment from this point is shaping up to generate a potential annualized return near 16% or so.


For both Vroom and Shift, the potential returns could be quite massive towards annualized 55% possibilities. I continue to view Vroom as the stronger play due to its lead and scale, but I also do concede that Shift has proven that Vroom's competitive stance may not be as strong as originally claimed. Shift has generated a clear comparable that in my opinion, has Wallstreet clearly viewing Carvana as the dominant leader, with less clarity on Vroom and Shift - with the key focal point being Gross Margin.


Conclusion


Vroom has been a very difficult stock to own, hold and manage. Despite the clear focus on Gross Margin, and Vroom's underperformance from Wallstreet's perspective, all is not lost. In fact, Vroom remains the strongest of the E-commerce used vehicle and wholesale pure plays when it comes to capital allocation. Additionally, Vroom is continuing to remain a strong second to Carvana's clear dominant position.


I expect consolidation to begin to occur at some point soon. I wouldn't be shocked to see Vroom acquire Shift; I wouldn't be surprised to see CarMax or AutoNation make a move on either Vroom or Shift. There are many areas where consolidation could occur including larger Internet companies, as well as traditional automotive OEMs like Ford Motor Company (F) or General Motors (GM). The difficulty here is that many of the larger players likely will fall victim of thinking they can compete directly through developing their own competitive products and services. This is the legacy mindset that perpetually allows for more innovative and laser-focused players to continue to scale and outperform.


If I could go back in time a year or so ago, I would definitely choose Carvana over Vroom. I may even consider a swap still in the event Carvana is sold off to a substantially lower valuation multiple. Aside from this, I will continue to own Vroom as I do believe that the current valuation multiple is much too depressed. Vroom currently trades 1.4 times EV/Revenue, and I am modeling the company to be fairly valued at 2.25 times. Looking at 2022 Revenue estimates and if met, Vroom could see its SP jump to $75 per share reflecting a 200% potential gain.


As part of this I am modeling Carvana to see an EV/Revenue multiple contraction towards 5 times, and Shift being just below 2 times as a more fair representation of the pure plays. When it comes to omni-channel peers, the EV/Revenue and Cash Flow multiples are expected to be lower and/or declining as they are not anticipated to grow as robustly by any means, in fact, they are at risk of losing market share as well over the long-term. Web-based companies with dealership partnerships are also at risk as they are directly connected to the physical business model. As mentioned by Vroom's risk section, any company is open to competing, but based on the existing structures, pure play vertical business models look well poised to continue to lead market growth and penetration.


The highly fragmented markets for used vehicle and wholesale unit sales should continue to benefit multiple players over the mid-term. Vroom is poised to continue to be one of the fastest growing E-commerce pure plays, and successful, will remain a strong leader across Shift and other competitors.

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