Thursday, October 30, 2014

A TrueCar Short Case - Victim of Its Own Success


(I started looking into shorting this when stock was trading at $20 but did not pull the trigger. Now it is around $17 going toward $16, have I missed the boat?  I’m hoping for TRUE to go up so I can short it... )

At $20/share, TRUE’s stock trades at 8x sales, ~150x forward P/E. LTM EBITDA and cash flows are both negative. As a result people have started looking into shorting the stock. A couple of short articles here:

Here I will layout my own short case from a different angle. My thesis different from others in that I think TRUE is an innovative company with a real value add, but ultimately will be undone by its lack of competitive moat.

What TrueCar Does and How it Makes Money

TrueCar (TRUE) does online lead generation for car dealers (mostly new cars). Its main property is website where car shoppers can see a range of prices that other people paid for the same car in their area. Where TrueCar differs from other website is the idea of binding price. Users can click a button on the website to get a price offer that dealers have to honor. In terms of revenue model, TrueCar is free to customers and dealers pay $299 for each successful transaction. The company also gets traffic from affiliates such as USAA, and TrueCar splits the fees there.

Understanding the Bull Perspective and Reframing the Question

The over-valuation problem is exaggerated. The market is clearly looking at something else aside from > 100x P/E. Management’s stated long term goal is raising market share from 3% to 10%, and raising EBITDA margin from 2-3% to 35%. If these goals are achieved, they would more than double their revenue and generate about ~$175mm of run rate EBITDA. With < $2bn of enterprise value, all the sudden you're looking at low teens multiple –arguably cheap for a business with high return on capital (if they hit that margin goal).

These plans are not as crazy as they sound. Revenue has been growing at 50%+ pace so doubling in a few years is not unreasonable. The biggest expense is sales and marketing. The idea is to slow down marketing spend once the company reaches a critical mass of customer recognition. In fact, the company can actually grow advertising dollar amount slightly and still decrease the percentage cost due to operating leverage.

So that’s what the market is looking at. As a potential short seller here, the question should be reframed as “do we have a high degree of confidence that revenue can't double and margin can't hit 35%?”

TrueCar’s Value Add – Why Customers Use Them and How That Can Change

I don’t doubt revenue can double but I question the ability for a company to taper down marketing and advertising expense, and still maintain or grow site traffic and drive car transactions. Ultimately, this can only happen if your product is that much better than everyone else’s (and able to sustain that advantage through the period we’re evaluating).

Why do customers use TRUE and not a substitute or a competitor? And what would change that? There are two customer sets here:  potential car buyers and dealers.

·         Car buyers.
o   Target customers are those who do not like to negotiate and distrust dealers. These car buyers are “satisfiers” instead of “maximizers” – they are not looking to buy a car for the absolute lowest price possible. Rather, these customers just want a fair price and not walk away with some lingering suspicion that they’re ripped off.
o   Where does this fear of getting ripped off comes from? It comes from wide dispersion of prices among dealers.
o   Arming customers with information is also a value-add but competitors do this as well. The “marginal value add” of TRUE is upfront, committed pricing (via price certificates).

·         Dealers. 
o   TrueCar replaces less efficient advertising spends.  TRUE will never replace all of dealer marketing because dealers still want to build their own brands, so TRUE can only aim to replace less efficient advertising budgets (most obviously less efficient lead generation firms)
o   convert ad spend to variable cost (because dealers pay only for successful transactions)

The points above imply that TRUE’s edge goes away if:

For car buyers, TrueCar’s value add goes away when the day comes that price dispersion is minimal. The industry is already moving toward One Price, with KMX, Sonic, Tesla…etc. all pushing some variant of pricing commitment. AutoNation has even talked about moving to directly selling cars online. If pricing transparency and commitment becomes the industry norm then TRUE is useless.

Similar things happen if competitors implement pricing commitment. CostCo and Edmunds already try to do no-haggle pricing, it’s not too far of a step toward offering a price commitment like TRUE does.  One can argue TRUE’s advantage here is tying into dealers inventory systems, but perhaps others can get information from DealerTrak or other sources.

For dealers, TrueCar’s comparative advantage goes away if other sources of advertising becomes more efficient, either by copying TRUE’s model or if they are forced to cut prices. As the market share of these relatively inefficient forms of advertising gets taken by TRUE, it’s hard to imagine they won’t increase quality to compete better

Ultimately, TRUE will be a victim of its own success because it is innovative but easy to duplicate. In the next few years, I can see the company push the car industry further toward One Price paradigm, force competitors to offer pricing commitment or becoming more efficient.  All these things are great for consumers, but diminish the necessity of using TrueCar. Without product advantages, it’s hard to keeping advertising down and still double revenue. In some ways, not shorting TRUE requires you to think that auto sales processes are still the same in 5 years and that other player can’t improve their game despite being eaten alive by TRUE.



Bear argument
·         The Industry is already moving toward one price and TRUECAR's value-add will diminish as price divergence decreases.
·         Unlike sites such as Yelp or Facebook, TRUE does not have the benefit of user networking externality. People use TrueCar because they want a fair price, not because all their buddies are hanging out on it, nor because they want extensive dealer reviews. As soon as the proposition of “fair price” diminishes (due to everyone already offering that), TRUE becomes unnecessary.
·         What happens when new car sales go south? 
o   Used car pricing are coming down due to increasing off-lease supply. This can spill over to new vehicle market. OEMs will defend sales with incentives but eventually lower pricing should cut into dealer margin.
o   When dealer gross margins are under pressure, Truecar's $299 per sale look less attractive. Dealers will push for lower cost lead generation or take advertising in house. Dealer consolidation would give them even more bargaining power.
o   As TRUE wins over other sources of advertising, these sources will lower their prices to compete.
o   Lower industry volumes will hurt the company.
·         Operational failures
o   I read that some dealers have dispute with TrueCar about how a successful lead is defined and how dealer has to pay.
o   Bait and switch at unscrupulous dealer can become legal liabilities for TrueCar

Bull argument
·         TRUE is an innovative and visionary company with a history of disrupting the industry. When TRUE first came out, the transparent pricing caused dealers to undercut each other and customers got the cheapest prices possible. This led to an industry-wide boycott by the dealers and near death for TrueCar. TRUE has since changed its business model to not let each dealer see each other’s pricing (so they don’t undercut each other).
o   Incredible track record of turnaround in dealer relationships. The company has doubled dealer participation from its trough. In fact, the leader of this dealer revolt, Jim Ziegler, is holding an upcoming conference and will have the President of TRUE as a keynote speaker.
o   TRUE is a cutting edge big data company. They are transforming a mom and pop business by leveraging new technologies such as Hadoop

·         TRUE as a potential M&A target
o   Combining with lead generation competitors would decrease the need of an advertising arms race and allow margin gains.
o   Vertical integration (True+ KAR = TrueKar?) TrueTrade is trying to compete with CarMax (KMX) by enabling a network of used car dealers to offer committed pricing on trade-ins, but without the need to hold inventory. Now, one reason KMX can do this competitively is because they run their own auctions, which helps KMX dispose unwanted trade-ins economically. A merger between TRUE and Kar Auctions Services (KAR) can replicate KMX’s functions. This might be interesting for KAR because its main competitors Manheim (owned by Cox, which also runs AutoTrader and offer upfront pricing on trade-ins) and KMX are already parts of larger entities. Also, TRUE owns ALG which would be extremely valuable to KAR.
·         Increasing part of a dealers marketing budget. Dealers still spend on newspaper, radio, and TV so there could be some low hanging fruits there. If automobiles demand decreases, TRUE may actually gain market share because dealers would want to shift marketing to TRUE’s variable cost model (they only charge for successful deals)
·         Margin increase can be achieved by lowering marketing cost once a critical market share is achieved.
·         Opportunity to go beyond dealer advertising spend and grab a share of manufacturer’s advertising and incentives.

Tuesday, October 7, 2014

UCP Lot Valuation

  • I was skeptical of the long thesis on UCP because analysts tout strong inventory valuations but glosses over the fact that it takes time to realize value - i.e. they do not apply a present value.
  • It turns out that the approach of valuing lots by ascribing value as % of home prices is flawed but surprisingly robust. This is because the 2 missing factors are offsetting: 1) Applying a discount rate would decrease value, but 2) this method also understates cash flows and correcting for that increases value. 
  • Valuation is $18/share.  UCP trades around $12 per share at the time of writing.

UCP and Its California Inventory
UCP, Inc. (UCP) is a land developer turned home builder that historically focused on California. Its operating subsidiary, UCP, LLC is 57.5% owned by PICO. As of 6/30/2014, UCP owns 4,639 lots and LTM net new order was only ~300 units. UCP has enough inventories to last years, so valuing the company requires valuing the lots.

When people hear that UCP owns lots in California, they think of San Francisco, Silicon Valley economy…etc. and assume high prices. However, UCP mostly operates in inland locations like Fresno and Madera where it could take 3 hours to reach the coast. According to Zillow, median home prices for Fresno and Madera are less than $200k. Other areas where UCP has strong presence are Monterey County in CA (prices in the $400-450k neighborhood) and Thurston County in Washington (low $200k’s range). These are not exactly your premium million dollar homes in San Francisco. UCP acquired Citizens Homes earlier this year, which allows them to expand into the Southeast.

The Long Thesis

This is an asset play. Much of UCP’s land inventories were bought during 2008-2009, when lots are cheap. These are now worth much more than what market value would suggest. With enough inventories to last several years, UCP also has some nice options:  a) monetize the lots by building homes themselves, b) sell lots to other builders, or c) sell itself to another company. Being acquired is a possibility due to the small market cap and their local footprints.


The bullish write ups I have seen tend to value the inventory without a discount rate, then net out the liabilities to result in a massive net asset value. There was a PICO article published 9/8/2014 on SA included detailed valuation of lots by locations. The methodology separates inventory into developed and undeveloped lots. For developed lots - assigns a reasonable home price for the area (say $450k for Monterey Bay area), and assume lots are worth certain percentage of home value (50% here). For undeveloped lots, just assign value per lot based on location, using UCP’s historical revenue per lots sold for context.

I duplicated the exercise below and got a very similar ~$350mm of value for the lots (164mm for developed lots and 183mm for undeveloped). Netting out liabilities and minority interest this would value UCP at ~18 per share.

UCP Lot Valuation

It's tempting to stop here without applying a discount, and point out as upsides the optioned lots (which are not included here) and UCP’s potential as M&A target.

There are 2 things missing here. The first is obvious - it will take years for UCP to monetize this inventory and thus time value discounting is not only necessary but makes a big difference. Clearly, it takes time for local housing demand to emerge, and for UCP to build and sell those houses. The second missing piece is what amounts should we be discounting?  Just spreading the $350mm of total value and discount back would be a mistake, because the total cash flows UCP will get is actually more than that.

The second point requires some explanation so bear with me. What exactly do we mean when we say a lot is worth x dollars?  An excellent article here makes it clear that the value of a land lot is what another builder is willing to pay for the lot, and still be able to generate some profit. The profit part is key. For example, if other builders are willing to pay UCP $100k to buy some inventory, incur another $80k of construction cost, and sell the house for $200k, their profit is then $20k. The lot to ASP ratio would be 50%. How much cash flows will UCP get for this lot? 

·         If UCP sells the lots to another, then you should discount just the $100k proceed from the lot sale. 
·         UCP however, plans to build the homes itself. In this case UCP gets $120k of incremental cash flows ($200k selling price – $80k construction cost). The other way to think about it is they get $100k of working capital back, plus $20k profit.

This is why the $350mm value above understates cash flows - because it implicitly assumes UCP will sell these lots to another builder, and thus fails to include the profits UCP will get upon a home sale.

I get to roughly $18/share. It turns out that applying a discount rate is offset by this extra cash flow - even with some very conservative assumptions about sales pace.

Value destroying growth is always a risk

Growth ambitions are dangerous in homebuilding. At the peak of cycles, financing becomes widely available so builders gorge themselves with expensive inventories. During a crisis when they should be buying cheap, they can’t because of financing constraints. In short, builders always risk buying at the worst times.

By virtue of having land that can last years, UCP can theoretically avoid this type of behavior. In my opinion, the best case for UCP would be to stop trying to expand, and focus on monetizing its existing lot inventory as quickly as possible. Of course, management teams never want to liquidate themselves and UCP has in fact been acquiring.This makes them more like other builders, but with subpar scale and diversification. Business expansion also makes UCP a less likely M&A target (which I wouldn’t count on as the basis for an investment anyways). These factors perhaps call for a higher discount rate than peers, but still result in a strong valuation.