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What Does Seth Klarman Like About Cars.com?

I think it's always interesting to take a look at the smaller holdings that appear in the portfolios of big-name hedge funds every quarter.

For example, in the third quarter, according to its 13F filing, Seth Klarman (Trades, Portfolio)'s Baupost initiated a new position in online automotive retailer Cars.com Inc. (NYSE:CARS).

Baupost's 13F reports that the hedge fund acquired 3 million shares of the company during the three months to the end of September.

The position was worth approximately $27 million at the end of September, representing 0.32% of the equity portfolio.

It is important to note that 13F filings only include equity holdings and do not take into account any cash or debt investments of hedge funds. What's more, these reports are backward-looking, and only tell us what happened in the three months to the end of September, they do not detail any movements since.

So what could Klarman like about Cars.com?

A value investment?

In the third quarter, shares of the company fell by around a third after management announced it was giving up on a plan to sell the business.

After spending 10 months and meeting 29 potential suitors, management explained, the company has decided to remain an independent entity. It seems the market was not pleased with this decision.

"This process did not yield actionable options for a sale of the company," Cars.com CEO Alex Vetter said in a second-quarter earnings call on Aug. 5.

Activist fund Starboard Value had been pushing for Cars to sell itself and for a leadership change if the company's results didn't improve.

Interestingly, Starboard dumped the bulk of its stake after the August announcement. Its holding dropped from around 10% to 3% soon after the report, and the fund has since liquidated its position.

As well as struggling to sell itself, Cars is also struggling to grow. For the second quarter, it reported a net loss of $6 million compared with a net income of $12.7 million in the year-ago period. Adjusted net income declined 42%, and revenue dropped 12%. Cars reported 18,891 dealership customers at the end of June, compared with 19,300 at the end of March.

For the third quarter, the company reported a loss of $6.38. Management expects a full-year revenue decline of between 6% and 9% and announced an impairment charge of $461 million.

Even after taking into account this revenue decline, Wall Street is forecasting adjusted earnings for the year of $1.32 that gives a forward price-earnings ratio of 9.3. Further growth is forecast in 2020. Based on these forecasts, the stock is trading at a 2020 price-earnings of 7.3.

At first glance, that looks cheap. But considering the company's problems so far this year, there is no guarantee Cars will be able to hit these Wall Street forecasts.

One of the most impressive qualities of this business is its cash generation. For the past three years, it has generated an average free cash flow per share of around $2.2, which puts the stock on a price-to-free cash flow yield of 18% and price-to-free cash flow ratio of 5.5.

Based on my research on Klarman and his strategy, I think this trade could be a play on either one of two approaches. Either the fund manager likes Cars.com because it is cheap, which it appears to be based on Wall Street forecasts. Or he expects some transaction to occur in the near future that will unlock value at the company and for its investors.

Klarman has said many times in the past that he likes to invest in opportunities where there is a value catalyst. As Cars recently called off the plan to sell itself, it seems strange Klarman would make a move now, but perhaps he sees hidden value the rest of the market does not.

Disclosure: The author owns no stocks mentioned.

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This article first appeared on GuruFocus.