I started watching Vroom (NASDAQ:VRM) stock last autumn, and it was off to a good start -- until the fourth-quarter 2020 earnings report (and accompanying tech stock rout) sent shares plummeting. Share prices are down over 30% from their most recent highs in February. The quarterly update had a lot of good stuff for shareholders, but this online car dealer is no slam dunk in the fast-growing migration of commerce to a digital format.

Here are three things you should know before deciding to purchase.  

1. Vroom is not quite an e-commerce pure-play

After the economic freeze last spring, Vroom reported another rally in autos sold on its e-commerce platform. Units sold during the period increased 74% year over year to 11,022. Even better, management said full-year 2021 e-commerce unit sales should increase by a triple-digit percentage as it laps the initial effects of COVID-19. Company forecasts suggest the first quarter of 2021 will see between 14,000 and 14,500 e-commerce units sold (an 80% increase at the midpoint of guidance).

Someone handing keys to man sitting in car

Image source: Getty Images.

Sounds pretty good, right? But wait, there's more. Vroom has other business outside of its e-commerce bread-and-butter. Its wholesale segment (critical to trade-ins on e-commerce, cars that get sold at auction if they don't meet certain quality standards) increased units sold by 69% in Q4 to 6,998 and generated a loss (more on that in a second). Wholesale units sold are expected to increase to 7,000 to 8,000 in Q1 and continue generating a loss.

Then there's the company's legacy car lot business, Texas Direct Auto (TDA), which sold 50% fewer units in Q4 compared to last year. TDA sold 1,777 cars in Q4, and the number is expected to fall to 1,400 to 1,500 in Q1 2021 as the Vroom segment gets prioritized.  

All told, while Vroom's e-commerce sales are expected to soar in the year ahead, bear in mind that growth rates will be tempered by its non-internet businesses.

2. Vroom performance all hinges on auto margins

A similar dynamic is playing out for gross profit on autos sold. Vroom thinks the full-year 2021 triple-digit growth in e-commerce unit sales will equate to more than a 200% increase in gross profit. That's great news, indicating the company is reaching a more efficient scale as it grows its internet presence.

However, as total e-commerce gross profit was just $60.9 million in 2020 (a slim gross margin of 6.6%), Vroom still has a long way to go before it's overall profitable. Case in point: Wholesale unit sales in Q1 are expected to generate an average gross loss of $450 to $600 per unit.

As wholesale is critical to the e-commerce platform's ability to accept trade-ins from customers, it effectively lowers the total profit on units sold digitally. For reference, Q1 e-commerce margin per unit sold is forecast to be $1,750 to $1,850.  

The overall picture is nonetheless set to improve this year for Vroom. Total gross profit across all three segments was a measly 5% during the final months of 2020, and soaring e-commerce and better unit economics will help improve this picture. But operating expenses will need to rise as well to support Vroom's growth. I don't foresee negative free cash flow (specifically, negative $367 million in 2020) completely disappearing in 2021, although the company should close in on break-even.

3. Mind the balance sheet on Vroom

While Vroom scales up its digital business, it does have ample cash on balance from its IPO last year. At the end of December, it reported having just shy of $1.06 billion in cash and equivalents and no debt. With free cash flow still in the red, it has a few years' worth of liquidity on balance, assuming the 2020 free cash flow run-rate holds. But keep an eye on that balance anyway.  

After the final quarterly update from 2020 and subsequent stock punishment, Vroom stock trades at a market cap of $4.6 billion -- or an enterprise value of $3.5 billion if subtracting cash on hand. Shares trade for 2.6 times 2020 sales to enterprise value, a seemingly cheap price tag for a company expecting massive growth in the year ahead.

But given paltry (but improving) gross profit margin, Vroom isn't cheap. It's a small company playing in a very large U.S. auto retail industry, though, and its financials will get better. There's long-term value to be had here, but know what you're buying before pulling the trigger.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.