CVNA - Carvana: Despite Improving Numbers The Clock Is Still Ticking

2023-05-08 09:00:00 ET

Summary

• Q1 results show that adjusted EBITDA margins have improved, but the company still can't cover OPEX and burns a large amount of cash.
• CVNA's current ratio seems healthy, but I believe the company is just burning through inventory and won't be able to continue operating at the current low levels.
• The bondholders call the shots when the common shares do not have any value left.

After releasing Q1 results on May 5 ^th , Carvana ( CVNA ) jumped over 25% post-market, buoyed by the strong reported figure of over $4,300 in GPU (gross profit per unit). The number represented a 52% year-on-year increase, the best result in company history, and such a result came when the company needed it the most. With CVNA being one of the most shorted tickers, the company remains a battleground between longs and shorts. The market can be crazy for longer than any single player can be solvent, but the math on this one still favors one side of the trade.

Carvana Q1 results

The company results were, in my opinion, a mixed bag. The evident positive on which the market decided to focus was that CVNA improved its EBITDA margin considerably on both a year-to-year and quarter-to-quarter basis, coming very close to breakeven. On the other hand, nobody noted that CVNA's growth story is dead, with revenues dropping by over one-fourth from $3.5 billion to approximately $2.6 billion. Strangely enough, the market suddenly no longer seems to care that top-line growth is the only flywheel of loss-making companies like CVNA.

Retail vehicles sold were 79,240 vs. 105,185 in Q1 2022, while wholesale vehicles sold were 35,110 from 50,280. Interestingly, the unit selling price for retail vehicles decreased by 11.2%, while wholesale cars fared much better and increased by 1.4%. Still, unit economics improved for both segments, with gross profit rising 71.8% for retail vehicles and a whopping 303.2% for wholesale ones. While it would be foolish to deny the improvements achieved by CVNA, it is also essential to put the revenue numbers in perspective.

Carvana's corporate structure went through a humongous "diet" in the quarter, with SG&A expenses coming at $472 million vs. $632 million last quarter (-25.3%) and $727 million (-35%) vs. the year-ago period. These are impressive reductions, but when all is said and done, the number still represented SG&A costs of $5,957 per vehicle against a gross profit of $4,303. The math is simple: Carvana still lost in the quarter $1,654 for every unit it managed to sell, and this is before considering the financing concerns. So, while the adjusted EBITDA margin improved remarkably, the net margin loss could only narrow from (14.5%) to (11.0%). The company lost another $269 million in the quarter, increasing its equity deficit on the books to $1.32 billion. Average outstanding shares increased by 17.7% year-on-year, and the already negative book value further decreased.

Financing

The elephant in the room remains the massive amount of liabilities, with about $5.7 billion in debt and the interest expenses of $159 million it generated in the quarter. The figure rose significantly from $64 million in interest expenses in Q1 2022. The rising financing cost reflects the deterioration in the company's economics and the mutated macro contest where liquidity is a much more valuable and scarcer asset.

As late as one year ago, Carvana raised $1.2 billion through an equity offering at $80. Even if the company were to launch another equity offering successfully now, it would take a 50% dilution to raise less than $0.5 billion.

The probability of such a capital raise is obviously dependent on CVNA's necessity to raise further cash to sustain its operations. The company closed Q1 2022 with $5.1 billion in current assets against $3.7 in current liabilities. The situation has vastly improved, with current assets amounting to $4.6 billion and the current ratio increasing from the year-ago 1.37x to the current 1.61x. With net losses narrowed, can CVNA continue to operate without new funds? Maybe so, but there are a couple of question marks.

Point 1. Inventory decreased from $3.3 billion in Q1 2022 to $1.5 billion in Q1 2023. It was a remarkable achievement. Nevertheless, even if it can be possible for the company to have further quarter-to-quarter reductions, arguably, some level of it is just necessary to sustain the business. Maybe CVNA will prove me wrong, but I haven't seen, during my life, many successful stores operating without any products. CVNA inventory rotation has been historically in the 4x – 5x range for the past five years. With TTM sales of $12.7 billion, the rotation has now increased to over 8x. Arguably, there is no proof that CVNA can't sustain the new, more efficient level. But it is more likely that the company has burned through whatever it could in the recent quarters without replenishing it, and it is now understocked.

Point 2. The $1.61 billion of finance receivables held for sale are a financial risk. Even if CVNA can secure a sale of these receivables, these appear at book value now but are only worth so much at maturity. These must be discounted to present value in a deal, or nobody would be interested. Another risk here is that CVNA has possibly loaned out vehicles to sub-prime buyers who could easily fall behind on payments in a recession and generate an impairment. Interestingly, CVNA's physical operations seem to concentrate in States like Texas and Florida, where car loan delinquency ratios are higher. Considering the current macro-outlook, any potential buyer of these credits would seek favorable terms to agree to take on such risks.

Considering the two points made, it is unlikely, in my view, that CVNA can remain in operation for much longer than a few months without another liquidity injection. The timeline seems to have slightly extended with the slowing cash burn. Still, if the macro environment continues to be fragile, consumers will start to defer the purchase of durable goods, which is the norm in every recession. It will also be more challenging for the company to generate sales and sustain fixed costs, even more so in light of the already substantial cuts on advertising recently deployed to protect cash.

Even if the company does not have to refinance its 2025 senior notes immediately and proactively launched a private exchange in March to extend their maturity, bondholders are not biting. Even if the deadline for the exchange has been prolonged for two weeks, from April 19 ^th to May 3 ^rd , I do not think there are many chances to go through. Reportedly, creditors are instead pressuring for a debt-to-equity swap which would likely dilute shareholders many times over, as the company has almost $5.7 billion long-term against a current market cap of $1.35 billion.

Investors' takeaway

Carvana's finance team has been excellent so far. The company has accessed both the credit and equity markets in the past years at very favorable terms. Ease of access has been able to sustain the company operations so far. New capital has covered a lack of profitability lasting 10+ years, with losses mounting even in a robust market for used cars. Nevertheless, with the end of the free money era and a worsening macro-outlook, times have changed, and the bankruptcy clock is ticking for CVNA.

It is possible that, even if a debt restructuring typically happens in a Ch.11 situation (which already says a lot about Carvana's condition), CVNA could have pulled another rabbit out of the hat in a more forgiving economy. But now, with bondholders out to take matters into their hands, I do not see any reasonable scenario under which any value is left for the holders of the common. The tangible book value turned negative in Q2 2022 and will not recover as the cash burn continues.

I have recently started a small, short position on the shares in anticipation of adverse developments from the bondholders' request for a debt-to-equity swap that could act as a catalyst. The company largely telegraphed the improving EBITDA margins in its March guidance , and they are nothing new or surprising. The pop after market closing on May 4 ^th was a bit unexpected and, in my opinion, irrational. Any sustained pop should be seen as an excellent chance to double down on existing short positions or start new ones. I have little doubt that shares are a SELL with a $1 price target (assuming successful new shares offering and significant dilution) within the next 12 months.

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