CVNA - Carvana Stock: Short Squeezes Always End In Tears

2023-06-09 09:36:37 ET

Summary

• Carvana stock exploded higher yesterday in a classic short squeeze rally.
• While this episode of buying can send the stock a lot higher, it's completely unsustainable.
• On a risk-adjusted basis, CVNA's value proposition for longs remains entirely unattractive.

Shares of beleaguered online vehicle retailer Carvana Co. (CVNA) added a cool 56% yesterday on the company's updated Q2 outlook . Management had a lot of good things to say, which we'll get to in a bit, and the stock absolutely exploded to the upside on extremely high volume. Carvana has been a battleground stock for some time, as its very survival has been at stake for a few quarters now. This is something I noted back in February , which is the last time I covered Carvana.

The stock was $11.37 at the time that article was published, and it subsequently fell to $6 and change. After Thursday's rally, it's now more than double the prior level, and I'm sure there will be plenty of comments suggesting I got this one wrong. That's fine, because I look for risk-adjusted returns where I can put the odds of success in my favor; success for me is not as simple as a stock going up or down. Back in February, I didn't like the risk/reward, and the stock fell almost half after that (before the current rally). Today, I think the risk/reward is so much worse. Therefore, I'm sticking to my sell rating.

A classic short squeeze in Carvana stock

Let's be clear; Carvana's current rally is a short squeeze, and nothing more. Short squeezes happen when a very high percentage of the float is short (Carvana is 60%+), and you start to get high-volume panic buying. Yesterday's volume was something like 170M shares, so we can certainly count that as high volume. If you captured this move, congratulations. However, these kinds of moves, by definition, are not sustainable.

We can see Carvana's rally needed to clear the high-$19s, which is where the last short squeeze rally topped out. Those that use technical analysis will not be surprised that's where the prior short squeeze topped out; that's the bottom from last summer. However, with that level cleared, there's room to potentially run on this round of the short squeeze, as there's some open air between the current price and the next potential resistance near $30.

The last short squeeze rally was 214% from bottom to top; if we project that out, this one could reach almost $50. I am not suggesting it will, but with 60%+ of the float short, and panic buying already underway, I wouldn't rule it out, either.

Carvana stock is clearly extremely overbought by all momentum measures, but it's a short squeeze, so those metrics don't mean much. To be clear, I think the risk/reward here is awful for longs, but if you're inclined to try and ride this wave, I would not hold under the prior short squeeze top at just under $20. If the stock fails that level, the short squeeze has almost certainly ended, and big losses are about to accrue. Above that, all bets are off and we could see $30 or $40 in quick order.

Now, the reason I'm not recommending anyone try to buy this stock is because short squeezes are generally very abbreviated periods of time, and they unravel extremely quickly. When I say I look for risk-adjusted, asymmetric opportunities, a short squeeze is the opposite of that. And to be fair, I'm certainly unwilling to short into a short squeeze, because with panic buying in progress, the upside is virtually unlimited.

A terrific update

Now, the most recent reason Carvana stock exploded higher was the management team's very bullish update on Q2. The company now expects adjusted EBITDA of $50 million, and adjusted gross profit per unit of at least $6,000. That's much better than the prior guidance of $5,000, and would be a new record for Carvana, if achieved. The company also remains focused on driving efficiencies that should help margins over time.

All of this is very good news for the company's future, and a 56% gain in the share price in one day may lead you to believe Carvana is out of the proverbial woods. However, I'm not sure a great deal has changed, because the issues Carvana has are deep, and it will take a lot more than that to fix it long term.

Let's briefly look at revenue and earnings estimates, starting with the top line.

There's no way to sugar-coat this, and I won't try to. Even in recent months, revenue estimates continue to fall. If Carvana comes in with a strong Q2 report later this summer, maybe we start to see them turn higher. But for now, Carvana desperately needs volume to rise, and I'm not seeing it.

That creates margin issues, which I've covered before, as Carvana has never had a 12-month rolling period where operating earnings were positive.

Gross margins were in the mid-teens during Carvana's boom period during the pandemic, but fell to 9.2% on a TTM basis at the end of last year. The most recent quarter was over 10%, and guidance for Q2 suggests it will rise again. If that happens, that's great, and will help immensely. But those that are paying $24 for the stock would do well to remember operating margins are still extremely negative, and almost certainly will be for a long time to come.

That leads to the losses you see above on an EPS basis, with the company set to lose massive sums of money for the period of 2023 to 2025. In fact, Carvana is expected to lose between $12 and $13 per share in total for the next three years, or about half of its current market cap ( after a 56% short squeeze rally). This company has a lot of issues, and this Q2 guidance update is not going to fix them.

The final issue that it appears investors seem to be ignoring is the horrendous state of the balance sheet , which we can see below.

The company has over $8 billion in net debt, and it's paying almost $600 million per year just in interest expense. For a company that is chronically unprofitable, that's an untenable position to be in. Either the company finds a way to fix its chronic unprofitability, or it will have to issue even more debt or common stock to fund its deficits. I think the odds of a magic profitability fix are extremely low, so that leaves very expensive debt with a high interest rate, or even more shareholder dilution.

The bottom line

Trying to value a short squeeze stock is a bit pointless because it's not being driven by fundamentals at the moment. However, when the short squeeze ends - and it will - the fundamentals will matter again. Below we have the stock's price-to-sales ratio, compared with CarMax, Inc. (KMX), which runs a similar business. However, CarMax makes a lot of money and has proven success over long periods of time; Carvana is neither of those things.

Nevertheless, if Carvana can right the ship over the coming years, and that's a really big if , it could theoretically trade around where CarMax does on a P/S basis. That would suggest about 100% upside on the valuation, but let me be clear in saying I do not think that's a reasonable scenario anytime soon. For now, I think Carvana's deficit to CarMax on this ratio is fully justified given Carvana's disastrous balance sheet and chronic unprofitability.

If trying to catch a short squeeze is your thing, Carvana is certainly a candidate for that until it fails the prior short squeeze top just under $20. However, I view short squeeze stocks as nothing more than gambling, and therefore, I'm not interested.

On a longer-term basis, while the Q2 update is a step in the right direction, that's all it is. Nothing has changed from the perspective of Carvana becoming profitable, or fixing is crushing debt load. For those reasons, I'm sticking with my sell rating, as I believe that even if the short squeeze powers Carvana stock higher for the next week or two, it will eventually be right back inside the range it was in before the short squeeze began. That's a long way down from here.

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