CVNA - Carvana Will Struggle To Survive The Decade

2023-04-18 12:11:48 ET

Summary

• Carvana has been a fast-growing upstart in the used car market for several years.
• However, financial, competitive, and secular pressures severely endanger the company at this time.
• Based on my estimations of the company's financial runway, the company is at risk of failing by the end of the decade, or soon after.

Thesis

A bullish article on Carvana Co. ( CVNA ) posted in January of this year posited that Carvana has a 50-50 chance of either going belly up or massively outperforming. The author gives multiple reasons for this opinion, but I disagree, and judge the company's odds of success to be much, much lower. Taking the long view, considering Carvana's massive and increasing debt, perilous path to profitability, competitive risks, and debatable lack of moat, I think this company will have a difficult time ahead. If it continues on the current course, I believe at best it will underperform against other auto industry firms while fighting to survive; at worst it may cease to exist by the end of the decade.

The Bullish Article - What Was Said, And Why I Disagree

Carvana Is Likely Not The Amazon Of Used Car Sales

In his article, the author said used car sales will shift online as the world continues to digitize everything once centered on brick-and-mortar operations, resulting in a trillion-dollar opportunity in the digital used car market. The author claimed that Carvana is positioning itself to win large market share in capitalizing on this trillion-dollar opportunity, similar to Amazon ( AMZN ) positioning itself to capitalize on the multi-trillion-dollar opportunity in ecommerce.

I will concede that there are similarities here, as Carvana has been growing its business (or at least growing its revenue ) at a rapid clip for the past several years, as Amazon did in its early days. However, the question remains: why should Carvana be the only online car dealer that succeeds? Electric vehicles, EVs, are poised to take over the car market in the long term, and Tesla ( TSLA ), by far the largest American EV producer and market share leader , already sells its cars entirely online. Further, multiple websites exist for used Tesla vehicles, such as Tesla's own website, the Only Used Tesla website, and of course, the website of small mom-and-pop-shop dealer CarMax ( KMX ), among others. Websites from sellers that list other brands and types of used EVs also exist. Such sellers include CarMax, Penske Automotive Group ( PAG ), and AutoNation ( AN ).

The author said at one point, "invest where you shop," and then stated that he had a great experience getting his last car from Carvana, but there are other dealers out there that are not Carvana that one could shop from and invest in. What exactly prevents these other car dealers from setting up their own websites and shifting larger and larger portions of their business online to get a slice of this trillion-dollar opportunity? I see little preventing them from doing so, especially since several of them have already done it. Consequently, I see a limited moat protecting Carvana from encroaching competition in the digital used car space.

Even assuming that the author was not claiming that Carvana would be the only, or even the biggest, player to emerge victorious in this lucrative market, why should Carvana be assumed to be successful in it at all, let alone as successful in its market as Amazon? Per the New York Times , one major reason Amazon survived the Dot Com bust was that it took on lots of debt early in its history when money was easy in order to manage losses while growing the business freely; indeed, Carvana did the same, as one can tell by its large debt pile. However, Amazon then quickly turned to efficiency and sustainability as financial conditions worsened around it; Carvana cannot say the same.

The similar strategy deployed by Amazon and Carvana of going into massive debt to achieve fast growth early on, followed by a pivot to sustainability, is noted. But while Amazon's version of this strategy resulted in a profit 7 years after its founding, Carvana is still taking heavy losses 11 years after its founding, with a path to profitability almost impossible for me to see. Instead, as seen in its financials, Carvana continues to burn money.

Carvana's "Experience" Does Not Cancel Out Carvana's Quality Concerns

Returning to the "invest where you shop" line, the author also stated that he was a big fan of Carvana's customer service (based again on his personal experience), and considered it a perk that will lure even more investors and customers to the firm. While this may be true for the author as a Carvana customer and investor, data suggests many others may disagree.

Per the Better Business Bureau, Carvana has had over 5000 complaints about its business in the past 3 years, after selling just north of 1 million vehicles in 2020 , 2021 , and 2022 combined. By comparison, Tesla had a bit over 2500 complaints about its business in the past 3 years, but delivered (i.e. produced and sold) ~2.75 million vehicles in 2020 , 2021 , and 2022 combined. In other words, Tesla earned only half the complaints of Carvana, despite Tesla selling almost 3 times as many vehicles as Carvana, and also managing the production of the vehicles it sold, thereby exposing it to a greater risk of mistakes compared to Carvana.

While Carvana's 5000 complaints out of 1 million vehicles sold is an admirable complaint ratio of ~0.5%, Tesla's rate is much lower at ~0.09%. Both companies are praised as up-and-coming innovative firms in their respective markets within the auto industry, making this a fair comparison in my opinion. It is also one that does not paint the best picture of the overall quality of Carvana's business, which draws in 5 times as many complaints as Tesla's business when adjusted for vehicle sales.

It is good that the author had a pleasant experience using Carvana, but with so many complaints, there is little value in counting Carvana's customer service as a pro for customers or investors because the overall quality of the business should be counted as a con (at least compared to other large and growing auto industry upstarts).

Carvana's Spectacle Is Not Necessarily A Positive

The author next claimed that Carvana's car vending machines are a brilliant marketing gimmick. I actually agree, but with a caveat: the car vending machines are a great idea so long as they are operating, and perceived , as intended. Stagnant and barren are words that could better fit the description for the use of the company's car vending machines in some locations, like Denver, Colorado - not quite the image the company is going for. This exposes these gimmicks as large expensive car towers with no purpose other than to wow potential buyers; a perceived lack of buyers or cars therefore has Coloradoans (and possibly vending machine observers in other locations) openly discussing Carvana's possible bankruptcy. No cars, no buyers, no purpose, all expense.

This is a danger of pouring money into gimmicks - if they don't work as intended, the company could suffer significant reputational damage, or at least raise doubts about its operational and financial strategies.

EVs May Not Expand Carvana's Trillion-Dollar Opportunity

To close this section, I would like to mention and expound on a potential secular headwind described by a user in the bullish article's comment section. Internal combustion engines have many parts that can be easily replaced as they break down; EVs have few parts that cannot be easily replaced as they break down. Furthermore, the battery pack of many EVs, especially Teslas, is part of the structure of the vehicle itself, meaning that as it ages and degrades, losing its charging capacity and range, it probably won't be replaced at all. As Teslas and other EVs begin to dominate the roads, there is a chance that used cars, now used EVs, will be less valuable for prospective buyers due to less manageable parts degradation. Owners of old EVs reaching the end of their life will consequently be more likely to give these vehicles to the manufacturers to scrap and recycle for parts, instead of giving their vehicles a second life in the used car market. In the end, these trends could cause the used car industry as we know it to shrink in size.

In such a circumstance, Carvana would face not just challenges from its own idiosyncratic flaws and failures, but the secular headwind of its industry shrinking as well.

Carvana's Complex Financials

The Basics

With Carvana's reputation as a very fast-growing firm, some otherwise-extraordinary elements of the financials were to be expected. From 2018-2022, Carvana's revenue grew exponentially, reaching ~$2 billion, ~$4 billion, $5.5 billion, $12.8 billion, and $13.6 billion for each consecutive year. Gross profit was similarly impressive, all things considered: $200 million, $500 million, $800 million, ~$2 billion, and $1.2 billion was earned in gross profit for each consecutive year in the same period, demonstrating clear growth in its market.

Unfortunately, the rest of Carvana's financials, chiefly those related to its business operations, are rather dismal. Net income for the 2018-2022 period consisted of losses of $55 million, $115 million, $170 million, $135 million, and a huge loss of nearly $1.6 billion. Operational cash flow losses were ~$400 million, $750 million, $600 million, $2.6 billion, and ~$1.3 billion for the same period. Carvana's cash amounts to just $755 million, versus outstanding debt of $8.9 billion.

Overall, like many upstarts, the financial position is poor, in spite of, or because of, the firm's aggressive market share growth. The question in the end is whether or not the growth is sustainable. To deduce this, one must examine the company's burn rate and compare that to its cash and other liquid assets to see the length of its cash runway. As I attempted to do so, a few complications arose.

A Few Financial Discrepancies

The author of the bullish article also informed readers that "the company has about $4 billion in liquidity resources" (emphasis added, hyperlink in original). This line in the author's piece stuck out to me, as it contrasts sharply with the severe lack of cash the company has according to available data. A closer look at the author's source explains how he got this figure, and reveals two things: 1) the figure divides Carvana's over $4 billion of liquidity into "~$2.7 billion in cash and revolving availability, and ~$2.1 billion in unpledged real estate and other assets"; and 2) the figure came from Carvana investor material citing Q2'22 data.

First of all, this means the $4 billion figure is quite dated, as the "cash and revolving availability" portion has likely been heavily impacted by Carvana's cash burn. By any measure, Carvana has burned many millions of dollars since Q2'22. The supposed $4 billion liquidity will therefore have decreased by a significant margin since its appearance in Carvana's investment material.

Second of all, I take issue with the classification of $2.1 billion of "unpledged real estate and other assets" as a source of liquidity. I understand that the unpledged real estate can be put up as collateral in exchange for loans, and the "other assets" can be sold for capital, but labeling these as liquidity sources seems inappropriate. Perhaps this is a matter of differing financial perspective, but I would not consider a plan to put useful, maybe even critical, assets and property at risk to be a prudent method of obtaining liquidity. To be sure, Carvana would have no choice but to do these things if its debts came due. Still, with operational cash flow indicating that the company's business is not yet capable of sustaining itself, and that the company is far from a path to profitability, putting assets up and property for capital and collateral seems like it would only worsen the financial situation if the company remains unable to service its debts over time.

I think I disagree with the classification of unpledged real estate and other assets as part of Carvana's liquidity because to me, putting these up as a liquidity source shouldn't be part of the business plan for the company, but a wakeup call that the business's days are over.

My Estimate(s) Of Carvana's Runway

As far as determining Carvana's runway, here is how I will attempt to do it: I will measure how long the company must use its liquid assets to offset losses before the business achieves positive cash flow of operations, then assume the company reaches net income positivity and other beneficial financial metrics 3-5 years afterward so as to pay off its debt, assuming the business can produce a profit large enough to do so by then. Yes, several assumptions will be made herein.

First, I will separate the ~$4 billion in Q2'22 liquidity available into ~$2.7 in cash and "revolving availability," and ~$2.1 in assets and property. For now, I will assume that 1) the company refuses to sell assets or pledge property unless absolutely necessary, 2) the company won't be able to obtain sufficient loans to help cover the op. cash flow, and 3) that the company will have to rely on its Q2'22 cash-and-revolving liquidity to offset op. cash flow losses. I will also average out the Q3-Q4'22 operational cash flow and make this amount the Q1'23 op. cash flow; these are the quarters most likely to reflect the firm's internal pivot to profitability as 2022 financial and monetary conditions worsened, and the firm's Q1'23 results are not yet released.

Starting from a cash-and-revolving liquidity base of $2.7 billion in Q2'22, I subtract combined op. cash flow losses of $821 million for Q3-Q4'22, and estimated op. cash flow losses of ~$410 million in Q1'23. This brings the $2.7 billion liquidity down to $1.47 billion, assuming the firm paid for nothing else of note. From there, I will assume the company brings its op. cash losses down from liberal pandemic burn rates to more reasonable rates, and run its annual burn rates in reverse. In other words, for the remainder of 2023, I will say the op. cash burn will reflect 2020 levels; for 2024, the burn rate will equal 2019 levels, etc., until reaching 2028 burn reflecting 2015 levels. After 2015, the inverse exponential curve starts to level off, so let's say the projected future year cash flow in 2029 will not reflect the cash burn of 2014, but will instead be breakeven.

With a remainder of ~$1.5 billion in Q1'23, we assume that Q2-Q4'23 will have op. cash flow losses corresponding to cash losses for FY2020, FY24 op. cash losses will correspond to cash losses for FY2019, and so on until reaching FY2028, with that year's losses corresponding to FY2015. After that, FY2029 should be the breakeven year, assuming the runway extends that far. $1.5 billion - (combined op. cash flow losses from FY2015-FY2020) = -$770 million. It seems that Carvana's runway cannot extend to 2029 under the set conditions; by my estimate, it only has enough runway to stretch its cash-and-revolving liquidity into early 2025.

Alright, let's change the conditions a bit: the company is now comfortable selling some assets or setting up some property as collateral, up to $2.1 billion worth in total. $1.5 billion + $2.1 billion - (combined op. cash flow losses from FY2015-FY2020) = ~$1.3 billion. This change allows the firm to reach the 2029 breakeven point (and presumably reach positive overall financials circa 2032-34) with ~$1.3 billion to spare, assuming the asset sales and pledging of property does not negatively affect business operations.

Yet, this last assumption may not hold. Carvana appears to already be behind on paying current short-term debt and total debt, so lenders may be hesitant about giving it more loans, even if the firm offered up properties as collateral. If true, the company would have to turn to selling assets, which may negatively impact business operations, thereby increasing op. cash flow losses or reducing revenues, either of which would leave the company less able to fund operations. This makes the assets and property a bad source of liquidity for Carvana to turn to, and the chances of it helping Carvana survive its financial troubles in the long term are slim in my view, even if it grants the firm much-needed short term relief.

Financials Summary

To sum up this section, Carvana's financials, which are at least as poor as any startup's, are worsening the company's outlook. Based on some reasonable assumptions and rough calculations, I would say the firm has a good chance of failing by the end of the decade. This is without considering the likelihood that competitors start to take market share and revenue from Carvana in the digital used car space, or the possibility that EVs shrink the size of Carvana's market as they begin to dominate roads. Carvana's poor financial position therefore leaves it very vulnerable to these possible headwinds, making it likely to underperform or even collapse by decade's end.

Valuation

CVNA seems to have little valuation data available for it at this time. However, the two metrics available, Enterprise Value to Sales and Price to Sales, say plenty about the stock. Both ratios are under 1, implying absolute undervaluation. While CVNA's EV/Sales is ~0.65, P/S is a shocking 0.07. Even without comparing CVNA to its sector's valuations (EV/Sales of ~1.10, P/S of ~0.85), a P/S ratio that low signals a major disconnect regarding the stock. Either the market is missing a major opportunity and snubbing CVNA while it is on a massive discount, or the market regards CVNA as a near-worthless stock based on its price, and half as valuable as the average stock in its sector based on its enterprise value.

I think the market has the right idea on this firm. These attractive valuations do not make up for the high risk involved in owning this name. Watch out, value investors - this is a clear value trap.

Risks To thesis

As for the risks to my thesis, Carvana could manage to reach sustained cash flow positivity via faster improvements in op. cash flow than I expected, and could translate that to an earlier-than-expected improvement in overall financials such that the firm can begin to service its debts sooner and more effectively. Carvana could also find a way to solicit more loans from enough lenders to extend its cash runway, tapping into the $2.1 billion in asset/property liquidity without impairing operations or negatively affecting revenue. Carvana could also engage in a capital raise, which would irritate investors due to the dilution, but would give the company more leeway to fund operating losses; this would actually be relatively advantageous right now since the company's stock price has increased by over 90% year-to-date at time of writing, and the market cap is currently $1.7 billion. Carvana could also manage to convince lenders to give it loans large enough to fund its operating losses between now and end of decade without selling assets or pledging property (though I am not certain how the firm would persuade them to allow this). Finally, my Carvana thesis would be at risk if the used car market does not shrink due to the potential issues surrounding EV parts degradation; if the used car market stays the same or increases in size as EVs come onto roads en masse (especially if right-to-repair movements make EV parts and EV battery packs easy to fix or switch out), then Carvana would not have to suffer from the secular headwind of a shrinking used car market.

Even with these numerous risks, though, I believe the odds are still in favor of my Carvana thesis bearing out.

Conclusion

Carvana is a fast-growing used car dealer that is attempting to pioneer a business model built on totally digitized used car sales. However, its current financial setup is on shakier ground than Amazon's was in its early days. As things stand, Carvana's finances may be poor enough to jeopardize its long term stability, depending on just how quickly it can decrease losses, turn them to profits, and pay off debt; even so, the costs to do this may put the firm in a financial lose-lose situation. All the while, I believe the company's moat in the digital used car space is smaller than advertised, meaning competitive risk is higher than some might expect. The coming wave of EVs may also produce secular headwinds that shrink the size of the entire used car industry, including Carvana's bread-and-butter digital used car sales market.

For these reasons, I believe it is fairly likely that Carvana either underperforms other firms in the auto industry for several years due to its struggles, or goes under by the end of the decade, if not soon after. I therefore rate CVNA a sell.

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