Summary
- Carvana has sufficient liquidity resources from 2.6 billion of inventory, and $2 billion of real estate that will cover expected cash outflows from operations, capex, and interest expenses through 2023.
- Equity financing will be an option for Carvana if needed. Ernie Garcia II, who owns 41% of the company equity, has a strong incentive to rescue the company.
- While the market is overly concerned, 13 executive officers and directors with better knowledge about the day-to-day operations and financials are showing confidence.
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At $8 a share, Carvana (CVNA) is now only worth $1.5 billion, or 1/30th of $43 billion at the beginning of this year. We believe bankruptcy is highly unlikely - here's what that means to contrarian investors.
The Market's View (Why Carvana Might Go Bankrupt)
Currently, Carvana is highly unpopular in the stock market, and nine out of 10 Carvana-related news items are negative, reflecting a potential bankruptcy case. CVNA is also one of the most shorted stocks in the market. As of Nov. 28, 41 million shares of CVNA have been sold short, making short interest as high as 42% of 98 million floating shares (excluding 8.5 million Class A shares owned by Ernie Garcia II and ECG III).
There are several key reasons why the market believes the company's bankruptcy is highly likely. First, the market has said that Carvana's daily operations are burning a lot of cash in recent quarters. But, in our opinion, the company's effort to reduce costs failed to show meaningful results in Q3. This is typical market behavior that lacks insights and just extrapolates the short-term quarterly numbers into the near-term future. Some even argue that Carvana's e-commerce model isn't sustainable based on unprofitable quarters, despite the benefits from the pandemic lockdown and the used car price surge.
Second, the market has said that the current economic headwinds will worsen the cash burn from operations. Many consumers are putting off purchasing a car as auto loans have become costly due to significantly higher interest rates. Sales will continue to fall, and their finance receivables will be unattractive to sell. All these will put downward pressure on GPU (gross profit per unit), and operating cash outflows will not improve despite management's cost-cutting efforts.
Third, the market has argued that Carvana already has too much debt, and interest expenses are too high. The market believes additional debt financing will be challenging in the period of the credit crunch, and Carvana will fail to service its debt obligation. We agree that Carvana is indeed faced with economic headwinds. However, the market has overstressed the possibility of an unlikely outcome, overlooking the fact that the company has the means to survive such a challenging period.
Liquidity Analysis for Q4 2022 Through Q4 2024
The company's current priority is to ensure it remains solvent during the anticipated economic turmoil. Here we provide a detailed liquidity analysis of how the company will fare if a recession continues for the next nine quarters through the end of 2024. Also, we have a conservative approach to project cash flows for each quarter.
Cash Outflow Projection
There are mainly three areas of cash outflows for the period: 1) operating cash outflows excluding interest and inventory, 2) interest expenses, and 3) capital expenditure. There will be no senior notes principal repayment before October 2025.
Period | Operating Cash Outflow Ex-Interest and Inventory |
Q4 2022 | -$250 million |
FY2023 | -$500 million |
FY2024 | Breakeven |
We expect Carvana's cost reduction efforts to start to pay out over time in the first half of 2023. Starting Q4 at a similar level to the recent two quarters, -$245 million and -$251 million in Q2 and Q3, respectively, Carvana's cost reduction efforts will start to pay off. We project quarterly operating cash outflows to decrease gradually and meaningfully through 2023, and then positive quarterly operating cash flows, excluding interest and inventory, sometime in 2024.
Management is now highly focused on improving profitability instead of growth. We believe it will take advantage of lots of low-hanging fruit for cost reduction, given the fact that Carvana had only been focused on growth previously.
- Much less need for advertising: With an average customer rating of 4.7 out of five among 170K reviewers, word-of-mouth marketing has been strong for Carvana. We believe that the company will effectively cut advertising dollars in the no-growth period.
- More cost-efficient logistics: With the added ADESA facilities and elimination of costlier deliveries such as long haul, logistics expenses will be reduced significantly.
- Lower inventory: As of today, Carvana still shows 5x to 10x more inventory than CarMax (KMX) within 250 miles. We believe Carvana's unique nationwide pooled inventory will allow a lower level of inventory to shorten average days inventory outstanding and reduce depreciation.
- Reduced workforce: In May and November 2022, the company announced layoffs of 4,000 employees in total, a decrease of 19% in its workforce compared to December 2021.
Starting with a $90 million reduction in SG&A in Q3, we expect Carvana to significantly improve profitability during this challenging period. Management repeatedly emphasized during the Q3 earnings call how dedicated they are to reducing costs and enhancing operating efficiency in the near term.
Period | Interest Payments |
Q4 2022 | -$156 million |
FY2023 | -$668 million |
FY2024 | -$740 million |
We assumed an effective interest rate of 9% for asset-backed loans through Q4 2024. Given the effective interest rate for asset-backed loans in Q3 was ~ 4.5%, this interest rate is conservatively assumed. Also, we expect inflation to ease gradually during the recession with falling car prices, rentals, and oil prices, etc. This will likely lead the Fed to put a break on interest hikes in the near future.
These projected interest expenses are also based on the existing debt balance and additional asset-backed financing, which we will explain below.
Next up is capital expenditure:
Period | Interest Payments |
Q4 2022 | -$50 million |
FY2023 | -$200 million |
FY2024 | -$200 million |
These projections are based on Carvana's updated operating plan released in August 2022. The company planned to spend, for each quarter starting Q4 2022, $50 million in capital expenditure, half of which was budgeted for increasing production capacity at ADESA sites. Given that the company is now more focused on reducing costs than expansion, we might see significantly less capex for the next nine quarters vs. this projection. For example, in Q3, the company spent $10 million less in capital expenditure than the August plan. We project a total of $2.8 billion in cash outflows through Q4 2024.
Liquidity Capacity and Cash Injections
Now, let's examine if Carvana has sufficient liquidity capacity to survive this challenging period and remain solvent as a going concern. We believe Carvana can unlock its liquidity capacity in the following three areas: 1) inventory reduction and existing cash, 2) asset-backed financing, and 3) equity offerings.
Here's a look at inventory reduction and existing cash:
Period | Cash Resources |
Cash Balance as of 9/30 (Ex-Restricted Cash) | $316 million |
Inventory Reduction Q4 '22 through Q1 '23 | $660 million |
Carvana's $2.6 billion worth of current used car inventory is considered to be reasonably liquid thanks to the used car retailer's day-to-day business operations. As Carvana plans to reduce its inventory to improve profitability, we assume the inventory level to be lowered to $2 billion at least, sourcing cash of over $0.6 billion. By reducing $600 million worth of inventory, Carvana will see an increase of $660 million in cash. Here we conservatively estimate average car sale prices to be 10% higher than costs. With the current cash balance of $316 million, we believe Carvana will add cash of ~$1 billion to its liquidity in the very near term.
Here's a look at asset-backed financing:
Period | Projected Cash Injection |
FY2023 | $1 billion |
FY2024 | $0.3 billion |
As of Sept. 30, 2022, Carvana had $2.6 billion worth of inventory and $2 billion worth of unpledged real estate. Backed by these assets, Carvana has financing arrangements such as floor plan facilities, real estate financing (e.g., asset-sale leaseback), and finance receivables facilities, etc. with Ally Financial (ALLY) and several other lenders.
The market is skeptical about Carvana's ability to utilize these financing tools despite the CEO repeatedly confirming its liquidity resources and its capability to finance. This is where we believe the market has overstated its concern about the credit crunch. We believe that Carvana is still an important business partner for the lenders, and the company still has a lot of room to utilize its floor plan facilities. Over the last six months, the company reduced the outstanding balance of short-term revolving facilities from $2.8 billion as of March 31 down to $0.6 billion as of Sept. 30. Besides, the relationship with Ally Financial remains solid, evidenced by the comments of Ally Financial CEO Jeff Brown during the Q3 earnings call :
And I think as you know, Carvana's business model is effectively to sell a car, and there's not really a lot of put back. So, in terms of retail exposure to us, it's - the paper is performing quite well. In fact, I would say on a like-to-like basis, their credit performance performs every bit is good, if not, a tick better than our own auto - core auto dealer originated paper.
So, we feel we're obviously watching them but they've been a really good partner. And obviously, they're faced with industry dynamics, inflation pressures, trying to align inventory to where demand is. But I think Ernie has done a really responsible job of kind of cleaning up operations, lowering costs, slowing in the growth. But in terms of a retail flow partner, we have no complaints whatsoever about them. And consumers still like the model.
Given the current annual interest burden of over $600 million, we expect management to prudently increase the debt balance. Our assumption is for Carvana to utilize only 30% to 40% of the asset-backed financing capacity of $4 billion throughout the end of 2024.
We did a sensitivity analysis to understand an increased interest burden for the additional debt financing.
Source: Third Square Capital Management
Based on an additional borrowing of $1.3 billion, and at an effective interest rate of 9%, the company is expected to see an increased interest burden of $117 million, which we believe is manageable.
Here's a look at equity offerings:
Period | Projected Cash Injection |
FY2024 | $ 800 million |
There are compelling reasons to believe that Carvana's largest shareholder, Ernest Garcia II, will inject a significant amount of cash whenever needed. For the period from 2019 through August 2021, the father of the CEO cashed in $4 billion by selling 15.1 million CVNA shares, or 17% of his 86 million share equity stakes. Later in April and June 2022, he purchased $440 million worth of CVNA shares at $80/share and $21/share, respectively. We believe Garcia still has a significant fund at his disposal.
Reason No. 1: Garcia has a significant incentive to save the company if cash is needed. He is the largest shareholder and currently owns 41% of Carvana's equity. His equity in Carvana was once worth $27 billion in August 2021, when the stock peaked at over $370 per share. And now at ~$8/share, his equity is worth only 1/45th of the peak.
Reason No. 2: Garcia understands the used car retail business and Carvana's long-term growth potential. Although he is not involved in Carvana's day-to-day operations, he has been in the used car business for over 30 years, and he helped incubate Carvana during its early days. He has not sold any shares since August 2021, which shows a sign of his confidence.
Reason No. 3: Garcia has a history of investing in Carvana through participating in equity offerings. He injected $25 million at $45 a share in April 2020 and $400 million at $80 a share in April 2022. In addition, he purchased additional 2 million shares when the stock dropped to $21/share in June 2022.
We believe that in the event of equity offerings, there will be a good number of investors who want to take advantage of this highly discounted valuation. Carvana has shown tremendous success over the past 10 years and already paved the future path for the e-commerce of used cars, just like what Amazon (AMZN) did over the past two decades. Despite the liquidity crunch that the current economy is faced with, we believe some investors will step in to grab the opportunity. To understand a potential equity dilution from equity financing, we did a sensitivity analysis.
Source: Third Square Capital Management
In general, an equity offering is an unpleasant event for the existing shareholders due to the dilution of their equity stakes. However, given the highly discounted valuation that assumes a potential bankruptcy, there is a far greater return for patient shareholders to expect for a sacrifice of a 15%-30% dilution.
We believe Carvana has sufficient liquidity capacity to weather the storm and will remain solvent through 2024. Below is a table to help you understand the quarterly projection of cash injections.
Source: Third Square Capital Management
Note that there is short-term debt of $213 million due within the next 12 months. We reflected it in our projection for asset-backed financing.
Thoughts on Used Car Demand for 2023 and 2024
Currently, the market expects higher interest rates and worsening consumer spending to further dampen the demand for used cars in the coming year. However, we expect the negative macroeconomic factors will be offset by the normalization of used car prices, and further downside of used car sales is somewhat limited.
Historically, used car sales in the U.S. over the past 32 years ranged between 35 million and 44 million vehicles per year. For 2022, used vehicle sales are expected to be only 36 million, near the bottom of the historic range. Also, it will be a 12% decline vs, 2021, which is steep given yearly changes in used vehicle sales are mostly less than +/-5%. This year's steep decline in sales was mainly due to a combination of unprecedented pricing surges and higher interest rates.
Compared to new vehicle sales, demand for used vehicles is more stable and consistent as U.S. consumers need to drive regardless of economic conditions, and the more price-sensitive consumers will buy used cars instead of new cars.
Source: Cox Automotive
Source: Cox Automotive
Carvana's Insiders Showing Confidence
Tracking the Carvana insider transaction history, we can see that all 14 insiders - including seven executives, five directors, Ernie Garcia II, and Ernie Garcia III - have been buying shares and increasing their equity stakes as the stock plummeted in 2022. In addition, there was no single sale by the insiders other than predetermined stock sales, which are typically insignificant numbers. Contrary to the market's concerns about bankruptcy, the insiders who closely oversee the daily operations are showing confidence in the company.
Source: Carvana SEC Filings
Source: Carvana SEC Filings
All 14 insiders increased their equity stakes in the company from the beginning of 2022.
Conclusion - Carvana is a Great Contrarian Investing Opportunity
We believe that the myopic market has overreacted to the short-term operational results and overstated concerns about the economic headwinds. Despite the current challenges, we strongly believe the company will remain solvent throughout the recession with sufficient liquidity. When we exit the recession, Carvana - with a better cost structure - will likely unlock even more profits in the long-term future than originally projected. And the No. 1 online used car retailer should continue to disrupt the $800 billion used car industry.
What the market overlooks most is Carvana is not just an average used car retailer. It is an industry disrupter with a proven track record of making its customers happy, with a 4.7 rating out of five in over 170,000 reviews . We believe that the company will continue to perform better than the industry average, even during the recession.
We are confident that Carvana will make a great contrarian investment case, and believe that the company's long-term equity value should be close to $100 billion in the next seven years.
For further details see:
Carvana: A Great Contrarian Investing Opportunity