Summary
- Carvana is set to report Q4 earnings next week.
- CVNA stock had a short squeeze rally that appears to have fizzled out.
- Carvana is at serious risk of an untenable funding gap.
Beleaguered used car retailer Carvana ( CVNA ) is set to report earnings next week, and heading into that, the stock has seen an epic short squeeze rally. That has produced a stock that's absurdly overvalued and detached from the way the company's bonds are trading.
I last covered Carvana in December when I said it was wise to take the $5 per share and head for the hills. Of course, the stock is double that level now, so there's plenty of shade being thrown my way for "missing" the rally. However, I stand by my recommendation fully as my risk management principles don't allow for gambling on meme stocks that have 60%-plus of the float shorted. That's what Carvana is now, and it's trading on short interest alone, not fundamentals, in my view. That cannot be sustained, and therefore, I'm sticking to my sell recommendation on Carvana.
I don't know what management is going to say next week, but given the way the fundamentals have deteriorated in recent quarters, I suspect we're going to get a worsening balance sheet, heavily negative free cash flow, and further reduced operating margins. If I'm right, Carvana's shares are poised for massive devaluation as the risk of bankruptcy grows.
An epic short squeeze in Carvana stock
Let's begin with a chart, as I always do, to get the lay of the land from a technical perspective. The stock has soared in recent weeks, but as I said, this rally has all the hallmarks of a short squeeze. Short squeezes, by definition, are unsustainable. That means this one will fade as well, and we're already seeing cracks in the façade heading into the earnings report.
There's price support around $6, and the stock is testing the 20-day exponential moving average. That's about where the good news ends for the bulls, as I see a stock that is tired and is ready to pull back. Is the earnings report the catalyst for the end of the short squeeze? I think there's a good chance of that, and I simply cannot fathom trying to hold this stock into the earnings report.
The PPO has turned lower from extremely overbought levels, as have the other momentum indicators. The 10-day rate of change reached 120% during the squeeze, but interestingly, the accumulation/distribution line is at its lows. That's how you know rallies are being sold, rather than bought, which again, is what you see during unsustainable rallies.
I won't beat the dead horse, but this one is precariously hanging on, and once it breaks, it is likely to do so in spectacular fashion.
Now, let's take a look at why I think $10+ is an absolute gift if you own this stock.
An untenable situation
Analysts expect $3.07 billion in revenue for the quarter and a loss of $2.34 per share.
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What's really interesting with this rally is that the company is expected to lose the equivalent of 21% of its market cap in a single quarter, and it isn't like the other quarters have been blockbusters. The losses here are absolutely massive, and there's simply no way to sustain it.
Carvana benefited massively from COVID-related shutdowns, and I was once bullish on the stock for that reason. But that rally ended a long time ago on the evidence that Carvana's model simply doesn't work. The company is chronically unprofitable, and even with an explosion of revenue in the past several quarters, it still hasn't managed to do anything besides lose more and more money, and at accelerating rates.
We know used car prices soared during the pandemic as new cars were difficult to get, which should have seen margins rise for Carvana. They didn't, however, and the latest CPI print showed yet another decline month-over-month, this time of 1.9%. Year-over-year, used car prices were down almost 12%.
For those who sell used cars, this lack of pricing power means inventory bought during times when prices were higher is carried at unfavorable prices, selling times are longer, and what the companies can actually get for their inventory is now lower.
That, in part, is why revenue is expected to decline this year from 2022 levels. The other reason is that more traditional channels of used car retailing are fully open and back to normal. None of this is good for Carvana, but as I said above, the company couldn't manage to get that close to break even when it had every advantage. Let's now take a look at the damage that has been done to the equity.
Margins have declined very steadily, and as I mentioned, this is only going to get worse as used car prices fall. Carvana needs two things to try and break even. First, it needs really high volumes, and second, it needs prices to go up.
Those things aren't happening, and trailing twelve-month margins continue to accelerate to the downside. The company's costs are far too high for the gross profit it produces, which is why the black bars continue to grow to the downside. I expect this to get worse in Q4 as we get results next week.
This creates other problems besides earnings, as Carvana has a major cash flow issue. Below is free cash flow on a trailing-twelve-months basis, as well as FCF margin.
FCF is extremely negative irrespective of the time frame chosen, and by definition, any enterprise that cannot produce at least $1 of FCF is doomed to fail. Cash must be raised in some way sustainably for an enterprise to survive, and while Carvana can issue common stock and debt to fund its FCF deficits, there are points where investors will stop funding those things. I don't think we're far off from that, particularly on the debt front. As it becomes ever clearer that Carvana's future is in doubt, these sources of funding are almost certain to dry up.
Carvana now has more than $7 billion in net debt, as it has issued debt time and again to fund its FCF deficits. The problem is that it is extremely leveraged today, and given that its margins and FCF continue to worsen, there's no path out of this debt. Worse, I don't think Carvana will be able to issue new debt given where its debt is trading today. This one , for instance, is a 10.25%, $3.275 billion issue that is trading for 56% of fair value. That means it's yielding nearly 20% , which is the return bondholders are requiring to hold Carvana's debt. This is not a healthy company, and bondholders are fleeing accordingly. You don't have to take my word for it when it comes to Carvana's ability to remain a going concern. Bondholders are telling you there's an enormous amount of risk here.
The other source of funding is common shares, which Carvana has used freely as well.
Growth in common shares has been nothing short of astounding, as Carvana uses its stock as a piggy bank. If by some miracle things turn around for Carvana, it will have so many shares outstanding as to make it all the more difficult to produce a meaningful profit on a per-share basis. Right now, interestingly enough, Carvana's use of common stock as a source of funding has made its per-share losses lower than they otherwise would have been, as losses are spread over more shares.
Final thoughts
When Carvana reports next week, here are the things I'm looking for. First, if the company beats on revenue, the market will likely be a bit more tempered when it comes to bearishness. Volume is everything, so if Carvana manages to beat on revenue, traders are likely to look favorably upon it. The opposite is true, however.
In addition, margins are critical and if they've accelerated to the downside yet again, it's further proof that Carvana may struggle to remain in business. Gross margins are extremely important, as are operating margins, given the company hasn't been able to reduce costs enough to offset its declining gross margins.
Finally, the company's cash and net debt positions, in my view, have almost certainly weakened since the last report. By just how much remains to be seen, but keep in mind that Carvana's very survival is at stake, so we must keep a keen eye on the balance sheet, as well as FCF generation.
With all of this in mind, my fundamental valuation of the equity is essentially zero. I personally do not think Carvana is going to survive, and therefore, the equity is likely to be worthless, or close to it. I cannot imagine placing a buy order for this stock at $10+, and I certainly would not recommend you do that either. Shorting a short squeeze stock is incredibly risky, so I'm not doing that either. But Carvana remains a sell in the strongest possible terms ahead of its earnings report.
For further details see:
Carvana Q4 Earnings Preview: Survival Is At Stake