Why is Carvana falling apart?
Carvana (ticker: CVNA) was once a pandemic darling. Carvana was built around the idea of simplifying the car buying process to “buy online, pick up in store”. The idea has a lot of appeal: buying a car is like tar and feathering yourself repeatedly and paying for the privilege to do it.
Figure 1: The British tax collector had a choice: buy a car from the dealership or be tarred and feathered. The rest they say is history.
The stock peaked at $376 per share during the last 12 months but then cratered to a recent low below $21 (at the time of this writing). As late as August 2021, analysts and the news media were saying (at a recent high of $360) that the stock had more room to run, projecting revenue growth that would exceed 30%. At the time used car shortages lead to higher gross margins on sales. To illustrate, at the time the company was getting over $5000 per car up from a historical average of $1000-$2000 per car.
Carvana’s business model is built on offering loans along with its car sales and then packaging those loans with many loans to financial institutions. This is a common practice called securitization that has been used with mortgages and other loans. The idea being that most of the money is made in originating the loan, while servicing the loan generates money over the long run. Much of this process works when interest and bond rates are near zero. When the cost to borrow is zero and the loan is asset backed, then repossessing the car and selling it again offsets the borrowing cost. After selling the loans, Carvana had the cash to go buy used cars and repeat the entire process. Although the loans are doing well, as interest rates rise, the cost to borrow will increase and loan profitability will be more difficult to obtain.
Bhere are three legs to a successful business and a company has to ensure that each leg is well supported or the business will fall apart. The stakeholders - investors, customers, and employees - all have to receive a profit in some way or another or the company will ultimately fail. The company has had problems with transferring titles of its cars to consumers because Carvana hadn’t completely obtained the title of the car before passing it along. In some cases it was a paperwork issue but in other cases Carvana was selling a title it didn’t have (which is illegal in many states). Its lax internal controls have led to Carvana losing its dealer’s license for a second time. Prior to that suspension, North Carolina, Florida, and Michigan had also suspended Carvana.
So with all the negative news surrounding this growth stock, what does that mean for us as value investors?
Figure 2. The value investing process as described in most Value Investing books
Value investors generally sit out the meteoric rise of companies as they become Wall Street darlings. And for good reason, early stage businesses with unproven business models often have growing pains. Any sign of problems or any miss on the growth trajectory causes a steep and often catastrophic reversal in share price. Even so the fear of catching a falling knife is also part of the equation here. To separate the gold from the shiny yellow rocks the first question is does the company have a viability problem?
Both on a short term and long term basis, companies must cover their debt obligations or go to bankruptcy. Carvana has never been profitable on a free cash flow basis. Carvana’s recent April 2022 unsecured notes generated $3.3 billion in cash but at a whopping 10.25% interest rate. $2.2B of these funds are being used to pay for ADESA, a car auction house, and the remainder will be used for operations. The problem here is that any investor looking at this deal will see a company with no way to continue to pay for itself without issuing more debt OR diluting itself significantly.
Caravana’s woes are worth looking into to see if value and price are mismatched. But it doesn’t appear to have its business plan fully sorted out and costs under control. With dilution being a significant risk, any valuation scenario would also be impacted. Investors would do well to look in other areas to find better businesses that are both more profitable and undervalued.