Once a market darling, Carvana Co. (CVNA, Financial) today stands as a cautionary tale of how a hyped-up growth stock may fail to live up to expectations. This story stock boasts a revolutionary online used car dealer business model that both buyers and sellers love for its ease of use, but the company took several risks that backfired big time. These mistakes have left if fighting for its life in the notoriously low-margin and highly cyclical used car space.
However, now that the stock is trading below its initial public offering price and the company is making efforts to get its costs under control and restructure its debt, investors have begun to wonder whether Carvana has turnaround potential. Shares have doubled year to date in response to renewed optimism that with some new tailwinds, perhaps a price-sales ratio of just 0.07 is too low.
Sometimes, a declining business never recovers, though, and the possibility of bankruptcy cannot be ruled out given Carvana’s extremely weak financial position. Let’s take a look at what went wrong with Carvana to see if its problems are fixable, or if they will drive the company (and its investors) into the ground.
Accumulating inventory at all-time highs
The Covid-19 pandemic resulted in semiconductor shortages, and the automotive industry was among the hardest hit due to the combination of a sudden restriction in supply with an increase in per-vehicle chip density.
This caused used car prices to skyrocket since new car availability was limited. Carvana took full advantage of this to push through more sales volume; in fact, with its unique and innovative online business model, the company seemed to be in the best possible position to snap up market share during the pandemic.
Before Carvana, if you wanted to buy or sell a car entirely online, you had to brave Craigslist, eBay (EBAY, Financial) or another general e-commerce site where scammers have a relatively easy time pulling a fast one on unsuspecting victims. While not perfect, Carvana took a lot of the danger and uncertainty out of online used car sales, making the model viable at scale. Its iconic car vending machines were also a breath of fresh air in a mostly static industry.
The company even managed to pull off a profit in the second quarter of fiscal 2021. The positive bottom line did not last, though. Since Carvana was accumulating as much inventory as it could at record high prices, margins were squeezed as soon as demand began to cool off.
Unsustainable debt
Accumulating too much inventory at cyclical highs has added to Carvana’s already significant debt burden. This is not a problem unique to Carvana, though one could argue it was exacerbated by the online model, which makes it tougher to respond to shifts in market sentiment in a timely fashion. As of this writing, Carvana had an Altman Z-Score of 0.65, which implies a risk of bankruptcy, though the current ratio of 1.77 shows it should be able to keep up with near-term liabilities.
In addition to heavy investments for rapid growth and inventory accumulation, Carvana’s lean methodology is also partially to blame for its poor financial situation. Wall Street Journal reporters Kristin Broughton and Margot Patrick explained the problem as follows:
"When Carvana makes a car loan to a buyer, it packages it with other loans and sells the debt to investors… While other auto lenders also sell loans to investors, they typically keep the debt on their books, recording gains and losses over time. Carvana, on the other hand, doesn’t retain the debt and immediately books gains on the cash sales."
This methodology gives the company an injection of cash right away, which is great when times are good, but it backfires when the market sours as the company does not have loan repayments to pad its numbers. This has left Carvana with only cost-cutting measures as a way to bring costs under control.
Operating expenses out of control
Fortunately (or unfortunately) for Carvana, there are plenty of areas where it can implement cost-cutting measures, as its total operating expense for 2022 was $2.7 billion, or 20.1% of sales. For comparison, fellow used car retailer CarMax (KMX, Financial) spent just 8.6% of its revenue on total operating expense in 2022, and new and used car dealership aggregator Lithia Motors (LAD, Financial) spent 11.6%.
Carvana’s total operating expense was only 15.9% of revenue in 2021, and the big boost in costs came from the company mistakenly positioning itself for growth going into 2022.
"Now, with the interest rates going up and demand falling, they're stuck with these vehicles at record prices," observed Diana Lee, co-founder and CEO of Constellation and a former automotive brand consultant, in an interview with Autoweek. "They don't own these vehicles - they're paying an interest rate for every car that they're holding on to. It's a float of that vehicle, and the float doesn't get paid until they actually make a transaction and sell those vehicles."
Carvana cannot do much with its expensive inventory other than sell it, even if it is at a loss. What it can do to cut costs is lay off staff, implement more efficient operational and management processes and restructure debt. All in all, the company expects its cost-cutting measures to result in annualized operational savings of $1 billion by the second quarter of 2023 compared to the second quarter of 2022.
That might have been enough to push Carvana back to profitability at the current sales run rate, if it were not for the massive Adesa acquisition. In May of last year, Carvana acquired Adesa U.S.’s physical wholesale auction business from KAR Auction Services (KAR, Financial) for $2.2 billion. Despite the near-term hit to profitability, the company remains positive about the acquisition’s long-term potential for synergies such as greater access to real estate, logistics improvements and vertical integration.
Outlook
The automotive industry is notorious for its cyclicality, and Carvana went all-in positioning itself for growth when it should have been bracing for a cyclical downturn, resulting in massive operational inefficiencies and losses.
The company is doing what it can to survive the impact, and it does have some wiggle room to reduce operating expenses and restructure debt. Any equity offerings or divestments likely would not move the needle much due to the unfavorable market situation. There is a very real risk of bankruptcy that investors should not ignore, though the company appears confident in its stability at current interest rates.
Things will likely get worse before they get better. Carvana has provided guidance for its first quarter of 2023, and it expects operating revenue of between $2.4 billion and $2.6 billion, down from $3.5 billion a year earlier, though on the bright side, it expects a net loss between $50 million and $100 million, which would be a huge improvement from the net loss of $348 million in the year-ago quarter.
For now, the rapid growth era is over for Carvana. Whether or not it can return to growth mode on the next cyclical upswing depends on whether it can survive adverse market conditions, and whether its competitive advantages can hold up years in the future when competitors have become more comfortable implementing online-only sales.
