• Brett Schafer

Not So Deep Dive: Carvana Stock

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Show Notes

(Ryan) What they do: Carvana is the second largest used car retailer in the US and were the first ones to introduce an e-commerce only strategy (meaning no dealerships). So I’ll try to walk through the life of a car in Carvana’s system to illustrate what they do:

Carvana purchases cars in one of two ways. Either directly from consumers or through wholesale auctions (directly from consumers is less costly). Carvana then picks up the cars directly from the sellers home or location using a multi-car holding truck. Those cars are then taken to one of Carvana’s 17 inspection and reconditioning centers (IRCs) scattered throughout the US. These are massive facilities (100 acres). At the IRC’s, each car is given a thorough inspection, then either listed on their website as available inventory for purchase or if it doesn’t pass, it’s sent to their wholesale channel.

Customers who are shopping on Carvana get to shop a range of vehicles, are presented with transparent pricing (no haggling), and can order the car directly from the website. Once the car is purchased, that car gets either delivered directly to a customer’s house or is sent to one of Carvana’s 30 “vending machines” where the customer can go pick it up. Customers that choose the vending machine option show up with a carvana coin and the car drops down. These cut out some last-mile logistics and serve as a good marketing tool. Once the customer has the car, there is a 7 day return policy (substitute for not having a test drive).

Now I did skip over one part. During the customer’s buying process, they are offered financing. This is important for Carvana. Carvana extends them an auto-loan, which they originate, but then Carvana tries to securitize and sell those loans to another company. A lot of those loans are purchased by Ally financial. This financing component makes up the bulk of their “other” revenue segment. There is also service contracts and guaranteed asset protection coverage.

Last thing I’ll add, Carvana has 3 reporting segments: Retail, Wholesale, and other. We haven’t touched on wholesale. If a car isn’t good enough to sell to customers they will sell through the wholesale channel, and this is often done through a 3rd party auction provider. These are lower gross margin than selling to a customer, but we will talk about it later in the episode.

(Ryan) History: The history actually starts with the founders dad. In the early 1990’s, Ernie Garcia the 2nd (the dad), bought a rental car company out of bankruptcy and built a used-car retailer that became one of the largest in the US. It was called DriveTime. His son, Ernie Garcia the 3rd, joined the company in 2007 as the Treasurer after a graduating from Stanford as an engineer and a few years in investment banking.

5 years after joining the company, Ernie came up with the idea for an e-commerce only retailer of cars and received funding from his Dad or his dad’s company to build the idea. At the time, the two companies were fairly intertwined. They shared a lot of resources like facilities and back-office functions. When they first launched the site, I believe I heard the CEO say that they had about 40 cars available. Last quarter, they sold 105k units. Carvana went public in 2017, and has raised several rounds of funding since through stock issuances.

(Brett) Industry/Landscape/Competition:

  • Used car market had 40.9 million unit sales in the U.S. last year. Multiply that by what a car costs and you get hundreds of billions in annual revenue potential. Margins are slim though.

  • Competitors: Carmax, Auto Nation, small dealerships, Vroom. Market is highly fragmented and Carvana is pitching themselves as the company to consolidate the market.

(Brett) Management and Ownership:

  • Founder/CEO/Chairman: Ernest Garcia III. Started the company as a part of DriveTime back in 2012. DriveTime is an automotive company run by his father Ernest Garcia II. He has 17% voting power and got paid $5 million in total compensation last year. Recently gifted employees each 23 shares of stock.

  • The rest of the executive team gets paid between $2 mil and $4 mil a year.

  • Other important person: Ernest Garcia II. He has 84% voting power according to the proxy statement, although he is not an executive or on the board. He runs DriveTime, which has multiple related party transactions with Carvana. These include purchasing wholesale vehicles from Carvana. Investors should probably investigate these transactions.

  • Overall takeaway is that the Garcia family has control of this business through the class B stock

(Brett) Valuation:

  • Market cap of $5.67 billion, ticker CVNA

  • EV of $11.67 billion by my count (subject to change given tons of moving parts with financing since quarter-end). Depends if you want to count short-term financing in debt or add back inventory (I didn’t subtract inventory).

  • Trailing EV/S of 0.83

  • Trailing EV/GP of 6.1

  • Negative EV/OI and negative EV/FCF

  • Total share count has gone from 132.27 million in 2017 to 188.6 million today (if I’m doing the conversion between A and B correctly)

(Ryan) Earnings:

  • Q1 revenue was $3.5B, up 56% YoY

  • They sold ~105K cars, +14% YoY

  • Their total gross profit was $298M, down 12% YoY

  • One metric that they report that’s important to track is the gross profit per unit. This quarter it $2,833, down 23% YoY

  • And the company had -$813M in FCF for the quarter.

  • They attributed the weak quarter to a number of factors both internal and external

  • Internal: Omicron and Winter storms hurt their IRC’s and logistics. But they also moved inventory build-up to newly built IRC’s which were further away from their average customer. All of this increased costs per unit.

  • External: Affordability and consumer sentiment combined drove fewer industry wide sales. Additionally, they ramp for growth 6-12 months in advance meaning that they over spent on inventory, which they had to service.

(Ryan) Balance sheet and liquidity:

Alright, this was a tough task. I’ll go through what the balance sheet looked like as of the last quarter, but since they reported they also raised money, so I’ll go through that as well. (Keep in mind their Q1 ended on march 31st).

Assets: These are thing that I think could be converted to cash.

  • $247M in cash

  • $3.3B in vehicle inventory

Liabilities: I’m only going to do the non-asset backed debt.

  • Current portion of the long-term debt is $178M

  • According to the 10-Q, they also have ~$2.4B in senior unsecured notes with an interest rate averaging just over 5%. Most of this debt is due after 2027.

After Q1:

  • On Apr. 26th, 2022, Carvana issued 15.6M shares (or ~$1.25B worth of stock) to the public at an average price of ~$77. (today the stock sits at $26)

  • The Garcia parties bought 34.5% of that issuance.

  • On May 6th, (10 days after the issuance), Carvana issued $3.25B of 2030 unsecured notes at an interest rate of 10.25%.

  • Moral of the story, they are burning a lot of money but they were able to buy time.

Anecdotal Evidence:

  • (Ryan) I would certainly consider them. I have no problem not doing a test drive if there is a 7-day return period. However I did see a social media post recently that I think is interesting:

  • (Brett) If I was buying a used car I’d probably check them out. Seems super convenient.

Future growth opportunities:

  • (Ryan) Growth is going to come from more of the same. But aside from just building out more infrastructure the 10th man blog, which I highly recommend, gives 4 ways for Carvan to grow its gross profit per unit. 1) Purchasing more cars from consumers than wholesalers (generally the same price but the auctioneer clips a fee), 2) Greater utilization rates of their IRCs, 3) Using more in-house transportation than 3rd parties, and 4) Fewer days to sale (don’t want to hold the inventory because it depreciates).

  • (Brett) ADESA physical auction business acquisition. This was for $2.2 billion and financed with the debt offering they just closed. Will add 56 locations and 6.5 million square feet for inventory management and better logistics. Bad timing but seems like a good fit. From CC: “This is the equivalent of approximately 30 greenfield Carvana IRC locations in terms of the production volume that we expect to unlock over time. Adding the ADESA U.S. footprint will dramatically improve our logistics network over time. With the addition of these locations, we will eventually have reconditioned inventory within 50 miles of 58% of the U.S. population and within 200 miles of 94%. This will have the benefit of reducing shipping distances, times and costs, accelerating us to our long-term financial model.”

Highlights and lowlights:

  • (Ryan) Highlights: It’s a disruptive model. And I think this is a classic example of innovators dilemma. They could start directly with the hub and spoke online model without having to cannibalize their existing dealerships. Allowed them to gain share fast. Lowlights: I don’t see the consumer environment getting better any time soon. This is a complex logistical business to run, and I just frankly don’t see how this can be profitable. Plus, I think big funds have an informational advantage here in tracking inventory, i don’t like that and it makes me feel like the price decline over the last 2 months is because that information is trackable.

  • (Brett) Highlights: Seems like the best customer experience for buying used cars, with phenomenal top-line growth, and steady expansion of gross profit per unit until 2022. Lowlights: hemorrhaging money, needing to manage inventory, impacted by wild swings in interest rates, related party transactions, dilution. Garcia II and his relationship to DriveTime make me a bit nervous.

Bull Case:

  • (Ryan) Certainly tons of upside if things go right. Brett gave you the numbers on revenue. Management’s long-term projections are for 8-13.5% EBITDA margins. Let’s assume the mid-point of that since this is the bull case. They would have $5.7B in EBITDA on that revenue figure you just mentioned. Let’s say this traded at 5x EBITDA, that would be a 5-bagger from here.

  • (Brett) Let’s say revenue grows at 30% annually for the next five years. Annual revenue would be $52 billion. If gross margin gets back to 15% (expanded to that over last five years before dipping this quarter) and the company can achieve free cash flow margin of 4%, that is $2.08 billion in annual free cash flow. Compared to current EV, it is highly likely you make some money here.

Bear Case:

  • (Ryan) Bankruptcy. When industry-wide sales begin to decline, it appears every segment of Carvana’s business suffers. More wholesale means less margin. They’ve been so reliant on their stock price over the years, but I think that’s pretty much gone now.

  • (Brett) They run out of money or have to heavily dilute shareholders. This could happen either due to macro factors, inability to turnover inventory, or just simply not getting any form of operating leverage, which they haven’t proven they can do sustainably.

Disclosure: The author and podcast guests are not your financial advisors. Ryan Henderson and Brett Schafer are general partners and portfolio managers at Arch Capital. Clients of Arch Capital may hold securities discussed on this show.

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