This post is a summary of my analysis of Carvana. I hope you enjoy reading it and feel free to add your take and agree/disagree with what's mentioned below.
Disclaimer: I do not own any shares of Carvana and have no intentions of opening a position.
The post covers the following:
- Introduction & Fundamental analysis of the business.
- Historical financial performance
- The balance sheet (and the liquidity challenge)
- The useless “key operating metrics”
- Assumptions & valuation
- Valuation based on assumptions different than mine
Introduction
Carvana is a company referred to as “The Amazon of cars” (Is it going to live up to that expectation, we're yet to see) and is an eCommerce platform for buying/selling used cars.
This is known as a fairly low-margin business, but the companies in this industry also engage in selling financing loans (as they are the first to make any such offers to potential customers) as well as earn various commissions (such as insurance). This part has a gross margin of 100% as, well, there's no cost to it.
Unlike the traditional competitors in this industry, Carvana has no brick-and-mortar stores, but it does have over 30 vending machines. This model allows them to have lower variable costs, increase scalability and also build brand awareness as such vending machines definitely stand out.
Their business model can be outlined through the lenses of a vehicle lifecycle:
- Vehicle Acquisition
- (In-house) inspection and reconditioning
- Photography and merchandising
- Transportation and fulfillment (as early as the next day)
Carvana is public since April 2017 and the IPO price was $15/share. On the first trading day, roughly one-third of the valuation was gone. However, by mid-August 2021, the share price was over $360, representing a return of over 30x. Today, the share price is close to $11 (down 97% from the peak). We will come back to this share price movement later in the post.
Historical financial performance
The company's revenue grew incredibly fast, from $2b back in 2018 to $14b for the LTM (“last twelve months”) ending September 30th, 2022. This was fueled not only by Covid-19 (When the traditional brick-and-mortar competitors had to close their stores) but also by the increase in the prices of used cars.
Their gross margin went from 10% in 2018 to 15% in 2021 and is now down to 11% for LTM.
However, that percentage isn't sufficient (yet) to cover their SG&A expenses, which decreased from 22% of revenue back in 2018 to 19% for the LTM.
This means Carvana is yet to reach profitability and its operating margin is -8%.
This can be translated to per-vehicle calculation.
| 2018 | 2019 | 2020 | 2021 | LTM | |
|---|---|---|---|---|---|
| Revenue per vehicle | $20,774 | $22,191 | $22,887 | $30,134 | $32,022 |
| Cost per vehicle | $16,684 | $19,339 | $19,635 | $25,597 | $28,445 |
| Gross profit per vehicle | $2,090 | $2,852 | $3,252 | $4,537 | $3,577 |
| SG&A per vehicle | $4,519 | $4,431 | $4,613 | $4,781 | $6,210 |
| Loss per vehicle | $(2,429) | $(1,579) | $(1,361) | $(244) | $(2,633) |
| Vehicles sold | 94,108 | 177,549 | 244,111 | 425,237 | 438,635 |
The management is targeting a 15-19% gross margin in the long run and an operating profit between 7.5% and 13%. How realistic is this? There is only 1 competitor that has an operating margin within that range, and that is AutoNation (8% operating margin), so I'll let you be the judge of that.
All the other competitors have either lower operating margins (most often below 5%) or are unprofitable.
The balance sheet (and the liquidity challenge)
Up until this point, it seems like a story of a growth company that is trying to figure out its way to profitability. However, the balance sheet shows a different side of this journey.
Although this is a money-losing company, with losses of $1.2b for the LTM, for some reason, its cash balance has always been fairly low. As of September 30th, 2022, Carvana had $316m of cash.
Other than the inventory of $2.6b (roughly 90k vehicles), it is important to note that they acquired Adesa, a physical auction business, with 56 sites that can be used for storage, photography, and reconditioning of vehicles. Overall, this seems like an acquisition that fits well within the business.
Here's the big problem, the company has A LOT of debt and I mean A LOT! Here's how it evolved over the last 5 years:
| 2018 | 2019 | 2020 | 2021 | Sept. 2022 |
|---|---|---|---|---|
| $633 | $1,630 | $1,890 | $5,803 | $8,073 |
The last increase was to fund the acquisition of Adesa and since they are quite leveraged, the interest rate was 10.25%!
In the last quarter that they reported, the interest expense was $153m!
So, here's an unprofitable company, losing over $1b from its operations in a year, with a very low cash balance and a huge debt burden. On top of that, they borrow more, to make an acquisition.
Now, one of the main questions is, how can they survive?
A lot of additional funding is required, likely $3-4 billion until they break even.
The challenge is, how can they get this funding? In theory, there are two main ways:
- Issue more shares – This would be difficult as their share price has dropped significantly and their entire market cap is now $2b. In hindsight, it is strange that the management did not issue shares when the share price was $360+, knowing that the company will be unprofitable for quite a while.
- Get more debt – This is also difficult as the interest rates offered to them are double-digit.
The management has two priorities, reduce expenses significantly and become free cash flow positive.
The useless “key operating metrics”
In one part of the public reports, there are the so-called “key operating metrics”, which I find useless, but you can disagree with me. Here they are (as well as my comment in brackets):
– Retail units sold – This is irrelevant unless these vehicles are sold to generate a net profit.
– Population coverage – Unless people are making purchases that create value for Carvana's shareholders, this is also irrelevant.
– Average monthly unique visitors (in thousands) – This reminds me of everything I've heard about the dot-com bubble. Bragging about numbers that do not translate into cash flow.
– Total website units – Same as the first point, it doesn't matter if there are 50k vehicles listed or 80k. None of that is a proxy for how well the company is doing and whether these vehicles are sold at a profit or not.
– Total gross profit per unit – This one was quite close to being a good operating metric, but they decided to use gross profit instead of net profit per unit.
Assumptions & valuation
In order to make a valuation, we need to assume that Carvana will actually go through this period and secure additional funding. Otherwise, there's no valuation to be done as the company is on its way to bankruptcy.
So, here are my assumptions:
Revenue growth: 10% in year 1, then 5% for the next 4 years, then down to 2% (this is translated to 51% revenue growth in 10 years)
Operating margin: 7.5% by year 10 (-5% in year 1, -3% in year 2, break-even in year 3, 2% in year 4, etc.) – the low end of the management's long-term target. This might also be a stretch but stay with me for now.
Discount rate (WACC-based): 8.8% (Cost of equity of almost 20%, and after-tax cost of debt of roughly 6%) –> reducing over time to 7.7% (close to having a beta of 1) – Yes, I know, this might also be a stretch, but look at the outcome, even under these assumptions
Outcome (in millions):
| PV of CFs over the next 10 years | -$172 |
|---|---|
| PV of terminal value | $7,951 |
| Value of the business | 7,779 |
| + Cash | $316 |
| + Other non-operating assets | $835 |
| – Debt | $8,073 |
| – Value of equity options | $100 |
| Value of equity | $757 |
| # of shares | 189 |
| Value per share | $4.01 |
Based on the assumptions above, the outcome is roughly $4/share, leading to the conclusion that Carvana is overvalued.
Valuation based on assumptions different than mine
Of course, I could be significantly wrong in my assumptions. The table below shows how the valuation changes (per share), based on assumptions regarding the revenue 10 years from now and the operating margin.
| Revenue / Op. margin | 5% | 7.5% | 10% | 12.5% |
|---|---|---|---|---|
| 40% ($19.7b) | -$15.7 | $2.6 | $19.6 | $37.5 |
| 51% ($21.1b) | -$15.6 | $4.0 | $22.3 | $41.6 |
| 75% ($24.6b) | -$15.6 | $9.0 | $32.2 | $56.5 |
| 100% ($28.1b) | -$15.3 | $10.5 | $34.8 | $60.4 |
Unless Carvana can deliver an operating margin of 7.5% or more, the company is worthless (based on the assumptions above). However, if it can deliver an operating margin of 10%+, then it's undervalued. In any case, there's no justification for the price at the $360/share level, other than fear of missing out.
I hope you enjoyed the post.
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