The Bear Case Against Carvana

Rich Duprey, The Motley Fool

Updated Sat, Jun 1, 2019, 8:06 AM

Since it peaked at almost $77 a share earlier this month, the stock price of used car dealer Carvana (NYSE: CVNA) has retreated by more than 20%. Much of that slide was propelled by a first-quarter earnings report that missed Wall Street's bottom line expectations, followed by news this month that it would launch a fresh debt and equity offering. However, there may be further declines to come.

Although Carvana offers a number of benefits to used car buyers, its model may not hold enough that's unique or industry-changing to justify its current valuation.

Car being delivered via Carvana flatbed truck

Image source: Carvana.

A better car-buying experience...

Carvana wants to modernize and streamline the used-car buying experience by selling direct to consumers in over 100 U.S. cities via its website. No salespeople, no haggling. You surf its inventory of around 15,000 vehicles, choose the one you want, and Carvana will even complete financing and paperwork for you online before delivering the car to your door. Or, if you live near one of its 16 vending machine towers, you can pick it up there, and watch the spectacle of your car being delivered to you via an automated parking garage.

The company's online-centric model keeps overhead low, while the negotiation-free pricing policy lets it make up in volume for the lower profits it realizes on each individual sale. Consumers seem to be responding.

In Q1, it sold 36,766 vehicles -- twice as many as it moved a year earlier -- generating revenue of $755.2 million, a 110% increase from the year-ago period. It also more than tripled the number of used cars it purchased directly from consumers.

...But not a profitable one

What investors apparently didn't like was that Carvana's net losses widened to $82.6 million, or $0.69 per share. Its adjusted net loss of $0.53 per share was worse than the $0.49 per share analysts had been expecting.

The company saw its cash on hand shrink to $85 million while long-term debt grew to about $500 million. It also has current liabilities of around $630 million, giving it total liabilities of $1.18 billion. Its total assets of $1.3 billion, though, more than backstop those debts. Still, those figures help explain why word of Carvana's debt and equity offering pushed its stock lower. It will be diluting existing shareholders by issuing 3.5 million new shares, and taking on an additional $250 million in senior notes due in 2023.

Carvana has 48.9 million shares outstanding, but the newly issued equity represents 10% of the company's traded shares, also known as its float. Debt by itself isn't a bad thing for a business, but too much can be burdensome. In Carvana's interest payments have swelled to $15 million, or more than 17% of its gross profits. With this additional offering, they'll likely consume more.

The dealer model still does better

But Carvana has other worries too. Used car prices are falling broadly. Although the company reported that its own sales prices rose 2.8% in Q1, J.D. Power forecasts that used car prices will be flat in 2019, while those for vehicles up to eight years old will dip by 0.1%. It does believe the market for used cars will remain robust as new car prices rise, but pricing pressure could still be a drag on Carvana's business.

More importantly, the company is suffering significant net losses on each car sold. Despite reporting a rising gross profit of $2,429 per vehicle sold in Q1, Carvana's retail net loss per vehicle was $2,157. In comparison, the average dealer reported a profit of $6 per used car sold. Even though Carvana sports a business model that supposedly strips out most of the overhead expenses of a dealership, it's still reporting significant losses. As it builds out more lots and vending machines, its overhead costs will only increase.

Different name, same issue

The problem with Carvana's attempt to revolutionize the way cars are sold is that the auto market was already fairly efficient. Millions of transactions occur annually across thousands of dealerships, as well as private-party sales, letting buyers gain more insight into the transaction through data available from sites like Kelley Blue Book and Edmunds. Carvana hasn't so much cut out the middleman as replaced him, though it has also introduced more transparency into a system that is still very opaque.

Delivering a better customer experience doesn't always mean a successful business, though. Beepi, like Carvana, was going to revolutionize car sales via an online peer-to-peer marketplace for buying, selling, and leasing used cars. Transactions were carried out on a smartphone or computer. It quickly went out of business.

Other similar dealers such as Shift and Vroom -- which acquired some of Beepi -- have also faced problems.

Carvana also incurs substantial costs to inspect, repair, and market its cars, as well as prepare all the paperwork, finance the purchases, and deliver the vehicles to the customer. Those vending machines are not cost-free either. Its expenses for those services rose right in line with its sales, so it has yet to begin realizing any efficiencies from its growth.

Its business model may provide customers with a somewhat more hassle-free way to buy a car, but Carvana itself may ultimately prove to be little more than a gimmick disguised as an investment.

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