Carvana: A Questionable Used Car Business Model - Part Two

Carvana Co CVNA has recently reported earnings and revenue growth of 13% YoY. The company continues to bleed red ink and had a net loss of ~$106 million in the second quarter, which increased 66% from Q2 2019, while net cash outflow was a staggering ~$175 million. Vehicle unit sales are growing slightly faster than revenue, but losses continue to scale linearly demonstrating again the more cars they sell, the more money they lose. I outlined the structural business concerns that prevent this company from scaling in my previous article in May.

But now, there are several additional concerns and headwinds investors should consider. The company is now clearly flattening the revenue curve (as show below), which could become a catastrophic situation for a hyper-growth company with a $35 billion valuation, only ~$4 billion in yearly sales, and operating with a gross margin of only 13.4%. At this valuation, the company is trading almost 10x sales, which is extremely generous considering their gross margin profile.

Certainly, the pandemic has been disruptive to many businesses in Q2, but revenue growth flattening is visible for a few quarters in a row. Considering the company has sequentially expanded from 161 to 261 regions from Q1 to Q2 and now covers 73.2% of the U.S. population, it now begs the question of why revenue isn't growing any faster.

The Red Flags

The latest earnings again affirm multiple red flags in Carvana’s core business model. As shown in the chart below, the GPU (Gross Profit per Unit) is not only trending in the wrong direction but is also significantly lower than the competition (CarMax, Inc KMX and Lithia Motors Inc LAD were selected for the comparison below as they recently reported earnings). Consumer demand for vehicles is price sensitive. If multiple suppliers offer substantially the same vehicle, the one with the lower price will get the sale. On average, Carvana is selling cars about $1,000 lower than the competitors without any fundamental structural cost advantage. This implies Carvana is selling their vehicles at lower prices with the sole objective to grow volume (as used-car companies generally have access to the same car inventory sold at auctions and at similar prices). Even more concerning is that in Q2, the company experienced a significant drop in GPU from Q1, and considering Carvana said on the conference call they were supply-constrained, they should have easily been able to raise prices and generate more gross profits. A falling GPU implies soft demand and not the other way around.

Similar to GPU, the Average Car Selling price is also trending in the wrong direction. This trend typically implies one of two things: they are selling to customers with lower income and hence accepting higher credit risk, or they are again trying to undercut their competitors with the sole purpose of generating volume growth with minimal consideration to profitability.

This reduction in ASP is even more concerning as the Manheim Vehicle Index published strong upward trends in May and June, meaning demand for used cars was high. And considering brick and mortar used car dealerships were at a significant disadvantage, it is hard to find a logical explanation as to why Carvana's ASP has fallen.

Online Competition

The pandemic has been a very strong tailwind for any online retailer, which should have greatly benefited Carvana. Shopify Inc SHOP CEO Tobias Lutke said the outbreak has accelerated the expansion of e-commerce to levels expected in 2030. It appears traditional used car retailers have very quickly adjusted to this new reality, as seen in their recent earnings reports. AutoNation, Inc. AN for example has rolled express online selling tools enabling customers to buy and sell vehicles online while its store-to-door delivery option allows customers to take delivery at home. CarMax is also offering contactless curbside pick-up and has strongly invested in their online sales tools.

Additionally, pure online competitors such as Vroom Inc VRM and Shift are emerging and offering the exact same online value proposition, again demonstrating the low barrier to entry into this space. If Carvana really has such a competitive advantage over traditional retailers their YoY grown would be much higher than the 13% reported.

Some of the competition also has a toolbox not available to Carvana. Many of them also operate new car dealerships, giving them early access to lease returns and higher value trade-ins. The cars they don’t want end up at auctions and ultimately in Carvana’s inventory. 

Conclusion

The latest earnings are clearly suggesting Carvana is a busted growth story with a fundamentally broken business model, a business model that consists of raising money in the public markets, which have been incredibly favorable to Carvana, and wrapping that money in every car they sell to generate rapid unit growth while fueling a narrative about industry dominace, scalability and unacheivable profitability targets. Then repeat that cycle over and over again as long as the stock price goes up. That kind of business model almost looks like some kind of modern age pyramid scheme rather than a profitable business, whereas early inverstors recruit new investors to provide cash flow (while the stock price is used as a re-payment method). To that end, on Aug 7 2020, six Carvana executives combined sold $184 million worth of stock; most of them sold between 75% and 95% of their vested holdings.

On profitability, the CEO constantly deflects any questions related to that topic. The valuation of Carvana now exceeds Ford, which sells 6 million vehicles per year or ~30x more than Carvana. Unless there are some drastic structural changes, it is just a matter of time before this stock mirrors so many other disruptive unprofitable online companies to eventually come back down to earth. Once the shoe starts to drop, professional money managers will have to dump it, lest they explain to their management why they are holding a structurally uninvestable company.