Understanding Carvana's Economic Engine

In this segment from Industry Focus: Consumer Goods, host Vincent Shen and Fool.com contributor Asit Sharma dig into high-tech used-car industry upstart Carvana's (CVNA -0.36%) recent financial performance, including its impressive vehicle-level gross margin. Learn what "GPU" means in the car retailing industry, and why improving on this number is so vital to the company's eventual profitability.

A full transcript follows the video.

This video was recorded on Nov. 20, 2018.

Vincent Shen: With Carvana's latest results, you can probably guess that things are looking pretty good given the way the stock has tripled in the past 18 months' time. But I'm curious, Asit, what has jumped out to you in terms of financial performance or anything else?

Asit Sharma: Several things. One is this record of 19 consecutive quarters of triple-digit unit retail growth and revenue growth. That's a really strong statistic. It also speaks to the fact that this company is still very small. They just celebrated their milestone of 100,000 cars sold. Upon that, actually, CEO Ernie Garcia has given a stock grant to employees, it's worth about $36 million, to celebrate that milestone and keep the troops revved up. The astonishing growth actually presents one thing we see often in companies like this, which are using data and technology to grow very quickly -- the bottom line is, right now, in a loss position.

But before we get to that bottom line, let's look at this most recent quarter, which is the third quarter of 2018. Sales increased 137% over the prior quarter to about $486 million. Gross profit increased 181% to $57 million. We're going to talk about gross margin and the way Carvana cobbles together its gross margin because I think it's very important for investors to grasp this going forward. But before we do that, let's just work down to the bottom line. Selling and general administrative expenses increased 97%. The net loss before income and taxes increased 62%.

I just threw a lot of numbers at you, listeners. The big takeaway here is that revenue is growing at a faster rate than expenses, so the company's creating operating leverage. Even though that net loss grew 62% year over year, from close to $40 million to $64 million, revenue grew at a higher rate, and that allowed gross margin to also grow at a higher rate than expenses, which have kept pace. These are largely selling expenses, general and administrative expenses. And now, the company is spending more on technology.

Let's talk about gross profit, which is one of the really interesting value drivers for Carvana. Their total gross profit per unit, or GPU, is $2,263. The company has a long-term goal of $3,000 GPU. That's a pretty decent gross profit for a used car company, and it should enable that bottom line to come closer to parity over time. The way that Carvana builds this gross margin is extremely interesting to me. The close lion's share of this comes from retail sales. If you take this number of about $2,200, roughly half that comes from the retail used cars it sells.

Another 47% comes from finance receivables. What happens, as Vince told you, when you buy a car from Carvana, you're offered financing, often at attractive rates versus your bank. If you take that loan, the company then has this long-term financing receivable on its books. It's going to collect money from you month after month. Carvana bundles up these car loans, and it sells them at a premium without recourse. That means, if myself or Vince stopped paying on our car loans, that doesn't go back to Carvana. They don't have to make that loss. That belongs with the person who bought that bundle of loans. This is a really lucrative business for the company. As I said, it supplies about half of the gross margin. As Carvana has expanded into over 200 metropolitan areas, that's it's extended reach across the country, it ups the number of cars it's selling each month. That drives this total bulk of finance and receivables that it sells.

So, as a shareholder or prospective investor, keep your eye on this GPU number as it tracks toward $3,000.

Shen: That's awesome, I'm really glad you mentioned that breakdown for the GPU number and some of the mechanics behind that. It's interesting to see that, for the full year, Carvana expects their unit sales to come in at around 95,000, with $2 billion of revenue. Asit, chime in if I'm forgetting something. I know GPU was a big metric that management definitely spoke to quite often. Some other things that listeners should be tracking as they evaluate this business, the big ones that jumped out to me. That unit sales volume, seeing that number continue to track higher. Also, something like average days to sale. Management has mentioned how that factors in, again, to that GPU number. More broadly, you mentioned the runway for the number of markets that Carvana can enter. I'm also going to be following the number of markets Carvana is in. Also, the advertising spend.

To give you some perspective on how this GPU number has tracked over time, that medium to long-term goal of $3,000 has been scaling up so quickly. It's surprising to see. You go back to 2014, when Carvana operated in just three markets. They said they had negative gross profit per unit of $200. Two years later, it's in 21 markets, with gross profit per unit of just over $1,000. Then, another two years later, now, they're starting to work closer and closer to that $3,000 goal.