Few people look forward to the process of buying a used car. Carvana (NYSE:CVNA) purports to upend the traditional used car lot experience and make it enjoyable.
Some investors have bought into the premise, bidding the stock price up 123% in one year. Meanwhile, the percentage of float shorted is currently 35%, as other investors just don't see it given company metrics.
Clearly there are strong emotions on each side of the investment coin. The idea of consolidating the used car business for better prices is a good one, but the company hasn't proven it can be done profitably yet.
Is Carvana really the Amazon of cars?
Carvana, an online-only used car dealer, gives customers the opportunity to shop, finance, and sell or trade-in cars from the comfort of their own home. There's even an option for home delivery of the chosen car, and a seven-day return policy if you decide you don't like it.
The idea is that cutting out dealerships saves a lot of money, resulting in lower prices for the consumer. Customers can browse the inventory of 15,000 used cars on the company's website and take possession of their selected car within a couple of days.
The model reminds us of Amazon's early days with books, but significant differences undermine Carvana's value thesis.
Amazon could incentivize customers to purchase more books per order, lowering incremental shipping costs. Also, book production is centralized, providing opportunity to streamline incoming inventory shipping costs. Amazon found ways to take steps out of the process, saving money, while Carvana is adding steps.
Pooling heavy inventory and shipping all over the country is expensive. How much more is a consumer willing to pay for a used car from 2,000 miles away? And a car has to be transported at least twice-first to the Carvana refurbishment center (IRC), then to the customer.
While at the IRC, a car has to be inspected, diagnosed, and repaired by a mechanic. It's a labor-intensive process that requires more labor and physical plant costs as volume increases. Those costs are unavoidable, and place pressure on profits.
All the while, Carvana is facing competition from local sources of used cars sitting in car lots and driveways. Armed with Carfax and mechanic reports, consumers are better equipped than ever to make good purchase decisions on their own.
Investors are holding their collective breath
Fourth quarter 2019 earnings are scheduled to be released Feb. 26, and investors are anxious to see if the company is any closer to profitability. Revenue has been steadily increasing quarter to quarter, but other metrics will merit increased scrutiny.
Net loss -- At the end of the third quarter Carvana's net loss was 144% more than the same quarter a year before.
Cash burn -- For the first nine months of 2019, Carvana reported about $435 million in net cash used up in operations — cash burn increased 65% from the year before.
Financial health -- Needing more cash, in May 2019, Carvana announced its intention to raise more than $500 million by selling 3.5 million Series A common shares, and another $250 million from issuing more 8.875% senior notes due in 2023 in a private offering to be used for "general corporate purposes."
At the time of the announcement Morgan Stanley analyst Armintas Sinkevicius estimated that the additional capital would provide Carvana with enough cash to operate through the second half of 2020.
Should investors jump on for the ride?
Carvana's closest competitor is CarMax (NYSE:KMX), which has a slightly different business model. CarMax customers identify potential car purchases online, but routinely take cars for a test drive from physical CarMax locations before completing the transaction. In Carvana's vision, customers are happy to trade the test-drive experience for a lower price and seven-day return policy.
To statistically compare, Carvana's price/sales ratio of 3.67 times its most recent 12 months' sales looks astronomical compared to Carmax's 0.77. The company's 12% gross margin is lower than CarMax's 13%. Finally, Carvana has a negative 4% net margin, while CarMax's net margin is a positive 4%.
Jan. 22 Morgan Stanley analyst Adam Jonas reiterated an Underweight rating on Carvana, saying "We are constructive on CVNA's ability to disrupt the used car dealership model. However, we believe this potential upside is more than priced into the stock, and our 2023 Adjusted EBITDA estimate is 35%-40% below consensus."
I agree with Mr. Jonas in thinking the stock price is over-valued, especially when compared with its closest competitor, CarMax. Carvana may succeed in disrupting the traditional used car market and pioneering a new kind of business, but until it can move closer to profitability investors should stay on the sidelines. There will be better entry points as Carvana matures.