Carvana (NYSE:CVNA) is a fast-growing e-commerce platform for buying and selling used cars. Listed in 2017, it has had a good run, with revenue more than quadrupling between 2017 and 2019. Despite its solid performance, Carvana is still a very young company with huge growth potential that could last for the next five to 10 years.

Man shopping online

Source: Getty Image

Compelling business model

Carvana operates an integrated e-commerce platform that covers every aspect of used car retailing, including online sales, financing, logistics, inspection and repair centers, software development, and more. This end-to-end business model disrupts traditional used car sales in several crucial ways.

Customer-centric operations

One of the most important aspects of Carvana's business model is its intense focus on delighting its customers by providing the best user experience, selection, and value.

Traditionally, shopping for a used car from a local dealership is largely unpleasant, tedious, and time-consuming. Prospective buyers must search for a car in the showroom, negotiate with trained salespeople, and fill out reams of paperwork -- a process that can take days, with no assurance that shoppers will leave with a car they want (and can afford).

Carvana aims to change this. Its integrated online sales model allows customers to conduct the whole buying process from the comfort of their home: selecting and viewing their favorite car, arranging for financing, trading in their existing car, and receiving their new one. Carvana will deliver the new car and collect the old car from the customer using its branded car hauler. 

Customers in certain markets can also choose to pick up their vehicles at one of the company's car vending machines, multistory glass towers that Carvana uses to store vehicles. The company also offers its customers a seven-day return and 100-day warranty policy for every purchase, reassuring shoppers that they can buy online without getting cheated.

Better selection, lower prices

Moreover, Carvana's nationally pooled inventory of 33,500 cars  provides a wide selection of options for customers to choose from, increasing the odds that customers can find their ideal car.

In contrast, traditional dealerships usually offer a limited selection; they typically optimize inventory holdings at each dealership location, even if they offer many more vehicles across multiple locations. Hence, buyers usually have little choice but to drive to a few dealerships across multiple locations to search for a car, which can be a frustrating experience. 

Also, Carvana's integrated, online-only model, run by its proprietary technology, requires minimal physical presence, saving money on expenses such as rent and salary found at traditional brick-and-mortar dealerships. In addition, its pooled inventory approach can help shorten the time it needs to sell any given car. That further reduces its cost structure, since the longer a car remains unsold, the more depreciation charges rob the car of its value. Carvana can pass on its savings to customers through lower sales prices.

Highly scalable operations

Another thing to like about Carvana's business is its capital-light nature. Traditionally, a brick-and-mortar car retailer has to invest in fixed assets -- which can cost up to $22 million per dealership -- and additional working capital to pay for operating expenses.

In comparison, Carvana needs very little initial capital when entering a new market, since there's no need to separately invest in new local inventory. or spend much on operating expenses. Normally, it will cost the company about $0.5 million to buy one or two delivery trucks, a multicar hauler, and some furniture and fittings. It will also need to spend some money hiring a team of customer advocates and initiating local advertising. As a market scales, Carvana may then choose to invest in a car vending machine -- which costs about $5 million -- to improve fulfillment and further increase customer awareness.

This capital- and labor-light model allows the company to rapidly expand its market reach. Starting from a single market in Atlanta in 2013, it has now expanded into  161 markets as of the first quarter of 2020 -- covering about 66.9% of the total US population.  

Despite its swift expansion, Carvana accounts for less than 1%  of the secondhand car sales market -- which is estimated at $764 billion, with the top dealer and top 100 used-car retailers accounting for 1.8%, and 8.6%, respectively, of the total market share.  

With a less expensive and more nimble approach to selling cars, Carvana looks well-positioned to rapidly expand its business over the next few years.

Signs of success

Though the company's still in its early days, key performance metrics suggest that Carvana's  approach is working:

  1. Used-car sales volume surged from 6,500 in 2015 to 177,500 in 2019. 
  2. Customers rated the company an average of 4.7 out of 5, based on over 45,000 satisfaction surveys, from the company's inception through Dec. 31, 2019. 
  3. Gross profit per unit jumped from $206 in 2015 to $2,852 in 2019 thanks to factors such as an increase in car purchases directly from customers -- which cost less as opposed to buying from auction --, lower average days to sale, and higher complementary services sold. .

Risks that investors should know

Despite all the positive factors mentioned above, investors should carefully watch several key risks for this young company.

Continuous losses 

Carvana will likely keep losing money for the foreseeable future. From 2017 to 2019, its annual net loss more than doubled from $164 million to $365 million, owing to the company's continuous investment to expand its business.  

Since the company is still in a very early stage of development, there's no guarantee that it will achieve the necessary scale to break even on its business operations, let alone turn profitable.

Fortunately, there are signs that it is progressing toward profitability. Gross profit margin has improved from 5.3% in 2016 to 12.9% in 2019, while net loss margin has declined from 28.2% to 16.7% over the same period.  

Lots of competition

Carvana operates in a highly competitive industry with major competitors, including major dealerships such as CarMax (NYSE:KMX) and AutoNation (NYSE:AN), online car sellers such as Shift and Vroom, and other independent dealerships across the country. Besides, there's a possibility that internet players like (NASDAQ:AMZN) may decide to join the party someday. Many of these companies have a longer track record, greater financial resources, and more operational know-how, which may post a significant threat to Carvana's long-term growth.

Still, Carvana's integrated online business model has some advantages over these players -- for example, Carvana can sell to customers in smaller markets where these players have no presence, mainly because these markets are too small to justify an investment in independent stores. Moreover, the US used car market is massive (see above) and should have enough room for multiple players. 

Why you should watch this stock

Since its IPO in 2017, Carvana's stock has shot up by roughly 105% each year, for a current valuation of roughly 1.75 times sales. Comparatively, Carmax's stock is currently trading at a valuation of below 1 times sales.

On one hand, investors might argue that Carvana deserves to trade a premium valuation considering all the positive factors mentioned above. Yet buying at today's price offers investors a low margin of safety, especially considering that the business has yet to turn a profit. On balance, I think investors should play it safe and keep the stock on their watchlist until its valuation becomes more attractive.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.