Carvana Just Crushed Earnings, but Investors Should Be Careful

The used car market has been on a tear for the last 12 months, simply because consumers are struggling to get their hands on new cars, so they're forced to compromise. Really, nobody expects to buy a car and have it rise in value, but that's exactly what's happening for many used vehicle owners right now. 

Consumers might recognize Carvana (CVNA -0.36%) for its giant car-filled vending machines. Once a novelty, the company has now become the second-largest used car dealer in America. It just delivered its first-ever quarter of positive net income, but there are signs the favorable market conditions buoying its results are heading in reverse.

Historically, long-term strength in used car prices is not a trend investors can bank on, so investors may want to tread carefully.

Second-quarter highlights

Carvana had a blowout quarter, and it's tough to fault the company from an operational perspective. The environment for used cars may have been strong, but it takes strategic prowess to nearly triple revenues in the space of a year. 

Image source: Getty Images.

It's a testament to the company's use of high-tech tools like artificial intelligence to track the car market and identify vehicles that are in high demand. Carvana's then able to keep cars in stock that consumers are actually looking for.

Data Source: Company filings 

Carvana was founded in 2012 and took five years to sell its 100,000th car. It just topped 100,000 in a single quarter for the first time, but the 96% year-over-year growth is even more telling. As a technology company harnessing the power of the internet, scale is everything -- it can sell more cars using less input (staff or sales expenses, for example), and therefore profit margins balloon as that volume climbs. 

This scale is reflected in the company's gross profit per unit of $5,120 in the second quarter, 87% higher than in Q2 2020. But not only did it sell more cars, it benefited from what the company described as "an appreciating retail market pricing environment" -- in other words, used car prices rising. It's easy to increase gross profits when you buy a car and it appreciates in value while it sits around in inventory.

The culprit causing these rising prices is a worldwide semiconductor shortage depriving car manufacturers of high-powered computer chips, delaying production. But as the shortage gradually subsides, new cars will be more readily available and the frenzy in the used market should cool off. In fact, key data suggests that's already happening. 

It might be over

Manheim is a used vehicle auction house that provides important insights on consumer demand and car prices. The data it provides is so comprehensive that it's even relied on by some insurance companies to calculate premiums. 

Each month, the company publishes the "Manheim Used Vehicle Value Index," and there are some clear signs of a slowdown in prices. The index peaked at 203.0 in May and has now fallen for two straight months, coming in at 195.2 in July. Additionally, the highest point of year-over-year growth occurred in April when prices were up 54%, a rate which has now slowed to just 23%.

Cox Automotive data also shows an intriguing shift. Used car sales were down 15% in July, while new car sales ticked up 4%, suggesting the supply backlog might be abating. Carvana only sells used cars and has benefited from a year of soaring demand, but there's mounting evidence this hot market is slowing. 

Finally, it appears consumers are fed up with the craziness. According to the University of Michigan Survey of Consumer Sentiment, just 41% of respondents thought it was a good time to buy a car in June, a major drop from the 68% in June last year. Also, it was by far the lowest reading in the last 12 months. 

Investor takeaway

Carvana just delivered its first-ever quarter of positive net income, and that's a major achievement. But the favorable market conditions that helped it get there are clearly dissipating, and it's almost certain to hit the company's gross margins. Investors should consider the consequences of Carvana's cars in inventory now falling in value, as opposed to appreciating. 

Analysts are predicting a full-year loss of $1.67 per share, indicating they don't expect material profits for the last two quarters of 2021. Next year Carvana should inch closer to breakeven, with a narrower loss of $0.65 per share expected.

But as long as the company continues to double or triple revenues each quarter (on a year-over-year basis), it will build the scale it needs to be profitable over the long term, and that should be the center of focus for investors. In the short term, the used car market gyrations are just noise that should smooth out over the coming years.