Consumers in the United States buy more than 30 million used cars each year. Carvana (CVNA -2.65%) is trying to give the used car buying process an e-commerce touch, striving for click-to-buy ease, no haggling, and no spending hours at the dealership.
The company went public in 2017, and its stock has been a winner, up almost 500% over the past five years, despite falling to near 52-week lows amid the bear market in growth and tech stocks. However, there's one potential problem with Carvana that investors should know about before buying shares.
A chart says a thousand words
Carvana is a rapidly growing company; revenue growth has averaged 103% annually over the past five years. But unfortunately, growing companies often lose money because they heavily spend on hiring employees and marketing to grow the business.
Ideally, a company's revenue grows faster than its expenses, leading to positive free cash flow, cash profits left after operating expenses, and capital investments. This is often called operating leverage, and it sets a path to a company becoming profitable.
However, you can see in the chart above how free cash flow has gotten increasingly negative as revenue has grown larger. The two metrics are diverging instead of both moving higher. This isn't sustainable because negative free cash flow means the company is burning cash and will eventually need to raise more through debt or by offering more shares of stock.
Should investors be worried?
Carvana essentially flips cars -- it uses debt to fund the vehicles it buys. As the business grows, it's taking on more debt to fund more car purchases. You can see below how total long-term debt is beginning to add up. There are two potential problems here.
First, interest rates could continue rising, especially since the Federal Funds Rate will likely rise several times over the coming year to combat high inflation. This makes debt more expensive, a direct headwind for a company borrowing money like Carvana is.
Secondly, the business isn't producing any cash, so Carvana won't be able to pay this debt down or afford its interest payments once its cash runs out. The solution to this will be for Carvana to raise money by issuing new shares of stock, but that's dilutive to investors because new shares decrease the value of existing shares. It's like cutting the same pie into smaller slices. It's especially tough after the stock has declined 75% from its highs.
So to answer the question, yes, I believe Carvana's cash burn is a concern because of its financials -- $247 million won't last long when your free cash flow is billions into the negative.
The stock itself has been caught up in the bear market rocking most technology and growth stocks. Investors might be tempted to buy the dip; however, I would be cautious about that, even as shares are down so much over the past year. Instead, investors should consider waiting to buy shares until Carvana's free cash flow trends in the right direction.