2022 has been brutal for some previous high-flying stocks. There might be no better example than Carvana (CVNA 0.29%), a stock that was once up 500% over the last three years but is now down 54%.
The online used-car marketplace that is trying to disrupt the dealership model saw phenomenal growth over the last few years but has recently run into a huge slowdown and liquidity concerns, causing investors to sour on the stock. The company also made a poorly timed acquisition of ADESA's physical auction business and just raised debt with an annual interest payment of more than 10%.
Carvana is now down almost 90% this year in a brutal wipeout to its share price. Is this the perfect time to buy the dip? Let's take a look.
Image source: Getty Images.
What is Carvana?
Carvana was born out of a different automotive company called DriveTime around a decade ago and went public in 2017. It is now one of the largest used car retailers in the United States and one of the only ones to offer an e-commerce-only strategy. The company purchases cars either directly from consumers or through wholesale auctions and then sells them to its customer base, either through its website or the mobile application. To get the cars to people, it runs its own inventory management and logistics services, plus, it has various unique distribution centers dubbed "car vending machines" that also serve as advertisements for the platform.
In order to assuage customer fears over making a large purchase online, Carvana has a 7-day risk-free return policy, no questions asked. This gives customers an option to the typical test drive before making a car purchase.
Carvana makes money in a few different ways. First, it earns a spread on the difference in price from when it bought and sold the car. Second, it offers various add-on purchases for its customers, the most important being financing for the vehicle. Carvana then packages the loans and sells them to other financial institutions like Ally Financial at a premium. From 2014 to Q1 2021, Carvana's gross profit per unit (car) sold went from around $0 to $3,656. Investors were quite excited about the gross margin leverage the company was achieving, and with minimal competition, it seemed like a large chunk of the trillion-dollar used car market was out there for the taking.
Pandemic hangover causing troubles
So what happened to Carvana from 2021 to early 2022? Well, a lot of things.
Macroeconomic issues like inflation, lapping stimulus payments, supply chain issues, and rising interest rates have severely hurt Carvana's demand and profitability. In Q1 of 2022, gross profit per unit sold was down to $2,833, with retail units sold only increasing 14% year-over-year in the period and gross profit down 12%. Since Carvana was planning for much stronger growth, management said it has overhired and spent too much money, leading to a net loss of $506 million in the period.
Two things are exacerbating these developments.
First, given the need for a giant inventory and logistics system to store and deliver cars for customers, Carvana's business is highly capital intensive. Just in Q1, it spent $220 million on capital expenditures, further blowing a hole in its balance sheet. If the demand from customers doesn't show up, the returns on all this spending will be low.
Second, in February, Carvana announced a $2.2 billion acquisition of ADESA's physical car auction business. The acquisition makes sense strategically, giving Carvana tons of real estate and a wholesale business under its umbrella, but couldn't have come at a worse time. In order to finance the purchase -- as well as strengthen its balance sheet -- Carvana raised $1.25 billion worth of stock and issued $3.25 billion worth of 2030 bonds at an interest rate of 10.25%. Given the high yield on this debt, you can see how quickly Carvana's situation has turned negative.
Is there bankruptcy risk?
At the end of the first quarter, Carvana only had $247 million in unrestricted cash on its balance sheet. In the quarter, it had a free cash outflow of over $800 million. As you can see, the capital raises were necessary for Carvana to stay in business, because at its current trajectory it would have run out of money soon after Q1 ended. With around $2 billion in new cash on its balance sheet (remember, some of the capital raised went to the ADESA acquisition), Carvana now has at least a few quarters to continue operating at its current burn rate.
While it's not highly likely, investors need to consider bankruptcy as a downside risk with Carvana stock. If capital markets dry up (meaning no one wants to lend them money) and the business doesn't turn around soon, there is a real chance this company simply runs out of cash.
Why I'm staying away
At a market cap of only $5 billion and with close to $2 billion in gross profit generated in 2021, now might seem like a good time to buy shares of Carvana if you think it can make it out of this tough operating period and continue gaining share of the gigantic used car market. But good investors never risk permanently losing all of an investment, because it will wipe out all of the hard-earned savings that went into it. For this reason alone, I'm passing on investing in Carvana stock.
