Here's How Carvana Will Start Making Profits

A lot of fast-growing stocks have taken a big hit in 2022, and Carvana (CVNA 5.85%) was no exception. In response, the company made several changes, including layoffs in the first quarter, and it took on additional debt to build out car inventory and give management more flexibility. Wall Street wasn't impressed, and several hedge funds began shorting the company. The stock is now trading down about 94% from highs set last August.

My family has owned shares in Carvana for several years now. With the drop, we went from having a nice 10-bagger in the stock to seeing our investment go underwater. Has this drop scared me off the stock? Not really. The stock had a mighty drop in early 2020, too, at the start of the pandemic but then skyrocketed higher. I've come to see Carvana as a battleground stock that's likely to have a huge short position for some time, making for a very volatile investment.

But I think this is an outstanding company, and I remain very bullish. Let's take a look at the bear case, and see why it hasn't dissuaded me from my optimism about Carvana stock.

Image source: Getty Images.

Why are some people negative on Carvana?

Motley Fool contributor Brett Schafer has put forth the bear case admirably and the article is well worth your time. Some of the issues he raises include:

• Carvana's business is highly capital intensive.
• The company is bleeding cash, spending $220 million in Q1.
• The ADESA acquisition was poorly timed.
• The company added billions in debt and is paying 10% interest on its debt.

But I have a few quibbles with some of his arguments. With almost $3 billion in cash, Carvana has years to burn through its cash, not "a few quarters." And we shouldn't assume the company will continue to lose $220 million like it did in Q1. Carvana estimates its capital expenditures will be $150 million in the second quarter, $100 million in the third quarter, and $50 million in the fourth quarter. 

Carvana sold 425,000 cars last year. Even in Q1, which was a bad quarter for sales, the company sold 105,000 cars, and revenue spiked 50% year over year.

Carvana measures gross profit per unit (GPU) to define how well the business is doing. Each unit is one car. Historically, the more cars Carvana sells, the higher the GPU. This makes intuitive sense -- as you scale, your fixed costs are smaller and smaller as a percentage. So Carvana's rise in GPU is a thing of beauty.

Data is from Update on Carvana's Operating Plan (page 5). 

What happened in Q1?

In Q1 of fiscal 2022, Carvana's GPU was $2,833. Clearly, it was a bad quarter for the company. The bears are saying that there is no demand for cars. But actually, it's a supply problem. Supply chains have been disrupted, causing cars to get more and more expensive. Acquiring more supply, as Carvana did, will fix supply issues.

Historically, Carvana's best quarters have been when a significant number of its vehicles (one-third) were priced under $15,000. In Q1, only 3% of its inventory was under that price. So Carvana plans on adding lower-priced inventory this year.

The company is already seeing Q2 numbers for GPU that are better than Q1. It expects GPU to return to over $4,000 in the rest of the year. If and when Carvana gets back to $4,500 GPU, it will be free-cash-flow-positive once it reaches 800,000 annual car sales. The company expects to be earnings before interest, taxes, depreciation, and amortization (EBITDA)-positive next year.

Adding liquidity gives the company flexibility

Another way to increase GPU is to decrease costs. Carvana is aiming for $4,000 selling, general, and administrative (SG&A) costs per car by Q4. In two years the goal is to reduce that number to $3,000 SG&A per car.

If it pulls that off, then Carvana only needs 600,000 in annual sales to start generating positive cash flows at $4,500 GPU.

What's nice about the company's cash horde is that it gives management a lot of options. It's got more than one route to pursue free cash flow positivity, either by cutting costs or pursuing sales growth.

I expect Carvana to add even more debt in the future

While the best stocks tend to have zero debt, if you're going to be the top car-seller in the world, you're going to need a lot of money to pull that off. The high debt load is a necessary cost of retailing. Walmart has $66 billion in debt. Amazon has $147 billion.

Debt is always dangerous. It's the path to bankruptcy. But some business models require a lot of debt, and retailing is one of them. So while Carvana's $6 billion in debt is scary, vis-a-vis the company's $3 billion market cap, it's not scary given the $14 billion in revenue the company has pulled in over the last 12 months. Or the rapid rise in the company's business over the last several years. 

Carvana is now the No. 2 used auto dealer in the U.S., behind CarMax (KMX 2.67%), the Blockbuster Video of the used car industry. I agree with CarMax management that the future of auto sales will be online. As the top dog and a first mover in online car sales, Carvana has all the advantages and will win this fight.

With the high short position and the maximum negativity on this stock, I expect it to be incredibly volatile in 2022. When Carvana starts churning out positive free cash flow in the next year or two, the stock will be worth a lot more than it is today.