The process of buying a used car isn't fun. Carvana (CVNA 0.29%) was founded in 2012 to fix that problem. The company's convenient delivery services removed pain points and reduced friction, proving extremely popular over the past few years. Carvana sold over 100,000 retail units in each of the past six quarters, doubling its pre-pandemic sales rate.

The tide is going out

Warren Buffett once said, "You don't find out who's been swimming naked until the tide goes out." When interest rates were low and demand for used cars was strong, Carvana enjoyed exceptional growth. The company never managed to turn a profit, although it was easy to chalk that up to "investing in growth" or some other thing that money-losing companies tend to say.

The tide has now gone out. Interest rates have surged this year, greatly increasing typical payments on used cars and reducing demand. Carvana's retail units sold dropped 8% in the third quarter. At the same time, Carvana's strategy of using debt to fuel its growth has become far more expensive. The company's total long-term debt has more than doubled since the end of 2021 to $6.3 billion, with much of that increase due to $3.275 billion of senior notes that bear a 10.25% interest rate.

Those notes funded the acquisition of ADESA U.S., a major provider of wholesale vehicle auctions. The way Carvana reports its gross profit per vehicle is a little strange. It takes its total gross profit and divides by the number of retail units sold, but that total gross profit includes the contribution from wholesale vehicle sales. Thus, the ADESA acquisition boosted the per-unit gross profit contribution from wholesale vehicle sales.

Unfortunately, gross profit coming from the actual sale of vehicles at retail and from loans plummeted. Total gross profit per vehicle stood at just $3,500 during the third quarter, down a whopping 25% year over year. Tacking on the ADESA business didn't come close to offsetting the retail weakness.

So Carvana borrowed at 10.25% to acquire a wholesale vehicle auction company, paying $2.2 billion plus another $1 billion for site improvement, and the company's entire wholesale operation generated somewhere around $46 million of gross profit during the third quarter. To be fair, a stated goal of the acquisition was to expand Carvana's infrastructure, increase reconditioning capacity, and speed up delivery times. But still, it's hard to see how the math works out.

Insurmountable interest payments

Carvana generated $359 million of gross profit in the third quarter on sales of $3.4 billion. Gross margin was 10.6%, down from 15% in the prior-year period. Total interest expense more than tripled to $153 million thanks to the debt issued to finance the ADESA deal, and operating expenses rose despite the drop in revenue. Taken all together, net income attributable to Carvana was a loss of $283 million.

Carvana can grow its way out of this problem by selling more units and generating more gross profit, but that requires capital to grow its vehicle inventory and increased demand from customers. The company has just $316 million of unrestricted cash on the balance sheet, and free cash flow was a loss of over $1 billion through the first nine months of this year. Free cash flow benefited from a reduction in the value of inventory of $638 million.

The company has a revolving credit line with nearly $2 billion of capacity, and it has some real estate it could pledge for additional loans. But demand is slumping, so it makes no sense to invest in additional inventory. But without higher unit sales, Carvana will continue to burn through the little cash it has. You see the problem.

This probably doesn't end well

Carvana's unit sales are declining, and its gross profit per unit sale is tumbling even faster. It's paying 10.25% interest on a $3.275 billion chunk of debt, on top of interest on the rest of its lower-interest debt. The company is burning through cash even as it reduces inventory.

Carvana needs to sell far more cars each quarter for the numbers to work out. How it gets there in this economic environment is a mystery. The stock is already down 98% from its all-time high, but that doesn't mean it can't keep falling. The balance sheet is a mess, interest payments are onerous, and the prospects for unit sales growth in the near-term are dim.

Another Buffett quote: "Time is the friend of the wonderful company, the enemy of the mediocre." Carvana is in a race against time, and I'm not seeing a path to victory.