Bankruptcy is a legal proceeding that occurs when a company is unable to meet its debt obligations and needs to be restructured -- a process that usually results in common stockholders being completely wiped out.
Let's discuss three reasons why online used car dealership Carvana (CVNA -0.60%) could be on the path to this unfortunate scenario.
1. Operations are deteriorating
Like many e-commerce companies, Carvana performed well during the height of the COVID-19 pandemic, with revenue soaring by 42% and 129% in 2020 and 2021, respectively.
Perhaps thinking the boom times would go on forever, the company rapidly expanded its workforce and infrastructure to anticipate growth that would never materialize. Now those decisions are coming back to bite management and shareholders alike.
Third-quarter revenue dropped 3% year over year to $3.4 billion amid a slowdown in used car sales (units sold fell 8% to 102,570 cars). From a macroeconomic perspective, the company faces two monumental challenges.
First, high inflation erodes consumer purchasing power, softening demand for big-ticket purchases like used cars. Second, rising interest rates make it harder for consumers to get the credit they need to finance car purchases at an affordable rate.
Carvana's net loss expanded from $68 million to $508 million. And with just $316 million in cash and equivalents compared to a whopping $6.6 billion in long-term debt, the company could be heading into a solvency crisis, which means it may struggle to pay off its creditors.
Interest expense (which totaled $153 million) is another big problem, because as the Fed raises its federal funds rate, the interest paid on Carvana's variable-rate debt will also increase.
2. Creditors are growing concerned
Unlike common stockholders, a company's creditors are primarily concerned with getting their capital back -- if the stock price goes to zero, so be it. And with Carvana's operational problems mounting, debt holders are becoming increasingly concerned.
According to Bloomberg, some of the company's largest creditors have signed an agreement committing them to work together while negotiating on this issue.
Image source: Getty Images.
Together, these firms hold $4 billion (roughly 65%) of Carvana's outstanding debt. By agreeing to work together, they hope to prevent bickering and maximize their bargaining power in the event of a possible restructuring, according to Bloomberg.
To be fair, debt restructuring doesn't necessarily mean bankruptcy. And Carvana could possibly meet its obligations without wiping out common stockholders. But the creditors' pact is a sign of an increasingly dire outlook.
At the time of writing, Carvana's bonds maturing in 2030 trade for under half of their value, which suggests investors are skeptical about the company's ability to repay the loans.
Avoid Carvana for now
A cheap stock doesn't necessarily represent a good deal. And despite dropping by a staggering 98% year to date, Carvana still has room for continued declines. With operations stagnating and creditors already plotting their exit strategy, the shares are best avoided for now.
