Online used car retailer Carvana (CVNA -0.36%) is probably not the future of the used car industry. After demand and prices for vehicles boomed during the first two years of the pandemic, the market for used cars is now correcting hard. Carvana is seeing its sales volumes decline, and the gross profit it generates per vehicle has tumbled. Weighed down by a mountain of debt, the company may not survive.
I hadn't looked at Carvana's financial statements at all until a few months ago. I knew enough about the company before then to avoid the stock entirely. Car vending machines? Net losses even when demand for used cars was crazy? An extreme valuation at its peak? It was an easy pass for me. When I did finally take a look, though, there was one weird thing that stood out for me: The way Carvana calculates how much gross margin it generates from each car it sells at retail.
Playing games
In the article linked to in the first paragraph, I briefly mentioned that Carvana's gross profit accounting seemed a bit off: "The way Carvana reports its gross profit per vehicle is a little strange," I wrote. Having chewed on it since then, I think it's not only a little strange, but also downright misleading.
Carvana's No. 1 objective is to grow the number of cars it sells at retail, and its No. 2 objective is to grow the total gross profit it generates per unit. In the third quarter, the company sold 102,570 retail units and generated $3,500 in gross profit per unit.
Carvana defines gross profit per unit as the total gross profit divided by the number of retail units sold during a given period. Total gross profit encompasses gross profit generated directly from retail sales, gains on the sales of loans, a few other odds and ends, and the gross profit generated from wholesale sales of vehicles. It's that last item that throws up some red flags.
Carvana sold 102,570 vehicles at retail in the third quarter, and it also sold a large number of vehicles at wholesale. Carvana takes its gross profit from all vehicle sales, retail and wholesale, and divides it by only the number of retail units to arrive at its gross profit per unit figure.
Carvana does break out the components of gross profit per unit, but that just makes it even weirder. The wholesale contribution was $448 per unit sold in the third quarter. That is not the wholesale gross profit generated per wholesale unit sold. That is the wholesale gross profit generated per retail unit sold. How that number is meaningful is beyond me.
Make it make sense
Carvana's explanation as to why it does its math like this doesn't make a lot of sense. In its quarterly filing, the company claims that it accounts for gross profit per unit in this way because it operates an integrated business that aims to increase the total number of retail units sold. Retail and wholesale units run through the same reconditioning and inspection centers, and use the same logistics and delivery networks. Thus, it asserts, the gross profits generated from each are interrelated.
Buried in its Securities and Exchange Commission filings, though, Carvana does break out its wholesale gross profit per wholesale unit sold. The company sold 47,763 wholesale units in the third quarter -- roughly half the number of retail units. Each wholesale unit generated $691 in gross profit. So despite Carvana's explanation, it seems to have no trouble separating out retail and wholesale gross profit.
Imagine I run a cookie factory. I make snickerdoodles, and I make thin mints. My mission statement says my goal is to increase the number of snickerdoodles I sell and the gross profit per snickerdoodle. I use the same equipment to make each type of cookie and deliver them in the same trucks.
I could allocate costs associated with each type of cookie and come up with a gross profit per snickerdoodle and a gross profit per thin mint. Those would be useful metrics to have as I optimize my cookie factory. Or, I could take the total gross profit from the whole factory and divide it by the number of snickerdoodles sold. Snickerdoodles and thin mints are interrelated, you see.
That's essentially what Carvana is doing. Carvana's gross profit per unit metric is inflated by the wholesale business. It's a metric designed to paint the rosiest picture possible, backed by a hand-wavy explanation that doesn't pass the smell test.
Of course, none of this really matters now. Carvana stock is down nearly 99% from its all-time high, its bonds are selling at distressed levels, and it looks unlikely that the company will survive in its current form. But there's a good lesson here. If you see a management team going out of their way to pretty up their company's important metrics, run. When it rains, it pours.
