Carvana (CVNA 2.85%) was a Wall Street darling, with the shares at one point up more than 2,500% from their initial public offering (IPO) price. And then reality set in and the shares are now trading for less than their IPO price. Things could get even worse.
An impressive sight, but what about Carvana's business?
Wall Street loves a good story, which often leads to investors missing important warning signs. Carvana is a company that has been flashing warning signs for a long time.
Sure, the car dealer's vehicle vending machines are an awesome thing to behold. But that's not enough to make the stock a good investment. Nor is a plan to simply bring the internet to the highly fragmented, competitive used car sector.
To be fair, the company's revenues grew steadily up until 2022, when they stagnated, helping to sour analysts and investors on the stock. Given Carvana's focus on growth, however, it's not shocking that investors were willing to overlook troubling trends for a long time. However, in the end, a business needs to make money, and that's not happening at Carvana.
Here's what smart investors have been watching as they consider Carvana's long-term future.
1. Income growth, but rising losses
At its core, the Carvana business is pretty simple: Buy used cars and sell them. This is not really a high-tech business model. It's growing fast, but unprofitably, isn't a win.
And that's exactly what's happened. Revenues have rocketed higher, while losses have lingered for years. Being an industry consolidator isn't desirable if a company isn't generating the profits to afford the acquisitions it's making, or if those acquisitions don't actually boost the bottom line.
CVNA EPS Diluted (Annual) data by YCharts
The company eagerly reports that it is turning a "gross profit" on the cars it sells, roughly $3,500 per vehicle in the third quarter of 2022, but that figure doesn't actually include all the other costs of running the business, such as corporate and interest expenses. Those two items (roughly $809 million combined) dwarf the company's gross profit ($359 million).
2. Where's the money coming from?
This is an important question, because Carvana has been increasingly relying on debt funding to keep itself going. There was a steady climb in the company's total debt up until 2020, when debt started to spike. That pushed the company's debt-to-equity ratio, a measure of leverage, to worrying levels.
In comparison, Carvana's debt-to-equity ratio is roughly twice that of used car giant CarMax. For reference, CarMax has been profitable every year since Carvana's IPO. It's probably not fair to expect Carvana to be as profitable as CarMax, given their businesses are at different stages of development, but having massively more leverage is a troubling sign.
CVNA Financial Debt to Equity (Quarterly) data by YCharts
3. Carrying the weight
The fact that CarMax makes money and Carvana does not is actually quite important when it comes to thinking about leverage. CarMax, with profits, can easily afford to pay the interest expenses it incurs. Carvana, with no profits, can't.
Carvana has had a negative trailing-12-month times-interest-earned ratio from day one. Creditors generally prefer to loan money to companies that generate enough earnings to comfortably pay their interest expenses. In the early years, creditors might be willing to give management some leeway on this, but eventually that patience wears off.
When that happens, there's a reconsideration of the risk/reward balance that usually results in a struggling company facing higher interest costs. That usually makes the problem worse, not better.
CVNA Times Interest Earned (TTM) data by YCharts
On that note, Carvana issued debt in April 2022 with a coupon of 10.25%. Sure, interest rates have been going up more broadly, but that coupon suggests that bond investors see the company having very risky credit. Notably, Carvana's third-quarter interest expense was more than three times what it was a year ago.
Given this information, it's probably not surprising that Carvana has been assigned a below-investment-grade (often called junk) rating by the major credit agencies. And while it received a downgrade around the time it issued the above noted debt, the balance sheet has never been considered investment grade.
A company doesn't have to have an investment-grade rating to make it worth owning, but financially strong companies tend to be safer than financially weak ones. Clearly, Carvana is not a financially strong company.
The walking dead
There's a name for companies that can't cover their interest costs: "zombies." Add in an increasing reliance on leverage and ongoing losses, and it seems as if the largess of Carvana's lenders is what's keeping it alive.
While the situation did get materially worse in 2022, the trends here have been on clear display for much longer. This is a stock that only the most aggressive investors should be considering, and even then, caution is in order. If Carvana can't get to a point where it's reliably covering its interest costs, there's not likely to be much of a future for the company.
