Carvana's Boom and Bust: The Takeaways for Investors

In this podcast, Motley Fool senior analyst Asit Sharma joins Motley Fool producer Ricky Mulvey to look at some justifiable reasons why stocks dropped last year and which strong businesses may have been swept up in the tide. They discuss:

• Carvana's boom and bust, and the takeaways for investors.
• If Zoom has a "sticky" product.
• How Roku is addressing a tougher advertising landscape.
• Meta's valuation, as well as questions about its leadership.
• Mindset advice if you want to be a contrarian investor.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

This video was recorded on Jan. 07, 2023. 

Asit Sharma: There's no existential threat hanging over Roku. They can weather this environment that is not their best environment. At the same time, they keep increasing those key metrics, and that's what you want to see. Can you gain share, can you gain users, can you make them more active during a bad period if you've got the solid financial picture to come out of that environment in a stronger position? That's where, again, they may surprise some investors in the future.

Chris Hill: I'm Chris Hill, and that's Motley Fool senior analyst Asit Sharma. In a tough environment, some businesses break, and some come out stronger on the other side. Ricky Mulvey caught up with Sharma to talk about some of the most significant stock drops of 2022, what growth at all costs meant for a business like Carvana, and advice for anyone who really wants to be a contrarian investor. 

Ricky Mulvey: S&P is down more than 20%. I can't use year to date. It's still early in the year. S&P 500 is down about 20% year over year. Nasdaq is down about 34%. Many stocks are down even more. I think my mentality, and I think maybe other stock investors are thinking, great, now I have a chance to buy low, hopefully, sell high. So are you really a contrarian, and what's your mindset advice to those folks who are trying to play that game?

Asit Sharma: My first piece of advice is to be a steady and frequent buyer in the market, whether the market is going up or down. Some people refer to this as dollar-cost averaging, which is a fine way to look at it. Many of us take a pause when markets get really pushed down, when they head to extremes, like a spiritual mental break, and then we start looking around for bargains. There's nothing wrong with that. If there are companies that you liked before the market has pulled everything down, those are the first ones to look at, maybe a company that you thought was a great business is oversold in some ways, to use more of a trading term, but for whatever it's worth, and that can be an excellent time for the person who's going to hold that stock for several years to take a position or add to a position. So that the way I usually look at it is, hey, what are the quality businesses that I liked before that maybe I just looked away from? I didn't want to see the car wreck, but now that I'm looking again, are there some pieces here I can pick up and buy some shares?

Ricky Mulvey: Before we get into some of the new companies, I want to check up on some of the companies we discussed last time. This was 10 months ago, and I know that we're always looking at 3- to 5-year time horizons, still kind of interesting. The first one we looked at on the last show was Lululemon. At that point it was trading around $333, pretty much flat at about $326 now. The other one we looked at was Zoom Video. That was at $113. Now that's trading at 67 bucks. Any reflections on those two companies before we get into the new examples?

Asit Sharma: I think the fact that Lululemon has held its ground maybe is a testament to something I believe we discussed, but it's quite central to the business thesis that this company has a lot of pricing power. It's got loyal customers who want to buy a certain type of material for their athletics and yoga, and they have demonstrated through the pandemic, through upheaval in the economy, that those articles of clothing are going to get replaced on a regular basis. They can even raise prices, and they'll still have buyers. So this is about being able to maintain your margins in an inflationary environment. Lululemon's got that in spades. Maybe the thing that's changed about Zoom since we last talked is that growth has slowed even more, and now investors are starting to wonder, is it just the fact that Zoom is transitioning to a higher-value client, that is more enterprise clients, versus what they call online customers, maybe you or me or a small organization.

Let's say you and I run a club, and we need to buy their services. Those are dropping off, but there is this really nice playing field for Zoom, selling Zoom Phone licenses, selling their auxiliary products, Zoom Rooms, etc., to major corporations. In this transition, I think investors are also scared that maybe they're going to cede some market share to Microsoft Teams and other competitors. That's been a little bit of a depressionary force on Zoom shares. I still like it, Ricky, and I think, over the long term, it's a company that's going to have really nice cash flow, and it's reasonably valued here. So I'm not sure if we said it was a bargain then. I'm not calling it a bargain now, but I wouldn't dissuade someone who wants to pick up some Zoom and, again, hold this for a multiyear holding period.

Ricky Mulvey: It's cheaper. That's for sure. I think there's still some stock-based comp questions and some stickiness questions. Do they have pricing power over Microsoft? But there is an inertia when an entire organization is on a certain platform. The ease of switching becomes significantly more difficult. Let's talk about some stocks that have had a rough 2022. Some new ones. How about that? I think the poster child of high growth and then getting just absolutely crushed was Carvana. Stock was worth about $360 in late 2021. In fact, it was the third-fastest company to join the Fortune 500 after [Alphabet's] Google. It's Google and Amazon and then Carvana. It had 65% revenue growth in 2020, 105% revenue growth in 2021 when it was doing about $13 billion in sales. Now, the stock is traded at less than five dollars. Almost half of its shares outstanding are still shorted, and the debt investors are pricing in a high risk of default. Something happened in between those two events, Asit. What did?

Asit Sharma: Ricky, I think that conditions worked to Carvana's favor in the early days. You and I were chatting about this. You sent similar notes over to me when we were thinking up this show. Look, the economy was strong, there was a demand for used cars, there was a younger cohort of buyers who didn't necessarily need to go to a car lot and kick the tires. They provided some fuel for this business model, and at the same time, the prevailing interest rates allowed Carvana to basically finance this rapid growth. Now, even at that point there were a few things that were at least yellow flags to some investors, and I want to just lay out this case as well. The company is more capital intensive than many think. They have these reconditioning centers all over the U.S. These reconditioning centers enable them to reach most of the population, but they take in used cars, then they make sure that the cars are as the buyer expects. They clean them.

They have to transport them with their trucks. I actually don't think those big, beautiful Carvana vending machines are really the capital issue here. Some people say that then they've spent money on those machines. That was just a fraction of the spend. Really these conditioning centers took up a lot of capital. The fact that they were using the capital markets to finance their operation also was a yellow flag, and the reason is this. When you broke apart the gross margin that Carvana was making in the good days on their cars, the real gravy was coming from this financing element where they could gather loan receivables from so many buyers, bundle them up, and sell them to institutional investors.

That's a good deal if you're making your margin as a finance company, but man, we've seen that story blew up over the years for so many different businesses, from small, quirky finance companies to GE Capital. It's a tough business to be in, if that's where the real profit in your business is coming from, and this is one of the things that happened to Carvana. Now, there are other parts of the story, of course. We had a pandemic, we had rising interest rates, and we had kinks in the supply chain which, at one point, made used cars cheap, and then jacked the price of used cars up with interest rates exploding. The demand decreased, unsecured borrowers, so now those prices are decreasing. Carvana has inventory, these lower prices. There are a few more parts to this story why it became this poster child is, as you rightfully call it, for growth stocks. But I want to pause here before I give any more reasons and just ask for any feedback or additions to this picture I'm trying to paint.

Ricky Mulvey: Ask for feedback. This is like now we're in a meeting, not a podcast, Asit.

Asit Sharma: I think we meet too much before these podcasts, Ricky. Maybe that's it.

Ricky Mulvey: I know.

Asit Sharma: Maybe we're still in pre-production here.

Ricky Mulvey: Got to start fresh. I think it's easy to dunk on Carvana, and there are legitimate reasons to do that. But at the beginning, there is a real value proposition which is, hey, don't you hate going to a used car dealership where some of the practices are pretty much the same from the time that The Grapes of Wrath was written during the Dust Bowl? Hey, we're going to sell you this car. Wait, the one you came in for isn't here, but we got this other great one. So let's just automate that process so you know what you're getting, and we'll bring it to your door. But that's where the problems were created because maybe you do need a human element in the car buying and selling process, which is to say that Carvana was essentially doing iBuying with used cars.

Now, the way that I might describe the car that I would want to sell to them is going to be significantly different from the way that the seller sees it. This was also a case where you saw the growth story come apart in a number of ways where it wasn't that responsible growth. They were really focusing on that. In some cases, acquisitions. In some cases, it was look at how many more cars we're selling and higher prices are benefiting us, but they didn't have the operations to back it up. There's a lot of cases where buyers were waiting for months after their car titles for purchases. Then that creates a problem where I believe that, in some cases, they were selling stolen cars to people. Folks are getting their car taken from them because they don't have the license or registration for it.

Asit Sharma: This is definitely a problem of fast growth, and I know they got into trouble with a couple of states simply because they weren't able to process their own paperwork fast enough to certify title. We can look at this, and we can also look at the fact that the company made some poor decisions even as their business model was starting to suffer. They acquired a used car wholesaler called ADESA, and with an already stretched balance sheet, Ricky, they took on another 3 billion dollars' worth of debt. Rough numbers here, I think the actual acquisition was just over 2 billion dollars.

That debt sits at 10.25%. So there's an enormous interest expense associated with this acquisition, and they bought it at a time when inventory was still relatively fairly priced, but used car prices had plummeted. So whatever inventory now is their own, plus the addition of that is perhaps not priced for profit. They've got this operation in a time when the purchase of used cars is slowing, which is really going to be a cash burden on them to service that debt and to try to turn a profit out of this.

Ricky Mulvey: You saw the operations come apart in a number of ways with Carvana. One thing that might've been a yellow flag too is the distribution of voting rights which completely belong to the Garcia family that owned and ran the company. So there weren't those checks in place to make maybe better capital decisions and then even some operational decisions when they had to lay off workers. A lot of companies, high-growth companies, have had to do that lately.

But they did it in a mass Zoom meeting, essentially, and they didn't allow the people to ask questions to their managers. I think they were just giving folks four weeks of severance, and this is a company that had continued to preach, what is it, treat customers like they were your mother and have that close relationship with them. If you've been through a Zoom layoff, they're already brutal as it is, and to do it in that even less human way, it's awful. It's not a good look for the company, and it raises a lot of questions about the way leadership makes difficult decisions. I'll say that as nicely as possible, Asit.

Asit Sharma: Look, Ricky. This is a company when times were good that strove to show it was all about the employees. They gave their entire employee base a nice stock grant a few years ago. But I guess you see the true caliber of management when times are tough, and let's extend a little bit beyond Carvana here because they're not the only company that has recently had layoffs in a really rapid fashion and done with minimal human interface. I think that's a terrible way to sever a relationship that's important to your bottom line. I think companies should really think carefully in an era, where, yes, many of us are working from home via Zoom, how you go about terminating a relationship. I think it should always be done one-on-one.

If there is a case where it's a huge company, and it's just not physically possible because of numbers, certainly there are better ways to do it than some of these illustrations we've seen recently. I don't want to dump just on Carvana. They're not the only ones who are doing this, but a little bit of humanism will persuade shareholders that you really are walking the walk when you say, as a company, we've got the interests of all our stakeholders at heart, our vendors, our employees, our customers, our shareholders. Tough times are what separates those who really mean that from those who are just trying to slap some verbiage up on a corporate site.

Ricky Mulvey: Let's talk about a company, though, that might have a brighter future, and that company is Roku. Certainly harder to sell ads right now. Roku makes digital media players for streaming video. They're going to have to update the Wikipedia because now they make televisions as well. Stock is down 80% over the past year. But it had a financially strong history, in some cases. Roku was free cash flow positive in 2021. Now it's not, and they're expecting revenue growth to slow and be negative in the latest quarter. I've talked to a few Fools about this. Roku is an interesting one where I understand that the landscape is difficult. Is it a business problem, or is it a landscape problem for our friends at Roku?

Asit Sharma: Either -- it's a little bit of both. I would say more of it is a landscape problem. I do think that it's just the macro environment has not been kind to Roku. This is a company that is still increasing in all its key metrics in this last quarter. This is the quarter 3 of 2022. Average revenue per user grew 10%. Active accounts grew by 16%. Their streaming hours grew by 21% to 22 billion streaming hours, and revenue increased. Now, as you pointed out, that revenue didn't end up in profitable operations. They're losing money this year, and as you rightly point out, cash flow has gone negative.

What I see in this primarily is something that surprises me. I would've assumed from just the narrative that it's really the players that are dragging down that profit picture, but the gross profit picture isn't that wildly different from the previous year. If you take a look at their nine months that they report on for 2022, so far, we'll get the full year not too far in the future. Really, it's a higher research and development spend and a higher sales and marketing spend that are generating most of the losses. Now sales and marketing in a bad economy, they have to spend more with their content partners, and they have to spend more in sales and marketing to move the players. This is to be expected. The research and development, you actually always like to see increases in R&D spend.

I'm a little concerned though in this push to brand other devices and maybe create a Roku ecosystem beyond players. I'm hoping that some of this research and development spend isn't going into a non-core competency that won't help Roku out. But going back to the landscape, the cord cutting revolution is only getting stronger. Roku continues to be a really prominent player in this. I think they have a bright future in terms of digital advertising. I think some of their recent problems, such as not being included on the Disney paid ad tier, they'll work out in the future. It is on the ropes. The stock has taken a huge beating. But over a long-term holding period, this one might surprise some investors. So I wouldn't leave this totally, if you are a Roku believer. I do know that some Fools that I respect have been adding shares on the way down. So there you have it.

Ricky Mulvey: It was at CES 2023, Roku announces that it's going to start selling branded televisions. The argument for that is they need to expand into different areas, figure out some different ways to get their product to consumers. The argument against that would be a lot of the business model has been based on the idea that Roku has been platform-neutral. You can plug in the USB and the HDMI cord, pretty much anything, and will get this beautiful user interface up that is easy to understand. Where are you on the branded televisions? Are you happy to see that, or do you wish they would stick to the dongles?

Asit Sharma: In the best case, I would say stick with the dongles. It doesn't bother me too much, Ricky, but a little bit of what management is projecting goes beyond branded TVs into maybe other types of devices. As I alluded to this earlier, that is just not their core competency, not their wheelhouse. I would say just keep an eye on it. I don't think it's going to make their performance any worse than it's been. But if we start seeing the Roku toaster, I'd be worried. 

Ricky Mulvey: Tim Sparks just messaged us that we need to title this podcast "Stick with the Dongles." I'm going to start doing the CNBC echo boom voice with, what do the dongles mean for Roku? Right now, the company is trading at less than 2 times sales compared to almost 13 times sales in 2021. It is important to note that, a lot of its business model, we're going to sell these devices at a loss and then make up for it on the back end. We've heard that before with Peloton. Is that a model that you can pull off in a more difficult, higher interest rate environment?

Asit Sharma: Yeah. It becomes more difficult, and that's why they're under pressure now. One thing that you would look for in trying to determine, hey, is this a company that can get off the mat if this environment's going to linger around like this, and it's unfavorable to their model, is the balance sheet, and I keep going back to this. If you take a look at their resources, this company, Roku, has about 2 billion dollars in net working capital on their books and no real long-term debt. They've got some long-term operational lease liabilities but nothing substantial. Their cash burn really hasn't been that bad, and they could control it.

They could pull back on some of that R&D spend. They can control it by pulling back a little bit on their administrative expense, a little bit of sales and marketing. There's no existential threat hanging over Roku, they can weather this environment that is not their best environment. At the same time they keep increasing those key metrics and that's what you want to see, can you gain share? Can you gain users? Can you make them more active during a bad period if you've got the solid financial picture to come out of that environment in a stronger position, and that's where again they may surprise some investors in the future.

Ricky Mulvey: Speaking of stocks that are down, Meta is down 60% over the past year. It's now seen as a value stock by many, I know you disagree with that, so you think the pessimism is warranted for our friends in the metaverse?

Asit Sharma: I say this knowing fully well that Meta could definitely rise, the stock could rise, in the near term. The reason I don't think that it's a value stock is I don't think that Meta is doing enough to move the needle in their digital advertising business. I think it's become, despite what management says in conference calls, really a second priority for the company because the leader of Meta, Mark Zuckerberg, is so fixated on gaining new revenue in the metaverse. This is a large bet with an uncertain payoff over an uncertain time period. This is where the concentration of management is in this company, and that's why to look at this purely on a valuation basis may provide some shorter-term traders with a gain because it is so oversold.

But over the long term, I think that the capital allocation of this company is still heading to thwart any kinds of gains they could get in their advertising business because they just aren't focused and aren't honed in on their core competency, which I've been using this phrase today, so let's use it with Meta as well. This is not a company that is going to see a near-term rise in their operating earnings from billions and billions of dollars of both income statement investment and capital expenditure on metaverse activities. We can go in more detail on what those actual activities entail. But let me pause here so I can have a little bit of push back from you. 

Ricky Mulvey: No. This isn't from me. I'm borrowing this opinion from Aswath Damodaran in a lot of his posts. But I think he makes the case that, at this point, the company is basically valued on a basis that it's never going to grow again, and every single cent they're spending on the metaverse is just going to be incinerated. Now you might justify that with the leadership issues which I have with Meta. I think it's basically a sole proprietorship where Mark Zuckerberg has, I think, it's 13% of the shares but 57% of the voting power. That's why you're seeing maybe this unchecked expensive play into an area where they haven't really released a business plan.

I thought this was a good quote from one of Damodaran's blogposts: "[T]he qualities that made him a successful founder (over confidence, stubbornness in the face of failure, arrogance) may very well keep him on his pre-determined path, and without any checks and balances, Facebook will lose a lot more money over a longer period, before he gives in." That being said, it has data on basically every single person on the planet, and it's being traded like it will never grow again. I'm a very hesitant bull on this. I'm not like this is the stock that I'm probably the most ashamed of owning, and it's because of leadership. I don't know if you heard his interview. Zuckerberg went on Rogan, Asit, and he was discussing martial arts and how he loves this intense martial arts training and doing jujitsu.

He said he's had a 100% hit rate, getting his friends to participate in jujitsu and martial arts. I think there's a parallel where, to me, that signals that he's surrounding himself with "yes" people. I did jujitsu a little bit. I understand the mental health benefits, I should get back into it. But that's a separate podcast. But the bear case for it is that, for martial arts, sometimes people are trying to kick you in the face. In jujitsu, sometimes people are trying to break your arms. So it's not for everybody. I have so many questions and hesitancies about leadership, but I still think there's a strong company underlying it.

Asit Sharma: I agree with you, Ricky, in that there is a strong business there underneath all of the weird and hard-to-parse business results that are coming out of Meta. I think many people believe that Professor Damodaran is just like this numbers whiz, and he is. Don't get me wrong. But that's not how he values companies. He values companies according to narrative. To him, the narrative is equally important to the determination of the future cash flows, and it's always informed his valuation exercises. We've been lucky at the Fool he has come several times and just was able to sit in on a talk he gave to Fool analysts a few months ago. Again he was stressing this idea that you have to understand what you think the narrative is, and you keep adjusting your future expectations based not just on what your spreadsheet is telling you. Anyone can run a spreadsheet.

To this I say I agree with him on the fact the advertising core business is now undervalued at this point. I think there's always been a risk compression that's hit their multiple because Facebook has never, I shouldn't say never, but for so many years has not been run in a way that is conducive to creating the best shareholder value. They've ignored privacy issues of their users, they have allowed user data to be manipulated, and they really have run the business in a mercenary fashion, which has come back to bite them time and time again on privacy issues.

This is, if you go back in history, for such a wonderful business, why it never traded at quite the multiples of some competitors because people perceive a risk in the way Mark Zuckerberg runs this company. Without Sheryl Sandberg there, I say, look there's probably a better place if you just look in terms of total opportunity cost for someone's investment dollars when you've got an undervalued core of the business that's being overshadowed by very questionable investment. Why not just put your dollars elsewhere in a clear investment picture? That's where I part ways with the professor on this. I think he's totally right to call out the valuation principle here, that there may be some intrinsic value that investors are overlooking that could burst back above the surface.

I stated that's going to be temporary because, without any challenge to Mark Zuckerberg's running of this company, with no way for shareholders to vote him out of that position, and no constraints in the form of, say, Sheryl Sandberg, I believe there's a lot more risk even to that digital model. That doesn't mean that he is necessarily going to be able to make that model prosper over a 3- to 5-year period. He's really not paying attention to it. So I would say what Professor Damodaran is identifying is a shorter-term gain for shorter-term traders or investors. If that's your bent, and I wrote this in a Stock Advisor deep dive a few months ago, for sure, nibble at some shares, but I advise people don't go like all in on Meta. 

Ricky Mulvey: Asit Sharma. Always good chatting with you. Thanks for coming on the show. 

Asit Sharma: Same here. Thanks.

Chris Hill: As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Chris Hill. Thanks for listening. We'll see you tomorrow.