Wall Street loves a good story, and Carvana (CVNA 5.85%) had one, with its fancy used car "vending machines" and online business model.
But investors are notoriously fickle, frequently moving to newer stories when old ones grow tired. Given the 95% price decline in Carvana's stock over the past year, it's pretty clear that Mr. Market's infatuation has ended. Is this an opportunity to get in on the cheap, or a warning sign that Carvana's future is troubled?
Interesting, but is it sustainable?
Carvana is trying to upend the used car market, which is fairly fragmented and, with a few exceptions, has not kept up with modern times. Sure, CarMax (KMX 2.67%) and new car dealers that also sell used autos have material online presences, but pay attention to the smaller places selling cars near you. There's likely a big difference. The new car dealers, meanwhile, would rather you buy a new car than a used one, so the investment incentives in the used car arena aren't the same as for a CarMax, which itself is predominantly a brick-and-mortar operation.
Image source: Getty Images.
In other words, there is a place for a company like Carvana to build an online-centric used car business. Add in the company's theatrically appealing "vending machines" and it's no wonder that investors took an early liking to the company's story.
The story got an extra boost during the early days of the coronavirus pandemic in 2020 and into 2021. With customers practicing social distancing to slow the spread of the illness, going online was the easiest option. Like many other retailers with online-centric businesses, Carvana's stock took off even though it had yet to turn a full-year profit.
That's not actually uncommon for a young company as it looks to build a business, but as 2021 progressed it became clear that Carvana didn't look anywhere near sustainable profitability. The stock started to plunge in the middle of the year, and it just kept going as 2022 results seemed to cement the new negative narrative around the company.
Risk versus reward
Here's the interesting thing about this story for contrarian types: When Carvana's stock was trading hands at $300 or more, it was, in hindsight, a wildly risky investment. Now, with the stock at around $6.50, more aggressive investors might wonder if the Carvana business model has enough legs to make it worth buying. The answer is probably not.
Through the first nine months of 2022 sales increased nearly 19% year over year, which is a big number. But the cost of goods sold line item on the company's income statement went up 27%. In the end, gross profit fell 25%. And when you add in the cost of running the business (selling, general, and administrative expenses), which rose nearly 50% year over year, and interest expenses, which were higher by 175%, you get a pre-tax loss that basically exploded.
That's not hyperbole: Through the first nine months of 2021 Carvana's pre-tax loss was $105 million. Over the same span in 2022, the company lost $1.45 billion. Normally a change like that would include some sort of one-time write off, but that wasn't the case.
Carvana is trying to cut costs, but it seems investors are worried that management focused on growing sales without any regard for profits. Given the numbers here, it is hard to argue that this isn't the case. It's perhaps even harder to suggest that Carvana has proven that it has a sustainable business model. Given the still-difficult economic environment, noting both high inflation and still-rising interest rates, it's hard to believe that the fourth quarter of 2022 will be materially better than the rest of that year.
A lot to prove
While Carvana does have an interesting business model, results so far have not been very good, at least if you care about owning a profitable business. Management appears to be shifting gears, but it is far from clear that it can turn this money-bleeding business into a profitable one. Until there's at least some sustained momentum toward positive earnings, most investors should view the massive stock drop as a warning sign that the risks here outweigh the potential rewards right now.
