Carvana shareholders have gone on a wild ride in the last few years. The stock went on a tear during 2020 and 2021 after the pandemic gave the used car marketplace a huge boost in demand. But then in 2022, things took a turn for the worse when people realized the company was hemorrhaging money and in a terrible spot financially. The stock fell a breathtaking 98%.
Yet, as of this writing, shares of the stock are up 40% so far in 2023 -- and January isn't even over yet. Clearly, investors can't make up their minds on owning shares of Carvana or not. So is Carvana (CVNA +4.87%) ready to continue its comeback this year? Or should investors avoid buying shares?
Lack of profitability and a sinking used car market
Even after its recent spurt higher, Carvana's stock is still way down from all-time highs. Investors are extremely worried about its cash burn, which just seems to get worse every year.
CVNA Free Cash Flow data by YCharts
Multiple factors caused Carvana's free cash flow to move in the wrong direction last year. But none were more important than declining used car prices. Carvana's business model works via buying used cars and then selling them to other people on its marketplace. When Carvana buys a car, it is taking inventory risk. That means if a car depreciates significantly on its balance sheet, it will have to sell it for a loss, which might not make up for the fees it earns as an online marketplace.
Carvana had no problem with this in 2020 and 2021. In fact, used car prices soared at the fastest rate in recorded history, with supply chains crunched during this time period. Average used car prices rose almost 100% in just two short years. This actually helped Carvana mightily as it was able to earn a greater gross profit per transaction.
But since 2022, with used car supply normalizing, prices have started to fall. This is obviously bad news for Carvana and is why its gross margin declined to 10.6% last quarter, compared to 15% in 2021.
The company has also made some major capital allocation mistakes that should be critiqued with the benefit of hindsight. First, it continued to expand the number of locations for its "car vending machines," which are just giant structures with cars in them, around the U.S. Second, it decided to buy the ADESA car auction business for $2.2 billion in early 2022 in a debt-financed purchase. Looking at the share price and how much cash the company burned in 2022, management is probably regretting those two decisions right now.
More pain is coming
Carvana has financed this huge cash burn by selling shares of its stock and raising debt. As of today, its shares outstanding are up a whopping 606% since its initial public offering (IPO) a few years back, greatly diluting any long-term shareholders. Long-term debt has gone from close to nothing to $6.6 billion at the end of last quarter, creating a huge interest expense burden for the company.
Used car prices have only barely fallen from their peak. With companies like Tesla slashing prices by 10% to 20% for new models, rising interest rates affecting consumer affordability, and an influx of supply from manufacturers, it is likely that used car prices will fall even further in 2023. This will hurt Carvana's financials. It might also encourage management to raise more debt or sell more stock through an equity offering, both of which would be bad news for shareholders.
This rising stock price in early 2023 is just a flash in the pan. Put your money elsewhere until Carvana proves it actually has a sustainable business model.
