Carvana (CVNA 2.85%) stock just experienced a dramatic turnabout. The stock price is up more than 200% since the beginning of the year as investors communicating through Reddit investing boards have again banded together to buy shares of a distressed company in the hopes of inducing a short squeeze.
With Carvana in severe financial straits, buying such a stock brings a significant risk of an eventual wipeout. Investors should understand how the higher stock price could help the company. Still, they should probably see the jump in shares as a cautionary tale rather than an opportunity for a quick return on this retail stock.
The short-squeeze case for Carvana
Carvana pioneered online transactions to buy a used car. This eliminated much of the overhead associated with car purchases, such as commissions for salespeople and large properties to showcase vehicles. But a worrisome economy, rising interest rates for auto loans, and concerns that auto sales will slow led many shareholders to sour on this model. When Carvana's net margins fell to negative 15%, investors lost some tolerance for what was effectively a money-losing company.
Consequently, Carvana's finances need the capital infusion a short squeeze could provide. In the third quarter of 2022, Carvana lost $283 million. Since the company only had $316 million in liquidity, it likely cannot remain in business for long at the current pace of losses.
A short squeeze presents an opportunity for Carvana. Carvana has not issued a significant number of new shares since April 2022, when it added almost 16 million shares. At the approximate $4.50 share price at the beginning of 2023, issuing another 16 million shares would have raised approximately $72 million. Given that third-quarter loss, $72 million would not have changed Carvana's trajectory.
CVNA shares outstanding data by YCharts.
However, at $15 per share (its approximate peak so far this year), issuing 16 million shares would raise $240 million. Such a cash infusion would cover almost 85% of the reported losses in the third quarter, and could buy Carvana a little time. Many of Carvana's investors take comfort in remembering GameStop's short squeeze in early 2021, which brought capital infusions when the company used this same strategy.
How that does not help the shareholder
Short squeezes do not guarantee sustained returns. Other short-squeeze stocks, such as AMC Entertainment, eventually ended up as penny stocks again. And a stock issuance dilutes the value of current shares. Hence, shareholders who buy at these prices likely set themselves up for a haircut.
Even worse, such a move can highlight what has not changed. Carvana is a company that consistently lost money, even in an environment with low interest rates. Today, with rising interest rates, fewer consumers can afford to buy a car. Moreover, now that the supply of cars has begun to normalize, the company might have to sell much of its used car inventory at a loss.
Furthermore, investors should remember that Carvana became a penny stock by falling into financial straits in the first place. At the end of the third quarter, it held more than $7 billion in total debt, a devastating situation considering the company's book value is only $374 million. And if Cavana cannot issue shares at these higher prices, it might have no other options to attract new funding.
Continue to avoid Carvana
With the burden of saving Carvana falling on the shoulders of shareholders, it likely doesn't pay to invest in the company. The short squeeze could continue and give the company more breathing room financially, but the much greater danger is that the rally will fizzle and Carvana will hit the wall, which could wipe out shareholders. Such a possibility makes this stock too risky to touch.
