One of the top-performing stocks in the last year has been Carvana (CVNA 8.79%). Since the beginning of 2023, shares of the online used car marketplace are up a whopping 1,690%, handily beating the returns of even the best growth stocks. For reference, this is more than three times the returns of Nvidia stock over the same time frame.
It is hard to beat the returns Carvana has put up for investors over the past year. Investors have gotten more optimistic about the company's prospects as it skirted bankruptcy, refinanced its debt, and inched closer to profitability.
But what does that mean for investors right now? Should you buy Carvana stock before it rips higher yet again?
Sacrificing growth to achieve profitability
Carvana stock got into trouble when management got too aggressive in trying to grow market share. From 2017 to 2021, the number of retail cars sold on the Carvana marketplace went from 44,000 to 425,000. In just a few years, the marketplace went from a niche player to one of the largest used car companies in the United States.
The problem is, growth at Carvana was prioritized without focusing on profitability. From 2017 to 2022, Carvana's free cash flow continued to get worse and worse, even though revenue was soaring. At its worst, Carvana was burning over $3 billion in cash each year on revenue of over $10 billion.
It was at this moment that the stock plummeted, falling more than 95% in one year. Management took a hard look in the mirror and (smartly) decided to prioritize profits over growth at all costs. Since 2021, Carvana has tamed down this growth and weeded out unprofitable transactions on its marketplace.
In 2023, Carvana's units sold declined to 313,000 versus 425,000 in 2021, with revenue down to $10.77 billion compared to $12.8 billion. Profits look much better even at a smaller revenue level, with free cash flow actually positive in 2023. Some of this is due to inventory adjustments and not actual profits, but this is a great turnaround and shows that Carvana has eliminated unprofitable transactions from its marketplace.
The question investors need to be asking today is if Carvana can start growing again without sacrificing this positive free cash flow. The company turned around its financial statements by heavily decreasing its operating expenses (advertising, research, etc.) to just 16.7% of revenue. Over the long term, it hopes to get total operating expenses down between 6% to 8% of sales in order to further increase its margins. But so far, it hasn't proven it can be efficient with expenses while also growing revenue.
CVNA Free Cash Flow data by YCharts
Don't forget the heavy debt levels
If you just looked at Carvana's income statement and cash flow, you'd think this is a company on a great financial trajectory. But investors should not forget the balance sheet. Carvana has just $530 million in cash and $5.4 billion in long-term debt, giving it a precarious financial position. If the business starts teetering, Carvana could run into trouble.
We are already seeing management having to get creative in order to manage these loans. It did a bond-swap deal with some of its bondholders in 2023 and has started to use an at-the-money (ATM) stock offering in order to add more cash to the balance sheet. These deals helped Carvana save on some near-term expenses and raise cash levels, but show that the company is not in a comfortable financial position, even though the stock is up more than tenfold in the last year.
However this debt is managed, investors should understand that a lot of the profits this business generates will not be returned to them; it will be used to pay interest on these loans and pay back the principal debt holders. This has to be factored in any analysis of Carvana stock.
Should you buy the stock today?
At today's stock price, Carvana has a market cap of $10 billion. Add its net debt of approximately $5 billion, and its enterprise value (EV) is $15 billion. It is hard to value Carvana, given its inconsistent profitability. Luckily, management has given long-term profit margin goals that we can use to back into a theoretical EV-to-earnings (EV/E) ratio for Carvana at its current level of sales.
In the long term, Carvana expects its gross margin to hit 15%-19%. That means the midpoint is 17%. It expects operating expenses to be 6%-8% of sales, which would bring its operating income margin down to 10%. Add in its high interest payments and taxes, and net income margin could likely be around 5% for Carvana at scale.
On 2023 revenue levels, that equates to $540 million in net income. Using our EV/E formula, this is a theoretical earnings ratio of 27.7, which is right around the S&P 500 index average.
What this shows is that you should only be buying Carvana today if you believe the business can grow to much larger levels over the next few years while also not running into cash flow troubles. If it can grow and generate profits, the stock will likely keep pushing higher. If it can't do both, it is hard to see how Carvana's stock keeps going up.
