Carvana Vs. Peers: It Does Not Measure Up

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About: Carvana Co. (CVNA), Includes: AN, KMX, LAD
by: Concerned Investor
Summary

Carvana is now commanding an impressive $7 billion valuation, many multiples higher than its peers relative to any metric tracked in the industry, including units sold, revenues, and earnings.

We believe this valuation makes little sense in view of its performance to date and the industry at large.

This article provides an analysis of Carvana's most recent quarterly results as compared to CarMax, AutoNation, and Lithia Motors, concluding that Carvana is massively overvalued.

We believe Carvana is deserving of a much lower valuation - at best in line with its peers - with a share value in the range of $5-9.

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Overview

Carvana (CVNA), a relatively new company seeking to disrupt the used car retailing business by selling cars online, is now commanding an impressive $7 billion valuation – many multiples higher than its peers relative to virtually any metric tracked in the industry, including units sold, revenues, and earnings (which, for Carvana, have been negative since inception, and growing). This valuation, in our view, makes no sense, and so we are short the stock. This article provides our analysis.

About Carvana

Carvana is a 5-year-old company seeking to disrupt the used car retailing business by allowing customers to skip the dealership and view and order cars online, with convenient at-home delivery. Like so many new online retail companies, Carvana seeks to become the Amazon (NASDAQ:AMZN) of the used car dealerships. On first glance, this seems like a great idea, as the used car retailing experience remains one of the few brick-and-mortar experiences yet to be displaced by an online process, and consumers consistently rate the car purchasing experience as one of the most dreaded.

Carvana went public in the spring of 2017 at around $13.50 a share. After briefly falling to around $8.14/share (on 5/4/2017), it gradually climbed to $72/share (on 9/12/18), only to reverse course prior to the most recent earnings release and fall to a low of $35/share (on 10/30/18). Amazingly, after earnings on Nov. 7, 2018, wherein it announced missing estimates by $0.11 a share, the stock climbed back up to $48/share, commanding an impressive $7 billion valuation.

As discussed herein, this valuation makes little sense in view of Carvana’s performance to date and as compared to the auto-retailing industry at large. To illustrate this point, we prepared a spreadsheet comparing the most recent quarterly results of Carvana against several of the largest auto-retailers in the country, including CarMax (KMX), AutoNation (AN), and Lithia Motors (LAD). This spreadsheet in its entirety is shown below, with sections highlighted throughout this article.

Figure 1. Comparison of Quarterly Key Metrics - Spreadsheet comparing most recent quarterly results of Carvana, CarMax, AutoNation, and Lithia Motors (note, some figures estimated based on reported metrics). (See Carvana Q3 2018 Quarterly Report; CarMax Q3 2018 Quarterly Report; CarMax FY2017 Annual Report; AutoNation Q3 2018 Quarterly Report; Lithia Motors Q32018 Quarterly Report).

Summary

We believe Carvana is massively overvalued relative to its peers for at least the following reasons:

  • Carvana is not in the service business, which for many companies in the retail automotive space delivers the vast majority of the gross profits.
  • Its gross profit per unit (or GPU) is far too low and is not likely to increase without further stunting growth.
  • Its SG&A per unit is too high relative to its peers and is unlikely to come down in view of the substantial advertising and delivery costs required to sell a unit sight-unseen to an end-consumer.
  • Its sales are small and are slowing q-o-q — a bad sign since, in our view, Carvana must ultimately sell multiple millions of vehicles (far more than any other retailer in history) to reach similar profits as its peers.
  • We place an asterisk by Carvana’s F&I figures because: 1) they appear unusually high for a used car operation (at nearly 2X CarMax’s), 2) they have an outsized impact on gross profits and NOI because 100% of F&I revenues flow down to gross profits, and 3) the entity from whom Carvana receives F&I commissions is one that is majority owned and controlled by the Garcias.
  • Finally, there are new competitors on Carvana’s heels, including Vroom and Shift, both of whom recently partnered with large established brick-and-mortar dealerships.

For these reasons and others discussed herein, we believe Carvana is deserving of a valuation, at best, in line with its peers on a revenue multiple basis - implying a valuation in the range of $1.26 billion (or ~$8.90/share) to $0.272 billion (or ~$1.92/share), with a midpoint of $0.77 billion (or ~$5.40/share). We believe this valuation appropriately represents the high-end of Carvana’s value because, in our view, Carvana’s business model is not likely to generate similar profits in the long run as its peers given its lack of a service business, slowing sales, structurally lower GPU and higher SG&A/unit costs.

Detailed Analysis

Not in Service Business

Carvana plans to make money by generating more money on each sale of a used vehicle than it spends. As obvious as this model may seem given Carvana’s stated business, most auto retailers derive a substantial portion of their gross profits from service revenues.

Figure 2. Spreadsheet showing Carvana has no service revenues, which for most auto-retailers comprises a substantial part of gross profits.

Significantly, Carvana has no service business, nor is likely to build this line of business in the near future. Thus, as compared to many of its auto-retailing peers, Carvana’s business model begins at a substantial deficit.

GPU is far too Low

Presently, Carvana’s GPU is at $2,300/unit. While this figure has grown q-o-q, we believe one is better served to ask: why is the figure so much lower than the industry average?

As shown below, virtually all of the major retailers start with a similar Average Purchase Price (APP) or cost (at ~18K/vehicle). Nonetheless, Carvana consistently underperforms its peers, generating a mere $1,166 in GP per vehicle (not counting GP relating to F&I and Wholesale, discussed later).

Figure 3. Spreadsheet showing all companies start with similar Average Purchase Price or cost (APP), but Carvana’s Average Sale Price ((ASP)) and Used Unit GP substantially lags its peers.

It is our belief that Carvana’s lower GPU is structural — meaning that it cannot be substantially increased without further stunting growth, as we believe the lower price is needed to induce the consumer to purchase their desired vehicle sight-unseen online, rather than in-person from an established brick-and-mortar dealership (which is a far more emotional decision). Carvana’s recent slowing growth over the past several quarters as it has raised prices supports this view.

https://static.seekingalpha.com/uploads/2018/11/29/17449412-15435074645942185.png

Figure 4. Spreadsheet showing Carvana’s Quarterly Unit Sales slowing q-o-q. See quarterly reports for each period.

Even more problematic for Carvana is that fact that even if it reaches parity with industry norms and achieves a $3,000 GPU, the company sells far too few used vehicles at far too high a cost to be able to generate meaningful shareholder profits. These issues are discussed in the following sections.

Sales are Small and Slowing

Carvana most recently announced quarterly sales of 25,300. As shown below, these sales are significantly smaller than each of the established players (remember, too, that the figures below are QUARTERLY figures, not yearly figures where the differences would be even more pronounced).

Figure 5. Spreadsheet showing Carvana’s Quarterly Unit Sales substantially lag peers.

As mentioned previously, these sales appear to be slowing q-o-q - which is particularly alarming given that Carvana has been growing markets exponentially and is spending far more than its peers on advertising on a per unit basis. Were Carvana likely to reach unit sales figures on-par with its peers, one would expect to see its sales continuing to accelerate q-o-q as it expands exponentially into new markets, rather than leveling off at this early stage.

https://static.seekingalpha.com/uploads/2018/11/29/17449412-15435133654816506.png

Figure 6. Spreadsheet showing Carvana’s Quarterly Unit Sales slowing q-o-q. See quarterly reports for each period.

https://static.seekingalpha.com/uploads/2018/11/29/17449412-15435133918066857.png

Figure 7. Spreadsheet showing Carvana growing markets exponentially. (See Carvana FY2017 Annual Report; Carvana Q3 2018 Quarterly Report)

Figure 8. Spreadsheet showing Carvana’s Unit Advertising spend compared to peers.

In view of its slowing sales, we believe it is unlikely that Carvana will achieve unit sales approaching its peers, much less approaching CarMax’s (at nearly 8x present levels).

Finally, we believe that Carvana must ultimately sell far more vehicles than its peers (i.e., multiple millions/year) to justify its current valuation given its lower GPU (as discussed above) and higher SG&A/unit costs (as discussed in the next section). Again, we think this is extremely unlikely in view of Carvana’s current low unit sales, slowing growth, and the fact that no auto retailer in history has come close to selling multiple millions of vehicles a year.

Figure 9. Spreadsheet comparing Carvana Total GP/unit to Total SG&A/unit vs KMX.

SG&A per Unit is too high and not coming down

Carvana’s SG&A/unit costs are substantially higher than its competitors in virtually every category - from Comp & Benefits, to Advertising and Logistics - and even in the nebulous and all-encompassing “Other” category.

Figure 10. Spreadsheet comparing Carvana SG&A/unit costs vs. peers.

Before getting into the specifics regarding Carvana, it is worth noting that the unit SG&A costs for AutoNation and Lithia are understandably higher than those of CarMax because AN and LAD run large service businesses, complete with larger facilities, more employees, and other related expenses — expenses which we believe account for as much as 1/3 to 1/2 the unit SG&A costs for each of these companies. Stripped of these expenses, AutoNation’s and Lithia’s SG&A/unit costs approach CarMax’s at around $2,300/unit.

Figure 11. Spreadsheet showing AN and LAD SG&A/unit costs are higher vs. peers due to Service Business.

Thus, on an apples-to-apples basis, Carvana is spending nearly 2x the costs of its competitors (~$4,600 vs. $2,300). These expenses do not appear to be ones that are likely to come down with time for at least two reasons: First, to-date, Carvana has been able to scale extremely efficiently by taking advantage of facilities and infrastructure built and operated by Drivetime - another used car company majority owned and controlled by the Garcias that claims to be the largest “subprime” used car dealership in the country with over 135 physical dealerships in 27 states (and selling over 120K units/yr). (See Cox Automotive Invests in Silverrock Holdings, Enters F&I Space - Cox Automotive Inc.; and DriveTime | Used Cars & Financing Online).

As revealed in Carvana’s 10-K, Drivetime has generously extended to Carvana access to all of its critical infrastructure - including its mission critical IRCs and local storefronts (aka dealerships) - on a “pro rata” basis.

This arrangement is memorialized in two agreements, entitled the “Shared Services Agreement” and “Lease Agreement,” by and between Carvana and Drivetime — both of which provide that people, facilities, and other infrastructure may be used on a “pro rata” and/or “actual use” basis.

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Figure 12. See Carvana FY2017 Annual Report.

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Figure 13. See Carvana FY2017 Annual Report.

To be sure, this relationship has proven extremely favorable to Carvana, as it has allowed Carvana to scale quickly and do so extraordinarily efficiently. However, we believe Carvana must soon extricate itself from Drivetime as the two companies are competitors after all! When that happens, Carvana will no longer be able to incur expenses on a “pro rata” basis, but will instead have to incur 100% of the costs of needed resources and infrastructure, which often come front-loaded. For this reason, we believe Carvana’s SG&A expenses are likely to remain elevated into the foreseeable future.

For its part, Carvana acknowledges this risk in its 10-K, where it states:

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Figure 14. Carvana FY2017 Annual Report.

Second, and even more critically, we believe a substantial portion of Carvana’s unit SG&A expenses are “structural” and are not likely to diminish significantly with time or scale — specifically, its advertising and logistics expenses (discussed in the next two sub-sections):

High Advertising Cost

In its most recent quarter, Carvana spent over $27.5 million on advertising - or nearly $1,100 per unit sold. That is unusual in the extreme, as the typical brick-and-mortar dealership spends less than $400/unit in advertising.

Figure 15. Spreadsheet comparing Carvana’s Unit Advertising costs vs. peers.

We do not believe this expense is likely to come down substantially with time or scale, as we believe the higher ad spend is needed to make up for the fact that Carvana does not have (in most markets) physical locations complete with large bright signage on major highways and roads – which of course serve to advertise/reinforce the retailer’s brand to the local consuming public. We also believe it is that much more difficult (i.e., costly) from an advertising perspective to sell a consumer on buying a car sight-unseen online than it is for a dealership to sell a car to a consumer who can “kick the tires” and interact with a salesperson when making their decision (the latter is a far more emotional decision). Accordingly, we remain skeptical that Carvana will be able to significantly decrease its advertising spend over time to be in line with industry norms without stunting growth.

Carvana often points to the following graph to support its position that, with time, its advertising spend per unit is likely to decrease to be in line with industry norms.

https://static.seekingalpha.com/uploads/2018/11/29/17449412-15435074710681298.png

Figure 16. Customer Acquisition Costs By Cohort (See Carvana FY2017 Annual Report; see also, Carvana Q4 2017 Letter to Shareholders).

We, however, find this argument and data unconvincing for the following reasons: First, notice the “2013 cohort” data consists of a single market (Atlanta, GA):

https://static.seekingalpha.com/uploads/2018/11/29/17449412-1543507464907635.png

Figure 17. See Carvana FY2017 Annual Report.

Second, the 2014, 2015, and 2016 cohorts consist of 20 established markets that have all been opened for more than a year — making it a much larger data sample — and all end in the range of $900-2000/unit.

https://static.seekingalpha.com/uploads/2018/11/29/17449412-15435074652435856.png Figure 18. See Carvana FY2017 Annual Report.

https://static.seekingalpha.com/uploads/2018/11/29/17449412-15435074716152546.png

Figure 19. Customer Acquisition costs by Cohort, modified to show range of Unit Advertising expenditure for 2014, 2015, and 2016 cohorts. (see Carvana FY2017 Annual Report).

Third, we believe the data is even worse than Carvana leads-on because, as shown below, Carvana maintains a very high concentration of physical locations within many of the early cohorts, causing the unit advertising spend to be less than it ordinarily would be within many of these markets.

https://static.seekingalpha.com/uploads/2018/11/29/17449412-1543507472187075.png

Figure 20. List of physical locations of Carvana through FY 2017 (see Carvana FY2017 Annual Report).

https://static.seekingalpha.com/uploads/2018/11/29/17449412-1543507465192661.png Figure 21. Clip from August, 2016 Business Wire article listing early Carvana markets. (See Carvana Expands East Coast Footprint with Washington, D.C. Launch). Notice the high concentration of markets with physical locations.

High Delivery Costs

In addition to spending far more per car on advertising, Carvana must also spend a substantial sum (nearly $400) to deliver each unit to the end consumer — a cost entirely unique to Carvana’s business model, as no such cost exists for the typical brick-and-mortar dealership.

Figure 22. Spreadsheet comparing Carvana Unit Logistics expense vs. peers.

While the Logistics cost is sure to come down as Carvana builds additional reconditioning facilities closer to its end consumers, we do not believe the cost is likely to decrease dramatically from present levels over time.

These two costs alone add an additional $1,300-1,500 to Carvana’s unit SG&A expenses. Thus, even if we assume that Carvana can bring all other SG&A unit expenses in line with its peers (which, again, we think is unlikely), it will need to sell vehicles at substantially higher prices to generate the same level of unit profitability as its peers just to overcome its higher advertising and logistics expenses. As discussed above, we do not see this as likely in view of Carvana’s decelerating growth in the face of rising prices.

F&I figures seem Unusually High

Carvana’s GPU figure is not only alarming because of the low spread between the average unit sale price and cost (as discussed above) but also because nearly all of the remaining amount of the GPU is made up of “Other” revenue — which appears to be nearly 2x the amount of revenue derived by CarMax. Why?

Figure 23. Spreadsheet comparing “Other” Gross Profits vs. peers. Notice Carvana’s is nearly 2x KMX’s. Note, AutoNation’s and Lithia’s Unit F&I revenues are understandably higher than Carvana’s and CarMax’s since the majority of cars sold by AN and LAD are new cars that sell for an avg of $35-37K. These cars command much higher F&I premiums and sell-through percentages than used cars like those sold by Carvana and CarMax.

Is it that Carvana is generating more lucrative loans with higher rate than CarMax (unlikely, in our view, given that online buyers are usually very price sensitive)? Is it that Carvana’s GAP and service contracts (VSCs) are that much more expensive than CarMax’s (also unlikely given the price sensitivity of online consumers, the fact that these products together do not cost more than $1,000-2,000, and that Carvana does not charge the usual “doc/title fees” which typically amounts to several hundred dollars)? Is it converting a much higher percentage of customers to purchase these products (unlikely given that it does not have the benefit of an F&I salesperson/desk)? Or does Carvana simply have a more favorable commission structure with its providers than others in the industry?

In the end, the investor is left wondering because Carvana does not break-out its “Other" revenues and so the investor has no way to know whether the figure makes sense relative to industry norms. Here, we simply note: i) the figure is nearly 2x the size of CarMax’s; ii) the figure is worth close scrutiny since 100 percent of these revenues flow down to gross profits and thus a small change in this figure can have an outsized impact on gross profits and NOI; and iii) the entity from whom it purchases VSCs is a closely related entity (SilverRock Holdings) that is majority owned and controlled by the Garcias (See Cox Automotive Invests in Silverrock Holdings, Enters F&I Space - Cox Automotive Inc.).

Carvana is No Longer Alone

When Carvana first began selling cars several years ago, there were just a handful of companies that sold used vehicles online while offering at home delivery, including Beepi, Shift, and Vroom.

Beepi made news early on by raising multiple hundreds of millions of dollars (into even higher valuations), only to soon thereafter flame-out and declare bankruptcy (see Beepi shutting down after blowing through $150M in VC - New York Business Journal). Vroom (founded in 2013 and backed by General Catalyst Partners) and Shift (founded in 2014 and backed by Goldman Sachs, Highland Capital Partners and others) have both raised - and presumably lost - hundreds of millions of dollars while slowly growing sales and revenues.

Significantly, both of these companies just joined forces with much larger established auto-retailers. Shift recently announced a partnership with Lithia and took in an investment of $54 million in the third quarter of 2018 (see Lithia Announces Strategic Partnership with Shift Technologies). Soon after, Vroom announced an investment and partnership with AutoNation, while taking in a similar amount of money (see AutoNation Invests $50M in Vroom, a Leading Online Car Retailer).

We believe both of these tie-ups bode poorly for Carvana as they provide each of these competitors with the necessary infrastructure and inventory to quickly scale. They also all but ensure the online used car retailing space will remain competitive into the foreseeable future, and is not likely to coalesce into one large retailer, like Amazon — as the Carvana longs surely hope.

Closing

In closing, we believe Carvana is massively overvalued relative to its peers at $7 billion. Instead, we believe the company is deserving of a valuation, at best, consistent with its peers relative to revenues - implying a valuation in the range of $1.26 billion (or ~$8.90/share) to $0.272 billion (or ~$1.92/share), with a midpoint of $0.77 billion (or ~$5.40/share). We believe this valuation appropriately represents the high-end of Carvana’s valuation since, in our view, Carvana’s business model is not likely to generate similar profits as its peers in the long run given its lack of a service business, slowing sales, structurally lower GPU and higher SG&A/unit costs.

For the foregoing reasons, we are short the stock.

Disclosure: I am/we are short CVNA.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.