Carvana: Shying Away From The Valuation

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About: Carvana Co. (CVNA)
by: Gary Alexander
Summary

Shares of Carvana have more than doubled this year, rising again after the new-age car company reported strong growth in Q1.

Retail unit sales and revenues saw approximately 2x growth.

The company also recently launched four new markets in the mid-Atlantic region, expanding Carvana's reach to roughly 150 metro markets across the U.S.

However, free cash flow losses loom large. Carvana's ~$85 million of remaining cash is insufficient to finance the company's continued cash burn.

After slamming on the brakes last year due to a growing concern for higher losses, shares of Carvana (CVNA) have rallied sharply again this year, eradicating bears with the strength of its growth rates. The Arizona-based car company, perhaps best known for its iconic "car vending machines" where customers pick up their purchases from giant revolving towers, went public two years ago at just $15 per share and has since become one of the best-performing public offerings of its vintage. The question for investors now: can Carvana continue its rally further into 2019?

Chart Data by YCharts

In my view, there are a lot of positive notes to report on Carvana's growth. However, two factors hold me back on investing in the stock. The first is valuation: despite its rapid growth rates, Carvana trades at an insane multiple of revenues, especially for a company that rakes in such thin gross margins. Though it advertised the appearance of a technology company during its IPO, Carvana's business is really no more than an old-fashioned car dealer.

The second is Carvana's losses. While the company has certainly achieved some operating leverage and improved its EBITDA margins, its free cash flow losses are still ballooning. At the same time, Carvana's liquidity - most of it raised during its IPO - has dried up, and the company may face the necessity of raising dilutive capital soon. With share prices high, raising equity capital would be no issue for Carvana - but as we've seen with other secondary issuers, share prices tend to see some pressure after a secondary offering.

In my view, investors should lock in gains in Carvana and invest elsewhere. The company's massive YTD rally has more than compensated for the fundamental strengths it reported in Q1.

First, the good news: growth and gross profit

It would be remiss not to acknowledge the strengths of Carvana's Q1 earnings report before diving into the bearish details. In particular, retail unit sales soared to 36,766, up a staggering 99% y/y. Note that since its IPO in 2Q17, Carvana's scale has more than tripled:

Figure 1. Carvana retail unit sales Source: Carvana Q1 shareholder letter

Carvana also noted that it grew substantially in the quarter by buying up cars from its customers and reselling them. Per the commentary from its shareholder letter:

Total vehicles acquired from customers grew by 232% in Q1 2019 vs. Q1 2018, meaning that we bought 40% as many cars from our customers as we sold in the first quarter, up from 24% in Q1 2018 and 36% last quarter. The industry leader in our market buys approximately 100% as many cars as they sell, illustrating the huge potential in this business. Wholesale units sold, which are primarily sourced from customers, increased by 186% to 6,701 in Q1 2019 from 2,342 in Q1 2018. Retail units sold sourced from customers increased to about 14% from about 6% in Q1 2018. This was lower than the 17% in Q4 due to the expected rapid growth in auction-sourced inventory in preparation for Q1 2019."

This strength in retail unit sales (which comprise ~90% of the business; the remainder is made up of sales to wholesale dealers) drove 110% y/y revenue growth to $755.2 million, far outpacing Wall Street's consensus estimate of $715.4 million (+98% y/y).

In addition to its top-line strength, Carvana has also been improving its take rate on each sale. Gross profit per unit (GPU), excluding a one-time Milestone Gift that Carvana gave to its employees, was $2,408, up 30% y/y:

Figure 2. Carvana GPU trends Source: Carvana Q1 shareholder letter

Total gross profits hit 11.8% this quarter. In Carvana's long-term plan, the company intends to reach gross margins of as high as 19%, as shown in its long-term operating model below:

Figure 3. Carvana Q1 performance vs. long-term model Source: Carvana Q1 shareholder letter

Valuation more than compensates for this growth

In spite of these impressive growth statistics, however, I'd argue that Carvana's current valuation more than compensates. At the company's current share price of $67, Carvana trades at a market cap of $9.7 billion - nearly five times the $2 billion valuation that Carvana notched two years ago in its IPO.

By comparison, note that CarMax (KMX) - the largest used-car retailer in the U.S., and about five times Carvana's scale with annual revenues of just under $20 billion - currently trades at a market cap of ~$13 billion, only about 30% greater than Carvana's.

If we net out the $85.3 million of cash and $434.8 million of debt on Carvana's balance sheet, we arrive at a current enterprise value of $10.1 billion for the company. Here's how that stacks up against management's latest outlook for FY19:

Figure 4. Carvana FY19 guidance update Source: Carvana Q1 shareholder letter

Carvana is calling for 82% y/y growth at its midpoint revenue guidance of $3.55 billion, indicating that the company is currently trading at a revenue multiple of 2.85x EV/FY19 revenues. CarMax, by comparison, is barely trading above 1x forward revenues:

Chart Data by YCharts

Of course, Carvana is by far the faster-growing company. But even at double or triple Carvana's current scale, Carvana would still be trading at a richer valuation multiple than CarMax. For a company that notches a low teens gross margin, a ~3x forward revenue multiple is unsustainable.

Near-term liquidity concerns

Another issue buried under the excitement of Carvana's growth rates is its cash burn profile. In its most recent quarter alone, Carvana has burned through $214.5 million of operating cash flow and used up an additional $43.2 million in capex - for a total free cash flow loss of -$257.7 million, a 62% y/y greater loss than -$159.4 million in the year-ago quarter:

Figure 5. Carvana cash flows Source: Carvana Q1 shareholder letter

We note that Carvana has enabled a significant portion of its growth by financing customer purchases in-house, then selling its finance receivables later. These originations made up the bulk of Carvana's FCF losses this quarter.

Unfortunately, Carvana's cash balances seem to be running thin. As of the end of Q1, Carvana had just $85.3 million of cash left on the books. Even if you add the $151.2 million of finance receivables currently on the balance sheet as an asset that Carvana can quickly convert to cash, Carvana's total liquidity of ~$236.5 million is barely sufficient for the company to sustain just one more quarter of losses.

Key takeaways

Carvana's year-to-date rally presents a fantastic opportunity for investors to lock in their gains. While Carvana's supremacy in growth can't be questioned, its ballooning FCF losses in light of a thinning balance sheet as well as an overextended valuation raise the question of whether its rally can continue. If the company is forced to raise capital in the near term, shares will wobble - as we've seen with other secondary offerings. I'd stay on the sidelines until share prices come down.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.