Saga Partners - Carvana: The Key Debate

Summary

• Carvana experienced some of the most disruption and headwinds over the past year.
• I have discussed CVNA stock several times since we first purchased it in 2019 but want to provide an update given the stock’s decline and negative headlines.
• The key debate is whether Carvana has the liquidity runway to get to free cash flow breakeven.

Joe Raedle

The following segment was excerpted from this fund letter.

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Carvana (NYSE:CVNA)

I have discussed Carvana several times since we first purchased it in 2019 but want to provide an update given the stock’s decline and negative headlines. Historically, Carvana has grown gross profits at a faster rate than operating costs. In 2021, Carvana grew retail unit volumes 74% to over 400,000 cars to become the second largest used car dealer after CarMax. Carvana reached $1.9 billion in gross profits, EBITDA breakeven, and expectations entering 2022 were for continued unit volume growth and scale operating costs.

Source: Company filings, Saga Partners

What happened in 2022?

Similar to Redfin, Carvana has been impacted by pretty extreme industry disruptions/volatility. Supply chain bottlenecks restricted new car production and caused prices to rise. When combined with higher interest rates, car affordability declined and used car volumes crashed.

Carvana plans and hires for expected capacity 6-12 months into the future. Entering 2022 the Company expected to grow unit volumes in the ~30% range year-over-year and therefore faced a cost structure far too high for the retail unit volumes experienced. Since demand has come in below expectations, management is now pursuing cost cuts to get back to EBITDA breakeven.

While adjusting to a more adverse macro environment would not typically be overly problematic, Carvana’s acquisition of Adesa in April added $3.25 billion of 10.25% debt to its balance sheet. While the acquisition made strategic sense and enables Carvana to more than triple its reconditioning capacity and sell cars through the wholesale channel easier, it added more than $300 million in annual interest expense right before one of the steepest declines in used car industry volume experienced in history.

The key debate is whether Carvana has the liquidity runway to get to free cash flow breakeven. Carvana has three major buckets that make up the majority of operating expenses: compensation & benefits, advertising expense, and other overhead (roughly half of which is transaction & customer benefit costs). While these costs are fairly fixed in the short-term, they are more variable in the intermediate-term. Carvana has the ability to drastically cut costs if needed, to better match the demand environment.

Based on actions taken by management, it is expected that operating costs should fall to ~$400 million per quarter ($1.6 billion run rate) by Q3’23. This was roughly where operating costs were in Q1 and Q2 2021, when Carvana sold ~100,000 retail units. At that time, they were growing unit volumes ~75% year-over-year which suggests they were not operating at potential efficiency. As Carvana shifts focus from growth to efficiency, it is reasonable to expect costs to be able to come down commensurate with those unit volumes.

One can estimate what retail unit volumes may do throughout the next year, but at that cost basis, it would take ~100,000 retail units per quarter and a gross profit per retail unit of $4,000 to reach EBITDA breakeven. Without any additional operating efficiencies, ~125,000 retail units per quarter would get them to free cash flow breakeven to cover their interest expense and priority capital expenditures. If units remain depressed for longer than expected, management could cut operating costs further, however the ~$600 million in annual interest expense is pretty fixed absent a debt restructuring.

Depending on Q4’22 results, Carvana will likely have ~$1.4 billion in committed liquidity, netting out restricted cash if its floor plan were fully drawn. As expense cuts go through, they should reach EBITDA breakeven by Q3’23. At that point they will likely have ~$1 billion in committed liquidity to cover ~$150-200 million in quarterly interest and capex, giving them until the end of 2024 for used car volumes to recover to more normalized levels. This does not even consider the ~$2 billion in unpledged real estate that provides them with further liquidity options if needed.

The fact we have to even consider a scenario of whether Carvana will get through an extended downturn could be considered a red flag. I would tend to agree in most situations, but Carvana has experienced a highly unusual environment. Part of the margin of safety to their operating results is that they have the unit economics to cut costs if demand were to decrease. They also have ample liquidity to provide a runway to do so. They are now having to pull that lever given the adverse environment.

Perhaps Carvana was overly aggressive by expanding capacity too fast. However, one can also argue that in the long-term that buying and selling cars online is such an obviously better customer experience than the traditional used car buying experience. Therefore, it should take a decent share of overall used car sales and there is a winner-take-most dynamic to the company that can best integrate the online used car buying/selling experience. Once the infrastructure is built, it would be extremely difficult for anyone else to compete with and displace the company with the greatest market share. While Carvana is the clear online used car dealer leader today, it is very possible for a CarMax (KMX), Vroom (VRM), CarGurus (CARG), Lithia Motors (LAD), General Motor’s (GM) CarBravo, or even Amazon (AMZN) to either scale their operations or enter the space. The prize for winning is substantial with potentially little left over for second place. Therefore, being aggressive in scaling its infrastructure is the right decision to make, with the understanding that it takes a lot of initial capital and one needs to be able to survive any potential downturn.

While Carvana has been negatively portrayed in the headlines, it has a strong customer value proposition, attractive unit economics compared to traditional brick & mortar dealerships, and a large market opportunity. It has the cost structure to get to EBITDA breakeven in the foreseeable future, and free cash flow breakeven as retail volumes begin to normalize sometime over the next two years. Some may ask why we have not added to our Carvana position if I continue to have conviction in Carvana’s long-term outlook and shares have continued to decline into the end of the year. The answer is that we have limits to how much capital we are willing to put into any single investment and have reached that limit last June. That may mean we are limiting some upside by not adding to what could potentially be one of the best opportunities available at the current price, but it also limits the risk that any single position might permanently impair the Portfolio.

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Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.