In July 2021, Carvana stock peaked at $377. By November 4, 2022 its shares had lost 98% of their value — falling to about $9. With 36.3% of its float sold short, many investors stand to profit should Carvana shares keep falling — to as low as $1, Morgan Stanley said.
Unless the meme crowd goes on the rampage against Carvana short sellers, the arguments favoring a drop in its stock price remain compelling. These include
- Disappointing Q3 financial report
- Declining industry demand
- Weaker cash position
- Lower profits from selling loans
- Poor credit rating
- Gloomy forecast
Disappointing Q3 Financial Report
The worst thing a company can do during a quarterly earnings call is to fall short of expectations. Carvana clearly achieved that dubious distinction on November 3 — missing “Wall Street’s top- and bottom-line expectations for the third quarter,” according to CNBC.
Here is the litany of bad news:
- Revenue of $3.39 billion fell 2.7% — $320 million below estimates according to Refinitiv.
- Carvana’s loss per share was larger than expected at $2.67 per share.
- Gross profit decreased 31% to $359 million.
- Retail units sold declined 8% to 102,570 vehicles compared with the year before
- Gross profit per unit fell over 24% to $3,500.
Consumers are struggling to afford what Carvana sells. As CEO Ernie Garcia III told the Wall Street Journal, “monthly payments for customers buying a car now are about 160% more than before the pandemic.” Due to higher interest rates, Carvana’s gains from selling customer car loans to outside investors are smaller.
Declining Industry Demand
The pandemic was great for used vehicle retailers. However, in 2022 industry fortunes reversed.
During the pandemic new vehicle supply fell way short of demand due to supply chain problems and semiconductor shortages. Consumers in need of vehicles opted for a pre-owned car or truck — driving up used vehicle pricing and profits.
2022’s macroeconomic challenges have altered consumer behavior towards used-vehicles. With high inflation, rising interest rates and fear of recession, consumers are less willing to pay record prices for used-vehicles.
This drop in demand has hurt the industry. According to CNBC, the result has been “declines for Carvana and CarMax” and warnings of softening demand for used vehicles from “large franchised new and used vehicle dealers such as Lithia Motors
Weaker Cash Position
Carvana has been a veritable cash incinerator. Between June and September 2022, its cash balance declined by $734 million — leaving Carvana with a mere $316 million in cash.
Carvana tried to reassure investors by saying it “could borrow about $2 billion to buy cars and make loans, and could raise another $2 billion from real estate,” according to the Journal.
Seth Basham, equity analyst at Wedbush Securities, forecasts that Carvana needs to raise more capital. If not, he estimates that it “won’t be able to maintain enough cash to meet its floor plan financing requirements (which were recently amended under tighter terms) and finance its business through 2023,” according to the Journal.
I think Carvana is taking an overly optimistic view of its ability to raise more cash. As the Journal reported, Garcia said “that [Carvana] had $4.4 billion in liquidity, even though just half of that is committed. Much of the rest is based on assumptions that might not pan out.”
What’s more, Garcia declined to comment on possible stock sales to lower its debt load. Instead, he told investors that Carvana could get the liquidity it needs by cutting costs. After reducing headcount by 12%, “there isn’t potential there for huge savings” from slashing further its $656 million in operating expense, noted the Journal
Poor Credit Rating
Carvana’s credit rating took a tumble this spring. As I wrote in May, in late April Moody’s downgraded Carvana’s corporate family rating to Caa1.
Moody’s reasons for the downgrade included:
- “Very weak credit metrics, persistent lack of profitability, and negative free cash flow generation,”
- “Governance considerations” — such as Carvana’s decision to make current its “external floor plan facilities” despite the expectation for significant negative free cash flow. and
- Its decision to “finance the acquisition of [wholesale auction service] ADESA partially with debt despite its very high leverage.”
Moody’s said it could downgrade its ratings “if the company was unable to generate positive operating earnings on a sustained basis or liquidity were to weaken for any reason.”
Carvana remained buoyant. As CEO Ernie Garcia told investors on April 20, “While it might be a little harder to see this quarter than most, we remain squarely on the path to building the largest and most profitable automotive retailer and to changing the way people buy and sell cars. The march continues.”
While Moody’s has not changed its rating, Carvana’s November 4 report prompted Morgan Stanley analyst Adam Jonas “to pull his rating on the auto retailer and said its stock could be worth as little as $1,” according to Bloomberg.
This rating change is a big reversal for Jonas who in early March had a $430 price target for the stock. Jonas cited deterioration in the used car market and a volatile funding environment for the change.
Jonas wrote: “While the company is continuing to pursue cost cutting actions, we believe a deterioration in the used car market combined with a volatile interest rate/funding environment (bonds trading at 20% yield) add material risk to the outlook, contributing to a wide range of outcomes (positive and negative),” reported CNBC.
Meanwhile, the value of Carvana’s bonds is down — suggesting that the company’s ability to meet its obligations is weakening. For example, “Carvana’s 5.875% senior unsecured bonds maturing in 2028 slumped to a record low of 36 cents on the dollar Friday afternoon in New York,” reported Bloomberg.
Lower Profit From Selling Loans
In the past, Carvana made a big chunk of its profit from selling the loans that buyers took out to purchase its used vehicles. According to FT, “the gains from selling loans along with other ancillary fees have typically accounted for more than half of Carvana’s gross profit per unit.”
Those gains have plunged since peaking in 2021. Gross profit per unit from selling loans and other fees has dropped 23% from $2,500 to $1,921 in the third quarter of 2022, according to FT.
Carvana is not optimistic about 2023. Garcia described next year as “a difficult one.” As he told investors last Thursday, “Cars are an expensive, discretionary, often-financed purchase that inflated much more than other goods in the economy over the last couple years and it is clearly having an impact on people’s purchasing decisions.”
Garcia described the end of the third quarter as the “most unaffordable point ever” for customers who finance a vehicle purchase. Though they have declined 7% in the last year, according to auction house Manheim; in October, used car prices were still 43% more expensive than three years earlier, according to the Journal.
With average rates on used car loans hitting 9.6% in October — the highest in about 10.5 years — the average monthly payment for a used vehicle rose 8% to $564 in October compared to a year earlier, according to Edmunds.
One short seller is pessimistic about Carvana’s future. According to FT, Spruce Point Capital Management’s founder Ben Axler said, “Carvana has not generated any positive cash flow since first reporting financials in 2014 — over eight years ago. Now that capital has become more expensive, [it] will truly test investors’ appetite for funding its lossmaking business ambitions.”
Carvana sees a bright future. “While progress is rarely linear, we remain on the path to becoming the largest and most profitable auto retailer,” Garcia told FT.