CVNA - Carvana

[Broeb22]

I wanted to start the thread on Carvana as more of a curiosity than a truly serious investment thread.

 

My interest in the business is that Carvana has set itself up to be the low-cost provider of used cars in the U.S.

 

They currently do not make money, but they are scaling pretty rapidly with losses coming down significantly and gross margins increasing rapidly in the most recent quarter to ~$1900 per vehicle from ~$1100-1200 per vehicle. CVNA's overall gross profit is 9.5% right now vs. 13.5% at KMX.

 

CarMax earns $3000 in gross profit per vehicle, and earns a 6% pre-tax margin (although as much as 2.5 percentage points are related to the Auto Finance segment which isn't comparable to CVNA).  So, perhaps 3.5% is the right long-term pre-tax margin for CVNA.  (I could argue that as CVNA scales it will add in-house financing to its offerings.) At that margin, CVNA would be earning close to $100MM pre-tax in 2019 relative to a $3.9 billion market cap. Certainly not a "value" investment at these prices, but 100% growth the last few years, and thus >50% CAGR over the next few years could make multiples a lot more reasonable if the business model is sustainable.

 

Now for the bad. The Garcia family controls the stock through a dual-class structure. Obviously, not something you want to see as a minority investor. But what makes it worse is that the Garcia family does not have a spotless past. While I can't say anything bad about the current CEO, his father was involved in the S&L crisis in the late 80's and early 90's.

 

This is a situation where I see a potential disruptor in its early stages, but am unwilling given current losses and governance issues to commit capital.

 

Has anyone else looked at this business? Would be interested in anyone else's take on this interesting business.

 

http://articles.latimes.com/1990-10-31/business/fi-3371_1_desert-land

https://www.bloomberg.com/news/articles/2017-06-06/cars-in-vending-machines-a-fading-ipo-and-an-ex-con-behind-them

 

 

[KJP]

Carvana is building a "vending machine" near me, so your post caught my interest.  I've never worked for a car dealership and I've only spent a few hours looking over the the financials of Carvana and Carmax, so take these thoughts for what they're worth.

 

Can you make money simply by selling used cars at transparent prices?  As an outsider to the industry, selling used cars at transparent prices seems like a very tough business. You're selling essentially commodities with full price transparency, which allows others to easily undercut you if they choose.  In addition, cars are one of the most expensive purchases most people in the U.S. make, so I suspect the purchase decisions are often well-researched, and the internet provides an easy way to do that research. 

 

So, how can you ever make real money doing it?  I suspect there are at least four ways:  (1) you can source used cars at lower costs than your competitors, which probably requires a source that is not a public auction at which other dealers participate; (2) you have lower non-COGS expenses per unit, which I will call "distribution" expenses; (3) you can convince buyers to pay you more for essentially the same product, e.g., a trusted dealership brand; and (4) you don't actually make any money selling used cars -- you make your money performing what I will call "ancillary services," meaning services or business lines that you can provide at very little incremental cost because of the infrastructure you have in place for selling used cars at retail.

 

How does CarMax make money? To test whether any of my musings above hold water, I took a quick look at CarMax's most recent 10-K.  Based on CarMax's commercials, the average person probably believes that CarMax makes money primarily by selling used cars and perhaps benefits from (3) above.  I doubt that's true.  It looks to me like CarMax makes its money from (4) and possibly (1).

 

In 2017, CarMax generated $2.3 billion in gross profit + $420 million from originating and servicing auto loans, and had $1.6 billion in SG&A, for an EBIT of about $1.1 billion.  The gross profit included the following "ancillary" revenue sources:

 

$390 million from wholesaling used cars at auto auctions it conducts on its own lots.  These are cars they acquire via trade-in but which don't meet their standards for refurbishing and selling at retail.  The average selling price for these wholesale cars is only about $5300, but they generate $971 per car in gross profit, for a gross margin of almost 19%.  CarMax only gets 10% GP margin on the cars it sells at retail.  Moreover, they hold their wholesale auctions on site on a weekly or biweekly basis and have a 95% wholesale sell rate.  So, they're turning over this wholesale inventory very quickly at a very healthy GP margin.  Moreover, I assume that the same staff that's on-site to sell their new cars is also acquiring these used cars as trade-ins.  So, it appears that there is very little incremental SG&A associated with this wholesaling side business.  Therefore, a good portion of that $390 million in GP should flow down to EBIT.

 

$369 million in "other" gross profit on just $546 million in "other" revenue  This very high gross margin revenue stream comes largely from (i) reselling third-party warranty products, including extended service plans and gap insurance, and (ii) commissions from third-party auto financiers who finance the purchases of buyers who do not qualify for CarMax's own, in-house financing.  Once again, I assume the people selling these ancillary products are the same people selling the used cars to retail buyers, and they do it from the same locations.  So, once again, there appears to be very little incremental SG&A associated with this gross profit stream. 

 

If you add the $420 million from the financing division, $390 million in wholesale gross profit and $369 million in "other" gross profit, you get about $1.2 billion.  There is, of course, some SG&A associated with the activities that generated all of this gross profit, but given that all of these activities piggyback on the infrastructure that already exists to sell used cars to retail buyers, I suspect the incremental SG&A is very low.  Thus, I suspect that the vast majority of CarMax's $1.1 billion in EBIT actually comes from all of these various ancillary activities, rather than from the straight sales of used cars to retail buyers.

 

If the analysis above is right, then CarMax is much like other auto dealers, which I understand make most of their money on ancillary services like financing and service/repair, rather than on the sales of new or used cars.

 

Can Carvana generate the same types of ancillary revenues as CarMax?  If the analysis above is right, then I think one of the key questions for Carvana is whether it can generate the same type of ancillary revenues as CarMax without having the same type of brick-and-mortar physical locations. 

 

Financing revenue I suspect Carvana can eventually generate at least a good portion of the financing related revenue CarMax generates, because the key there seems to be the customer relationship, rather than the physical location.  One caveat is that CarMax also services the auto loans it originates (it securitizes the loans, but keeps the servicing portion).  I don't know whether having significant dealership locations creates any cost or other advantages with respect to loan servicing. 

 

Extended service plans and gap insurance In theory, Carvana should also be able to sell extended protection plans and gap insurance, but in practice I wonder whether selling those types of products face-to-face materially increases the attachment rates.  That would be something to monitor over time with Carvana.

 

Wholesaling  Carvana is already doing some wholesaling.  But I don't know whether the lack of traditional dealership locations will impede its ability to acquire wholesaling inventory at low prices or prevent them from conducting their own auctions, which I assume are (at sufficient volumes) much cheaper than using a third-party auction service.

 

Does (or will) Carvana actually have a cost advantage?  As discussed above, the "ancillary" services discussed above piggyback on a brisk business selling higher-quality used cars to retail buyers.  Thus, all those revenue streams depend on the retail business offering competitive prices, which would be at risk if Carvana or some other company could offer significantly lower prices for the same vehicles.

 

Can Carvana actually do that?  Currently, Carvana gets most of its inventory from auctions.  This appears to be a higher priced source of inventory than trade-ins.  So, at least for now, Carvana appears to start from an initial cost disadvantage relative to dealers who acquire their own used inventory via trade-in.  Can Carvana move its business model toward acquiring more inventory at low cost via trade-in?

 

Second, is Carvana's distribution method ultimately going to result in lower SG&A per unit than traditional dealerships?  This remains to be seen and will be an interesting thing to watch.

 

Finally, note that Carvana currently depends a floor-plan financing for its inventory.  If that source of financing remains available, that would allow them to scale up quickly, which would otherwise be impossible given the working capital intensive nature of selling used cars.  Relatedly, even Carvana's model requires significant PP&E.  You need to account for that needed capital when assessing future enterprise and equity values.

 

[Spekulatius]

^ Excellent analysis from KJP and I believe his conclusions to be correct.

[bobozou]

+1 KJP

 

Thanks for the great thoughts and analysis

[Cigarbutt]

Good info and analysis by KJP.

 

Some thoughts:

 

-The used car buying behavior has been changing (time spent looking on the internet versus time spent seeing models, need to test drive, open the hood and kick the tires).

 

-Still considered a large ticket item (with many components: financing, guarantees, other services and trade-ins) and a physical location for stores still has value.

 

-The gross margin on used vehicles sold has been under pressure for some years and this is related to a fragmented competitive landscape as well as profits coming from other ancillary services. The dynamics will continue to change.

 

-Carmax has captured a profitable market share because the process is more transparent in these highly asymmetric transactions and many clients value this option.

 

-Carvana, despite the "story" and the vending machine concept is not that different from Carmax.

 

-Carvana, even if can grow, carries significant execution risk.

 

-IMO, Carvana's financial setup contains many non-transparent issues (class structure, insider arrangements).

 

-Established players can adapt to changing consumer behavior within their actual structure especially if they already have a national presence.

 

-Carvana's story could go on for a while with the easy money potentially available but that too may change.

 

[KJP]

I recently came across two bullish writeups on Carvana that provide a counterpoint to the skepticism shown by me and others:

 

http://www.haydencapital.com/wp-content/uploads/Hayden-Capital-Quarterly-Letter-2018-Q4.pdf [starts on page 12]

https://www.valueinvestorsclub.com/idea/CARVANA_CO_CVNA/7557201389

 

There are many assumptions in both, such as extrapolating past cohort penetration rates into new markets, that are very hard to assess.  But I think the writeups illustrate what has to happen for the business to be successful and provide a starting point for thinking through potential strengths and weaknesses of the model. 

 

I think both writeups could be strengthened by having more explanation about why CarMax can't copy what Carvana's model if it proves to be successful.   

 

 

[ebdem]

Here are some more bullish arguments on Carvana by Cliff Sosin:

[lucasnascimento]

How do you think about the voting rights being in control of Ernie's father? How can I sleep well as the owner of the company was once guilty in relation to fraud? I really like the company and Ernie (the CEO), but that ownership structure is frightening. I am more inclined to believe that the father's past story can be a potential source of alpha given that lots of funds just skip looking at this company because of his track record, so I am looking for compelling arguments on why the structure may not be a problem on this case. Thanks

[gfp]

So CVNA is interesting to me from the short side.  I noticed they just raised $600 million in equity at $45 per share ($50 mil from father and son "Ernie"s).

 

Bloomberg and other sites are showing market cap at $12 Billion.  Is this right?  I thought only one class of shares had any economic interest and the other class was just super-voting.  Can someone who follows this stock chime in on the current share count (for economic purposes).  13.3 million shares have been issued since the last 10-Q.

 

What is the market cap of this thing?

 

*edit: my best guess is 169 million shares since there are LLC units that can be converted into class A shares.  So Market Cap is over $13 Billion

[BRK7]

So, CVNA reported 1Q results last night.  Revenue was +45% in line with expectations.  But the net loss grew by 122%, and the reported EPS of -$1.18 was, $0.59 shy of consensus, according to Seeking Alpha.

 

I found the conference call to be was surreal in how promotional/positive it was.  Maybe it worked---the stock is up 10% today and approaching $100, even as Morgan Stanley lowered its price target to $23.  On the other hand, there are major brokerage firms with a bullish view.

 

However it ends up, this is going to be interesting.

[thepupil]

anecdotally, I have been in the market for a car and I keep checking posted prices of various vehicles over the past month or two. Car gurus rates whether or not a car is a "good deal". Carvana cars over the past month or two have migrated from generally not being good deals to mostly being good deals. I don't know if this is because used car prices are dropping generally so Cargurus rating system is not re-valibrating quickly enough to lower prices, or if this is because Carvana is selling inventory at less profitable prices.

[Packer16]

I was in the market for a used car last year so I thought let me give Carvana a try.  I found the same car for $1,000 less at a local privately owned used car company (Auction Direct).  I initially went to AD to test drive the type of car I wanted but found the same model & age car for $1,000 cheaper & another Toyota wo the NAV package for an addition $1,000.  It was not until I did the test drive that I found out I do not need the nav package so I was able to $2,000 versus Carvana.  So IMO the low cost approach here appears to be marketing stick.  What have been others experiences?

 

Packer

[Guest roark33]

CVNA seems like a great example of people pointing out the obvious problems in their business models and they might be wrong for a long time till they aren't. 

[KJP]

I was in the market for a used car last year so I thought let me give Carvana a try.  I found the same car for $1,000 less at a local privately owned used car company (Auction Direct).  I initially went to AD to test drive the type of car I wanted but found the same model & age car for $1,000 cheaper & another Toyota wo the NAV package for an addition $1,000.  It was not until I did the test drive that I found out I do not need the nav package so I was able to $2,000 versus Carvana.  So IMO the low cost approach here appears to be marketing stick.  What have been others experiences?

 

Packer

 

If you're willing to haggle a bit and walk out, Carvana is not cheaper.  But based on the success of CarMax and many people I know, there are alot of people who hate negotiating.

[KJP]

Hayden Capital's Q1 letter has an interesting discussion of some business model developments at Carvana:  http://www.haydencapital.com/wp-content/uploads/Hayden-Capital-Quarterly-Letter-2020-Q1.pdf

 

This looks like a smart move to me.  At bottom, Carvana appears to be a logistics business that presumably needs route density to be profitable, so running third-party inventory through the logistics system for a fee makes sense, particularly where they also get to keep the high margin business of selling ancillary products like financing and gap insurance.  But I'd be surprised if this doesn't really squeeze traditional dealers who participate by stripping them of those high margin revenue streams.   

[Jurgis]

I was in the market for a used car last year so I thought let me give Carvana a try.  I found the same car for $1,000 less at a local privately owned used car company (Auction Direct).  I initially went to AD to test drive the type of car I wanted but found the same model & age car for $1,000 cheaper & another Toyota wo the NAV package for an addition $1,000.  It was not until I did the test drive that I found out I do not need the nav package so I was able to $2,000 versus Carvana.  So IMO the low cost approach here appears to be marketing stick.  What have been others experiences?

 

Packer

 

If you're willing to haggle a bit and walk out, Carvana is not cheaper.  But based on the success of CarMax and many people I know, there are alot of people who hate negotiating.

 

I rather hate negotiating. But I'd have hard time buying used car without a test drive. The last two times I bought used car, I went to a dealer and the first one I took on a test drive had serious issues. One did not start. Another one had some other electrical problems I think. Yeah, Carvana allows 7 day return, but that's a huge hassle IMO.

 

Although, yeah, I looked at the website and some cars/prices seem to be OK. So if I knew it's not gonna be a lemon, I might buy... (that's assuming I'm not gonna go electric with next car).

[fareastwarriors]

Go electric and never look back.

8)

[NoCalledStrikes]

I shopped Carvana last year looking for a cheap used car for a teenager.  Carvana online shopping was easy, the selection was good for what appear to be mostly off-lease cars, and I seriously considered buying one car in particular and went through all the clicks to get near a purchase. However, the prices were clearly high, aka Carmax level pricing.  Being a value guy, I held off and eventually ended up with a better car (older, cheaper, but still low miles) for less money. However if I properly valued my time, I should have paid the Carvana price and just had the car show up in my driveway by magic, rather than spend my life visiting 6 lots across town to see junky cars and talk to weaselly car dealers. 

 

Life is short, car lots are hell.  Someone who figures out how to sell used cars at attractive fixed prices is going to make a killing. Carmax seems to be onto something, but their inventory management seems to bite them in the butt every now and then as used cars depreciate quickly in different cycles. Also sourcing anything but rentals and offlease is hard to do in volume, so Carvana's use of consignment vehicles may be the ticket.

 

 

 

[Packer16]

Hayden Capital's Q1 letter has an interesting discussion of some business model developments at Carvana:  http://www.haydencapital.com/wp-content/uploads/Hayden-Capital-Quarterly-Letter-2020-Q1.pdf

 

This looks like a smart move to me.  At bottom, Carvana appears to be a logistics business that presumably needs route density to be profitable, so running third-party inventory through the logistics system for a fee makes sense, particularly where they also get to keep the high margin business of selling ancillary products like financing and gap insurance.  But I'd be surprised if this doesn't really squeeze traditional dealers who participate by stripping them of those high margin revenue streams. 

 

The real problem IMO about the third-party inventory is your typical dealer does not like Carvana & the last place they would place a car is with these guys.  Dealers respect CarMax not Carvana.  The ancillary business has been very disappointing to date versus CarMax & if they cannot make more progress there I think these guys are toast.  If you are thinking about investing here test drive their product versus the competition.  It may look good in powerpoint presentations & for investors but in real life I found Carvana to be marketing fluff.  What do I know I am a cheap value investor.

 

Packer

[Packer16]

I was in the market for a used car last year so I thought let me give Carvana a try.  I found the same car for $1,000 less at a local privately owned used car company (Auction Direct).  I initially went to AD to test drive the type of car I wanted but found the same model & age car for $1,000 cheaper & another Toyota wo the NAV package for an addition $1,000.  It was not until I did the test drive that I found out I do not need the nav package so I was able to $2,000 versus Carvana.  So IMO the low cost approach here appears to be marketing stick.  What have been others experiences?

 

Packer

 

If you're willing to haggle a bit and walk out, Carvana is not cheaper.  But based on the success of CarMax and many people I know, there are alot of people who hate negotiating.

 

Thing is I did not have to negotiate to that deal.  It was the sticker price.  I hate negotiating for cars also so I found this a pleasant surprise.

 

Packer

[JWK]

One of the main advantages Carvana claims is that since they´ll be able to cover entire country their selection pool will be far larger than their competitors, but this assumes that the carpool of any given market is limited.

 

I live in Sweden (10m) and we have a functioning second-hand online market for cars (www.blocket.se) even though we have a small population given our rather large size. The reason from what I understand is that the main activity is in mainly 10-20 different types of cars and outside of those the market is per definition niche. This would imply that Carvana is trying to create a scale-advantage based on a niche-market.

 

I´m not saying this company will fail, and their development clearly shows they´re on to something, but 2,5% market share after 5 years on their starting market seems rather low if they´re valued at 5x sales without a profit.

 

 

[Spekulatius]

Never dealt with Carvana before. I do agree that a haggle free experience and return option may be worth something. In haven’t dealt with Carmax either, but Heard- that it’s actually a good source if you looking for some rare vehicles that may be hard to get at locally.

 

Just poking around my beloved late model Subaru’s, it is clear I can get better deals locally than I can get at either Carmax or Carvana. One deal here is just a dozen miles from  me and offers even home delivery, ~5% below Carvana prices. Of course mileage (pun intended) varies across location and model.

 

Looks like it is actually a great time to look for a used car right now, as prices look better than they used to be.

[fareastwarriors]

Father, Son Used-Car Sellers Get $5 Billion Richer in a Day

 

 

Online used-car company expects record sales, profit margins

Carvana, which rallied 31% Tuesday, has never posted a profit

 

https://www.bloomberg.com/news/articles/2020-09-22/father-and-son-used-car-sellers-get-5-billion-richer-in-one-day