Carvana: Illuminating the Path

When do they press the button?

Carvana reported its first-quarter results on May 4th. For context, the company had previously provided very encouraging preliminary first-quarter results in late March that the market seemed to oddly underreact to, which I wrote about in Carvana: The Disconnect. Interestingly, Carvana’s actual first-quarter results came in at or above the high end of the previously announced preliminary results. CVNA closed up 24% the day after earnings and is currently trading about 108% higher than its pre-earnings close.

While that sort of stock price move would be huge in almost every other situation, I consider this move fairly muted. Why? Well, 18 months ago Carvana was a 50%-100% annual grower that was consolidating the U.S. used car industry with a triple-digit stock price and a ~$50 billion market cap. These days it is widely thought of as a shitco that never made economic sense that is destined for bankruptcy with a (until very recently) single-digit stock price and a ~$2 billion market cap. Before earnings, the stock was down 98% from its August 2021 all-time high of $370 per share. Today, despite the 108% move higher this month, the stock is still down 96%. So whether we’re talking about a $7.20 stock or a $15 stock, the equity market value is either $1.4 billion or $2.8 billion. Frankly, there isn’t much difference when considering that surviving this used car recession intact and eventually prospering would put the company’s stock price in a completely different galaxy.

Carvana offers investors a binary outcome. Either the company gets to free cash flow neutral before running out of liquidity resources (and without unacceptable levels of equity dilution), in which case it will be back on a path towards selling two million retail units annually and more over time at attractive unit economics. The stock price would be a clear multi-bagger from the current price. On the other hand, if liquidity resources are exhausted and they are forced to raise equity or swap debt for equity at depressed prices or even file Chapter 11, equity investors would clearly do less well.

An investment with a fairly binary outcome should be priced like an option. If it works, it can grow in value by several multiples. If it doesn’t, it could go to zero. So the investment should be priced based on the perceived probabilities of the different outcomes. To state what should be obvious, the probability of the company surviving intact and returning to growth clearly increased with its first-quarter report. The company is very likely to turn profitable on an adjusted EBITDA basis in the current quarter—which is management’s guidance—and appears to have several levers to continue improving non-GAAP GPU and reducing non-GAAP SG&A in the coming quarters. In the not-so-distant future, management is going to start to pull the growth levers again, notably by increasing advertising and inventory selection off low levels, which will almost certainly increase retail unit volume, which in turn should grow adjusted EBITDA to increasingly offset the large amount of interest expense.

In December, co-founder and CEO Ernie Garcia estimated that ~40% of the retail unit decline was self-inflicted; that is, relating to their decision to reduce advertising, inventory selection, exit certain markets, and the general prioritization of profitability over growth. The other 60% of the volume decline was related to macroeconomic conditions impacting used car affordability, namely high used car prices and high auto loan rates. So I believe bringing back a large portion of that 40% lost volume attributable to its profitability initiatives is largely under the company’s control whenever management decides to ease up on the self-inflicted headwinds. For example, when the time is right, it will increase advertising and inventory selection, both of which are known to improve traffic and sales conversion.

Pushing the Button

Management has outlined its plans in terms of three steps.

Against all expectations just weeks or months ago—consensus adjusted EBITDA for the year was -$453 million going into first-quarter earnings, which I highlighted in Carvana: The Disconnect—Step 1 is now suddenly in the bag. Carvana just reported -$24 million of adjusted EBITDA in the first quarter and has guided to positive adjusted EBITDA in the current quarter. That is a long way from the -$291 million in the fourth quarter. Here’s the context, including my guess for 2Q:

Management is now working on Step 2. That means continuing to drive non-GAAP GPU up and drive non-GAAP SG&A per unit down. Remember the key formula:

(Non-GAAP GPU - Non-GAAP SG&A per unit) x retail units = Adjusted EBITDA

While adjusted EBITDA is far from true cash flow—interest expense and capex is another substantial hurdle to overcome—it is certainly the key building block on the road there. And of course, stock-based compensation is a real economic expense, but it’s also non-cash and not relevant when evaluating liquidity.

What’s most interesting to me is the question, “When does management go to Step 3 and push the growth button?” They say they want to complete Step 2—drive the business to “significant positive unit economics”—first before pressing the button. And if you listen to them, it sounds like it could be another 9-12 months of cost cutting first. Here’s Ernie on the first-quarter call:

If you take that at face value, it seems like they plan to continue optimizing the unit economics for the rest of 2023, more or less, before starting to turn the growth dials up again. That would be a great outcome that would more than likely send the stock soaring at some point.

But at the same time, I wonder whether…

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