Speculative technology stocks have been on a wild ride the last five years, but online used car dealer Carvana CVNA is an extreme case:
- The company had its initial public offering in April 2017, closing its first day of trading at around $11 per share (down 26% from the IPO price of $15).
- The stock lurched to a pre-COVID high of $110 per share by February 2020, only to collapse a month later to $29 as the market panicked about the coronavirus pandemic.
- It didn’t take long for investors to realize the pandemic could be a bonanza for Carvana. Consumers were flush with government stimulus money, couldn’t spend it on services like travel or dining out, and were more open than ever to buying things online—even major purchases like a used car. By April 2020, Carvana was nearly back to its pre-COVID high.
- Then the stock really took off, pulled along by the speculative fervor surrounding many technology stocks in late 2020 and early 2021. At its all-time high in August 2021, Carvana was trading for $370 per share.
- The collapse since then has been one for the history books. From the high, Carvana is down almost 99% to a recent price around $5 (as of Dec. 8).
In dollar terms, an investor who put $100 into Carvana on the day of the IPO would have had about $1,000 in February 2020, $260 in March 2020, $3,400 in August 2021, and only about $45 today!
used car retail is a fragmented industry
Retail is inherently competitive, but most segments of the industry have consolidated over the past 50 years—first because of big-box stores and then because of e-commerce. Larger retailers offer better selection and lower prices, which more than compensates for consumers having to drive a bit farther away or losing the personal touch of a neighborhood store. Local grocery stores and general stores lost market share to Walmart and Target. Local hardware stores were displaced by Home Depot and Lowe’s. Eventually, Amazon gobbled up market share across categories, offering superior convenience in addition to better selection and prices.
Automotive retail has been an exception. On the new vehicle side, dealer franchise laws in many states prohibit auto manufacturers from selling directly to consumers, while protecting independent dealers from competition within a geographic area. Tesla has been pressuring states to reconsider these laws, since it only wants to sell its vehicles directly. Larger new car dealership chains have emerged, such as AutoNation and Lithia Motors, but the auto manufacturers are careful not to allow them to get too much market share in any given region. Their national market share is less than 2% for new cars and less than 1% for used.
The used car market has fewer regulatory restrictions, and auto manufacturers don’t get a say over how their cars are re-sold. In terms of volumes, the used car market is significantly larger and less cyclical than the new car market. According to the Bureau of Transportation Statistics, U.S. new vehicle sales averaged about 16 million units annually over the past 20 years, while used vehicle sales averaged about 40 million. Both of those numbers were relatively stagnant during that time—there were cyclical ups and downs, but no secular growth.
That leaves two ways for a dealership to grow earnings: Steal market share from competitors or improve profits per vehicle sold. Fortunately, the industry is so fragmented that there is plenty of room for a top player to gain market share. CarMax KMX is the largest used car dealer, with a retail market share slightly above 2%. Including its wholesale business—where CarMax buys cars from consumers but sells them to other dealers, usually because they don’t meet its quality standards—CarMax touches around 4% of the used cars sold in the U.S.
The transition to a big-box model has been slower than in other retail segments because of the unique dynamics of the used car market. First, there’s the diversity of inventory. Colgate toothpaste is identical whether you buy it at Walmart or Target, but no two used Toyota Corollas are exactly alike. Used cars can differ in terms of the year, mileage, color, condition, historical accidents, maintenance history, and so on. If a consumer has their heart set on a blue Corolla that’s less than three years old with fewer than 30,000 miles, they may be willing to choose a dealer based on who has the car in stock rather than going to the dealer first and selecting from the available inventory.
Second, the way inventory is acquired also makes used car retail unique. It is a true two-sided marketplace, with consumers both selling cars to, and buying cars from dealers. Acquiring inventory directly from consumers is usually more profitable than buying wholesale from other dealers: There’s less competition, less need to ship vehicles between multiple locations, and buyers avoid the fees charged by wholesalers. New car dealers have an advantage here (relative to pure-play used car dealers), because they can acquire inventory through trade-ins and cars coming off leases.
Third, cars are heavy, which makes them expensive to ship and diminishes the benefits of a national network. Shipping an SUV or pickup truck across the U.S. might cost $2,000. Dealers typically pass those costs to customers to protect their already slim profit margins. More often, they try to sell cars in the same market where they acquire them.
Fourth, cars are expensive—the biggest purchase most people make aside from their houses. Dealers and consumers are accustomed to haggling over price, even though it’s an unpleasant experience for both sides. Most consumers want to see a vehicle in person and take it for a test drive before committing to buy it. Financing is a major consideration, with CarMax arranging financing for around three-quarters of its retail customers. And trust is important, since sellers know more about their cars than the buyers do. All of these factors create opportunities for a well-run nationwide dealership, but it takes time to develop operational solutions, scale, and a trusted reputation.
CarMax and Carvana
We own a small position in CarMax in both our Expanding Moat and Defensive Moat strategies. Over the last 30 years, CarMax has brought the same customer-friendly advantages as other big-box stores to used car retail: superior selection; low, no-haggle pricing; guaranteed quality; and a more pleasant shopping experience.
CarMax’s business model has proven surprisingly difficult to replicate. According to Cox Automotive, almost half of used cars are sold in private-party transactions, avoiding dealers altogether. Because selling privately is an option, consumers aren’t willing to pay a big markup to dealers, so margins are tight and there’s little room for error. Dealers need scale to cover their fixed costs, maintain a wide variety of inventory, and make competitive offers when both buying and selling cars. The dealer’s brand is important for customer trust and to keep advertising costs down. A well-established finance subsidiary ensures access to capital on acceptable terms. A large store network helps with logistics costs and makes the stores more convenient for consumers. Even the shift to no-haggle pricing required cultural change on the part of salespeople and shoppers. For the 15 years through fiscal 2022 (ending Feb. 2022), CarMax grew gross profit 8.5% per year and earnings per share 14.5% per year, according to Bloomberg.
If CarMax is the Home Depot of used car retail, Carvana was hoping to be the Amazon. The company promised the same advantages as CarMax, but with the added convenience of being able to complete a purchase entirely online and have a car delivered to your driveway. Carvana’s business took off like a rocket, especially during the pandemic. Revenue increased 35-fold in the five years ending with calendar 2021, or a compound annual growth rate of more than 100%. Gross profit increased more than 100-fold. Carvana had grown to be about 40% the size of CarMax by revenue—with more than double the market cap (at Carvana’s peak)—despite CarMax’s 20-year head start.
There was only one problem: Carvana was never profitable. It started out deep in the red. In 2017, Carvana’s net margin was -19.1%, meaning that for every $1,000 in sales, it lost $191. The company steadily narrowed its losses as it gained scale, eventually reaching a -2.2% net margin in 2021. But that progress hit a brick wall in 2022, with the net margin through the first three quarters of this year deteriorating to -13.5%.
The most benign interpretation of the margin decline is that Carvana simply grew too quickly. Management claimed it was investing ahead of demand, building fulfillment capacity that would be needed as sales volumes grew, but which depressed margins in the short term. When growth slowed unexpectedly, the company ended up with way too much capacity. Management’s proposed solution is to right-size the cost structure for the current demand environment.
But selling over the Internet is not an economic moat. Anyone can create a website. If Carvana was hoping to build a sustainable competitive advantage, the strategy largely depended on two things: (1) having a brand that’s synonymous with online used car buying, so consumers go to carvana.com directly, and (2) having a fulfillment cost advantage by not operating retail stores, instead building out larger “inspection and reconditioning centers” that could benefit from scale efficiencies, lower labor costs, and cheaper real estate (by locating them farther from population centers). This is the basic playbook for any e-commerce company.
While this was a good story for investors, there’s little evidence that Carvana was on its way to developing a brand or cost advantage, even before the recent reversal in margins. The company spent about $2.0 billion on selling, general, and administrative expenses in 2021. CarMax spent $2.5 billion in its comparable fiscal year—only 25% more than Carvana, even though CarMax’s revenue was almost 150% higher. Carvana’s $1,638 in gross profit per retail vehicle sold also badly trailed CarMax’s $2,205.
So, where’s the competitive advantage for Carvana? Operating retail stores seems to be a more efficient model than using a smaller number of inspection and reconditioning centers that are farther from customers, and then having to deliver vehicles to individual addresses. Carvana also spent 47% more on advertising than CarMax for much lower sales volumes in 2021. Combined with the slimmer gross profits per vehicle, the implication is that Carvana was buying attention, instead of seeing its brand truly resonate with customers. CarMax spent a lot more on rent and sales commissions than Carvana, but that appears to have been the better use of resources. CarMax is hardly printing money, but its 2021 net margin was comfortably positive at 3.6%.
Carvana’s near-breakeven performance in 2021 probably wasn’t sustainable in any case. The company benefited from the rapid increase in used car prices that year, which has started to reverse over the past several months. Both CarMax and Carvana flip their inventory relatively quickly—holding vehicles for about two months on average—but during that time they can benefit or be hurt by unanticipated price changes. More importantly, Carvana earned $2,453 in “other gross profit” for each retail car it sold in 2021, up almost 50% year-over-year. Most of this came from the gain on sales of auto loans it originated, which benefited from low and stable interest rates and an unusually favorable credit environment. With sharply higher rates and fears of an economic recession, Carvana’s other gross profit per vehicle fell to $1,860 so far in 2022, and it could get worse if Carvana’s customers start to have trouble paying back their loans.
Carvana’s management has made cost-cutting its top priority, but that will be an uphill battle with volumes now declining. Third-quarter retail units sold were down 8%. While better than the estimated industry decline of 10%-15%, that still means fewer units over which to spread fixed costs. It doesn’t help that Carvana’s quarterly interest expense has more than tripled over the past year, mostly because of the ill-timed acquisition of used car wholesaler ADESA. The company’s bonds are trading at distressed levels, with yields north of 30%, making incremental debt financing prohibitively expensive. Carvana’s net debt is more than five times its current market, which is further evidence that investors see bankruptcy as a likely outcome. I estimate the company is burning around $500 million in free cash flow per quarter, not counting a recent inventory drawdown. Since Carvana only has about $300 million of cash on hand, the need for additional liquidity appears urgent. Issuing more shares might be an option, but it would be massively dilutive at the current share price, adding to the severe dilution already endured by shareholders since Carvana’s IPO.
Overall, Carvana went from hyper growth to the edge of bankruptcy in a span of 15 months. I’m not a credit analyst and I don’t have a strong opinion about how this plays out, but I don’t want to be anywhere near it.
In contrast, I’m optimistic about CarMax’s prospects over the next five to 10 years. The company faces similar near-term headwinds as Carvana, including declining used car prices, a more challenging financing environment, and weaker demand because of higher interest rates and economic fears. However, CarMax is confronting these headwinds from a position of relative strength, starting with having a profitable business model.
CarMax has good visibility into the used car market. It also turns its inventory a couple weeks faster than Carvana, which has helped it hold gross profits per retail unit remarkably steady for the past decade, around $2,200. Retail volumes were down about 6% in the quarter ended Aug. 31, but CarMax appears to be gaining market share. (CarMax reports on an irregular fiscal calendar, so it’s difficult to make an apples-to-apples comparison with Carvana.) Earnings per share were down by 54% in that quarter, reflecting both deleveraging of fixed costs and the investments CarMax is making in its own e-commerce offering. But CarMax still generated positive free cash flow, and its corporate liquidity and financing subsidiary both appear to be in much better shape than Carvana’s. CarMax also has a track record of successfully navigating past downturns, most notably in 2008-09.
CarMax’s e-commerce business is the most interesting part of the story for long-term investors. Management didn’t watch Carvana’s rise from the sidelines. CarMax has invested in every aspect of its online experience: instant appraisals on trade-ins, high-quality photos of cars for sale, pre-qualification and cost estimates for financing, and the ability to complete a purchase fully online. CarMax even offers home delivery in some markets, though most consumers prefer to visit a store and see the car in person before making a commitment. In other words, CarMax can do anything Carvana can do, but the reverse isn’t true: Carvana can’t match the logistics advantages of CarMax’s scale and store network, or give customers the option of a more traditional in-person buying experience. Carvana’s retrenchment should further strengthen CarMax’s competitive position.
five lessons from carvana
I’ll conclude with five lessons from Carvana that I think have broader applicability for our investment strategy:
1. Stock price movements are useless as an investment input. The most important tenet of my investment philosophy is to “think like a business owner,” which means focusing on business fundamentals like revenue growth and earnings, rather than the short-term whims of stock prices. While the current valuation of a stock is an important consideration, the stock’s historical performance is basically irrelevant—we don’t care where a stock has been, only where it’s going. Carvana’s wild ride created plenty of opportunities for an investor to feel like a genius or a fool, but the only thing that matters, in the long run, is whether the company can generate enough free cash flow to cover its debt and provide an attractive return to shareholders.
2. Tactics aren’t a moat. Carvana’s peak coincided with a period when investors were obsessed with “disruption.” The fact that Carvana sold cars online made it new and exciting, while CarMax seemed stodgy by comparison. But e-commerce is a tactic—not a moat—and it’s a strategy that CarMax has been able to imitate. For a sustainable competitive advantage, Carvana would need to demonstrate that it has a structural cost advantage. CarMax appears to have the edge instead.
3. E-commerce is a difficult business. This doesn’t just apply to Carvana. Physical retail was hard enough, but competition is only one click away on the Internet. As described above, there are two ways to build a moat in e-commerce: Have a great brand that brings customers to you directly, so you don’t have to spend as much on advertisements, or build enough scale and network density that it creates a logistics advantage. Amazon has these advantages in spades, but it still hasn’t been enough (so far) for consistent profitability in its e-commerce segment. For retailers not named Amazon, an omnichannel approach that combines e-commerce with physical stores seems to be a better strategy.
4. Unprofitable growth is meaningless. Anyone can sell dollar bills for $0.99. Investors get excited about rapid revenue growth, but it’s only meaningful if it eventually leads to profits. A company that never generates positive free cash flow, or has insufficient free cash flow to pay back its debt, has an intrinsic value of zero. That doesn’t mean all unprofitable companies are worthless, but they do need a path to leverage their costs over time.
5. You have to survive the short term to make it to the long term. I generally focus on what a business will look like five or 10 years in the future, in which case the current macroeconomic environment isn’t that relevant. But Carvana’s continual dependence on external capital put it in an inherently precarious situation—it may not be around to see the “long run.”
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