Stock Carvana: Bankruptcy May Be Inevitable (NYSE: CVNA)

Joe Raedle

Carvana (New York stock market :NYSE: CVNA) is a growing brand that people recognize as a go-to platform for buying and selling used cars. Carvana is generally easier and faster to manage than other platforms, making it a top choice for young car buyers and sellers. Carvana also presents itself as creating important savings for buyers thanks to its rationalization online platform.

Carvana has grown rapidly over the past two years as the lockdown caused many people to avoid in-person car dealerships. Additionally, as new car production dwindled due to numerous shortages in the supply chain, Carvana benefited from a boom in used car prices and sales. However, the company’s financial losses have increased dramatically, as the more cars it sells, the more money it appears to be losing. To make matters worse, the used vehicle boom appears to be over as used car prices have become much more expensive leading to a drop in demand. Additionally, rapidly rising interest rates have made financing used vehicles much more expensive, leading to a significant drop in demand for all vehicles.

To offset the massive decline in cash flow, Carvana relied on immense equity dilution and debt financing to maintain a positive cash balance. There are, in my view, no signs that the company will post positive operating profits in the next few years. Additionally, the company’s heavy interest charges may make actual net earnings unsustainable given today’s higher borrowing rates. CVNA has already lost about 85% of its value and I believe will likely go bankrupt within the next year as it becomes impossible for the company to continue borrowing while losing billions. While the downturn in the economy (particularly in automotive) may accelerate this trend, I believe it is inevitable due to the competitive nature of Carvana’s core business model.

The used car market is expected to slow further

In 2020, Carvana saw immense revenue growth thanks to a boom in used car sales. The spike was created by a variety of factors, including a major drop in new vehicle production, a huge increase in personal savings, and a massive drop in borrowing costs. See below:

Chart
Data by Y-Charts

In 2020, there was a sharp decline in vehicle production combined with a significant increase in personal savings. The increase in savings was driven by stimulus checks, additional unemployment benefits and reduced spending outlets. This trend has triggered a surge in demand for vehicles, as evidenced by the spike in auto loan debt in 2021. New vehicles have become more expensive, but used cars have grown faster due to the lack of inventory of new vehicles. See below:

Chart
Data by Y-Charts

After declining for years, used vehicle prices have increased dramatically over the past two years. The price ratio of used vehicles to new vehicles has also proliferated (note that the unit on the price ratio table is arbitrary). However, in 2022, the price ratio of used cars to new vehicles flattened out and showed signs of a smaller decline. As the first chart shows, new vehicle production in the United States is growing rapidly as supply chain shortages end. At the same time, flattening auto loan data and weak personal savings imply that demand for all vehicles has fallen significantly. Overall, these data indicate that Carvana is likely facing weaker demand and may soon have to offload inventory at a significant loss.

Carvana’s risk of bankruptcy is very high

The general direction of the US economy is a controversial topic today. That said, it is quite clear that the general direction of the US vehicle market is down. A variety of factors are driving the “auto recession”, including renewed supply growth, high vehicle prices, higher financing costs, decline in real wageslow personal savings and bad consumer sentiment. The auto industry is highly cyclical, so its collapse should come as no surprise given its recent boom.

In my opinion, Carvana will probably not survive this bust. To make a consistent profit, Carvana must sell vehicles at a higher price than it bought, with the difference large enough to offset all of the company’s many overheads. The company has a positive gross profit of around 10%, implying that it is selling cars above purchase price, but this ratio has dropped significantly over the past year as demand for vehicles used having slowed down. At the same time, Carvana’s inventory remains very high, implying that the company may need to further reduce selling prices to maintain cash balances. See below:

Chart
Data by Y-Charts

Last quarter, Carvana posted a larger revenue loss of $238 million, but reported positive operating cash flow due to lower inventory. The company’s ability to restore its balance sheet hinges on the continued decline in inventory. However, with the spike in used car prices and probably decliningCarvana will likely sell in a weakening market, which means its gross profit margins could decline further in coming quarters.

To generate a positive operating profit, I believe that Carvana will need to maintain a gross profit of at least 16-18%, although potentially higher, because it is unclear where its operating expense to sales ratio will stabilize. At this point, it is unclear whether Carvana can generate a consistent operating profit, as its business model may not be able to maintain gross margins high enough to offset operating costs. Also, in my opinion, it is doubtful that Carvana can generate a consistent profit given that a large portion of its gross profit is also allocated to interest charges. See below:

Chart
Data by Y-Charts

The ratio of operating expenses to revenues seems to be stabilizing around 18%, while an increasing share is devoted to interest expenses. This trend will likely increase as long as Carvana faces negative cash flow as it dilutes shareholders and significantly increases debt. See below:

Chart
Data by Y-Charts

Overall, I think it’s clear that Carvana is on the brink of insolvency. Opinions on this issue likely differ, and many analysts believe the company’s earnings will eventually turn positive. Indeed, the stock rose significantly on Monday after Piper Jefferies said it was undervalued due to its sharp drop in price, despite the agreed risk of bankruptcy being a “true” probability. Tome, given Carvana’s declining gross margins, high inventory, slowing used car market, rising borrowing rates and spiraling debt growth, Carvana’s bankruptcy is almost inevitable and could occur in the coming year, given the confluence of negative catalysts.

The essential

Overall, I think investors would be wise to steer clear of Carvana, as it looks likely CVNA will decline toward zero as it sinks deeper into insolvency. The macroeconomic turn against the used car market is certainly accelerating this potential. However, I believe that its eventual failure is almost inevitable because of its business model.

In my opinion, Carvana’s business model is great in theory and works well for buyers and sellers, but it can’t generate enough gross profit to offset operating costs. Additionally, Carvana’s online footprint opens up potential for competition, and with expensive purchases like vehicles, people will almost always gravitate to the platform where they find the best prices. With this in mind, it may be impossible for Carvana to sustainably increase selling prices. Of course, a positive operating profit can be achievable if the company could sufficiently reduce operating overhead.

Even then, I think the risk of Chapter 11 bankruptcy is still high due to its interest charges and soaring financial debt. Still, I wouldn’t personally short CVNA today. The stock is around 90% below its 52-week high and has a substantial short interest level of 30%. These factors give CVNA a relatively high squeeze risk, especially given the popularity of its brand. However, I might be more willing to bet against the stock if the stock faces a big enough squeeze to lower its short-term interest level below 10-15%,

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