Summary
Carvana has become a ten-bagger, rising more than 1,100% since the beginning of the year.
Although many shorts and Carvana bears are attributing these massive gains to the effect of a short squeeze, I believe credit should be given where it is due.
Carvana has made noteworthy progress from a financial performance perspective this year, and the company has been helped by the recovery of used car prices.
This analysis focuses on the positive adjusted EBITDA reported by the company for the second quarter. Digging deep into the earnings report, I have found several challenges that are concealed by positive adjusted EBITDA.
A few interesting pieces of commentary buried in the Q2 earnings report suggest Carvana is scaling down aggressively, inflating short-term profitability and boosting several business metrics.
Justin Sullivan/Getty Images News
When it comes to investing, I believe investment returns matter more than being right or wrong. The obvious question is whether an investor can continue to gamble, take uncalculated risks and enjoy lucrative returns consistently in the long run, but there is no harm in acknowledging that there are different strategies that work for different investors. This is why I want to congratulate investors who loaded up Carvana Co. $Carvana Co.(CVNA)$ shares at the end of last year while the outlook was grim with no recovery in sight. And if you are one of those investors that took a leap of faith, you were not alone. In an exclusive article for Beat Billions members, I highlighted last February how George Soros was betting on Carvana despite the company showing no signs of recovery. Carvana has become a ten-bagger, rising more than 1,100% since the beginning of the year. Although many shorts and Carvana bears are attributing these massive gains to the effect of a short squeeze, I believe credit should be given where it is due. Carvana has made noteworthy progress from a financial performance perspective this year, and the company has been helped by the recovery of used car prices. If not for these positive developments acting as catalysts to improve investor sentiment, a high short interest would have had no impact on CVNA stock.
Carvana's second-quarter earnings report discusses several areas of progress, including positive adjusted EBITDA, a debt restructuring deal, and record gross profit per unit. These numbers are truly impressive, but a look under the hood reveals the company's financial position is not as good as it sounds. While acknowledging the progress Carvana has made in recent months to turn its prospects around, I believe investors are better off booking the gains and never looking back.
Carvana's Positive Adjusted EBITDA Conceals Challenges
A couple of fellow Seeking Alpha analysts have already dug deep into Carvana's second-quarter earnings report, so I will not summarize Q2 earnings. These analysts have done a wonderful job discussing the implications of the debt restructuring deal as well. I will focus on discussing some of my interpretations of the company's adjusted EBITDA. Before I jump into the numbers, let me highlight what Warren Buffett wrote about EBITDA in his annual shareholder letter in 2000.
When Charlie and I read reports, references to EBITDA make us shudder - does management think the tooth fairy pays for capital expenditures? We're very suspicious of accounting methodology that is vague or unclear since too often that means management wishes to hide something.
For the second quarter, Carvana reported an adjusted EBITDA of $155 million, a notable improvement from an adjusted EBITDA loss of $216 million in Q2 2022. The following reconciliation shows how Carvana calculates adjusted EBITDA.
Exhibit 1: A reconciliation of net loss to adjusted EBITDA
10-Q
I am not a huge fan of using adjusted EBITDA as a profitability metric. Last month when I saw a news headline highlighting Carvana's plans to be "profitable" by the second quarter, I immediately went and rechecked the financial statements as I knew the company would never be able to be profitable this quickly. Then I realized the news item was referring to adjusted EBITDA, a questionable metric that was once supposed to give investors a clearer picture of a company's cash flow profile and profitability. That being said, as the above table illustrates, the biggest boost to Carvana's second-quarter adjusted EBITDA came in the form of a massive reduction in net loss from $439 million to $105 million. In isolation, this is a very positive development. As investors, however, we need to dig deeper to understand how Carvana's net loss dramatically improved on the back of a 24% decline in revenue.
A closer look at the components of Carvana's selling, general, and administrative expenses reveals the company slashed its costs aggressively, boosting operating income, and thereby adjusted EBITDA. Many factors helped Carvana report lower SG&A expenses compared to the previous year.
A reduction in compensation benefits that was enabled by trimming its headcount by more than 4,000 employees since May 2022.
Integrating the properties acquired as part of the ADESA acquisition while reducing the overall corporate footprint to account for the lower number of employees now expected to work from offices.
A substantial reduction in the marketing budget.
The changing stance on aggressively hiring employees is a positive development, which, in my opinion, will help Carvana report a permanent improvement in operating margins. The problems come to light when we evaluate the aggressive reduction in advertising spending.
Exhibit 2: A comparison of SG&A components between Q2 2022 and Q2 2023
10-Q
Advertising costs have been slashed from $131 million to $57 million. Rather than looking at this reduction in isolation, we need to accompany this observation with two interesting pieces of commentary included in company filings (emphasis added).
The reduction in retail units sold contributed to reductions in several categories of selling, general and administrative expenses.
While we intend to become increasingly efficient over time, we also anticipate that our operating expenses will increase substantially in the long term as we continue to expand our logistics network, increase our advertising spending, and serve more of the U.S. population. There is no guarantee that we will be able to realize the desired return on our investments.
What is evident from this commentary is that Carvana is scaling down today by selling fewer retail units to keep operating costs in check. Although Mr. Market will cheer a notable improvement in adjusted EBITDA in the short run, there is no way that Carvana will turn GAAP profitable without scaling aggressively from here. Managing costs to boost financial performance metrics in the short term is not a characteristic that I would expect from a company that I feel comfortable investing in.
There are more warning signs under the hood. While gross profit per unit reached a record high of $6,520 in the second quarter, many other key operating metrics trended lower. For instance, retail units sold declined by 35%, the average monthly unique visitors to Carvana's website decreased by a staggering 38%, and the inventory of vehicles available for sale on the website dwindled by a mammoth 52%. These are all pointing in one direction; Carvana has aggressively scaled down, improving adjusted EBITDA and other profitability metrics.
If we look at the inventory level of the company, we see another risk that is looming on the horizon. Before we discuss this looming risk, let me highlight another piece of commentary from the Q2 report which highlights how Carvana chose to scale back to improve certain financial performance metrics (emphasis added).
Moreover, growth in total website units indicates our ability to scale our vehicle purchasing, inspection, and reconditioning operations. As part of our inventory strategy, over time we may choose not to expand total website units while continuing to grow sales, thereby improving other key operating metrics of the business.
Although the company acknowledges the importance of expanding total website units, the company may, at times, choose not to scale in a bid to improve operating metrics. This is exactly what we are seeing today. Subsequently, in the second quarter, the value of the vehicle inventory declined to $1.3 billion from $1.9 billion a year ago. There is nothing wrong with managing inventory levels efficiently to drive profitability, but this also means that Carvana will have to acquire vehicles aggressively in the future to meet the demand for vehicles. Similar to how Carvana suffered in 2022 because of an inventory that was accumulated at higher prices, I fear the same thing could occur all over again if used car prices substantially decline soon after Carvana decides to expand its inventory. As illustrated below, used car prices recovered in the first quarter of this year before beginning a descent.
Exhibit 3: Manheim Used Vehicle Value Index
Manheim
Car affordability in the U.S. does not look good today, with the average finance rate for used cars continuing to climb higher.
Exhibit 4: Average finance rate of used car loans
Federal Reserve
I believe it is too early to claim that the U.S. has successfully avoided a recession, and the used car market can very much fall dramatically in the coming quarters. In the worst-case scenario, Carvana may end up building inventory before this possible collapse in car prices, making it difficult for the company to offload inventory at attractive prices. This risk, in my opinion, is not accurately reflected in Carvana's current market value.
Takeaway
Carvana is valued as a growth company with years of growth ahead, but the company's recent strategic decisions resemble that of a mature company trying to improve profitability. A classic recent example of a company that prioritized profits over growth and thereby got into a lot of trouble is The Kraft Heinz Company $The Kraft Heinz Company(KHC)$. Kraft Heinz slashed advertising costs substantially to improve profitability, only for the company to lose market share in the long run. I am not saying Carvana is headed that way, but I believe the positive adjusted EBITDA reported by the company for the second quarter looks much better on paper than it actually is. The debt restructuring deal and the equity capital raise are two prudent moves that will allow Carvana some breathing space, but these decisions by no means are sustainable business moves that could be repeated to drive long-term earnings growth. Rather, these are necessary yet evil measures that had to be taken to survive, and I am not ready to invest in a company that has been forced to survive when its initial plans involved growing aggressively to disrupt the second-hand vehicle market. Carvana's equity raise somewhat resembles that of Bethlehem Steel back in the 1990s as well, but it's too early to give a verdict, so I will monitor the developments from the sidelines. Investors who have been courageous enough to bet on Carvana a few months ago should, in my opinion, consider booking the gains at these elevated stock prices.
Source: Seeking Alpha
Comments