Summary
Carvana's reported 2Q23 total GPU and adjusted EBITDA are unsustainable.
Despite the debt restructuring's positive headlines, the term details (esp Y2025 notes repurchase agreement) reveal creditors' desire to exit.
Creditors are cautious, and equity holders are excited. Whenever they take different views, I am inclined to take my cue from creditors. This case is no different.
Joe Raedle
Background
After its 2Q23 earning release and debt restructuring announcement on July 19, Carvana $Carvana Co.(CVNA)$'s stock skyrocketed 50%+ and closed above $55/share. Its 8x YTD stock performance left its peers AutoNation $AutoNation(AN)$ and CarMa $CarMax(KMX)$ in the dust.
Data by YCharts
2Q23 Earnings/Debt Restructuring
If we take a look at the headlines, it is impressive.
On earnings, 2 KPI charts look promising:
Highest adjusted EBITDA ($150Mn) in the company's history.
Highest GPU (GAAP: $6520) in the company's history
CVNA (2Q23 Shareholder letters)
CVNA (2Q23 Shareholder letters)
On its debt restructuring, the headline says it:
Reduced interest expense by $430Mn/year for 2 years.
Reduced total debt by $1.2Bn.
Eliminated 83% of Y25/Y27 note maturities.
It sure was making a convincing case that Carvana hit a home run.
When I noticed that Apollo led the debt restructuring on the opposite of the table, I was obliged to dig deeper beyond the headline as I ask myself when was the last time Apollo took a nap, and let anyone steal their lunch?
In this article, I examined under the hood and discussed what's behind 2Q23 ER and debt restructuring headlines and what it all means.
To make sense of the whole situation, it is important to take a detour first to talk about Carvana's acute challenges.
Carvana's Challenges
In one word, it is cash flow.
Carvana has been a cash-burning machine. Its operation has burnt over $5Bn cash since 2020, and together with its $2.2Bn acquisition of ADESA in Y2022, It added nearly $7Bn liability (long-term debt, short-term borrowing, payable) on its balance sheet since 2020.
Carvana has embarked on a business turnaround plan since early this year. It aggressively cut operating expenses to the bone (OpEx ~$400-450Mn/qtr), and even managed to generate some positive cashflow this quarter (thanks to inventories reduction)
With its cut-to-the-bone $400Mn to $450Mn a quarter OpEx, napkin math shows a near operation break even (70k+ retail units sold, with normalized $6k total GPU).
The challenge is, with the marketing/sales expense cut, and inventory reduction, its current level of sales/GPU margin is still not sustainable (despite already a 30%+ YoY volume decline)
Not to mention its ~$500Mn/year interest payments (prior to debt restructuring). With less than $1Bn cash and equivalent on the balance sheet, that interest payment alone will deplete its cash by Y2024.
Under the hood of the Debt Restructure
Let's highlight how the deal achieves the headline fairy tale.
Saving $430Mn/year interest for 2 Years - No, this interest doesn't go away. That's achieved via the debt's PIK feature: instead of paying interest, it adds back to the debt. It is like a credit card's minimum monthly payment feature, except for the first 2 years, the minimum monthly payment is zero, and all unpaid interest will be added to the principal.
Reduce total debts by $1.3Bn. Its current total debt is $5.66Bn, the proposed new debt is up to $4.38Bn. I believe that is what it refers to $1.3B saving. Does it mean the bondholder waived over $1B debts outstanding? As I went through its sec 8k, I don't believe it was specifically talked about. However, note the following:
Concurrently with, but separate from the Exchange Offers, the commencement by the Company of a cash tender offer to purchase certain 2025 Notes;
In other words, the exchange offer is not an entire exchange from existing debt to new debt. A portion of it will be repurchased via the company cash tender offer at 96.25% of its face value (as a result of the equity raise).
Unlike existing unsecured debts, new debts are secured by Carvana and ADESA assets. There is a subtle point here - the new debts sit above the existing debts on the credit stack. In other words, any existing bondholder that is resistant to joining the new debt will be at risk of being pushed down the credit stack. That probably explains why 90% of bondholder interests are behind the new agreement.
Existing Debts (10-Q filing)
New Debt Agreement (10-Q filing)
Under the Hood of 2Q23 ER
GPU and adjusted EBITDA are Carvana's 2 favorite KPIs, both have reached its historical high in the 2nd quarter of 2023.
Management narrative is that it demonstrates its operating leverage, it will continue to improve and becomes a very profitable business.
But if we examine underneath the hood, it is clear that both KPIs are at their peak thanks to a combination of company-specific and macro tailwinds (e.g., sold aged excessive inventory when the resale price went up, higher than normalized loan sales volume, and favorable used vehicle market).
By Carvana's estimate, it increased gross profit by $70Mn for the quarter. As these gross profits flow through straight to EBITDA, these non-recurring benefits made up ~50% of 2Q23 claimed EBITDA.
Here is what the company discussed in the 2Q23 shareholder letter.
2Q23 (shareholder letter)
2Q23 (shareholder letter)
Put all pieces together
Carvana had no choice, it needs the debt restructuring to alleviate its interest payment burden to give itself a longer runway and a chance to survive.
If Apollo (and its fellow bondholders) really liked Carvana's business, it could have deployed its 'Loan-to-own' strategy. As it has played many times before, it can drag debt negotiation, exhaust all patience/hope of equity holders, and throw the last resort solution to convert its debt to equity and own the company for cheap. That's how it did with Caesars Entertainment $Caesars Entertainment(CZR)$ in 2015 and recently with Avaya in 2022. To learn more about Apollo's 'Loan-to-own' strategy, you might find great details in this book on how Apollo dealt with Caesars.
They are clearly not doing that. Having no desire to own the business, bondholders work with Carvana to navigate a narrow path to keep the turnaround dream alive.
That's how the debt restructuring is engineered to highlight its positive headlines. It is followed by an encouraging quarterly result that reinforces the management narrative that business turnaround progresses well, and its 3-step business transformation is on track to profitability and growth.
Bondholders gave a big concession to get PIK (payment-in-kind, essentially adding the interest back to bond principals) in lieu of interest payment for the next 2 years.
In return, Carvana agreed to repurchase any 2025 notes tendered at the price of 96.25 cents for $1 as a result of the equity raise.
These 2025 notes were traded at around $0.65 per $1 right before the debt restructuring. We will watch closely % of that 2025 debt will be tendered and repurchased. I won't be surprised that a vast majority part of the Y25 notes will be tendered.
Some might argue that by allowing PIK in the debt restructuring, creditors show confidence in Carvana's future. I would counter that is likely a shrewd move by the creditors to decorate some positive headlines, ignite capital market interest, and ensure a smooth equity raise.
In Summary
If we take a step back, the essence of this debt deal is bondholders defer near-term interest payments (for the next 2 years), to allow the company to ignite a sufficient amount of capital market interest, primed the best possible operating results, and raised funds.
In return, some of the equity raised will be used to repurchase bondholders' Y2025 notes.
Also, worth noting as a part of the restructuring, the new debts are now secured by Carvana and ADESA assets, with much higher interest going forward.
Whenever credit and equity holders have a different view of a company, and take the opposite side, I am always inclined to take my cue from creditors.
Carvana's case is no exception.
Source: Seeking Alpha
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