First, an important note: We have no beneficial interest for or against Carvana.
Carvana has been panned by us here, here, and here, by Grant’s Interest Rate Observer, Seeking Alpha, Medium and by numerous other skilled and historically informed investors. On January 7th of this year, Carvana was the lead out stock in our “Enron look-alikes” list based on a proprietary KCR screen designed to….identify Enrons. To be clear, just because the screen was designed to identify “Enrons,” in no way are we alleging Carvana committed fraud.
On Friday the 13th, Carvana investor relations website revealed a 53 page plan articulating the path to improve the firm’s ailing financial condition. The goal is to modify operations so that financial results lead to less cash burn, less equity issuance and less borrowing. The plan may not get them to FCF break-even after adjusting for SBC financing. Nor does it explain how it could possibly justify the firm’s current valuation.
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For context, AutoNation has revenues of $26.7bn vs. Carvana’s $14.1bn. What AutoNation lacks in “internet branding” and grandiose narratives, it makes up for in cash flow. Where Carvana burned -$3.3bn in the trailing 12 months, AutoNation generated +$1.5bn. Despite this, the equity of both firms trade at ~$7bn dollars. Not surprisingly, AutoNation ranked 167th in our Large Cap Model compared to Carvana, which ranked 851st.
Beware the Management of New Economy Stocks Bearing “Gifts”
- In late 2021, CVNA’s CEO, Ernie Garcia III, granted his employees $100ml in stock in a personal gift the company touted for its ability to reduce CVNA’s taxes in the event of an eventual profit
- The gift was structured so that each employee would receive 23 “Restricted Stock Units” worth $5,000 at the time of the grant, which “…vest after they complete their second year of employment.”
- Having just finished selling a blizzard of stock netting the CEO, his father, and a few others $4bn, one wonders if CVNA’s employees, being handed $5k in stock only to see it lose -80% of its value, might send their already dim rating of the company’s management plunging lower
- Could it be that behavior like this adds to the research done by the head of Wharton’s Forensic Analytics Lab, Dan Taylor, whose research on the rising profitability of insider trading led him to state, “Most Americans today believe the stock market is rigged, and they’re right.”?
While lacking the imagination of WeWork’s “Community Adjusted EBITDA”, Carvana’s “Adjusted EBITDA” is no less intriguing. Loaded with stock-based comp and other add backs, the calculation is novel indeed:
- The firm’s fix for their current cash burn? Massive firings. Accomplished by sacking 12% of their workforce in a manner that would make Al Dunlap blush
- Footnote 2 shows “Adjusted EBITDA” will exclude changes in the value of “beneficial interests in securitizations”
- Footnote 3 highlights that the employee stock gift will also be backed out of “Adjusted EBITDA”
The company notifies investors that their laid-off employees have the “opportunity to receive…the unvested value of previous Carvana Shares, as well as their 1 Million Unit Milestone gift from the CEO.” This strikes us as cold comfort with the stock down ~80% from receiving the “gift.”
In contrast to the fate of the employees, we would note that this company’s timing is remarkable. As Reuters stated, the firm just issued $1.25bn of new stock less than a month ago. Within weeks of that issuance, the stock was cut in half.
Illiquid Assets Feature Large in the Calculation of “Liquidity”
Page 9 of the deck features their calculation of liquidity. A recently acquired company (ADESA) and real estate are the new “liquidity.” We find the idea that ADESA is a source of liquidity bewildering considering slide 12.
On page 12, management reveals their new asset is both the location of “Priority growth capital expenditures” and “Elective growth capital expenditures,” while Carvana’s legacy assets receive only “maintenance capex.”
If you are left wondering, prior to the ADESA purchase, had Carvana maxed out its organic growth? You are not alone. For investors interested in Carvana based on a valuation that presumes vast increases in retail units sold, we strongly encourage you to review slides 41 – 49 before reading their annual report.
On these pages, the importance of ADESA to the future of Carvana is only magnified. The acquisition’s financing includes $1bn of senior unsecured notes to “prefund Capex” for ADESA. We also learn:
- The number one priority for ADESA is “Business as Usual” (page 42)
- Carvana will grow ADESA’s reconditioning capacity 10-fold, from 200k to 2 million units (page 41) and….
- Sweeping back to slide 13, we are reminded that the company only allots $40ml per quarter ($160ml p.a.) for Priority and Elective growth Capex – both of which are primarily at ADESA
To review. Nothing is changing. They will grow capacity 1,000%. They borrowed $1bn in prefunded ADESA Capex at 10.25%. But no more than $160ml of that $1bn will be put to work p.a. So…that billion that is costing 10.25%, is only going to be spent $160ml p.a. until 2028.
As Automotive News reported in Carvana rivals rethink ADESA, the acquisition has already caused problems and quotes Lithia’s CEO as saying he “believes seven manufacturers have pulled vehicles from ADESA.”
Solutions to a Liquidity Crisis: Is It Prime-Time for Carvana to Jump Back into Subprime?
- Page 32 – CVNA will increase the percentage of vehicle prices at $15k or less from 3% of inventory
- They note that “previous best quarters” were when ~33% of inventory was at the sub $15k per unit level
- Company focuses on per unit metrics, and this move to cheap cars could allow them to increase “units” while holding working capital constant – or even generate some FCF
- Assuming 33% of cars in the under $15k category is the new target, that would mechanically shift over a third of unit sales back into a cohort that is often the province of “deep subprime” borrowers
- Long the home of scandals too numerous to list, Consumer Reports recently highlighted the egregious and predatory tactics so common in the space
For those on the outside who watched Carvana’s empirically inexplicable rise, the presentation is a testament to the times. The firm’s conduct strikes us as an example of self-dealing excess. We want to reiterate our earlier note: we are not in any way, shape or form alleging anything illegal happened here. In our imperfect view, everything you need to know about the company can be found on the Securities and Exchange Commission website. Read through the disclosures on pages 12 – 22 of their 2020 form 10-k. From the byzantine ownership structure (page 12) to the myriad issues and risks afflicting the company, the disclosures look both rigorous and clear to us.
The deck must make perfect sense to insiders, the firm’s bankers, and the PE look-alikes who facilitated Carvana’s improbable rise to fortune in an age of speculative excess. Unlike the cash-incinerating stocks with no path to profits brought to the public in 1999 and 2000, this stock did not promptly implode.
Instead, its painfully implausible narrative somehow “caught”, and the thing proceeded to soar. When analyzing a growth stock, one of the important factors is the need to recognize the risks and uncertainties associated with a firm that appears to brazenly buy revenues.
They sell cars. And they use the internet. You don’t need to read shareholder letters, their form 10-k, or sit in on conference calls to know: that is not a competitive moat.
So why wouldn’t we take a position against Carvana? Look at the information above. This is a stock driven by insiders. Despite steep declines in the stock, we think this is still an “anything goes” market. We are not alone.
John Dizard has written for the Financial Times for 21 years. On May 14th, the day we began working on this piece, he wrote his farewell article Where the next financial crisis could come from. He notes that “When he started in February 2001, Enron’s ‘smartest guys in the room’ were on their way to engineering the biggest crash of the young century.”
He goes on to describe Private Equity as “…a small group of self-dealing oligarchs” and notes “The public sees and resents this…” He suggests firms like these may be the epicenter of the next financial crisis.
For younger investors we believe his piece is a “must read.” He reminds us that while history rhymes the focus of the next crisis may shift from banks to PE shops and other visionary firms with a surfeit of debt and a dearth of profits.
As we have documented, private equity returns have benefitted from out-of-control debt to EBITDA ratios and relentless multiple expansion. Carvana is a microcosm of this concept. A big idea backed by big names. But it also reminds us that the true costs of this cycle’s end will be overwhelmingly borne by the average American.
We wish Carvana’s existing employees the best of luck. For the thousands abruptly fired for no fault of their own, we are sorry. For America, we believe many more such scenarios are already playing out.
In our recent piece, Protecting Capital Amidst War, Drought, Famine & Rising Food Prices, we laid out in 4 quick pages our years-old thesis that difficult times are ahead. To those risks we would add the inevitable and understandable anger that has always characterized post-bubble losses. We reviewed this phenomenon in our summary of one of Galbraith’s books, Bull Markets and their Consequences. Anger is not the fodder of multiple expansion.
Despite the sharp sell-off in many previous highflyers we still see an abundance of severe overvaluation and low-quality fundamentals. Where others make promises and spin tales of exponential returns, we have and continue to preach prudence. If you are looking for durable dividends, fast growth stocks, or simple model portfolios and ranking tools that will help you stay disciplined in a volatile market, please reach out to us.
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May 20, 2022 |
| Authors: Matthew Malgari, Nathan Przybylo, Dr. Sanjeev Bhojraj and John Durkin
May 20, 2022
Authors: Matthew Malgari, Nathan Przybylo, Dr. Sanjeev Bhojraj and John Durkin