Evaluating Carvana’s Potential Carvana is an intriguing company to evaluate. It operates within the vast used car market but currently holds only about a 1% market share of this enormous opportunity. The used car market is also highly inefficient, which allows companies like Carvana and CarMax to step in and improve information transparency, easing concerns from potential buyers about purchasing used vehicles. However, the question remains: should long-term investors consider buying Carvana stock today? In this video, I will address that question by examining the company's revenue growth, profit margins, and returns on invested capital. I will also discuss recent strategic missteps that cost the company significantly post-pandemic and provide a valuation based on a forward price-to-earnings ratio, along with my own discounted cash flow analysis to estimate Carvana's fair value as a growing used car stock.
Earning Overview
Carvana's operating margin has improved to 7.5%, a notable increase over the past decade from a negative 25%. However, when looking at the long-term potential, I'm not overly optimistic about Carvana’s ability to sustain strong profit margins or generate significant returns on invested capital. This is because buying and selling used cars is a capital-intensive business model, which is not ideal for my investment preferences. As you’ve heard me mention before, I tend to favor asset-light business models, whereas Carvana operates with a very asset-heavy model. They purchase used cars for tens of thousands of dollars, hoping to resell them for a modest profit. However, it’s unrealistic to expect 50% to 75% margins on these transactions. You won’t be able to buy a used car for $20,000 and sell it for $30,000, as buyers have plenty of other options and won’t overpay for a vehicle by such a large margin. For this reason, while I’m optimistic about the company’s revenue growth.
Fundamental Analysis
I’m not as confident about its ability to expand margins. A similar concern applies to its return on invested capital, which currently stands at 3.5%. While it’s improving, I believe there’s a cap on this return. It seems unlikely that Carvana can push its return on invested capital beyond 20%, even with significant economies of scale, even if it were to increase its market share from 1% to 10%.
Carvana's Market Capitalization and Recent Struggles Over the past three years, Carvana’s market capitalization has experienced significant volatility. It collapsed into the hundreds of millions as the company made some critical strategic mistakes in the wake of the pandemic. During that time, used car prices soared, with some individuals, like myself, receiving higher offers to repurchase their cars than they initially paid. For instance, I purchased a 2017 Honda Accord and, during the pandemic in 2022, I was quoted a price higher than what I originally paid for it, despite adding tens of thousands of miles to it. This situation is quite rare, as used car values generally depreciate once they leave the dealership.
Pandemic’s Impact on Carvana’s Operations Carvana, which specializes in buying and selling used cars, purchased a large number of vehicles at these inflated prices during the pandemic. However, when the market corrected and car prices fell, Carvana found itself stuck with a lot of overpriced inventory, placing the company in dire financial straits. At one point, it was even at risk of going out of business. Thankfully, Carvana has since recovered, as evidenced by its rising valuation, now reaching $28 billion. This turnaround is also reflected in its recent revenue growth, which had been negative for several quarters but has now rebounded to 42% growth in the most recent quarter.
Guidance
The Inefficiencies of the Used Car Market As a graduate student in economics, I learned about the inherent inefficiencies in the used car market. This market is interesting because people tend to hold onto cars that are running well, typically only selling when the vehicle starts causing trouble. On the other hand, if a car is problematic, the owner is more likely to sell it. From a buyer's perspective, there's an asymmetry of information: sellers often know more about the car’s condition than the buyer does. This creates a potential opportunity for companies like Carvana and CarMax to step in, bridge this information gap, and provide assurances to buyers, which ultimately increases trust in the transaction.
Investor Outlook: While there’s some optimism about Carvana’s long-term growth potential, especially as the company attempts to increase its market share and capitalize on inefficiencies in the used car market, the company’s current valuation and business model lead to a mixed sentiment. Many investors are holding their positions, awaiting further evidence of Carvana’s ability to manage its capital-intensive operations while expanding profit margins. Others remain cautious, with some leaning towards a "hold" rather than a "buy" at the current price level, suggesting that Carvana's stock may be overpriced relative to its actual intrinsic value.
Free Cash Flow
Recent Performance: Carvana has faced challenges with free cash flow in recent years. After a period of heavy investment in growth, particularly during the pandemic, the company has struggled to produce consistent positive FCF. In fact, Carvana reported negative free cash flow in several quarters during its recovery period post-pandemic, which was largely driven by high capital expenditures, inventory purchases, and costs associated with its rapid expansion.
Recovery and Improvement: In more recent quarters, Carvana has shown signs of improvement in its free cash flow. For example, the company has been able to scale back on some of its investments and expenses, leading to a smaller negative free cash flow or a more controlled FCF burn. However, Carvana has not yet consistently achieved positive free cash flow on a quarterly or annual basis, a key challenge for the company going forward.
Capital-Intensive Model: Carvana’s business model, which involves buying and selling used cars at scale, requires significant capital outlays to purchase inventory, manage logistics, and maintain infrastructure. This capital intensity is a critical factor in Carvana’s ability to achieve consistent positive free cash flow. While the company’s revenue has shown growth, the margin on these sales and the costs of financing the large inventory of vehicles it holds create challenges in maintaining positive FCF.
Risks and Challenges
Carvana has faced challenges in generating consistent positive free cash flow, primarily due to the capital-intensive nature of its business. While there are signs of recovery, achieving sustainable positive FCF will be a critical milestone for the company moving forward. Investors are watching closely to see if Carvana can shift from a cash-consuming business model to one that consistently generates cash in the coming quarters.
High Leverage and Debt Load
Carvana has historically relied on debt to finance its operations, especially during periods of expansion. While the company has managed to reduce some of its debt in recent years, it still carries a significant debt load. High leverage increases financial risk, as the company must meet interest payments and repay principal, even during periods of underperformance. In case of a market downturn or unexpected challenges, Carvana could face difficulty servicing its debt, which could put it at risk of liquidity issues or even bankruptcy.
Market Competition
The used car market is highly competitive, with established players like CarMax, AutoNation, and traditional dealerships all vying for market share. Carvana faces intense competition not only from these legacy businesses but also from other online car buying platforms. The company's ability to stand out from competitors, especially in a market that has historically relied on traditional, in-person transactions, will be critical. Competitors with larger market shares and more established reputations may have an advantage in terms of pricing, inventory, and customer trust.
Inventory Management
As a business that deals with large volumes of used cars, Carvana must carefully manage its inventory to avoid overstocking vehicles that may not sell quickly. Poor inventory management can lead to excessive costs tied to unsold inventory or holding costs. Additionally, if Carvana purchases cars at high prices and the market declines, it risks losing money on those vehicles. Efficient inventory management is critical to avoid financial strain, especially when the market is unpredictable.
Valuation
Now, let’s talk about Carvana’s valuation. After conducting a discounted cash flow analysis, I calculated the intrinsic value of Carvana’s stock to be $103 per share, which is less than half its current market price of $213. The primary reason for this discrepancy is the high risk associated with the company. With a beta of 3.57, Carvana is considered highly volatile. Even adjusting the beta downward to 2 in my scenario, the intrinsic value only increased to $166 per share. This suggests that, based on my calculations, the stock is currently overvalued.
Comparison to CarMax When looking at Carvana through a forward price-to-earnings (P/E) ratio, it’s trading at three times the P/E ratio of CarMax. CarMax has a forward P/E of 14, while Carvana is trading at a forward P/E of 43. This 43 P/E ratio seems high for a business that has significant capital intensity, like Carvana, and relatively low margin potential.
Market sentiment
Carvana and CarMax: Capitalizing on Market Opportunity This is why I believe Carvana and CarMax have great potential. They both have the opportunity to capture a larger share of the fragmented used car market, which could lead to significant growth. And as we saw in the most recent quarter, Carvana has continued to report impressive margins, making it a strong contender in the industry.
Positive Sentiment Drivers:
Revenue Growth: The company has demonstrated strong revenue growth, with recent quarterly increases showing a rebound from earlier struggles. The fact that Carvana reported a 50% year-over-year increase in vehicle sales in its latest quarter contributes to the positive sentiment among growth-focused investors.
Market Opportunity: There’s a general belief in the growth potential within the used car market. Despite holding only a small portion of the market (around 1%), Carvana's efficient platform and the inefficiencies of the traditional used car market make it an attractive player for long-term growth.
Recovery from Pandemic Struggles: The company’s ability to recover from significant strategic missteps during the pandemic, including holding overpriced inventory, has also generated some confidence that it can manage and adapt to market fluctuations.
Negative Sentiment Drivers:
Capital-Intensive Business Model: Carvana operates in a highly capital-intensive industry, which often makes investors wary of its ability to generate high profit margins. The large inventory required to buy and sell used cars and the thin margins on these transactions present challenges for long-term profitability.
Profitability Concerns: Despite improvements in margins and returns on invested capital, there are concerns that Carvana won’t be able to generate strong profit margins or achieve high returns on invested capital in the long term. This pessimism is reflected in analyst forecasts and a relatively high forward price-to-earnings ratio.
Valuation Concerns: With Carvana’s stock trading at a premium—about 3x higher than CarMax in terms of the forward P/E ratio—many investors see the stock as overvalued. The discounted cash flow analysis and the company’s high beta (3.57) also indicate higher volatility and risk, contributing to concerns about its current market price.
Conclusion
In summary, looking at both the valuation and the company’s business model, Carvana appears overvalued at its current price. While I believe the company has strong long-term growth prospects in terms of revenue, I don’t see it achieving the kind of margin expansion or return on capital that would justify its high valuation. So, to answer the question of whether I think the stock is a buy, hold, or sell, I would say that at its current price, Carvana is more of a hold not a buy. I’ve updated my recommendation today to reflect this perspective.
Disclaimer: I want to make it clear that I am not a financial advisor, and nothing I say is intended to be a recommendation to buy or sell any financial instrument. Additionally, it's important to remember that there are no guarantees or certainties in trading or investing, and you should never invest money that you can't afford to lose.
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