Recap
On May 1, we published the article “Carvana: 2023 Barbarians At The Gate” and gave it a “Strong Buy” rating as we believe the company is likely to show improvement in profits.
They did.
Carvana Co., (NYSE: CVNA) narrowed the loss from -$1,441 million in Q4 last year to -$286 million in this Q1. That’s just impressive. The stock was up 24% after the earnings release. The stock was trading right above where bears felt comfortable adding short positions.
We get it.
In fact, we think the short ratio of 64% is still way too low. Why? The company has a market cap of $1.3 billion but a total debt of $8.2 billion. If you are a bond holder and need a hedge position through equity, Carvana’s market cap is just way too small for this.
But the good news is that our investment philosophy is not built on predicting the behavior of market participants. The sequential improvement in operating cash flow or profits is not our focus in this article. We want to dig deeper. We want to ask the question, “What is the true potential of Carvana?” We believe ADESA has the answers. Don’t judge a book by its cover.
What is ADESA?
ADESA is the second-largest U.S. wholesale used vehicle auction marketplace. At used car wholesale auctions, people see a large variety of vehicles of various makes, models, and conditions being auctioned off to the highest bidder. It’s where car dealerships dispose of the vehicles they can’t sell to retail customers.
Carvana bought ADESA last year for $2.2 billion in cash. ADESA has 56 U.S. sites. With the addition of ADESA, a Carvana inspection and reconditioning center is now within 100 miles of 78% of Americans. The management mentioned in the report that the acquisition of ADESA has improved efficiency. For example, according to the company, it reduced the inbound transport costs by $200 per wholesale unit sold and $90 per retail unit sold. We think that what they intended to imply but omitted to state is that Carvana will significantly increase its pricing power in the used car industry.
Carvana was hated by its peers
Carvana has less than 1% market share in the used car market. The used car market is highly fragmented. The used car market’s high fragmentation can be attributed to various factors that make it challenging for any one seller to dominate the market. These factors include convenience and distance from the customer, which make it difficult for sellers to reach all potential buyers. Additionally, the used car market offers a wide range of vehicle makes, models, and conditions, which increases the competition among sellers, and makes it hard for one to gain a significant market share.
It came as a surprise to us when we discovered that Carvana had received significant pushback from other car dealerships in the industry. In one instance, an independent car dealership spoke about how other dealerships would pull their inventories from ADESA to go against Carvana, which piqued our interest. We could sense that there was something underlying this pushback.
“Carvana can be a disruptor in the industry.”
Despite having less than 1% market share in a highly fragmented market, Carvana has made significant waves in the industry, causing some traditional dealerships to feel threatened. It’s as if someone’s child in a high school in China received straight A’s, and other parents feel resentful, fearing that this child might harm their own children’s chances of getting into Harvard.
The used car market has historically been a treasure-hunting place, similar to discount retailers such as TJ Maxx or Ross. Buyers never knew what they might find or at what price, which often led to a slower buying process. Carvana emerged as a disruptor in the industry, introducing a transparent online pricing model that offered buyers more clarity and speed in their purchase decisions. This transparency has brightened the dealership industry, making it easier for buyers to know what they are getting and at what price.
Wholesale auctions play an important role in setting price
However, Carvana’s online presence is just the tip of the iceberg when it comes to the company’s ambition. Wholesale auctions play a much bigger role in setting the pricing for the used car market.
Manheim is the largest auction dealer in the U.S. It has 145 auction places, and it sends out a monthly Manheim Market Report to set benchmark prices for the used car industry. The Holy Bible Kelly Blue Book was published by an affiliate of Manheim, a subsidiary of Cox Enterprise.
With the acquisition of ADEASA, Carvana is now poised to fully tap into its potential in the wholesale market and expand its reach even further.
Carvana was growing to the point where it needed to have its own auction platform to secure long-term success. Without an auction platform, Carvana needs to clean up their inventory through Manheim or another auction platform. This put them at a disadvantage, especially when it was growing rapidly and they needed to clean up the inventory fast.
With this consolidation, Carvana can now position itself as a central hub for wholesale used vehicle auctions, giving the company an advantage in setting benchmark prices for the industry.
Cars can be viewed as assets that can be traded and priced in a similar way to stocks. In a liquid market, these assets can be bought and sold at any time, and their value can fluctuate based on supply and demand. Carvana’s ADESA marketplace can increase the liquidity of the used car market by facilitating trades between the retail and wholesale markets.
Hence, Carvana’s acquisition of ADESA was a crucial move that not only improved its inventory turnover capability but also enhanced its strength in transparent pricing.
In our article “Carvana: 2023 Barbarians At The Gate”, we discuss why we believe Carvana is about price transparency. By offering used car prices online, it changed the price discovery process in the used car industry. As a result, we believe the used car market will change from being a transaction-focused industry to one that is long-term consumer driven.
It can be a win-win situation
Greater transparency in the used car market, facilitated by Carvana’s acquisition of ADESA, can benefit all parties involved—OEMs, consumers, and Carvana—making it a win-win situation. By providing a centralized hub for wholesale used vehicle auctions, Carvana can efficiently adjust the price of its inventory based on supply and demand between the retail and wholesale markets. This can help OEMs adjust prices faster and more accurately to manage their inventory.
For consumers, transparent pricing allows for a more informed decision-making process when purchasing a used car. They can have confidence in the prices they are paying and know that they are getting a fair deal.
Every coin has two sides
Carvana’s acquisition of ADESA was an aggressive move, with Manheim anticipating its arrival. Unfortunately, the acquisition took place before the Federal Reserve decided to hike rates. However, Carvana’s smart decision to raise an additional $2 billion on top of the $2.2 billion purchase price proved to be a life-saving move. This additional funding allowed Carvana to survive when it was forced to liquidate aged inventories due to the rate hike.
Despite Carvana’s Q1 2023 profits improving, Wall Street analysts were not impressed and chose to focus on the decrease in retail unit sales on a quarter over-quarter basis. We hold different perspectives and are excited to see its wholesale market unit sales grow significantly by 18% on a sequential basis. Moreover, we observed a substantial increase in the wholesale marketplace GPU, which rose to $328 as compared to $46 in the previous quarter. In addition, the non-GAAP wholesale marketplace GPU also witnessed a significant surge and reached $656 compared to $333 in Q4 2022.
Furthermore, we firmly believe that the market should and can adopt a more open-minded and optimistic approach towards the emergence of Carvana. For example, CarMax was one of the earliest dealerships to provide a 7-day guarantee of return for consumers after Carvana. We think CarMax has become a stronger company because of Carvana. In fact, during our recent visit to CarMax’s dealership, the sales representative informed us that he was not incentivized by the number of cars sold, thereby eliminating any potential conflict of interest. If accurate, this is the best endorsement for Carvana since other companies also hold the view that transparency benefits consumers.
More work to do but less risk now
Despite its progress, Carvana still has some challenges to overcome. The company’s management team has outlined three key steps to success, and Carvana has made significant strides in achieving these targets ahead of schedule. However, the next goal on their roadmap is to achieve positive adjusted EBITDA, a milestone that they anticipate reaching in Q2 2023.
Drive the business to positive Adjusted EBITDA.
Drive the business to significant positive unit economics.
After completing steps 1 and 2, return to growth.
We are of the opinion that these notable milestones can serve as key drivers for the company’s stock, with a particular focus on GPU and its market expense per unit metrics. Unit sales are not the focus in this high rate environment.
Carvana mentioned that it expected to increase GPU in Q2 to above the $5000 level from Q1. We particularly focus on its wholesale and financing profits. We believe the acquisition of ADESA can improve its GPU.
Consequently, we expect the stock to experience a substantial increase following either step 1 or step 2, with minimal potential downside from the current levels. Hence, we believe the risk and reward profile has improved since our last stand. While we cannot upgrade our “Strong Buy” rating as it is already the highest possible, we maintain our “Strong Buy” rating.
Final words
Thank you for taking the time to read our article.
People have different opinions about this company and its management. Most of the time, we don’t personally know the management as public investors. Therefore, our investment philosophy centers on evaluating the management’s actions to determine whether they are creating value for shareholders and consumers.
As a shareholder, it’s frustrating to see management selling shares at record highs. However, this could demonstrate the management’s discipline and level-headedness, indicating that they are not overly influenced by their own success, right?
During challenging times, we saw management’s patience in providing transparent communication to investors regarding their plans for a company turnaround. We also saw them resist yielding to creditor requests for debt-for-equity swaps. As investors, we evaluate management based on whether we can do better than they did. Ultimately, it’s what’s inside—the management’s actions and decisions—that counts.
Our guiding principle is to support companies that prioritize customer satisfaction and make a positive impact on society. We believe that the stock market should aid innovative companies in developing and improving the world we live in, rather than solely serving as a means for investors to trade for profits.
Recently, Charlie Munger expressed the idea that his success was a product of a specific time and a set of opportunities. However, we respectfully disagree. We believe that the U.S. is still in a prime position to foster innovative companies like Carvana, which have the potential to make a positive difference in the U.S.
Read the full article here
