Carvana: Turnaround Sounds Enticing, But Be Cautious

Carvana, the largest online used car dealer in the U.S., surged 56% on Thursday after management updated its second-quarter adjusted EBITDA. The total gross profit per unit increased by $1,000 to more than $6,000 per unit. Previously, the company had guided to "achieve positive adjusted EBITDA in the second quarter," and the updated guidance significantly exceeded previous expectations

Carvana has transferred the traditional used car distribution market from offline to online. Previously, the largest used car retailer in the United States was CarMax Inc, which was established in 1993 and mainly operated offline stores.

Through its e-commerce platform, consumers can buy and sell used cars. The company's platform allows consumers to search for vehicles that meet their criteria and provides a 360-degree panoramic view of the vehicle as well as close-ups of any defects, such as scratches. Buyers can have the car delivered to them or pick it up at one of the company's auto vending machines. Last year, it bought auto auction company ADESA for $2.2 billion.

From the end of 2022, the price of used cars has fallen rapidly, causing Carvana's inventory prices to be too high and having to sell at a loss. The high amount of debt leads to high interest expenses, making it difficult to break even.

Business conditions improved in the company's first-quarter financial report released last month. Carvana said in its financial report that the company's goal this year is to reduce sales and focus on profitability. The financial report shows that Carvana’s revenue in the first quarter was US$2.606 billion, which was lower than the US$3.497 billion in the same period last year. Sales volume declined, but gross profit increased.

——Carvana’s used car sales in the first quarter were 79,240 units, compared with 105,185 units in the same period last year, a decrease of 24.7%; wholesale sales in the first quarter were 35,110 units, compared with 50,280 units in the same period last year, a year-on-year decrease of 30.2%.

——Carvana’s used car retail gross profit in the first quarter was US$110 million; wholesale gross profit was US$70 million; other gross profit was US$161 million; total gross profit was US$341 million, higher than the US$298 million in the same period last year, an increase of 14.4% year-on-year.

——In the first quarter, Carvana’s second-hand car retail gross profit was US$1,388, and its wholesale gross profit was US$883, a year-on-year increase of 71.8% and 303.2% respectively

——The adjusted loss per share in the first quarter was $1.51, which was better than the consensus loss of $1.96, and the adjusted EBITDA (earnings before interest, tax, depreciation and amortization) was negative $24 million

The company has taken a series of measures to significantly reduce costs, including SG&A, marketing and logistics costs. The company has reduced its vehicle inventory, lowered its advertising expenses and plans to cut about 2,500 jobs to cut costs. SG&A expenses decreased by approximately 35% from $727 million in the first quarter of 2022 to $472 million in the first quarter of 2023. Marketing expenses fell to $56 million from $155 million a year ago. Logistics expenses fell to $35 million from $56 million the previous year. Through these successful cost-cutting measures, the company posted an Adjusted EBITDA margin of -0.9%, a significant improvement from the -10.3% margin recorded in the previous quarter.

In addition to the company's own efforts, the used car market has improved in recent months. According to CPI data from the US Bureau of Labor Statistics, used car prices rose 4.4% month-on-month in April after months of declines. As the chart below shows, used car prices tracked by CarGurus show that prices have continued to rise through most of 2023. As such, Carvana's results could benefit from macroeconomic tailwinds.

However, it's too early to call a turnaround for the company due to the company's debt load and potential macroeconomic concerns. Carvana's debt load is extremely high. The company has approximately $6.5 billion in long-term debt and approximately $694 million in cash and restricted cash. In the first quarter of 2023, the company's interest expense was $159 million, or about 46.6% of gross profit. Additionally, the company's depreciation and amortization expense for the first quarter of 2023 was $93 million. The two expenses together accounted for 78.8% of the gross profit. So while on the surface, achieving positive adjusted EBITDA might seem like a good idea, EBITDA is deceptive due to the company's interest expense and depreciation expense.

In addition, high loan interest rates may affect consumer purchases. The average interest rate on used car loans rose steadily throughout 2022 and reached 14.78% in the fourth quarter of 2022. In the interest rate environment, loan interest rates will continue to rise in 2023. As a result, it's becoming increasingly difficult for buyers to finance used car purchases, which could adversely affect Carvana sales.

Carvana has made tremendous progress in its turnaround. Both results and guidance improved due to a significant reduction in operating expenses. However, ignoring the company's high interest expense and depreciation expense as measured by adjusted EBITDA, the company's debt risk remains extremely high, especially amidst macroeconomic headwinds where higher lending rates discourage consumers' appetite for durable goods. The sharp decline in sales in the first quarter also illustrates this point. So it's still too early to talk about Carvana coming out of the woods.