Carvana Co. (CVNA, Financial) shares have impressive gains of over 300% year to date and have witnessed a strong rally for the week ending June 9 as a result of an improved second-quarter outlook.
The online auto retailer witnessed its shares rallying from the opening price of $18.82 on June 8 to a closing price of $24.23, delivering daily intraday gains of nearly 30%. The next day, however, the stock closed 21.30% lower at $19.07.
With a beta of 2.90, the stock is highly volatile, meaning it is not suitable for every investor. Further, the stock's strong rally faded quickly, which is no surprise as the company has many severe fundamental problems, including a high level of debt, unprofitability and burning cash. These problems indicate that investing in the stock may be irrational currently. Let’s take a closer look to determine why this may be.
An improved financial outlook was received with a lot of enthusiasm, but can it last?
On June 8, Carvana released its second-quarter 2023 outlook. The company guided for adjusted Ebitda above $50 million and non-GAAP total gross profit per unit above $6,000, which represents "a new company record and an over 63% improvement compared to second-quarter 2022.”
Further, the company's previous forecast did not provide a specific number for adjusted Ebitda, just that it would be positive.
As such, Carvana appears to be highly optimistic about its business prospects, mentioning it is executing its plan to drive profitability and is making progress to "improve unit economics in the form of a more robust GPU in Q2 2023 and to positive free cash flow in the future.”
I argue, however, that there has not been enough progress made related to profitability and free cash flow, which is supported by the company’s weak fundamentals.
Weak fundamentals are a reason to cast doubt on business operation's progress
I identified four factors that support the idea Carvana shares are not attractive now.
First, the company is unprofitable. Between 2018 and 2022, the company has recorded only net losses, which widened to the highest level of -$1.59 billion in 2022.
Second, as illustrated below, revenue has declined over the past three consecutive quarters.
Third, I see a severe financial health problem as Carvana has a debt-to-equity ratio of -13.56, which is underperforming a majority of peers in the vehicle and parts industry. The company has aslo been growing its debt in recent years. While short-term debt recorded a slight increase, the long-term debt surged from $3.57 billion in 2021 to $7.08 billion in 2022, an increase of about 98%.
The company also has negative shareholders equity, which means its liabilities exceed its assets. This is a strong sign of financial distress.
Fourth, the company is burning cash. It has generated negative free cash flow every year between 2018 and 2022. Further, for the first quarter, Carvana had on its balance sheet cash and short-term investments of $1.01 billion and long-term debt of $7.05 billion. With almost seven times higher debt compared to cash and short-term investments, things do not look very good for Carvana in terms of its financial health. Adding the negative free cash flow is another factor that is alarming as a company can repay its debt with cash generated from positive free cash flow, a trend that simply does not exist for quite some time for Carvana.
The online used car retailer has several business advantages that should help it be profitable
Carvana's business model has several key benefits that should make it profitable. These include a wider reach, lower overhead costs, convenience for customers, diverse inventory and scalability.
By operating online, Carvana can reach a much larger customer base compared to a traditional brick-and-mortar dealership, targeting customers from different geographical locations and increasing its chances of making sales. Online businesses generally have lower overhead costs compared to physical locations, saving on expenses like rent, utilities and maintenance, which can significantly impact profitability. Buying a used car online offers convenience to customers. They can browse through the inventory, compare prices and make a purchase from the comfort of their homes. This accessibility can attract more customers and increase sales. Carvana provides extensive information about each vehicle, including specifications, mileage, maintenance history and photos. This transparency builds trust with potential buyers and helps them make informed decisions.
Online businesses provide opportunities for data collection and analysis. By tracking customer behavior, preferences and sales data, Carvana can gain valuable insights to optimize its inventory, marketing strategies and customer experience. It also has the potential for scalability. Carvana can expand its operations by adding more inventory, expanding its customer base or even entering new markets.
These advantages demonstrate why an online used car seller business can be a viable and profitable venture in today's digital age.
In theory, these advantages should have already helped Carvana build a profitable business. However, the company is losing money and its financial health signals distress. These are valid reasons to avoid the stock until material progress in profitability occurs.
