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Shares of online car dealership Carvana (CVNA -15.64%) have fallen hard, dropping 97% from their high. That includes a staggering 39% decline the day after it released third-quarter earnings. A sharp decline can make a stock look like a lottery ticket and tempt risk-seeking investors into buying shares in the hopes of a rebound.
Unfortunately, Carvana is facing severe financial issues threatening the company’s future. Nobody can be sure what will happen, but I’ll break down the company’s troubles to show you why the stock’s risks aren’t worth rolling the dice on now.
If you’re unfamiliar with the company, Carvana is a used-car dealer using an e-commerce business model to challenge the industry’s status quo of traditional dealerships. It features online shopping, haggle-free inventory pricing, and flashy “vending machines“ — tall buildings with large windows where consumers can pick up their purchases. You can also have the vehicle delivered to you. It’s a straightforward user experience that cuts out the hours of stressful haggling that can come with buying a used car.
Carvana’s business depends on selling cars for a profit, but it must sell a lot of inventory because automotive sales are highly competitive. Many consumers will go out of their way to get the lowest price on a car. Carvana’s gross profit per unit was $3,500 in the third quarter. The company needs to sell enough vehicles for those gross profits to cover expenses like employees and marketing.
A big concern for Carvana is that business was great last year when a shortage of new vehicles caused demand (and prices) for used vehicles to surge. The average selling price of used cars and trucks increased by 40% from January 2021 to January 2022. But in an environment where Carvana thrived and gross profit per unit peaked at $4,672, the company still couldn’t make any cash profits.
CVNA Free Cash Flow data by YCharts. TTM = trailing 12 months.
Now that the economy is cooling, things are getting harder for Carvana, which is seemingly going backward financially. Unfortunately, its balance sheet looks like it can take on water only so much longer before the ship starts sinking.
Following the third quarter, Carvana has $316 million in cash and equivalents and total liquidity of $4.4 billion if you include the remaining untapped credit lines and unpledged real estate. The company burned $585 million in net cash from operating its business through the year’s first nine months. In other words, the business could run out of cash in less than a year at this pace, and that’s without considering a potential recession which could squeeze profit per vehicle.
You don’t want the company to start tapping the rest of its liquidity, because it can become a no-win situation. Carvana sells expensive inventory; the average price of a used vehicle was about $28K at one point this year. If there’s less liquidity to buy inventory, it can’t sell as many vehicles, and that will increase losses — it could be a lousy downward spiral for the business.
Remember, Carvana needs volume to make money, so the company must walk the tightrope of conserving cash without sacrificing the number of units it sells. The next couple of quarters could go a long way in determining the long-term durability of Carvana’s business.
Investors face a couple of potential outcomes. First, Carvana will do what it must to survive. You don’t want to tie up the company’s debt in operating expenses because you need it to acquire inventory. Issuing shares is the primary way a company can raise money outside of debt, and Carvana has already been doing this over the past few years.
CVNA Shares Outstanding data by YCharts.
But now, the share price has collapsed, and Carvana won’t be able to raise a meaningful amount of cash without significantly increasing the share count, a concept called dilution. A massive increase in shares would hurt the company’s per-share value and do a lot of damage to shareholders. That’s better than going out of business but underlines the grim situation and why the stock trades where it does.
There’s a chance Carvana won’t be a sustainable business over the long term, and the stock will go to zero. On the other hand, it’s hard to see the company surviving without harming shareholders by flooding the market with new shares. It looks like heads you lose, tails you still lose, and that’s just not appealing in a bear market where high-quality stocks are also falling.
Justin Pope has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
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