Author Topic: CVNA - Carvana  (Read 2262 times)

Broeb22

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CVNA - Carvana
« on: May 18, 2018, 03:46:26 PM »
I wanted to start the thread on Carvana as more of a curiosity than a truly serious investment thread.

My interest in the business is that Carvana has set itself up to be the low-cost provider of used cars in the U.S.

They currently do not make money, but they are scaling pretty rapidly with losses coming down significantly and gross margins increasing rapidly in the most recent quarter to ~$1900 per vehicle from ~$1100-1200 per vehicle. CVNA's overall gross profit is 9.5% right now vs. 13.5% at KMX.

CarMax earns $3000 in gross profit per vehicle, and earns a 6% pre-tax margin (although as much as 2.5 percentage points are related to the Auto Finance segment which isn't comparable to CVNA).  So, perhaps 3.5% is the right long-term pre-tax margin for CVNA.  (I could argue that as CVNA scales it will add in-house financing to its offerings.) At that margin, CVNA would be earning close to $100MM pre-tax in 2019 relative to a $3.9 billion market cap. Certainly not a "value" investment at these prices, but 100% growth the last few years, and thus >50% CAGR over the next few years could make multiples a lot more reasonable if the business model is sustainable.

Now for the bad. The Garcia family controls the stock through a dual-class structure. Obviously, not something you want to see as a minority investor. But what makes it worse is that the Garcia family does not have a spotless past. While I can't say anything bad about the current CEO, his father was involved in the S&L crisis in the late 80's and early 90's.

This is a situation where I see a potential disruptor in its early stages, but am unwilling given current losses and governance issues to commit capital.

Has anyone else looked at this business? Would be interested in anyone else's take on this interesting business.

http://articles.latimes.com/1990-10-31/business/fi-3371_1_desert-land
https://www.bloomberg.com/news/articles/2017-06-06/cars-in-vending-machines-a-fading-ipo-and-an-ex-con-behind-them



KJP

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Re: CVNA - Carvana
« Reply #1 on: May 20, 2018, 07:53:59 AM »
Carvana is building a "vending machine" near me, so your post caught my interest.  I've never worked for a car dealership and I've only spent a few hours looking over the the financials of Carvana and Carmax, so take these thoughts for what they're worth.

Can you make money simply by selling used cars at transparent prices?  As an outsider to the industry, selling used cars at transparent prices seems like a very tough business. You're selling essentially commodities with full price transparency, which allows others to easily undercut you if they choose.  In addition, cars are one of the most expensive purchases most people in the U.S. make, so I suspect the purchase decisions are often well-researched, and the internet provides an easy way to do that research. 

So, how can you ever make real money doing it?  I suspect there are at least four ways:  (1) you can source used cars at lower costs than your competitors, which probably requires a source that is not a public auction at which other dealers participate; (2) you have lower non-COGS expenses per unit, which I will call "distribution" expenses; (3) you can convince buyers to pay you more for essentially the same product, e.g., a trusted dealership brand; and (4) you don't actually make any money selling used cars -- you make your money performing what I will call "ancillary services," meaning services or business lines that you can provide at very little incremental cost because of the infrastructure you have in place for selling used cars at retail.

How does CarMax make money? To test whether any of my musings above hold water, I took a quick look at CarMax's most recent 10-K.  Based on CarMax's commercials, the average person probably believes that CarMax makes money primarily by selling used cars and perhaps benefits from (3) above.  I doubt that's true.  It looks to me like CarMax makes its money from (4) and possibly (1).

In 2017, CarMax generated $2.3 billion in gross profit + $420 million from originating and servicing auto loans, and had $1.6 billion in SG&A, for an EBIT of about $1.1 billion.  The gross profit included the following "ancillary" revenue sources:

$390 million from wholesaling used cars at auto auctions it conducts on its own lots.  These are cars they acquire via trade-in but which don't meet their standards for refurbishing and selling at retail.  The average selling price for these wholesale cars is only about $5300, but they generate $971 per car in gross profit, for a gross margin of almost 19%.  CarMax only gets 10% GP margin on the cars it sells at retail.  Moreover, they hold their wholesale auctions on site on a weekly or biweekly basis and have a 95% wholesale sell rate.  So, they're turning over this wholesale inventory very quickly at a very healthy GP margin.  Moreover, I assume that the same staff that's on-site to sell their new cars is also acquiring these used cars as trade-ins.  So, it appears that there is very little incremental SG&A associated with this wholesaling side business.  Therefore, a good portion of that $390 million in GP should flow down to EBIT.

$369 million in "other" gross profit on just $546 million in "other" revenue  This very high gross margin revenue stream comes largely from (i) reselling third-party warranty products, including extended service plans and gap insurance, and (ii) commissions from third-party auto financiers who finance the purchases of buyers who do not qualify for CarMax's own, in-house financing.  Once again, I assume the people selling these ancillary products are the same people selling the used cars to retail buyers, and they do it from the same locations.  So, once again, there appears to be very little incremental SG&A associated with this gross profit stream. 

If you add the $420 million from the financing division, $390 million in wholesale gross profit and $369 million in "other" gross profit, you get about $1.2 billion.  There is, of course, some SG&A associated with the activities that generated all of this gross profit, but given that all of these activities piggyback on the infrastructure that already exists to sell used cars to retail buyers, I suspect the incremental SG&A is very low.  Thus, I suspect that the vast majority of CarMax's $1.1 billion in EBIT actually comes from all of these various ancillary activities, rather than from the straight sales of used cars to retail buyers.

If the analysis above is right, then CarMax is much like other auto dealers, which I understand make most of their money on ancillary services like financing and service/repair, rather than on the sales of new or used cars.

Can Carvana generate the same types of ancillary revenues as CarMax?  If the analysis above is right, then I think one of the key questions for Carvana is whether it can generate the same type of ancillary revenues as CarMax without having the same type of brick-and-mortar physical locations. 

Financing revenue I suspect Carvana can eventually generate at least a good portion of the financing related revenue CarMax generates, because the key there seems to be the customer relationship, rather than the physical location.  One caveat is that CarMax also services the auto loans it originates (it securitizes the loans, but keeps the servicing portion).  I don't know whether having significant dealership locations creates any cost or other advantages with respect to loan servicing. 

Extended service plans and gap insurance In theory, Carvana should also be able to sell extended protection plans and gap insurance, but in practice I wonder whether selling those types of products face-to-face materially increases the attachment rates.  That would be something to monitor over time with Carvana.

Wholesaling  Carvana is already doing some wholesaling.  But I don't know whether the lack of traditional dealership locations will impede its ability to acquire wholesaling inventory at low prices or prevent them from conducting their own auctions, which I assume are (at sufficient volumes) much cheaper than using a third-party auction service.

Does (or will) Carvana actually have a cost advantage?  As discussed above, the "ancillary" services discussed above piggyback on a brisk business selling higher-quality used cars to retail buyers.  Thus, all those revenue streams depend on the retail business offering competitive prices, which would be at risk if Carvana or some other company could offer significantly lower prices for the same vehicles.

Can Carvana actually do that?  Currently, Carvana gets most of its inventory from auctions.  This appears to be a higher priced source of inventory than trade-ins.  So, at least for now, Carvana appears to start from an initial cost disadvantage relative to dealers who acquire their own used inventory via trade-in.  Can Carvana move its business model toward acquiring more inventory at low cost via trade-in?

Second, is Carvana's distribution method ultimately going to result in lower SG&A per unit than traditional dealerships?  This remains to be seen and will be an interesting thing to watch.

Finally, note that Carvana currently depends a floor-plan financing for its inventory.  If that source of financing remains available, that would allow them to scale up quickly, which would otherwise be impossible given the working capital intensive nature of selling used cars.  Relatedly, even Carvana's model requires significant PP&E.  You need to account for that needed capital when assessing future enterprise and equity values.
« Last Edit: May 20, 2018, 08:03:22 AM by KJP »

Spekulatius

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Re: CVNA - Carvana
« Reply #2 on: May 20, 2018, 08:33:58 AM »
^ Excellent analysis from KJP and I believe his conclusions to be correct.
To be a realist, one has to believe in miracles.

bobozou

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Re: CVNA - Carvana
« Reply #3 on: May 20, 2018, 09:14:04 AM »
+1 KJP

Thanks for the great thoughts and analysis

Cigarbutt

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Re: CVNA - Carvana
« Reply #4 on: May 23, 2018, 06:31:54 PM »
Good info and analysis by KJP.

Some thoughts:

-The used car buying behavior has been changing (time spent looking on the internet versus time spent seeing models, need to test drive, open the hood and kick the tires).

-Still considered a large ticket item (with many components: financing, guarantees, other services and trade-ins) and a physical location for stores still has value.

-The gross margin on used vehicles sold has been under pressure for some years and this is related to a fragmented competitive landscape as well as profits coming from other ancillary services. The dynamics will continue to change.

-Carmax has captured a profitable market share because the process is more transparent in these highly asymmetric transactions and many clients value this option.

-Carvana, despite the "story" and the vending machine concept is not that different from Carmax.

-Carvana, even if can grow, carries significant execution risk.

-IMO, Carvana's financial setup contains many non-transparent issues (class structure, insider arrangements).

-Established players can adapt to changing consumer behavior within their actual structure especially if they already have a national presence.

-Carvana's story could go on for a while with the easy money potentially available but that too may change.
 

KJP

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Re: CVNA - Carvana
« Reply #5 on: February 07, 2019, 06:31:32 AM »
I recently came across two bullish writeups on Carvana that provide a counterpoint to the skepticism shown by me and others:

http://www.haydencapital.com/wp-content/uploads/Hayden-Capital-Quarterly-Letter-2018-Q4.pdf [Starts on page 12]
https://www.valueinvestorsclub.com/idea/CARVANA_CO_CVNA/7557201389

There are many assumptions in both, such as extrapolating past cohort penetration rates into new markets, that are very hard to assess.  But I think the writeups illustrate what has to happen for the business to be successful and provide a starting point for thinking through potential strengths and weaknesses of the model. 

I think both writeups could be strengthened by having more explanation about why CarMax can't copy what Carvana's model if it proves to be successful.