Down 85% from peak, 4 reasons to bet Carvana stock will fall

Shares of Tempe, Arizona-based online used car retailer Carvana are heavily shorted. In mid-April, 20% of its shares were sold short, meaning traders borrowed shares from a broker, sold them on the open market and hoped to profit by buying back the shares at a lower price. to repay the loan.

But that short-term interest is down from the last time I reported on it here – November 2019 – when a whopping 51% of stocks were sold short. As I wrote at the time, I thought these shorts were in trouble for a simple reason – despite burning cash and a terrible credit score on its debt, Carvana had one thing investors loved – growth three digits.

After that, Carvana shares soared 365% to peak in August 2021 at around $377 per share.

Unfortunately for the bulls, Carvana’s stock quickly tumbled and it is now trading 85% below its peak.

Is it too late to take advantage of Carvana’s decline? Here are four reasons I think his stocks are sub-short:

  • Decrease of sales
  • Bespoke accounting for securitized auto loans
  • Negative cash flow
  • Lower debt rating

Decrease of sales

Although its revenue increased from the previous year, Carvana sold fewer used vehicles in the first quarter of 2022 than in the last quarter of 2021. Carvana reported a 7% drop in the number of cars sold to customers of detail in the first quarter. – 105,185 – about 7,800 less than it sold in the previous quarter, according to the the wall street journal.

To be fair, compared to the first quarter of 2021, revenue was up nearly 56% to $3.5 billion.

This represents a considerable slowdown for Carvana. As the Journal noted, since the spring of 2020, Carvana has “roughly doubled its quarterly sales volume as more consumers shopped online.” However, the Journal wrote that Carvana has “struggled backlogs in its logistics network and reconditioning centers” due to labor shortages resulting from the pandemic.

Unfortunately, its first-quarter slowdown was accompanied by a 622% increase in its net loss to $260 million and a nearly 23% drop in its gross profit per unit to $2,833. External factors — including rising interest rates, falling used-car prices, inflation-conscious consumers and a dwindling appetite for debt — are contributing to slowing growth, the Journal noted.

With shares down 85% from their peak, Carvana’s biggest challenge is convincing investors that it can meet its growth targets – which had driven its death-defying stock price.

Analysts doubt Carvana can meet its 2022 retail sales target – announced in February – of more than 550,000 cars – about 29% more than the 425,237 units sold in 2021, according to its letter to shareholders for the fourth quarter of 2021 .

It is not known if the company will achieve this goal. Carvana said, “Over the next few quarters, we expect to better align sales with expense levels through a combination of higher sales and expense efficiencies.”

It also doesn’t help investors that Carvana has stopped providing financial advice due to “rising interest rates, rising fuel prices and macroeconomic uncertainty, all of which are affecting the market for used cars,” according to the Journal.

Perhaps to seek new avenues for growth, Carvana is in the process of acquiring ADESA – America’s second-largest physical vehicle auction network – for $2.2 billion. Carvana expects the deal — funded by $3.275 billion in committed debt financing and “$1 billion in improvements at all 56 sites” — to add about two million new production units, according to the letter. to shareholders in the fourth quarter of 2021.

Something important for Carvana changed between February and April. On April 20, Carvana said it planned to sell $2 billion of common and preferred stock, in part to fund the ADESA deal – which “came as a surprise to investors because Carvana said it had received a funding committed,” the Journal noted.

Bespoke Accounting for Securitized Auto Loans

Securitization, that is, bundling loans and selling them as securities to investors, can work very well in good times. But when the tide goes out, securitization can cause problems.

A case in point is the 2008 financial crisis. Back then, lenders created subprime mortgages, bundled them together and sold them to investors – with sterling credit ratings that masked the risk. Investors – including Bear Stearns and Lehman Brothers – borrowed heavily to buy the subprime mortgage-backed securities – then crashed.

I’m not saying Carvana is going to cause a financial crisis on the order of 2008. However, Carvana is no stranger to securitization – wrapping up the car loans it makes to consumers who buy its used cars online. Dubbed other sales and revenue, Carvana generated about $1 billion from the sale of auto loans in 2021 – nearly 8% of total revenue, according to its 10K 2021

In my opinion, if a company chooses a different method of accounting than its peers, that alerts investors. This is exactly what Carvana does when it comes to accounting for car loan sales. As the Journal reported, “Carvana is making immediate gains, unlike competitors who are making gains over time.”

It would be useful for investors to know how much Carvana’s income would be reduced if he recorded his gains over time. How? The Journal suggests that Carvana’s accounting method “boosted its revenue when consumer credit — and investor demand for auto loan-backed securities — was particularly strong.”

Carvana’s accounting approach contributed significantly to its earnings and caught the attention of its auditor. In 2021, 54% of its $4,537 gross profit per vehicle came from “other profits,” compared to 36% in the second quarter.

Carvana’s method of accounting – which relies on “relatively delicate accounting to remove loans from its books” is an audit problem. According to an August 2021 report in CFO Dive, the company’s auditor, Grant Thornton, “identified initial sales as a critical audit matter, a reference to the complexity of the transaction.”

To be fair, Carvana’s accounting method is not a potential misapplication of the rules; however, it requires “a lot of moving parts to make it work”. And Carvana must buy a small portion of each bond in which the loans are sold to comply with a federal 5% “skin-in-the-game” requirement that was enacted after the 2008 financial crisis to ensure that companies do not pledge bad debts. to investors”, according to the Chief Financial Officer

CFO
Dive.

CFO Dive noted that this approach works in good times and backfires when times get tough. This is because when money is flowing, investors are willing to buy the auto loans at a premium and when the market pulls back, Carvana “could be forced to sell the loans at par or at a discount, leading to a sharp drop in revenue. “.

It seems to be happening now. As the Journal notes, “Investors are demanding higher yields for securities backed by riskier consumer loans. They are beginning to fear that rising rates and inflation will affect borrowers’ ability to make payments.

In March, Carvana issued two securitizations — one backed by prime auto loans, the other backed by subprime loans — with a combined value of about $1.49 billion. Financial data provider Finsight noted that investor demand for higher yields reduced Carvana’s profit on trades compared to the fourth quarter of 2021.

Falling profits are a broader challenge for Carvana’s management. JPMorgan Chase

JPM
analyst Rajat Gupta “estimated in March that the company’s gain-on-sale margin from loan securitizations – a measure that compares proceeds received to the total value of loans sold – declined to 4.4% in the first quarter, compared to 9.1% in the previous quarter,” the Journal noted.

Negative cash flow

FLOW2

As measured by free cash flow (FCF), Carvana is a cash incinerator. How? between 2017 and 2021, Carvana’s negative FCF grew at an average annual rate of nearly 87%, from -$278 million to -$3,374 million.

This rate of cash burn contributed to a 23% drop in Carvana shares last week. Automotive News attributed the stock decline to “increasing cash burn, resulting from soaring used vehicle prices, capital spending” as well as a drop in the value of its junk bond offering. of $3.3 billion” even after Apollo Global Management

APO
bought about half the debt.

Debt rating downgrade

Rating agencies are not fans of Carvana. On April 25, Moody’s downgraded Carvana’s corporate family rating to Caa1. Moody’s has a litany of reasons for the downgrade. These include “very weak credit metrics, a persistent lack of profitability and negative free cash flow generation.

Additionally, Moody’s cites “governance considerations” – such as Carvana’s decision to update its “external floor plan facilities” despite the expectation of significant negative free cash flow, as well as its decision to finance the acquisition of ADESA partly through debt despite its very high leverage. .”

Moody’s could downgrade its ratings “if the business is unable to generate positive operating income on a sustainable basis or if liquidity were to weaken for any reason.”

One of the possible reasons for this weakening is the outlook for the automotive e-commerce industry. Namely, William Blair analyst Sharon Zackfia expects rivals such as “Vroom, Shift and CarLotz to be largely disappointed with the number of units sold in the first quarter,” according to Automotive News.

Carvana does not give up. As CEO Ernie Garcia told investors on April 20, “While this quarter may be a little harder to see than most, we remain on the path of building the biggest and most profitable automotive retailers and changing the way people buy and sell cars. . The march continues.”