Shares of Tempe, Ariz.-based online used car retailer, Carvana, are heavily shorted. As of mid-April, 20% of its shares were sold short — meaning traders borrowed shares from a broker, sold them in the open market, and hoped to profit by buying back the shares at a lower price to repay the loan.
But that short interest is way down from the last time I wrote about it here — November 2019 — when a whopping 51% of the shares were sold short. As I wrote back then, I thought those shorts were in trouble for simple reason — despite burning through cash and a terrible credit rating on its debt, Carvana had one thing going for it that investors loved — triple digit growth.
After that, Carvana shares soared 365% to peak in August 2021 at about $377 a share.
Sadly for bulls, Carvana’s stock has been sledding downhill fast and it now trades a painful 85% below its peak.
Is it too late to profit from Carvana’s decline? Here are four reasons I think its shares are under-shorted:
- Declining sales
- Bespoke accounting for securitized auto loans
- Negative cash flow
- Debt rating downgrade
Although its revenues rose compared to the year before, Carvana sold fewer used vehicles in the first quarter of 2022 than it did in the final quarter of 2021. Carvana reported a 7% decline in the number of cars sold to retail customers in the first quarter — 105,185 — about 7,800 fewer than it sold in the prior quarter, according to the Wall Street Journal.
To be fair, compared to the first quarter of 2021, revenues rose nearly 56% to $3.5 billion.
That 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 with backlogs in its logistics network and reconditioning centers” due to labor shortages resulting from the pandemic.
Sadly, 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-wary consumers and a declining appetite for its debt — are contributing to slower growth, noted the Journal.
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 are skeptical that Carvana can meet its 2022 retail sales target — announced in February — of over 550,000 cars — about 29% more than the 425,237 units it sold in 2021, according to its Q4 2021 shareholder letter.
It is unclear whether the company will achieve that target. Carvana said, “Over the next several quarters, we expect to better align sales with expense levels through a combination of higher sales and expense efficiencies.”
Nor does it help investors that Carvana has stopped providing financial guidance due to “rising interest rates, rising fuel prices and macroeconomic uncertainty—all affecting the used-car market,” according to the Journal.
Perhaps to seek new avenues for growth, Carvana is in the process of acquiring ADESA — the second largest U.S. network of physical vehicle auctions — for $2.2 billion. Carvana expects the deal — financed with $3.275 billion in committed debt financing and “$1 billion in improvements across the 56 sites” — to add about two million new units of production, according to the Q4 2021 shareholder letter.
Something important to Carvana changed between February and April. On April 20, Carvana said it plans to sell $2 billion in common and preferred stock, in part to fund the ADESA deal — which “was a surprise to investors because Carvana had said it had received committed financing,” noted the Journal.
Bespoke Accounting For Securitized Auto Loans
Securitization — bundling loans and selling them as securities to investors — can work out pretty well in good times. But when the tide recedes, securitization can cause problems.
A case in point is the financial crisis of 2008. Back then lenders originated subprime mortgages, bundled them, and sold them to investors — with sterling credit ratings that masked the risk. The investors — including Bear Stearns and Lehman Brothers — borrowed heavily to buy the subprime mortgage backed securities — and then collapsed.
I am not saying that Carvana is going to cause a financial crisis on the order of 2008. However, Carvana is no stranger to securitization —packaging the auto loans it originates from consumers who buy its used cars online. Dubbed other sales and revenues, Carvana generated about $1 billion from selling auto loans in 2021 — nearly 8% of total revenue, according to its 2021 10K
In my opinion, if a company chooses a different accounting method from its peers, it raises a red flag for investors. Carvana is doing just that when it comes to accounting for sales of auto loans. As the Journal reported, “Carvana books immediate gains, unlike competitors that book them over time.”
It would be helpful for investors to know how much Carvana’s revenues would be reduced were it to book its gains over time. How so? The Journal implies that Carvana’s accounting method “turbocharged its revenue when consumer credit—and investor demand for securities backed by auto loans—was particularly strong.”
Carvana’s approach to accounting has contributed significantly to its profit and drawn the attention of its auditor. In 2021, a whopping 54% of its $4,537 in gross profit per vehicle came from “other profit” — up from 36% in the second quarter.
Carvana’s method of accounting — which relies on “relatively tricky accounting to get the loans off its books” is an audit concern. According to an August 2021 report in CFO Dive, the company’s auditor, Grant Thornton, “has identified the upfront sales as a critical audit matter, a reference to the transaction’s complexity.”
To be fair, Carvana’s accounting method is not a potential misapplication of the rules; however, it requires “a lot of moving pieces to make it work.” And Carvana must buy a small piece of each bond in which the loans are sold to comply with a 5% “federal skin-in-the-game requirement that was enacted after the 2008 financial crisis to ensure companies don’t pawn off bad loans to investors,” according to CFO
CFO Dive noted that this approach works in good times and backfires when times get tough. That’s because when money flows freely, investors are willing to buy the auto loans at a premium and when the market turns down, Carvana “could be forced to sell the loans either at par or a discount, leading to a big drop in revenue.”
That seems to be happening now. As the Journal noted, “Investors are demanding higher yields for securities backed by riskier consumer loans. They are beginning to worry that rising rates and inflation will affect borrowers’ ability to make their 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 the deals compared to the fourth quarter of 2021.
The declining profits are a broader challenge for Carvana management. JPMorgan Chase
Negative Cash Flow
As measured by free cash flow (FCF), Carvana is a cash incinerator. How so? between 2017 and 2021, Carvana’s negative FCF has expanded at a nearly 87% average annual rate from -$278 million to -$3,374 million.
That cash burn rate has contributed to a 23% plunge in Carvana’s stock last week. Automotive News attributed the stock decline to “a deepening cash burn, stemming from surging used-vehicle prices, capital spending” as well as a drop in the value of its $3.3 billion junk-bond offering “even after Apollo Global Management
Debt Rating Downgrade
Debt ratings agencies are not Carvana fans. 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, persistent lack of profitability, and negative free cash flow generation.
In addition Moody’s cites “governance considerations” — such as Carvana’s decision to make current its “external floor plan facilities” despite the expectation for significant negative free cash flow as well as its decision to finance the ADESA acquisition partially with debt despite its very high leverage.”
Moody’s could downgrade its ratings “if the company was unable to generate positive operating earnings on a sustained basis or liquidity were to weaken for any reason.”
One possible reason for such weakening is the outlook for auto e-commerce industry. To wit, William Blair analyst Sharon Zackfia expects rivals such as “Vroom, Shift and CarLotz to largely disappoint on the number of units sold during the first quarter,” according to Automotive News.
Carvana is not giving up. As CEO Ernie Garcia told investors on April 20, “While it might be a little harder to see this quarter than most, we remain squarely on the path to building the largest and most profitable automotive retailer and to changing the way people buy and sell cars. The march continues.”