Shares of Carvana Co. (CVNA, Financial) have gained an eye-popping 1,000% this year with the online car retailer making a strong comeback to shake off bankruptcy rumors. Even after this meteoric rise, at the current market price of around $50, the stock is still trading almost 80% below its 2021 highs, which goes to show the catastrophic decline in its market value from mid-2021 to December 2022. The strong market performance this year has been driven by several factors, including an improvement in financial performance, a notable improvement in investor sentiment toward growth stocks and the prospects for a rate cut toward the end of the year.
Carvana’s second-quarter earnings report sent its stock soaring more than 40% on July 19 as it reported better-than-expected earnings and painted a rosy picture for the coming quarter.
Although the improving fundamentals are certainly worthy of praise, investing in Carvana at these elevated prices does not seem to be a prudent move.
Improving financial performance
The second quarter of 2023 was the best quarter in the company’s history for adjusted Ebitda and gross profit per unit. The company reported gross profit per unit of $6,520, an increase of 94% compared to the second quarter of 2022. It also reported a 35% year-over-year decline in retail units sold to 76,530 and a 24% decline in revenue to $2.97 billion. According to Carvana, this decline represents its prioritization of profitability initiatives. The net loss margin improved from 11.3% a year ago to 3.5%, which is an indication that Carvana’s profitability has improved even on the back of lower revenue. This is a confirmation of the company’s claim that revenue declined on the back of a strong focus on profitability as it executes its transition from a growth-centered business to a more balanced approach that aims to find a middle ground between growth and profits.
Carvana reported adjusted Ebitda of $155 million for the second quarter, beating the analyst estimates of $57.5 million. This was the highlight of the quarterly performance. Building on this momentum, the used car retailer now expects to report positive adjusted Ebitda in the third quarter as well.
Debt restructuring to improve liquidity profile
One of Carvana’s major challenges in the recent past has been avoiding a liquidity crisis. The company is highly indebted after spending millions of dollars on acquisitions to achieve growth, and this massive pile of debt came back to haunt it last year when the Federal Reserves hiked interest rates aggressively to combat record-high inflation. Carvana tried in vain last month to strike a deal with bondholders to complete a bond exchange program that would allow it to extend maturities, raising further concerns about the company’s ability to service debt on schedule. On July 19, the company announced that a deal was reached with bondholders, alleviating concerns regarding its short-term liquidity needs.
According to the terms of this new agreement, 83% of Carvana’s unsecured note maturities in 2025 and 2027 will be eliminated by exchanging these notes with longer-dated bonds. This will eliminate $430 million in interest expenses per year through 2025, leaving Carvana with wiggle room to allocate funds for growth initiatives instead of being forced to pay down debt. This agreement also reduces its total debt burden by $1.2 billion.
The new deal is a step in the right direction as it will give the company some much-needed breathing room while the business turnaround plan gains traction.
Cost reductions to drive operating efficiencies
On the back of its failure to progress financially, Carvana launched a cost reduction program in 2022 to drive profit margins higher. Earlier this year, the company guided for $1 billion in annual cost savings by the end of the second quarter, boosting its initial cost-saving projections. On July 19, Carvana reported cost savings of $1.1 billion in the last 12 months, meeting its ambitious targets.
To save costs, Carvana started with a reduction in its headcount. The company eliminated 2,500 jobs in May 2022 and another 1,500 jobs last November. According to a Wall Street Journal report published on Jan. 13, the company reportedly slashed more jobs earlier this year while reducing the work hours of retained employees and scrapping open positions. This headcount reduction has helped Carvana align its workforce to achieve desired financial results, reversing the negative impact of aggressively expanding its workforce in the two years leading up to 2022.
Some of the other notable improvements in the cost base came from a reduction in inbound transportation costs on wholesale vehicles. The company has been able to reduce customer acquisition costs as well by scaling back on aggressive advertising. The company has been able to grow revenue while cutting its marketing budget, which is a good sign.
Overall, these cost reductions will permanently improve Carvana’s efficiencies, paving the way for a notable improvement in operating margins in the coming years.
The valuation looks overly optimistic
Carvana is not a profitable company yet. It reported a loss of $1.58 billion last year and the recent improvements in its financial performance may quickly reverse if the used car market weakens. In June, used car prices in the U.S., measured by the Manheim Used Vehicle Value Index, dropped by 10.3% year over year, erasing some of the gains registered in 2023. With consumer discretionary spending expected to come under massive pressure in a recessionary environment, it is not out of the woods yet as used car prices might stumble sharply in such a situation. Carvana is not ready for a setback of this nature.
On July 13, JPMorgan analysts downgraded Carvana based on valuation and assigned a price target of $10, citing the company’s market value has disconnected from its fundamentals yet again. Carvana is one of the most shorted stocks in the market, which has enabled it to benefit from a short squeeze in recent months. However, a valuation reality check could bring the stock down to a more reasonable level in the coming quarters, making it a risky bet currently.
Takeaway
Carvana shares skyrocketed after reporting notable improvements in its second-quarter earnings report, including a debt restructuring plan to improve short-term liquidity. The company is heading in the right direction, but is not yet out of the woods given that the used car market may not maintain its recent strength. The risk-reward profile is not aligned favorably for investors today.
