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Why Steel City Capital is Bearish on Carvana (CVNA) Stock

Steel City Capital Investments, LLC is the management company of the Steel City Capital fund. Michael G. Hacke is the fund’s founder and managing member. Recently, Steel City Capital released its Q1 2020 Investor Letter – a copy of which can be downloaded here. For Q1 2020, the fund reported a net return of -10.7%, while the S&P 500 returned -20.00%.

In the said letter, Michael G. Hacke highlighted a few stocks and Carvana Co. (NYSE:CVNA) is one of them. Carvana is an e-commerce platform for buying and selling used cars. Year-to-date, CVNA stock gained 0.4% and on April 24th it had a closing price of $92.24. Its market cap is of $15.38 billion. Here is what Michael G. Hacke said:

“CVNA is a rapidly growing e-commerce platform for buying and selling used cars. The company is seeking to disrupt and improve the traditional used car buying experience by moving the entire process – trade in, vehicle selection, financing, purchase, and delivery – online. While the narrative is attractive and has garnered significant investor interest, a peek “beneath the hood” reveals a clunker that has destroyed a significant amount of capital and will likely struggle against the current macroeconomic backdrop.

Perhaps the best way to highlight the absurdity of CVNA’s valuation is to compare it to CarMax (KMX), which is the largest used car retailer in the country. KMX is also one of the three largest participants in the highly concentrated wholesale auto auction market. Last year, KMX sold 832,640 used vehicles at retail, generating gross profit per retail vehicle of $2,724. Inclusive of wholesale operations and contributions from its financing portfolio, KMX generated gross profit per vehicle of $2,670. Deducting cash operating expenses of $1,251 per vehicle yields a cash profit of $1,419 per vehicle. Consolidated EBITDA was approximately $1.45 billion.

On a comparable basis, CVNA sold 177,549 vehicles at retail, a small fraction of KMX’s volume. Gross profit per used retail vehicle – excluding financing – was $1,796. Inclusive of contributions from vehicles sold on a wholesale basis and financing, CVNA generated gross profit per vehicle of $2,329. Because of CVNA’s significantly lower volume/lack of scale, cash operating expense was $3,276 per vehicle. CVNA lost $947 for each vehicle it sold last year. Consolidated EBITDA was negative $229 million.

Notwithstanding the massive divergence in unit economics and CVNA’s persistently negative EBITDA, investors have bid up its equity to ~$13.7 billion, about 30% more than KMX.

A key component of the bull case is that increasing unit volume will help CVNA to absorb its fixed costs, leading to improved profitability over time. On this point, I must concede the company has made steady progress. Prior to the coronavirus, I estimated an improvement in the company’s cash loss per vehicle to “only” $500 in FY’20. With that said, I believe there are three pertinent questions investors must ask at the current juncture:

1. What impact will the current macroeconomic backdrop have on the company?
2. At what cost will the company reach profitability?
3. Given the answers to 1 & 2 above, is CVNA worthy of its current valuation?

The current macroeconomic backdrop is unquestionably bad for CVNA. Fewer car sales will hamper the absorption of fixed costs and impede the company’s ability to narrow the loss it generates on each vehicle sale. Furthermore, used vehicles are piling up on lots across the country resulting in a large decline in used vehicle pricing. Manheim’s used vehicle price index tumbled 11.8% in the first half of April, easily surpassing the 5.5% drop in November 2008 as the worst month on record. Lower prices will hurt CVNA’s unit economics by crimping margins and reducing finance related fees (lower car prices = smaller initial loan balances).

Prior to widespread stay-at-home orders, street estimates implied that CVNA would burn through $1 billion of cash from 2020 to 2022. This is on top of the $1.8 billion of negative free cash flow reported since the company’s IPO in 2017. With the prospect of weaker than expected results at hand, logic suggests that CVNA’s financing gap will exceed $1 billion over the next several years.

As for whether or not the answers to questions 1 & 2 are supportive of CVNA’s current valuation, either on an absolute or relative basis, I’ll be brief: No.

A final thought – while I believe CVNA is an attractive short based on the financial merits alone, questions have also been raised as to whether the company is relying on questionable related party transactions to prop up its finance revenue. On March 30th, the company disclosed the following via an 8-K filing: “In addition, we have received a voluntary request from the SEC requesting information about our related party disclosure and accounting policies and procedures for historical loan sales and refinancings. We are providing relevant documentation in response to this request.” This is something I am watching closely.”

In Q3 2019, the number of bullish hedge fund positions on CVNA stock increased by about 7% from the previous quarter (see the chart here).

Disclosure: None. This article is originally published at Insider Monkey.

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