How Carvana went from Wall Street top pick to meme stock trading

Ernie Garcia, CEO, Carvana

Scott Mlyn | CNBC

Carvana CEO Ernie Garcia III regularly tells Wall Street that “the march continues” in the company’s mission to become the largest and most profitable used car dealership in the world.

The stock price has marched up again this year, just in the wrong direction for investors. In the space of six months, Carvana has gone from Wall Street’s favorite used-car dealer poised to capitalize on a resilient market to trading like a volatile meme stock amid cost-cutting measures and layoffs.

The Arizona-based used-car dealer’s fall, including a nearly 90% drop in its share price since November, resulted from a mix of changing market conditions and self-inflicted wounds. Many traditional traders continue to report record or near-record results, which sheds further light on Carvana’s woes.

Carvana grew exponentially during the coronavirus pandemic as shoppers switched to buying online rather than visiting a dealership, with the promise of hassle-free used vehicle sales and purchases at customers’ homes. But analysts are concerned about the company’s liquidity, mounting debt and growth this year is expected to be the slowest since it became a public company in 2017.

“By the company’s own account, it had accelerated growth into a consumer slowdown at exactly the wrong time, leading to a large mismatch between capacity and demand and causing a liquidity crunch,” Morgan Stanley’s Adam Jonas said in an investor note earlier this month, ranking the company Shares down company and lowered its price target from $360 to $105 per share.

The slowdown is due, among other things, to high vehicle prices, rising interest rates and fears of a recession. Carvana bought a record number of vehicles last year amid sky-high prices and rising inflation to prepare for unprecedented demand that has since slowed.

Analysts say Carvana is far from out, but it may have peaked. There are concerns about the future used car market and its near-term risks that outweigh the potential gains.

“Deteriorating capital market conditions and deteriorating trends in the used car industry have shaken our belief that Carvana can secure the necessary capital to achieve sufficient scale and self-funding status,” Stifel’s Scott W. Devitt said in an investor note last week.

Carvana stock has a “hold” rating with a price target of $89.30 per share, according to analyst estimates compiled by FactSet.

“We weren’t prepared”

Carvana’s stock traded at more than $300 a share before the company reported its third-quarter results on Nov. 4, when it missed Wall Street’s earnings expectations and internal operating problems became known.

Garcia, who also serves as chairman, told investors the company was unable to meet customer demand, resulting in it not listing its entire fleet of vehicles for sale on its website. He said it was because the company bought vehicles at a higher price than it could handle.

“We weren’t prepared for this,” said Garcia, who co-founded the company in 2012 and has grown it into a nearly $13 billion business.

To support future vehicle purchase throughput and refurbishment times, Carvana announced a definitive agreement on February 24 to purchase the US business of Adesa — the second-largest provider of wholesale vehicle auctions in the country — from KAR Global for 2.2 billion dollars known.

Garcia said at the time the deal “solidified” Carvana’s plan to become “the largest and most profitable auto dealership.” On the same day, he ended his prepared remarks with investors for the fourth quarter results by saying, “The march continues.”

The deal was welcomed by investors, who sent the stock soaring 34% to over $152 per share over the next two days. A steady decline followed due to recession fears and other macroeconomic trends impacting the used car market.

Overbuilt costly inventories

Gains from the transaction were short-lived given the macro environment and the company fell well short of Wall Street expectations for the first quarter, prompting a sell-off in company shares and a series of analyst downgrades.

The company has been criticized for overspending on marketing that included a lackluster 30-second Super Bowl advertisement and failing to prepare for potential slow or declining sales. Carvana argues that it overprepared for the first quarter after being underprepared for demand over the past year.

“We built for more than showed,” Garcia said during an April 20 conference call.

The results plummeted over the following week. Garcia described the issues as “temporary” and something the company will learn from. He acknowledged that Carvana may have prioritized growth over earnings as the company has delayed its plans to achieve positive earnings before interest and taxes by “a couple of quarters.”

The stock was hit again in late April when the online used-car dealer struggled to sell bonds and was forced to approach Apollo Global Management for $1.6 billion in the agreement to fund the Adesa deal rescue.

Analysts see the deal to fund the Adesa purchase as “unfavorable” at 10.25%. Existing bonds have already yielded more than 9%. Bloomberg News reported that Apollo bailed out the deal after investors demanded a yield of around 11% on a proposed $2.275 billion junk bond and around 14% on a $1 billion preferred asset

The unfavorable conditions will “inevitably delay the company’s path to positive free cash flow into 2024,” said Wells Fargo analyst Zachary Fadem. In a May 3 note to investors, he downgraded the stock and lowered its price target to $65 per share from $150.

RBC Capital Markets’ Joseph Spak expressed similar concerns about the deal, saying the integration “could get messy” over the next two years. He also downgraded the stock and lowered its price target.

“While the strategic rationale for Adesa makes sense, in our view the retrofitting and staffing of 56 facilities is likely to face an extended period of operational inefficiency over the next few years, with up to 18 to 24 months of sustained profit risk ahead,” he said In an investor statement early last month.

meme status

Carvana shares hit a two-year low last week before surging as much as 51% on the same day, along with “meme stocks” like GameStop and AMC.

Meme stocks refer to a select few stocks that suddenly gain popularity on the internet, leading to sky-high prices and unusually high trading volume.

For example, trading volume for Carvana on Thursday was over 41.7 million compared to its 30-day moving average volume of around 9 million. Trading in Carvana shares was suspended at least four times on Thursday.

Almost 29% of Carvana’s available-for-trade shares are short, according to FactSet, among the highest rates in U.S. markets.

Carvana tries to get back into Wall Street’s good graces. In an investor presentation released late Friday, the company defended the Adesa deal and updated its growth and cost-cutting plans, including reducing its vehicle acquisition costs.

The company said it is realigning its three key priorities: growing retail units and revenue, increasing overall gross profit per unit and demonstrating operational leverage.

“We have made significant progress on the first two goals,” the company said. But more needs to be done, particularly in terms of profitability, free cash flow, and selling, general and administrative expenses.

The company in the presentation again confirmed reports last week that it had laid off 2,500 employees, or about 12% of its total workforce, and that Carvana’s leadership team will waive salaries for the remainder of the year to help pay off employees who have been terminated.

Rivals record wins

Carvana’s recent troubles come as the country’s largest public dealer groups continue to report record or near-record profits despite low inventories and high prices.

The country’s largest auto dealer, AutoNation, last month reported record first-quarter earnings per share of $5.78. The company has aggressively switched to used vehicles in the face of a drop in new vehicle availability during the coronavirus pandemic. Revenue from its used-car business rose 47% in the quarter, bringing total revenue to nearly $6.8 billion.

Lithia Motors, which is in the midst of an aggressive growth plan to become the country’s largest vehicle dealership, said its first-quarter profit more than doubled year-over-year to $342.2 million. Average gross profit per unit for used vehicles — a statistic closely watched by investors — rose 32% to $3,037. In comparison, Carvana costs $2,833.

“Carvana seems to have gotten a lot of this tech-stock halo that Tesla has long benefited from,” said Morningstar analyst David Whiston, who covers major listed dealer groups but not Carvana. “I think maybe that was a little bit generous from the market.”

– CNBC’s Michael Bloom and Hannah Meow contributed to this report. How Carvana went from Wall Street top pick to meme stock trading

Jane Marczewski

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