#020 - Carvana

Carvana buys and sells used cars. It has built up the in-house infrastructure necessary to serve customers and expand into new markets. However, Carvana seems to be hated by many investors.

Carvana - (NYSE: CVNA)

Carvana buys and sells used cars. It has built up the in-house infrastructure necessary to serve customers and expand into new markets. However, Carvana seems to be hated by many investors.

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Please note that this article does not constitute investment advice in any form. This article is not a research report and is not intended to serve as the basis for any investment decision. All investments involve risk and the past performance of a security or financial product does not guarantee future returns. Investors have to conduct their own research before conducting any transaction. There is always the risk of losing parts or all of your money when you invest in securities or other financial products.

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Industry Overview

I’m working through the used car industry for the next couple of months. The used car industry may seem kinda bland or like a sketchy industry, but I think that means there might be opportunities in this sector and it’s worth pursuing. This space peaked my interests so I’m researching it.

Buying a car (used or new) can cause headaches for many consumers. Most people don’t have the best impression of car salesmen. People don’t want to spend a whole day negotiating over prices, financing, upgrades, and every other item that goes into buying a car.

Consumers can do their own research on the internet, determine what’s a fair price, and come to their own conclusions. Consumers can buy a car at home and have it delivered to their home. The internet helps to increase the number of SKUs available to consumers. Instead of having one dealership serve a small radius, Carvana can serve a larger radius with its logistics and last mile delivery option.

Consumers can go to dealerships (independent or franchised), try and buy a car from a friend, neighbor, or other person, or look to buy a car online. If you’ve done your research and you know what you want, wouldn’t it make sense to buy a car online assuming the company offers a return policy so you can test drive it on your own and take it to a mechanic? If you truly believe that buying a car is a hassle and people would rather purchase a car online and have it delivered, why isn’t an online used car retailer a good business idea (in theory it should be a good idea, in practice it might be totally different). If pricing for online used car retailers is within the same ballpark as dealerships, why wouldn’t you buy a car online if it could save you the pain of negotiating?

There are certainly people who don’t think buying a car online will ever be a big deal. There are others who have bought a car online and think it’s the future. The important thing to recognize is that the only important variables are what is the average consumer’s experience and is that trending up or down?

Of course, there are many concerns about car buying and Carvana has a whole list of concerns for many investors. I’m here to learn and write about what I’ve read and think. If you think differently, I’d love to hear your thoughts in a civil discussion.

Business Overview

Carvana is similar to Vroom in that it buys and sells used cars to consumers. Carvana is currently a retailer but has talked about being more than just a retailer by moving into being more of a marketplace that’s both 1P and 3P, meaning Carvana will be a retailer and a place for others to sell used cars online. This isn’t core to the Carvana thesis today, but it might be in a number of years.

Carvana collects revenue three different ways, through used vehicle, wholesale vehicle, and “other sales and revenues.” Used vehicle sales consist of (you guessed) selling vehicles to regulars consumers. Carvana buys car from a wide range of sources, brings these vehicles to an inspection and reconditioning center (IRCs), fixes up these vehicles, and sell it back to consumers.

Wholesale vehicle sales consist of Carvana selling used car units to other dealerships or other professional parties. Carvana’s in-house financing is “other sales and revenues” which consists of “gains on the sales of loans we originate, commissions we receive on sales of VSCs and sales of GAP waiver coverage.” Carvana then sells these finance receivables to banks like Ally Financial. Lots of investors have concerns about this in-house financing, but since I write a shallow dive, I did not dig too much into this piece of Carvana’s business model.

Carvana’s goal is to be fully vertically integrated. Carvana has its own fleet of inspection and reconditioning centers, an in-house auto logistics network, in-house customer support specialists, and even performs financing in-house. This is a huge difference from companies like Vroom. Vroom has a hybrid/asset-light business model where some business functions are in-house and some are outsourced to 3rd parties.

Carvana is run by Ernest Garcia III, who is the founder and CEO of Carvana. While I like to see companies run by owner-operators, there are still concerns about both Ernest Garcia III and his father, Ernest Garcia II. Carvana does have some serious scrutiny and doesn’t seem to be loved by too many investors, but there is still a strong opportunity in this space. Maybe Carvana isn’t the winner, but it doesn’t hurt to research Carvana to learn more about the space. While I think Carvana may be an attractive business from a high level perspective, there are plenty of other opportunities or “fat pitches” to be had. One doesn’t need to worry about missing Carvana when there are other attractive opportunities.

Total Addressable Market

There is massive potential for online, omni-channel, and physical used car retailers. The used car market is one of the largest industries and is very fragmented without any companies that capture a large portion of the market. The largest competitors in this space are CarMax and Carvana. There are other companies trying to compete in this space but Carvana and CarMax have had the most success thus far.

Many estimates (from both Carvana, other companies, and 3rd parties) have pegged this industry north of $750 billion. The market is large and fragmented. The largest player (CarMax) is said to have ~2% market share. Carvana is creeping up in some of their more mature markets. I’ve inserted a market penetration image from Carvana’s 10-K below.

“…101, 28, and 7 markets have now crossed the milestones of 1.0%, 1.5%, and 2.0% market penetration, respectively, an increase from 23, 7, and 2, respectively last year. As in past years, we generally continue to see similar trends across markets, including newer markets, smaller markets, and more proximate markets ramping even faster than average.”

Carvana 10-K

The image below is of Carvana’s market penetration since 2013. Most markets are trending nicely and will be interesting to see how far Carvana can penetrate some of these markets.

While this is a large space and Carvana continues to capture more market share, there are still concerns. Some investors worry that scaling in this market is much harder than Carvana has made it appear thus far and that Carvana may hit a road block when trying to penetrate more markets and penetrate existing markets more deeply.

Competitive Advantages

• Scale Economics Shared

  I think this one is likely a stretch but I think could be interesting. Basically if Carvana passes on potential scale advantages to customers then competitors will be unable to win any market share in this industry. Carvana’s infrastructure may be nearly impossible to build if companies aren’t able to compete on price and win market share and then reinvest in the business.

  If you’re buying used cars and assuming every car has the same mileage, dents, or damages, then you’ll shop at the company that has the lowest prices. Carvana’s vertical integration gives them an advantage of having everything in house and not relying on any third parties that take savings away from customers.

  Of course, this competitive advantage is impossible without scale. Carvana is investing in its infrastructure and has taken years of work and likely billions of dollars to build out this infrastructure and it won’t be an easy thing for competitors to copy.

• Brand

  If you have a great experience with Carvana then you’ll likely return in 5-6 years or however often to buy another used car (or maybe a new car in the future). If you have a great experience you’re also likely to tell your family, friends, and colleagues about it. This will spread the experience (good or bad) to others and will spread through word of mouth. Just like Amazon initially had great customer service and made consumers more comfortable, what if Carvana is able to build a strong and trusted brand?

Financials

Just a heads up, Carvana does not make a profit. This likely isn’t very surprising for many investors that follow Carvana or follow tech, but that doesn’t mean there aren’t interesting things to learn from Carvana.

I decided to focus on used vehicle sales and “other sales and revenue” (the financing portion) because I think these are the two most critical drivers for this business. Carvana has grown quite well over the past couple years and has even benefitted from COVID-19.

2020

• Used vehicle sales = ~ $4.7 billion

• Other sales and revenue = ~ $400 million

• Used vehicle gross profit = ~ $359 million

• Used vehicles sold = 244,111

• Wholesale vehicles sold = 55,204

• Used vehicle per unit gross profit = $1,472

• Other per unit gross profit = $1,642

• Number of markets = 266

• Used vehicle YOY revenue growth = 38.6%

• Other sales and revenues YOY revenue growth =59.2%

• Used vehicle gross profit margin = 7.6%

2019

• Used vehicle sales = ~ $3.4 billion

• Other sales and revenue = ~ $252 million

• Used vehicle gross profit = ~ $238 million

• Used vehicles sold = 177,549

• Wholesale vehicles sold = 39,895

• Used vehicle per unit gross profit = $1,340

• Other per unit gross profit = $1,418

• Number of markets = 146

• Used vehicle YOY revenue growth = 91.6%

• Other sales and revenues YOY revenue growth = 159.9%

• Used vehicle gross profit margin = 7.0%

2018

• Used vehicle sales = ~ $1.8bn

• Other sales and revenue = ~ $97 million

• Used vehicle gross profit = ~ $94 million

• Used vehicles sold = 94,108

• Wholesale vehicles sold = 15,125

• Used vehicle per unit gross profit = $1,002

• Other per unit gross profit = $1,029

• Number of markets = 85

• Used vehicle YOY revenue growth = 124.0%

• Other sales and revenues YOY revenue growth = 189.6%

• Used vehicle gross profit margin = 5.3%

What’s Interesting

• Large fragmented market?

  I touched on this aspect in my shallow dive on Vroom, I think this is one of the most exciting aspects of this industry and why I’m doing some shallow dives on companies in this space. If there is a company who can effectively scale and become the largest used car retailer and capture more than a 2% market share, then that company might be a big business. The question that needs to be asked is just how much can one company penetrate this market, is it 5%, 10%, 20%, 30%? While these percentage points may seem small and insignificant, when using it to compare to the size of this market, that could be tens of billions of dollars.

• Carvana’s in-house infrastructure?

  Carvana has spent years and plenty of money investing in building out its own infrastructure without relying on third parties. Other companies like Vroom work with 3rd parties, but this means Vroom can’t control the whole customer experience nor save costs for consumers. Building this infrastructure hasn’t been easy and Carvana has struggled over the years as a result. I believe this infrastructure is where Carvana’s potential competitive advantage stems from.

Future Questions

• What are some opportunities beyond being a 1P retailer?

  Carvana is primarily a 1P retailer right now, but I do think there are interesting upsides that investors don’t give them much credit for. If you think creatively about Carvana, what if Carvana becomes a marketplace that is both 1P and 3P? What if Carvana allows other companies to sell cars on its platform? Do these companies have to use Carvana’s inspection centers, logistics, or financing? If Carvana is helping these companies do more business and is doing a lot of the work in the process, what does Carvana charges these parties?

  Carvana’s infrastructure may also be appealing. Just like Amazon has turned its cost centers into profit centers (link), what if Carvana can do the same with its inspection and reconditioning centers, logistics infrastructure, and financing?

  While these are all very hypothetical points and shouldn’t be involved in a regular bull case for Carvana, I think there are very interesting and compelling opportunities for Carvana.

• How much can Carvana penetrate this market?

  The largest company in this space (CarMax and increasingly Carvana) has very little market share. Some estimates have CarMax at around 2% market share across the country and Carvana has market share of ~2% in some of its more mature markets. While there are plenty of reasons that companies might not be able to capture a large market share in the past, if there is a company that is able to capture a large market share, it would be handsomely rewarded.

  This will be rough math, but let’s play a little scenario, assuming this industry is $750bn. Carvana captures 20% market share, $150bn in revenue. 10% profit margins, $15bn in profit. Apply a 20x multiple, you get a $300bn business. While there are issues with this framework such as dilution, how long this takes to play out, whether or not capturing 20% market share is even feasible, if 10% profit margins are realistic, and then claims of fraud, this is an interesting framework and depending on your comfort in the business and management team, this could be an attractive investment.

• Financing?

  While I just glossed over financing in this shallow dive, I think this is an important area that I would need to understand in order to feel confident investing in Carvana. There are many resources out there to understand the lending and finance portion of this business, but I won’t be able to cover that information in a shallow dive.

Conclusion

Look, if you follow Carvana or have even heard about the company before, you are likely to know all about the concerns. You might even be roasting me or rolling your eyes thinking I’m insane, and honestly I might be a little insane, but I like to read about the bear thesis and write about the bull thesis. I saw this quote and think it’s true “Pessimists sound smart. Optimists retire young on beaches.”

I try to be optimistic in my analysis of a company because I think being optimistic is better than being a pessimist and missing opportunities. While this isn’t the case for Carvana, if you wait to invest in an opportunity with zero risk, you’ll live a boring and complacent life. I write shallow dives to filter through businesses quickly and find the companies that stick out to me the most and then I follow them on my own. I hope this newsletter can do the same for you.

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