Starting the Drive Against Carvana (CVNA)

Yes, Blackberry still makes Uncertain times for Big Tech days make unicorns-in-waiting, like Carvana, into lucrative ride for short investors.

What makes this bumpy, early-2019 equity market so interesting is the smell of burnt investor coffee in the room. You know the odor: The back-of-the-church, 12-Step program scent of that vat of strong black java brewing to give the addicts the cup of strength and salvation they need to face down what addicts them.

For investors, the pot of the strong dark stuff brewing is the will needed to face down their addiction, namely fast growing, over-priced technology stocks. What else is it but addiction when you purchase a share of something like Amazon (AMZN), Netflix (NFLX) or Facebook (FB). Price-to-earnings ratios that are so high that they make the ratio itself meaningless. Operating cash flow that never seems to actually come from the operation. And then there’s the blatant illegality of even the most basic digital age product. Be honest: “organic search” and “social media like” is nothing but stone cold theft.

But what can one money manager do? Woe betide the poor sap that does “not get” the tech unicorn for what it is: The invulnerable financial beast that brings nothing career shame and exile to anybody who opposes it.

And that’s what’s darn thrilling about watching the likes of Amazon, Netlfix and Facebook, getting smacked around over the past 6 months. These once mighty mystical tech unicorns turn out be pretty darn tame equity mules that get just as spooked as any other stock in a scary world where consumers will only have less money on average tomorrow than they do today, automation will destroy 8 out of 10 jobs and squabbling public sector officials can actually shut down the U.S. government. Big tech’s vulnerability has in turn raised fascinating structural opportunities in the lesser tech stocks in waiting. Those flashy public tech companies that try to act like unicorns, but don’t quite have the cache to metamorphose into full blown techno beasts.

Case in point, Carvana. (CVNA), the Tempe, Arizona based used-car company, that is hoping to emerge from its venture-funded chrysalis as the next magical unicorn that reinvents the buying and selling a used car.

The Right Car Stuff: Almost 

On its surface, the genetic engineering embedded in Carvana appear to be 100 percent, pure Predator-level tech monster. The operation was aimed at a used-car market that does never seems to say die. Used car pricing operations like Edmunds estimate that as consumers try to avoid the record high costs for new cars, used cars will sell briskly for some time.

Yet, the fast moving used-vehicle market has yet to yield its Web-enabled dominant player, like Priceline (PCLN) or Expedia (EXPE) is in the travel game. Carvana likes to point out that the used car market is a hopelessly fractionalized sector, controlled by something like 17,900 franchised auto dealerships. And figures we trust, estimate that even Web used-car giants like CarMax (KMX) might account for even 2% or maybe 4% of the total used vehicle business.

That’s essentially zero, in the world of Web scale giants like Amazon that control half of all domestic retail sales.

So, it’s not surprising that the average shy, real world-challenged younger Millennial customers prefers their smart-phones to dealing with this mess of a used-car market. Who would not be receptive to a well-funded, innovative way to buy a used car via a smart phone, with nary a human soul involved.

Enter Carvana, which amounts to a giant car vending machine that sells cars via any smart phone. Simply do some Web surfing of various reviews of the over 10,000 vehicles the company claims it offers. Then check out some YouTube videos on the car you might want. You then arrange financing, also on your phone, cut a deal that apparently saves real money over buying through a fully-manned dealership. Then you either head down to one of the 24 Carvana buildings, that amount to a giant un-manned parking garage that stores the cars where they are easily viewable, and then the giant elevator, sort of “potato chip bag getting machine” gets you a car.

If that is too much human interaction for customers, Carvana will deliver the same on a flatbed. What could be more Millennial?

No question, Carvana’s sales cycle is fun and different. And there is a deep well of customers that like buying cars this way. Quarterly revenues at the firm, at the end of 2018, came in at a nice $535 million, that beat some estimates by 8 percent, on sales that were basically double the same period, for 2017. Sure, net losses grew at a faster rate than sales, but these are acceptable loses in a start-up defined age by Tesla, that may never, ever make money.

But what’s truly interesting is the Carvana floated some not-horrifically priced bonds to professional investors: $350 million in 2023 8.875% senior notes, to be exact, that sold out so fast that the last $50 million of that offering was an upsized tranche bolted on at the last moment.

Oversubscribed bonds, in a money-burning, venture-funded tech company? That got our attention. Bonds build credibility and nicer looking balance sheet, if you think about it.

And made Carvana the unicorn-in-waiting that is very unicorn like.

For sure, fixed-income investing professionals were not the only members of the established investor heard driving into Carvana. The bets on this company are eye-popping, indeed. The biggest was New York City-based Spruce House Partnership that sank a cool $24.3 million into 730,000 million shares in 2018 in the operation. And if you take the time to dig through the SEC filings, you’ll see serious white-shoe dollars flowing into the stock, from the likes of Vanguard Group, BlackRock, Morgan Stanley, Bank of New York Mellon Corp, and on and on.

Carvana is making a name for itself in trendy public investing brands, too. The Motley Fool loves this stock. If this tricker is not a unicorn ready to bust loose and eat its market, what else is?

Not Exactly the Right Car Stuff. 

But then there is that smell of coffee in the investor room. And the sobering new realities of a rocky equity market and suddenly vulnerable big tech stocks. Car sales may be high, but they have clearly plateaued since record levels that pegged around 2016. In fact, sales in some categories of used cars are beginning to fall, at least according Kansas City-based DealerCue, a car valuation service.

Years of incentive-based leasing is also catching up to the industry; lease returns rates for 2019 is expected to be particularly high, meaning new car sales should stay flat, which will directly compress used car sales. And Carvana’s overall prospects in the market.

And a look at the competitive landscape inside this tightening market is grim indeed. Targeted Web car selling services like CarMax, CarGurus, Edmunds. CarFax, TrueCar, etc etc, all offer a reasonable used-car buying experience online, even though most do lead to organized brick and mortar dealerships. And those dealerships have been making organized stands against the Web middlemen for decades. Massive organized dealer groups now dominate car sales. The top 5 like AutoNation (AN) and Berkshire Hathaway Automotive, probably have ten times the scale in vehicles sales and consumer touch points as Carvana.

Figure something like 1,000,000 vehicles flowis through the top auto groups. That Carvana’s inventory of 10,000 not all that much.

In these trying times, the online giants have been sneaking to used-vehicle sales. Amazon Vehicles is a darn slick Web used-car experience, that will happily deliver a vehicle to you. EBay Cars and Trucks is a surprisingly good experience, with deep inventory. Google and Facebook both are more than happy to ship off search queries in cars to their own pipelines. We counted exactly 3 clicks from Google’s front page to a perfectly nice, used Nissan Rogue at a dealership within walking distance from our office.

But the monster sleeper in used cars is clearly Costco. This warehouse super store effortlessly cuts out the sales person, a la Carvana. Simply go to the Costco Web site, and after you order this week’s groceries, look at local used car inventory. Then request a pretty competitive quote on a nice car. And you can pay with your Costco card, and pick the thing up on the way home from the store. In our poking around, the reasonable prices appear competitive.

Think of the Costco incentive points on that deal?

Not So Strong Operating margins. 

Carvana may be fun but after the first purchase, retaining customers will be all about pricing, service and margins. Margins that we are hearing, from sources within the used automotive supply chain, are dramatically worse than the company likes to talk about.

The margin problem start with Carvana’s smallish inventory. It’s cars must be circulated around to different locals depending on demand. There is a regional geography to popular car brands California is Honda Country. Texans loves their Fords. Chevys rule in the Upper Midwest. Acrua crushes it in the Southeast. And moving vehicles around the meet demands is far more expensive than it sounds.

Take a look at this fascinating real time quote service from Direct Connect Auto Transport, based in Pompano Beach. Florida. This operation will happily quote you a live fee for shipping a car between even relatively close locations like Columbus, Ohio to Tempe, Arizona. The trip starts at $797.60 at a $.40 cents per mile. Just so you know, the current IRS cost per mile estimate is $.545 cents per mile.

That about $1,015 or a ton of money, for an average cost of a used car that was $19,657 in 2018, at least according to credible printed reports.

Just Look at Carvana’s Bonds

But the real insight on Carvana’s prospects, is the professional fixed income investor trying to digest Carvana’s 8.875% corporates bonds. These notes currently fetch, let’s be honest, a kindly CCC rating from Standard & Poors, far below what you think those coupons would should yield. And sure enough if you poke around the market for these notes, you’ll hear the story of concerns with Carvana on horrible competition, low margins, low barriers to entry, lack of clear brand differentiation and yes, generous ratings

Then there is the fact that a group led by Ernie Garcia, the CEO of Carvana, had to buy a full $25 million of that $350 million bond float to calm a jittery credit market to get that float out on the street.

A Sober 2019 for Carvana. 

We are not saying that Carvana could not overcome these hurdles. Carvana does not feel yet like Beepi, the similarly well-funded used-car start up that folded last year. Carvana is big, well funded and probably better managed.

But what we are saying is in this current unstable market, Carvana has to be more vulnerable than other tech company companies to the ups and downs of a tech world trying to come to terms with its structural problems. And that what makes Carvana such a fascinating target

We think, that the sensible active manager, that understand how to play the volume in betting against a thickly-traded stock and can be ready for when sellers still outrun buyers merely on volume, when long term, the sellers of this ticker are outpacing the buyers. And we’re not alone The short interest and short interest ratios on this stock have been both creeping up over the past several months. It all has the scent of fresh money.

See that’s the thing with sobering up. If you play getting clean right, that burnt coffee smell can lead you to a real pay off.