How Carvana went from a 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 retailer in the world.

Its stock price has marched this year as well, just in the wrong direction for investors. Within six months, Carvana has gone from Wall Street’s preferred used car retailer poised to capitalize on a robust market to trading like a volatile meme stock amid cost-cutting measures and layoffs.

The fall from grace for the Arizona-based used car retailer, including a nearly 90% decline in its stock price since November, resulted from a mix of changing market conditions as well as self-inflicted wounds. Many traditional dealers continue to report record or near-record results, shining further light on Carvana’s problems.

Carvana grew exponentially during the coronavirus pandemic, as shoppers shifted to online purchasing rather than visiting a dealership, with the promise of hassle-free selling and purchasing of used vehicles at a customer’s home. But analysts are concerned about the company’s liquidity, increasing debt and growth, which this year is expected to be its slowest since becoming a public company in 2017.

“By the company’s own admission, it had accelerated growth at precisely the wrong time into a consumer slowdown leaving a major mismatch between capacity and demand, creating a liquidity crunch,” Morgan Stanley’s Adam Jonas said in an investor note earlier this month, downgrading the company and slashing its price target to $105 a share from $360.

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

Analysts say Carvana is far from out, but it may have peaked. There are concerns regarding the used vehicle market going forward as well as its near-term risks outweighing the potential rewards.

“Deteriorating capital market conditions and worsening trends in the used vehicle industry have eroded our conviction in the path for Carvana to secure the necessary capital to realize sufficient scale and self-funding status,” Stifel’s Scott W. Devitt said last week in an investor note.

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

‘We weren’t prepared’

Carvana’s stock was at more than $300 a share ahead of the company reporting its third-quarter results on Nov. 4, when it missed Wall Street’s earnings expectations and internal operational problems were disclosed.

Garcia, who also serves as chair, told investors that the company couldn’t meet customer demand, causing it to not offer its entire fleet of vehicles on its website for consumers to purchase. He said it was a result of the company purchasing vehicles at a higher rate than it could process.

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

Overbuilt costly inventory

The gains from the deal were short-lived due to the macroeconomic environment and the company significantly missing Wall Street’s expectations for the first quarter, initiating a sell-off of the company’s stock and a host of downgrades by analysts.

The company was criticized for spending too much on marketing, which included a lackluster 30-second Super Bowl ad, and not preparing for a potential slowdown or downturn in sales. Carvana argues it overprepared for the first quarter, after being underprepared for the demand last year.

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

The results tanked shares during the following week. Garcia described the problems as “transitory” and something the company will learn from. He admitted that Carvana may have been prioritizing growth over profits, as the company pushed back plans to achieve positive earnings before interest and taxes by “a few quarters.”

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

Analysts view the deal to finance the purchase of Adesa as “unfavorable,” at a rate of 10.25%. Its existing bonds were already yielding upwards of 9%. Bloomberg News reported Apollo saved the deal after investors were demanding a yield of around 11% on a proposed $2.275 billion junk bond and around 14% on a $1 billion preferred piece.

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The unfavorable terms will “inevitably delay the path” to positive free cash flow for the company until 2024, said Wells Fargo analyst Zachary Fadem. In a note to investors on May 3, he downgraded the stock and cut its price target from $150 to $65 a share.

RBC Capital Markets’ Joseph Spak voiced similar concerns about the deal, saying the integration “could be messy” during the next two-plus years. He also downgraded the stock and cut its price target.

“While the strategic rationale for Adesa makes sense, in our view, retrofitting and staffing up 56 facilities over the next couple years is likely to face a prolonged period of operating inefficiencies with as much as 18-24 months of ongoing bottom-line risk upcoming,” he said in an investor note early last month.

Meme status

Carvana is attempting 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 lowering its vehicle acquisition costs.

The company said it’s refocusing its three key priorities: growing retail units and revenue, increasing total gross profit per unit and demonstrating operating leverage.

“We have made significant progress on the first two objectives,” the company said. However, it said it needed to do more, specifically regarding profitability, free cash flow, and selling, general and administrative costs.

The company, in the presentation, reconfirmed reports last week that it cut 2,500 employees, or about 12% of its total workforce, and that the Carvana executive team would forego salaries for the remainder of the year to contribute to severance pay for terminated employees.

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