98% below its high, Morgan Stanley says Carvana stock could fall to $1

In July 2021, Carvana stock peaked at $377. By November 4, 2022, its shares had lost 98% of their value, falling to around $9. With 36.3% of its free float sold short, many investors could profit if Carvana shares continue to fall – down to $1, Morgan Stanley said.

Unless the meme crowd rages against Carvana’s short sellers, the case for a lower share price remains compelling. These include

  • Disappointing Q3 financial report
  • Falling demand from industry
  • Lower cash position
  • Lower profits from the sale of loans
  • Bad credit score
  • Dark Forecast

Disappointing third quarter financial report

The worst thing a company can do on a quarterly earnings call is to fall short of expectations. Carvana clearly achieved that dubious distinction on Nov. 3 — missing “Wall Street expectations for third-quarter revenue and earnings,” according to CNBC.

Here is the litany of bad news:

  • Revenue of $3.39 billion fell 2.7%, down $320 million from estimates according to Refinitiv.
  • Carvana’s loss per share was larger than expected at $2.67 per share.
  • Gross profit fell 31% to $359 million.
  • Retail units sold decreased 8% to 102,570 vehicles from the previous year
  • Gross profit per unit fell more than 24% to $3,500.

Consumers find it hard to afford what Carvana sells. As CEO Ernie Garcia III told the Wall Street Journal, “monthly payments for customers buying a car are now about 160% higher than before the pandemic.” Due to higher interest rates, Carvana’s earnings from selling car loans to outside investors are lower.

Falling demand from industry

The pandemic has been great for used vehicle retailers. However, in 2022, the fortunes of the industry have reversed.

During the pandemic, the supply of new vehicles has been well below demand due to supply chain issues and shortages of semiconductors. Consumers in need of vehicles opted for a used car or truck, driving up used vehicle prices and profits.

The macroeconomic challenges of 2022 have changed consumer behavior towards used vehicles. With high inflation, rising interest rates and fears of a recession, consumers are less willing to pay record high prices for used vehicles.

This drop in demand has hurt the industry. According to CNBC, the result was “declines for Carvana and CarMax” and warnings of slowing demand for used vehicles from “large franchised new and used vehicle dealers such as Lithia Motors.”
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Lower cash position

Carvana was a veritable incinerator of cash. Between June and September 2022, its cash balance decreased by $734 million, leaving Carvana with just $316 million in cash.

Carvana tried to reassure investors by saying she “could borrow about $2 billion to buy cars and make loans, and could raise another $2 billion through real estate,” according to the Journal.

Seth Basham, equity analyst at Wedbush Securities, predicts Carvana needs to raise more capital. Otherwise, he estimates that he “will not be able to maintain sufficient liquidity to meet the financing needs of his floor plan (which were recently modified under stricter conditions) and finance his activities until 2023. “, according to the Journal.

I think Carvana is taking an overly optimistic view of its ability to raise more cash. As the Journal reported, Garcia said “that [Carvana] had $4.4 billion in cash, even though only half of it is committed. Much of the rest is based on assumptions that may not come to fruition.

Additionally, Garcia declined to comment on possible stock sales to reduce his debt. Instead, he told investors that Carvana could get the cash it needs by cutting costs. After cutting staff by 12%, “there’s no huge savings potential there” by further reducing its $656 million in operating expenses, the Journal noted.

Bad credit score

Carvana’s credit rating plummeted this spring. As I wrote in May, at the end of April, Moody’s lowered the rating of the Carvana family of companies to Caa1.

Moody’s reasons for the downgrade included:

  • “Very weak credit metrics, a persistent lack of profitability and negative free cash flow generation”
  • “Governance Considerations” – such as Carvana’s decision to update its “external floor plan facilities” despite expecting significant negative free cash flow. and
  • Its decision to “finance the acquisition of [wholesale auction service] ADESA partially indebted despite its very high leverage.

Moody’s said it could downgrade its ratings “if the company is unable to generate positive operating income on a sustainable basis or if liquidity were to weaken for any reason.”

Carvana remained dynamic. As CEO Ernie Garcia told investors on April 20, “While this quarter may be a little harder to see than most, we remain on the path of building the biggest and most profitable automotive retailers and changing the way people buy and sell cars. . The march continues.”

Although Moody’s did not change its rating, Carvana’s Nov. 4 report prompted Morgan Stanley analyst Adam Jonas “to withdraw its rating from the auto retailer and said its stock could be worth as little as $1.” , according to Bloomberg.

This rating change is a big reversal for Jonas who, in early March, had a price target of $430 for the stock. Jonas cited the deteriorating used car market and a volatile financing environment for change.

Jonas wrote: “As the company continues to pursue cost reduction actions, we believe that a deterioration in the used car market combined with a volatile interest rate/funding environment (bonds trading at 20% return) adds significant risk to the outlook, contributing to a wide range of outcomes (both positive and negative),” CNBC reported.

Meanwhile, the value of Carvana’s bonds is falling, suggesting that the company’s ability to meet its obligations is weakening. For example, “Carvana’s 5.875% senior debentures due 2028 fell to a record low of 36 cents on the dollar on Friday afternoon in New York,” Bloomberg reported.

Lower profits from the sale of loans

In the past, Carvana derived much of its profits from the sale of loans taken out by buyers to purchase its used vehicles. According to FT, “gains from the sale of loans together with other incidental costs have generally accounted for more than half of Carvana’s gross profit per unit”.

Those gains have fallen since peaking in 2021. Gross profit per unit from the sale of loans and other fees fell 23% from $2,500 to $1,921 in the third quarter of 2022, according to FT.

Dark Forecast

Carvana isn’t optimistic about 2023. Garcia described next year as “difficult”. As he told investors last Thursday, “Cars are an expensive, discretionary and often funded purchase that has ballooned far more than other assets in the economy over the past two years and that is clearly impacting people’s purchasing decisions.

Garcia described the end of the third quarter as the “most unaffordable point ever” for customers financing a vehicle purchase. Although they were down 7% last year, according to auction house Manheim; in October, used car prices were still 43% higher than three years ago, according to the Journal.

With average rates on used car loans hitting 9.6% in October — the highest in about 10.5 years — the average monthly payment for a used vehicle rose 8% to $564 in October compared to a year earlier, according to Edmunds.

A short seller is pessimistic about the future of Carvana. According to FT, Spruce Point Capital Management founder Ben Axler said: “Carvana has not generated any positive cash flow since the first financial report in 2014, more than eight years ago. Now that capital has become more expensive, [it] will truly test the appetite of investors to fund its loss-making business ambitions.

Carvana sees a bright future. “While progress is rarely linear, we remain on the path to becoming the largest and most profitable automotive retailer,” Garcia told FT.

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