Carvana (NYSE:CVNA) was going to completely disrupt the used car industry – that appeared inevitable. At least that was what the stock price appeared to indicate during the pandemic, as the stock soared to the stratosphere all the way until 2021. That dream appears to have come crashing down amidst the tech crash, as investors are suddenly questioning the rising leverage and path to profitability. With unprofitable stocks like CVNA, one is often told to look to the long term, but I question whether things will really get better with time. While the stock is as cheap as it has ever been, the potential downside remains very high.

CVNA Stock Price

CVNA peaked at around $376 per share in mid-2021. The stock has fallen 90% and now trades around $33 per share.

Crashes like that indicate that the stock traded at a bubble at the peak – which certainly appears to be the case here. The key question is: can the stock come back?

CVNA Stock Key Metrics

Prior to the pandemic, CVNA was aggressively growing by entering new markets and taking market share in existing markets. The pandemic only helped accelerate that strategy as seen below:

While the company grew both revenues and retail units sold at a fast pace in 2021, this last quarter saw the largest sequential decline in both metrics since 2016:

Such cyclicality shouldn’t be a surprise considering that the used car market has been operating under artificially tight conditions (due to supply chain disruptions). CVNA saw gross profit per unit decline to pre-pandemic levels in the quarter.

The near-term headwinds aren’t necessarily an issue. Other pandemic winners like e-commerce operators are also seeing growth decelerate temporarily due to tough comparables. With CVNA, however, the issue is more to do with the long-term big picture of profitability.

Is Carvana Profitable?

CVNA is not currently profitable and saw margins deteriorate this past quarter to an 11.6% EBITDA margin loss.

The company has guided for 8% to 13.5% EBITDA margins over the long term.

Like other unprofitable tech stocks, any fundamental interpretation of the investment thesis will inevitably count on making long-term assumptions regarding margins. As I discuss later, the long-term margin assumptions appear very aggressive.

Will Carvana Stock Go Back Up?

Wall Street analysts remain split on the stock, with an average rating of 3.51 out of 5.

The average price target of $102.55 per share represents around 200% upside.

I possess great doubts regarding the long-term viability of this business model, but given the 90% decline from all-time highs, there is ample reason to believe that investors could see volatile bounces in the near term.

Is Carvana A Good Long-Term Investment?

The investment thesis for CVNA is typically explained as follows. CVNA is disrupting the used car industry – a large market which typically does not have high consumer satisfaction scores.

Like Amazon (AMZN) in retail e-commerce, CVNA believes it offers a superior car buying experience.

The company expects that experience to improve as it builds out its network, as it would be able to build out more locations which increase available choice as well as reduce delivery times.

Wall Street still considers CVNA to have secular growth tailwinds as evidenced by the aggressive long-term consensus estimates.

Is CVNA Stock A Buy, Sell, Or Hold?

Judging based on consensus estimates, the value proposition isn’t hard to see. The stock is trading at 0.04x 2031e sales – assuming a long-term net margin of 6% (8% was the low end of management’s EBITDA margin guidance), the stock is trading at 0.67x 2031e earnings power. The stock would appear to have 10x upside to trade at a 6.7x earnings multiple in 10 years. And if the bullish thesis really plays out, then the stock probably will trade at a significantly higher multiple than 6.7x earnings.

The problem, though, isn’t that of valuation, as valuation is not providing any margin of safety here. This is one of those moments where one should think long and hard about the business model, as the path to profitability is not nearly as clear as some tech plays. I am highly skeptical that the company will be able to realize even the low end of long-term EBITDA margin guidance (8%). Consider that CarMax (KMX), the big profitable competitor that CVNA is supposedly disrupting, has generated a roughly 4% net margin over the past few years. How much more profitable can CVNA be? I don’t buy the notion that CVNA materially saves on fixed costs. Just like KMX has to operate dealerships, CVNA has its own physical infrastructure costs as, after all, the company must prepare and store inventory for sale. The main differentiating factor has typically been discussed as being the lack of sales commissions, but even there, I question the amount of shavable fat. KMX uses a similar no-haggle pricing structure and thus pays its sales reps with a fixed fee structure – suggesting that there is minimal marginal improvement that CVNA can make. Typical car dealerships pay their sales reps 25% of dealership profits – considering that dealerships tend to make most of their profits from maintenance services, here we once again must question how much CVNA can save. Any potential savings end up being around 2% to 5% of revenues at a maximum and would show up as a variable cost anyway. It is easy to state that CVNA will save on fixed costs – but it is difficult to understand exactly where those savings will come from. The bullish thesis requires CVNA to achieve higher margins than traditional dealerships, but one mustn’t rule out the possibility that the company will never achieve even comparable margins.

That brings us to the critical question: just exactly how is CVNA going to improve from the 0% adjusted EBITDA margin posted in 2021 (let alone the negative 11.6% adjusted EBITDA margin in the latest quarter) to the projected 8% range? If there are no clear fixed margin catalysts, then the main path would have to be through operating leverage from scale (selling more units). CVNA generated 15.1% gross margins in 2021, the highest of its history. I estimate that CVNA would need to increase sales by 53% at its existing locations at the same gross margin in order to generate 8% adjusted EBITDA margins. But how feasible is this? The answer to that question depends on whether one believes that CVNA will become the first-stop destination that AMZN has become in e-commerce. While CVNA’s customer service is undoubtedly first class, there is no reason why competing dealerships cannot replicate some of the things like home delivery and online purchase. In fact, KMX already does both. I also suspect that car transactions are highly price-sensitive and one must thus wonder if CVNA really will be able to achieve the scale needed for operating leverage and therefore profitability. Thus far I have only discussed KMX, but we should not ignore traditional dealerships like AutoNation (AN). We can see a snapshot of their income statement below:

As seen above, vehicle sales make up only a small proportion of overall gross profits. It wouldn’t be out of the question for these dealerships to try to accept lower gross margins on vehicle sales in order to drive greater service revenues. That trend would negatively impact CVNA’s ability to achieve its projected gross margins.

Those concerns are arguably enough to throw a wrench in any bull thesis. Unfortunately, there is also sufficient firepower for even a bearish thesis. In order to fund its acquisition of the ADESA US’s wholesale auction business, CVNA issued $3.275 billion of 10.25% senior unsecured notes due 2030. This adds to the $2.4 billion of senior notes already present on the balance sheet. Those $2.4 billion of senior notes carry annual interest expense of $133 million which plus the new senior notes brings total projected interest expense to $469 million on an annual basis. ADESA was producing around $100 million of annual average adjusted EBITDA as revealed below:

CVNA has projected $40 million of interest expense savings from lower balances on revolving facilities.

Those factors might bring the projected net interest expense down to $329 million (at least that is how CVNA seems to want investors to look at it). Recall that CVNA is not profitable even on an adjusted EBITDA basis. Interest expense alone would make up 5% of the current market cap every year. Bulls may make the argument that even 10% annual dilution isn’t an issue when the projected upside is 10x-20x – sure, I can buy that argument. Dilution is only one issue – the company had only $403 million of cash on its balance sheet as of the end of the quarter. Considering the current cash burn rate, I wouldn’t be surprised if the company had to raise additional funds, likely by issuing stock at these low prices. The $5.7 billion of debt on the balance sheet greatly increases the risk of an already risky investment thesis. It will take a lot of capital to build out CVNA’s vision, as its forward growth outlook is heavily predicated on being able to build out a wide-reaching physical infrastructure. But with the balance sheet already stretched as it is, one cannot be blamed for wondering if CVNA will have the necessary access to capital to fund the bullish thesis.

So let’s sum up the investment thesis. The stock trades cheaply if the bullish thesis plays out. However, the likelihood of that thesis playing out seems very low considering the uncertain path to profitability and high competitive landscape. Making matters worse, the company also has a large debt load which adds great financial risk to the story. I suspect that CVNA continues to have ardent bullish supporters largely due to the fact that the stock once traded 10x higher – but a clear argument could be made that the stock is a worthy short candidate. I could see many investors buying the name so that they could “diversify” their portfolio by adding a unique investment thesis, but this looks to me like a case of diworsification as the likelihood of that investment thesis coming to fruition looks very shaky at best. While I expect great downside for this stock over the long term, I hesitate to express a bearish view due to the high likelihood of near-term volatility to the upside. Investors can do much better in the current environment.