Carvana, the Rise, the Fall, and the Bounce-Back
Welcome to the 60th Pari Passu Newsletter,
Today we are diving into a fascinating story: Carvana. Tracked from their point of inception, the two companies that broke into the Fortune 500 the fastest were Amazon and Google. The third? Carvana [1].
In August 2021, Carvana (NYSE: CVNA) commanded a peak market capitalization of over $30bn. Known for its multi-story glass tower car vending machines, the company was the fastest-growing online used car dealer among several players seeking to disrupt the traditional dealer distribution model. Since its founding, Carvana has successfully delivered over four million cars through an in-house distribution network servicing over 80% of the US population [22].
By the end of 2022, however, Carvana’s shares had fallen from an all-time high of $360.98 to an all-time low of $3.72. Today, we will understand the rapid rise and fall of Carvana, as well as the critical role of Carvana’s recent out-of-court restructuring in the company’s potentially ongoing comeback.
Chapter 1: The Origins of Carvana
The Carvana story begins at Stanford, where Ernie Garcia III and Ben Huston met as sophomores. While Garcia began his career in finance at RBS Greenwich Capital and Huston entered the legal field as an associate at Latham and Watkins after attending Harvard Law School, the two reunited in 2011 to start Looterang. While Looterang, a mobile app offering local, personalized deals off a proprietary algorithm, failed due to their lack of expertise, the duo, joined by Ryan Keeton, decided to pivot to a new business [1].
The trio decided to pursue an industry that at least one of them knew thoroughly. Garcia’s father, Ernest Garcia II, owns and operates Drivetime Automotive, the fourth-largest used car retailer in the United States. Since the age of 15, the younger Garcia had worked at the company every summer, learning the car business. As a result, the automotive industry was selected by the trio, who noted that the automotive industry is the biggest consumer vertical in the United States and has been historically known for poor customer experience. The elder Garcia allowed the trio to build Carvana, intended to become the “Amazon of cars,” as a subsidiary of DriveTime [1, 2].
It is worth noting that the elder Garcia had experience running a public company, Ugly Duckling, before it was rebranded to DriveTime Automotive. After receiving a felony conviction stemming from fallout related to the Lincoln Saving & Loans scandal (five Senators had improperly intervened with regulators on behalf of the bank in return for campaign contributions), Garcia II, then a Phoenix real estate developer, decided to enter a different business. He acquired Ugly Duckling, a rental car chain, and merged it with a tiny finance company. Utilizing the new company’s combined capabilities, he was a seller and financier of used cars focused on customers with weak credit histories. As the stock market performed well in the 1990s, Garcia II raised $170mm via IPO. However, in 2002, after Ugly Duckling’s stock price had fallen from over $25 to $2.50, Garcia II took the company private again, repurchasing the shares he did not own for $18mm. Investors sued, saying they hadn’t been treated fairly, but the lawsuits failed to pan out. The take-private proved to be a savvy decision, as DriveTime eventually grew to have revenues of $2.5bn and a private valuation estimated to be over $1bn. Lessons learned from Garcia II’s operation of DriveTime appear to have influenced Garcia III and his team since Carvana’s early days [2].
Chapter 2: Carvana Accelerates
Carvana was officially founded in 2012, with Garcia III as CEO. Supported by $100mm of start-up capital provided by Garcia II and later financial support from investors such as Mark Walter, the CEO of Guggenheim Partners, who purchased convertible debt in 2015 via his investment firm CVAN Holdings, Carvana was able to experiment with experientially-focused distribution models that could significantly reduce the overhead of a traditional dealership. One of these efforts, a garage with a glass door and keypad, gained significant media coverage. Sensing an opportunity, Carvana’s management hired a German engineering team to develop an actual, patented car vending machine, which debuted in Nashville in November 2015 and helped set the company up for unprecedented growth [1, 2].
However, even before the launch of the car vending machine, Carvana had begun to prove that an online-only transaction process had merit. With a combination of innovative features such as 360-degree virtual vehicle viewing and traditional offerings such as trade-in valuations, financing, and warranties, over 27,500 transactions had taken place on the online platform by the end of 2016. While unprofitable, Carvana’s rate of growth was impressive. Revenue grew from $41.7mm in 2014 to $858.9mm in 2017 at a CAGR of 174%. Capitalizing on this rapid growth, Carvana raised $225mm in a 2017 IPO that valued the company at $2.1bn. Notably, the company went public as a “controlled company,” in which over 50% of voting power for the election of directors is held by a single entity, using a dual class share structure. Class B shares, solely owned by Garcia II and Garcia III, enjoy 10:1 super voting rights over Class A shares, effectively giving the Garcias full control over the company [2, 4].
Financed by continued equity sales (including a $100mm preferred stock sale via private placement the same year as its IPO) and increasing amounts of debt, Carvana quickly grew. Expanding market by market, Carvana had reached a total of over 260 markets by 2020. The thesis the company presented to investors was compelling. At the time of Carvana’s S-1 filing, the company claimed that there were 63,000 used car dealers, with the largest dealer brand only commanding 1.6% of the market and the top 100 used car auto retailers only commanding 7.0% share. Lacking the ability to execute transactions online despite 97% utilization of the internet for research in the car purchase process, traditional used car dealerships would be rapidly supplanted by Carvana. Moreover, while traditional car dealerships experienced low fixed costs and high variable costs, Carvana argued its business model was characterized by high initial fixed costs (to build out its infrastructure) and low variable costs (as a result of more efficient operations). Thus, Carvana could pass on estimated savings of ~$1,400 per vehicle to customers. However, until Carvana’s infrastructure could be sufficiently scaled, the company would remain unprofitable. In 2020, the company publicly announced it would target profitability in 2023 [2, 3, 4].
Carvana’s 41.8% top-line growth in 2020 certainly helped camouflage several growing concerns, such as the entrance of similar competitors like Vroom and growing digital adoption by traditional dealership chains like AutoNation and CarMax. At the same time, the company continued to work through various growing pains. For example, Carvana continued to build out its network of reconditioning centers to speed up the turnover of used-car stock, a historical bottleneck for the business.
A brief pandemic-induced lull in the business prompted management to cut 80% of hours across operations, but this was short-lived. As COVID appeared to wane, people refrained from visiting dealerships in person, but demand for used cars exploded, fueled by low interest rates, low gas prices, and minimal new car inventory due to supply chain challenges. This raised used car prices to record highs, tripling Carvana’s gross margin and creating a uniquely advantageous operating environment for the company. Management capitalized on consumer demand, rolling out a Touchless Delivery program that addressed the uptick in sales by opening 100 new markets across 24 states in one day. As a result, revenue grew from $5.6bn to $12.8bn in 2021, a 129.4% increase. Corresponding with Carvana’s financial outperformance, shares traded at all-time highs in the days following the announcement of Q2 2021 earnings results [1, 5, 15]
Chapter 3: Navigating the Narrow Road
Despite increasing sales, between reporting Q2 2021 earnings and FY 2021 earnings, Carvana’s stock tumbled from a peak of $360.98 to $152.57, a 57.7% decrease. With a broad industry slowdown setting in, increasing online competition, and continued bottlenecks weighing on Q3 2021 and Q4 2021 growth, analysts began to look past the pandemic push into the intensive future capital needs of Carvana. With growth slowing from a blistering pace to a much more moderate one, pressure on Carvana to generate profitability increased. JPMorgan automotive research analyst Rajat Gupta summarized street sentiment in January 2022, stating that not only was Carvana still burning cash after 10 years in business, but also that “we do not necessarily see the company’s business model as highly superior or disruptive to the market.” However, CEO Garcia III remained set on prioritizing growth over profitability in order to achieve more favorable long-term business economics. Essentially, Carvana was competing in an increasingly competitive and expensive race to scale in order to capture as much share of digital auto sales before its first mover advantage eroded [15].