Carvana – Why Balance Sheet Is So Important

Yesterday, shares of Carvana crashed by 43%. This comes after its largest creditors Apollo Global and Pacific Investment Management signed a pact to do proper credit negotiations instead of fighting what’s left over in Carvana. Typically, creditors do not enter into such arrangements unless they view the risk of bankruptcy to be high. This is why the stock crashed badly.

Before that, Carvana is known to be an innovative online used car retailer that is set to revolutionise the car purchase process. It gained many raving customers. It was disrupting the old way of buying and selling cars and set to capture market share away from its competitors.

But what went wrong?

Carvana’s income statement and balance sheet.

In the last twelve months, it burned up -$1.7 billion of cash.

Currently, it has $666 million in cash and $8.1 billion in debt.

The company played it too aggressively by overexpanding and thinking it could raise endless money to support its business model.

Given how consumers behave during times of uncertainty, the volume of car transactions is likely to drop. Car prices are also falling very quickly right now, which means Carvana might make a lesser gross profit per vehicle sold.

Finally, even if its creditors are kind enough to exchange its debt for equity of Carvana, it comes at a costly dilution to existing shareholders.

At this point, Carvana is valued as if it’s going to be bankrupt. If it does not, there is a chance of the stock to recover sharply. However, this is a risk investors should not take.

This is why, we should not be blinded by how sexy a business can be, we have to return to our roots of focusing on strong balance sheets.

Some takeaways:

• I generally avoid companies that are sensitive towards the economy. For eg, if interest rates go up, property and car transactions will drop. Companies in those industries will be hit badly. Wells Fargo mentioned their property loan originations fell as much as 60% in recent quarters.
• Avoid companies with a damaged balance sheet unless there is some certainty of the companies avoiding breakeven within the next few quarters or there is a strategic/friendly shareholder who’s willing to support the company.
• In the situation where you think there’s hope and you insist on taking the risk, keep the allocation to < 5%.
• Proper portfolio management is super crucial because certain companies may not perform as you expected and there could be losses. Often, these losses can be compensated by gains from other companies in your portfolio. But if it is a concentrated portfolio, it is tough to recover.