Description

 Carvana Thesis

Thesis

·         The market doesn’t understand Carvana’s competitive advantage, unit economics, and long-term earnings power.

·         A multisided platform is one of the toughest business models to get right as the business needs to overcome the chicken-and-egg problem of creating supply and demand and then having them interact with each other on attractive terms. Carvana’s long-term unit economics are currently being masked by high depreciation costs on their supply of inventory ($10 car depreciation per day, which affects gross profit per unit), large customer acquisition costs ($1,000 of advertising cost per unit sold), and large upfront investments in logistics and R&D.

·         We think Carvana will be the lowest cost operator in a fragmented industry. At scale, Carvana has a $1,000 per unit cost advantage vs brick and mortar dealerships due to $250 lower reconditioning costs per unit and $750 lower SG&A per unit.

·         The economies of scale in inventory, advertising, logistics, reconditioning, and R&D create enormous barriers to entry that will allow Carvana to be a monopolist and long-term share gainer.

·         At scale, Carvana should have steady state unit economics of $1,750 EBIT/car and after extrapolating existing cohort curves, by 2024 we expect them to sell 1MM units and earn $9 EPS.

Business

·         Retailers compete along 4 variables in retail: price, selection, service, and convenience. Retailers make tradeoffs among these variables to differentiate themselves and serve different market segments. Reduce service, selection and convenience as low as possible, but offer very low prices you end up with Costco. Provide low selection at high prices in accessible locations with fast service you get convenience stores. Provide great service, good selection, and decent convenience, but at high prices, and you have CarMax. Carvana on the other hand, wins on all 4 variables.

·         Carvana is a vertically integrated online platform for buying used cars. They remove the pain points and frictions from the traditional used car buying experience by giving customers what they want:

·         Lower and more transparent prices that are +$1,000 below industry averages according to YipitData, which doesn’t include Carvana’s free delivery cost to customers.

·         Wider inventory selection of 15,000 cars (and growing) vs <300 on a traditional dealer lot.

·         Better service where customers deal with friendly, non-commissioned customer advocates vs the traditional used car salesman the customer doesn’t (or shouldn’t) trust.

·         Greater convenience as customers can buy a car in under 15 minutes, have it delivered to their door for free as soon as the next day, and enjoy the comfort of a 7-day test own period where Carvana will pick up the car for free within 7 days if the customer decides to return the car. This convenience compares to multiple hours at a dealer and a test drive that consists of 4 right hand turns around the dealer’s lot.

·         Carvana’s website allows customers to complete all phases of a used vehicle purchase transaction:

·         Purchase a used vehicle: Carvana currently has a nationally pooled inventory of 15,000 cars (and growing) for sale on their website available to 57% of the U.S. population, where customers can select and purchase a vehicle directly from their desktop or mobile device.

·         Finance their purchase: customer can pay for their Carvana vehicle using cash, Carvana’s proprietary loan origination platform, or financing from third parties such as banks or credit unions. Customers who choose to apply for in-house financing fill out a short application form, select from a range of personalized and highly-transparent financing terms (10,000 variations of down payment, monthly payments, and length of loan for each customer), and, if approved, apply the financing to their purchase in the online checkout process. The company finances the whole credit spectrum and approximately 70% of vehicles sold are financed by Carvana.

·         Protect their purchase: customers have the option to protect their vehicle with a CarvanaCare-brands vehicle service contract (“VSC”), which is an extended warranty, as part of the online checkout process. VSCs provide customers with insurance against certain mechanical repairs after the expiration of their vehicle’s original manufacturer’s warranty. Carvana also offers GAP waiver coverage to customers, which contractually obligates Carvana to cancel the remaining principal outstanding after insurance proceeds in a total loss event (collision, etc).

·         Sell their car: Carvana allows customers to trade-in a vehicle and apply the trade-in value to their purchase, or to sell a vehicle independent of a purchase. Using Carvana’s digital appraisal tool, customers can complete a short appraisal form and receive an offer for their trade-in instantaneously.

·         Schedule delivery or pick up of car: using Carvana’s owned first party logistics network, customers can immediately choose available delivery slots for when they want Carvana to deliver or pick up their car.

·         To enable this customer experience, Carvana has built a vertically-integrated used vehicle supply chain, supported by proprietary software systems and data:

·         Vehicle sourcing and acquisition: Carvana currently acquires approximately 80% of used inventory from wholesale auctions. They also acquire approximately 16% of inventory from consumers and 5% from used vehicle suppliers, including franchise and independent dealers, leasing companies and car rental companies. Using proprietary machine learning algorithms and data from a variety of internal and external sources, they evaluate tens of thousands of cars daily to determine their fit with consumer demand, internal profitability targets and existing inventory mix.

·         Inspection and reconditioning: after acquiring a vehicle, it is transported to one of their inspection and reconditioning centers (“IRCs”), where it undergoes a 150-point inspection and is reconditioned to meet “Carvana Certified” standards. This process is supported by a custom used vehicle inventory management system, which tracks vehicles through each stage of the process and is seamlessly integrated with auto parts suppliers to facilitate the procurement of required parts.

·         Photography and merchandising: Carvana photographs vehicles using their proprietary photo booths located at each of their IRCs. This allows them to display interactive, 360-degree images of each vehicle on their website. Carvana annotates each vehicle image with a list of features and imperfections to assist customers in their evaluation of each vehicle for purchase.

·         Logistics and fulfillment: Carvana transports vehicles purchased by their customers to their local market for home delivery or pick-up. In markets where they have launched operations, delivery to the customer is completed by a Carvana employee through its owned logistics networks in a company branded delivery truck. In certain markets, customers have the option of picking up their car at one of the company’s vending machines. Carvana’s logistics and fulfillment operations are supported by their proprietary vehicle transportation management system, which optimizes the scheduling of transport routes and delivery slots.

·         A good video of Ernie Garcia III describing the business can be found here:

·         https://www.youtube.com/watch?v=UPlyCJXhHjQ

Unit Economics Analysis

·         Gross profit per unit (“GPU”)

·         Inventory turnover: Carvana currently has 65 inventory days to sale, which compares to Carmax and other dealers of approximately 40 days (apples to apples as Carvana has unique definition of inventory days to sale). To improve this metric Carvana simply needs to grow inventory at a slower pace than revenue and inventory turnover increases. We think they can improve inventory days by 15 days over the next several years, which should increase retail GPU by $150 as cars depreciate on average $10 per day.

·         Source more cars from customers: Carvana’s competitive advantage in acquiring cars from customers may be greater than their competitive advantage in selling cars to customers. Carvana’s lower cost structure (see SG&A per unit analysis below) allows them to offer a higher price for a consumer’s car than competitors, Carvana’s logistics network provides greater convenience for the consumer because Carvana picks up the car whenever and wherever the consumer wants, and the service is better because the offer process is automated and takes less than 5 minutes (the consumer doesn’t have to drive the car to a dealer and have it inspected for an hour or more). Cars sourced from customers benefits retail GPU and wholesale GPU (where cars are sold to auctions because they don’t meet retail requirements) because they are more profitable than cars sourced from wholesale auctions (no auction fees and less competitive bidding process).

1)      Retail GPU: Carvana sourced approximately 16% of retail cars sold from customers in Q3 (vs 6% in Q1), which compares with CarMax at 45%. We estimate the profit difference between an auction car and a car sourced from consumer to be approximately $650 based on CarMax’s wholesale GPU in FY17 of $962 less the auction fee CarMax charges to dealers of $125 and Carvana’s logistics cost of $200 to pick up the car (although this $200 cost is $0 on a trade-in due to free reverse logistics and not included in our forecast). Increasing cars sourced from customers to CarMax penetration levels should increase retail GPU by about $200 ($650 x 30%).

2)      Wholesale GPU: Carvana wholesaled approximately 17% of retail unit sales, which compares to CarMax of 57% in FY17. We are not assuming in our analysis that Carvana will run their own wholesale auctions like CarMax (although they likely will). To estimate Carvana’s wholesale GPU we take CarMax’s wholesale GPU of $962 less CarMax dealer auction fee of $125 less the seller auction fee Carvana will pay to Manheim, Adessa, etc of $125 and their transportation cost of $200 to get a wholesale GPU of $500. Increasing penetration of wholesale cars to levels seen at CarMax will increase total GPU by approximately $200.

·         Financing:

1)      Auto Finance at Traditional Dealerships: Typically, auto financing is arranged through the dealer at the time of purchase and provided through a wide variety of banks, credit unions, and independent finance companies who lend to prime, non-prime, and subprime customers. The dealer is typically compensated by the finance source through a fee based on the spread between the loan offer rate provided by the financial institution and the final loan rate the dealer negotiates with the customer. Most traditional dealers negotiate and manipulate the pricing on every aspect of the car deal. Because salespeople, sales managers and finance managers are paid a commission based on the profit spread in the deal, they have a strong incentive to negotiate the highest profit spread possible on each element of the transaction (total price, monthly payment, interest rate, trade-in value, vehicle service contract, etc) and shift margin between elements of the deal based on customer preference functions. This is why most offers at traditional dealerships are package deals with limited price discovery. The problem this creates for lenders in evaluating a loan is obvious: they don’t know the true price and value of the car, the trade-in or the vehicle service contract, and there is no consistency in pricing from one deal to the next.

2)      Carvana Finance Process Advantage: Financing, like all other elements of the sale process, is different at Carvana. Their transparent, no haggle pricing on the car, vehicle service contract, and trade-in offer also extends to any financing offer. This process produces data integrity and provides Carvana with a superior loan origination channel that yields consistent and predictable loan performance. Two principal risks in used auto lending are significantly reduced or eliminated by Carvana: 1) the risk of car collateral is reduced by Carvana’s consistent, 150-point reconditioning process that produces high quality cars. Also, because Carvana sells cars for +$1,000 below industry average, Carvana produces loans with better LTV and payment to income ratios and therefore better performing loans (lower cumulative net losses on like-for-like FICO scores), and 2) the “intermediary” risk is virtually eliminated by Carvana. There are no commission-driven finance or sales managers who may distort the facts on pricing, car quality, or consumer credit information. Thus, Carvana and outside lenders benefit from superior information quality in making financing decisions, which results in lower operating costs and credit costs for Carvana.

3)      Carvana Loan Economics: As loan performance history has grown, Carvana is starting to get better loan pricing from its financing partners. Our analysis suggests that Carvana loans have an 8.5% asset yield and are worth approximately $1,500 based on a 3.75% cost of funds, which compares to Carmax’s recent ABS funding costs of 3.15%. This improvement in pricing could add approximately $250-$500 ($700 price increase times either 50% or 100% of loans times 70% finance penetration) of GPU long-term over Q2 2018 GPU (they started getting better pricing in Q3 2018). See Carvana Auto Finance picture below for illustrative loan economics.

·         See Carvana Unit Economics picture below for more details on GPU walk.

·         SG&A per unit

·         Compensation and benefits: compensation and benefits consists of outside customer advocates who drive single car haulers to end customers, 9 car hauler drivers who transport cars from IRCs to local market hubs, HQ customer advocates who handle customer calls and title/registration, and corporate employees in R&D, finance, HR, senior management, etc. We think outside customer advocates can deliver 2 cars per day, which equates to a compensation cost of $80 per car (8 hours per day x $20/hour divided by 2 cars). The 9 car hauler driver we estimate to be about $133 compensation per car (see Carvana Logistics Economics below for more detail on this item). At the December 2018 Analyst Day, Carvana disclosed 600 HQ customer advocates, which equates to approximately $150 per car (this number should come down with PropelAI and other technology developments) based on expected March 2019 volumes and compensation estimates from Glassdoor. We then estimate a corporate cost of approximately $125MM. This corporate cost is based on a letter that Austin Ligon, co-founder and former CEO of Carmax, wrote on July 11, 2003 (published in 8-K) when he detailed CarMax’s economics.

·         Advertising expense: A national TV ad campaign costs about $125 million and is a fixed cost unless they want to add more commercials per day. CarMax for example spends about $100 million on their TV ads. As Carvana grows sales volumes these fixed costs decline per unit. We also estimate a variable customer acquisition cost of $75 per unit sold for search and banner ads based on CarMax advertising expenses.

·         Logistics: see Carvana Logistics Economics below and Logistics section in Industry Structure Analysis for more detail. Carvana currently has logistics cost per unit of $350, but these costs will decline with scale as capacity utilization increases and IRCs get built closer to end customers thereby reducing freight times. We’re conservatively assuming a slight improvement to $300 per unit long-term.

·         Other overhead: this item has similar cost buckets as CarMax, but we’re assuming $100 more per unit to be conservative.

Industry Structure Analysis

·         The U.S. used vehicle market is approximately $750 billion in sales, which represents approximately 40MM used vehicle transactions at an average sales price of $19k.

·         The used car auto retail industry is highly fragmented. There are approximately 63,000 used car dealerships in North America, comprised of 45,000 independent used car dealerships and nearly 18,000 franchise dealerships. The largest dealership is CarMax with 1.6% of the U.S. market and the top 100 used car auto retailers collectively hold approximately 7% of the U.S. market.

·         Carvana benefits from economies of scale that will be extremely difficult for competitors to replicate:

·         Positive network externalities in selection: Carvana’s logistics capabilities allow them to offer every car in their nationally pooled inventory to customers across their markets (approximately ¾ of cars have free delivery). As they add markets, it results in increasing demand, which enables them to carry a larger and broader inventory and in turn, improves their offering across markets and increases market shares within markets due to higher conversion rates. The cycle repeats. Based on an extrapolation of Carvana’s cohort curves, we think by 2022 Carvana will have more than +75,000 cars in inventory for customers to choose from, which compares to a traditional dealer lot of less than 300.

·         Logistics Route Density: Carvana’s proprietary logistics software and in-house delivery network of 9 and single car haulers allow them to predictably and efficiently transport cars while providing customers a distinctive fulfillment experience. We think Carvana currently ships cars at a cost of approximately 35 cents per mile, which will continue to decline with scale due to low variable costs on unused capacity (adding a 5^th car to a 9 car hauler has low incremental cost) and IRCs being closer to end customers (5 IRCs currently and have capacity for 50k cars each). This 35 cents per mile compares to 3^rd party providers that charge 75 cents to $1 per mile.

·         Reconditioning: Carvana’s IRCs are able to have lower reconditioning costs due to scale economies and flow shop vs job shop manufacturing at a traditional dealership. Carvana’s IRCs have capacity for 50k cars per year, which allows them to have higher labor utilization and they can better match skillset with skill. This allows Carvana to have an average reconditioning cost of $1,000 per car vs competitors like CarMax with $1,250 reconditioning cost per car.

·         National and Cumulative Advertising: Carvana has now reached the scale where they can utilize national TV advertising, which costs approximately ½ the cost of regional TV advertising. A national TV ad campaign costs about $125MM and is a fixed cost. As Carvana continues to grow it will reduce their current -$1,000 customer acquisition cost per unit to levels seen at CarMax of approximately -$225 per unit.

·         R&D: Carvana has spent the past 6 years improving their website design, vehicle sourcing and acquisition, financing technology, checkout process, logistics technology, etc. The R&D investments continue to grow and continue to increase platform utility and customer experiences. Competitors would have to replicate the cumulative investment Carvana has made in R&D and Carvana could replicate any differentiating features a competitor creates (similar to how Facebook/Instagram incorporated Snapchat-like features on their platform).

·         CarMax and Incumbent Dealers Competitive Response

·         CarMax recently announced that they will be offering home delivery and the ability to do online only checkout as part of a new omni-channel experience. While this increases convenience and service, CarMax is still at a structural disadvantage to Carvana regarding price and selection. CarMax prices its cars roughly +$1,000 more than Carvana and although they have roughly 70,000 cars in inventory as a company, only 3,000 cars are available in any given market for free shipping. In order to nationally pool their inventory and compete with Carvana’s selection, they will need to add logistics costs of approximately $500 per car. Unfortunately, as seen in the Carvana Unit Economics analysis below, CarMax only makes $1,500 per car and reducing prices $1,000 and adding $500 of logistics costs would blow up their income statement. Incumbent dealers have similar cost structures as CarMax and haven’t been able to improve their service with things as simple as no haggle pricing. Also, it is important to note that while AutoNation, Sonic, Lithia, etc own many stores in some cases, the stores are not centrally managed, but in fact are independently run by local store managers.

1)      http://investors.carmax.com/news-releases/news-releases-details/2018/CarMax-Brings-the-Future-of-Car-Buying-to-Atlanta/default.aspx

·         Amazon

·         Amazon is likely the only competitor that has the capital to replicate Carvana’s business model. However, we think they are unlikely to do so because 1) it would be a massive incremental leap that doesn’t leverage any of Amazon’s existing assets. It would likely take them at least 3 years to hire people and build out the logistics, reconditioning facilities, and technology. By 2022, Carvana will have +75,000 cars in inventory, and how would Amazon be able to compete on price, selection, convenience, and service, 2) Jeff Bezos has given interviews where he says Amazon always starts small with new product lines (they’d have to go big to not be at a selection and logistics disadvantage relative to Carvana) and the Amazon culture is one of inventiveness where they always fail when they try to compete with their own undifferentiated “me too” type product or service. We think it makes more sense that Amazon will try to buy Carvana. See minute 8 and 47 in first link and minute 9 in second link:

1)      https://www.youtube.com/watch?v=xv_vkA0jsyo

2)      https://www.youtube.com/watch?v=KPbKeNghRYE

Catalyst

Value is catalyst