Is Carvana out of options to become profitable?

The intention of my Carvana case study is to form in-dealership discussions about how to improve franchise dealer operations in three ways: improve efficiency, become more consumer friendly, and more profitable. I encourage you to use this analysis to pose several questions with your management team to provoke thoughtful discussion and implement best practices.

Overall Analysis:

I recommend reading the 12-page Letter to Shareholders by Ernie Garcia, CEO. Attached. One common theme that runs through the shareholder letter is they are short on solutions and believe time will fix this. This wait and see strategy is reflecting in the share price being down over 90%. The team hides behind “decreasing SG&A per retail unit sold” as how they will become profitable. They do have expenses that can be trimmed, obvious is the CEO is receiving bonuses for milestones that are not tied to profitability. However, there is a metaphor in the dealership world, “You can’t save yourself to profitability.” His results show, Carvana is down in units, profit, and their only expense reductions are to reduce headcount. He is managing this business as they are going out of business, not looking to the future. Their revenue is down 3% YOY yet vehicle prices are up 7% YOY across the US. Their main competitors Echo Park and CarMax are up in revenue, and they should be. As sale prices increase you expect revenues to increase, but Carvana is very forthright that they are mainly trying to reduce expenses to $4000 per retail unit sold (excluding ADESA expenses). That stretch goal alone is $1,000 more per unit than CarMax’s $3k/unit SG&A expense. Although this is their main goal, they offer no plans on how to decrease this number other than they do not expect to hit this in Q4. Other than reducing expenses they offer zero ways to increase their sales prices. As a retailer, the goal is to offer so much value that clients will pay more for your product. To me it seems like Carvana has given up on that goal. They have a wonderful value proposition, but they are running out of options. They are deliberately focusing less on repeat customers (see page 4 Shareholder letter). Their cash flow is in a very scary spot, their cash on hand is worrisome with the losses they average and their accounts payable is growing exponentially. It doesn’t seem like they are seasoned profitable car professionals thus their business isn’t. With all of this said, they can focus on five areas, and be profitable with their current expense structure. I have plenty of insight in how they can do this, but that’s not the purpose of this letter.

Inventory

They are planning to reduce inventory, yet they also acknowledge this will lower sales even further. I believe this is a false assumption, most franchise dealers operate well less than a 90-day supply. Carvana currently has about $2.57B in vehicle inventory, and they sell approximately $2.49B in a quarter (90-day supply). This is worrisome for Carvana as used vehicle values will continue to rapidly decline in Q4, and you do not want to be holding more inventory than they depreciate on average.

What is an ideal inventory level to have?

This depends on your inventory mix and what is the risk of depreciation. Average margins are 5-8% of the sales price depending on market conditions and depreciation averages 1-3% per month. 0–2-year cars depreciate faster than 2–6-year vehicles, so I recommend if your average margin is 6% and your vehicles are projected to depreciate 3% per month, you should keep less than 2 months of supply (3+3=6)

With depreciation heating up again how would you reduce your inventory down to a 60-day supply?

First, be strategic in pricing down your inventory. Don’t drop everything at once because your sales team won’t be able to handle all the leads properly. Focus on pricing down vehicles that are projected to have the most depreciation and the highest MDS. You can calculate future depreciation by looking at next month book values. These units become a race to the bottom, and you need to be the first in your market to be aggressively priced. Sales managers should price today what those vehicles will be priced at in two weeks.

Wholesale

This strategy is filled with golden opportunities that they do not even foresee. The ADESA purchase should have been a wildly good thing for Carvana, and it really spooked a lot of dealers when they executed the purchase. I feel like they make no mention and do not operate like they own ADESA. By that I mean, their only point on wholesale was to “utilize ADESA locations to reduce transport cost and cycle time.” I think that’s a good thing, however they are missing the entire golden opportunity that owning an auction house could bring a retailer.

If your group owned the auction house, what strategies would you use to buy the right inventory and sell for the highest price?

Auctions are inherently one of the few spots in our marketplace where you really get to see supply and demand. Thousands of buyers and thousands of sellers selling similar vehicles for all different prices. However, the Carvana purchase spooked a lot of sellers, so ADESA’s volume has dropped. They need to be maximizing this relationship to buy, as an owner and retailer, I would first offer a bid to every no sale that is a desirable inventory piece, and my bid would be

$500 over the last bidder. To encourage more units to flow through your auction house you need a high sales rate, and it starts with making those sales happen. Second, to bring trust back to the auction and more dealers, you need to offer extremely reduced sales/buy fees. Manheim has seen a large influx of inventory, and their fees are consistently increasing. Be a price leader to get the inventory back. As depreciation has dramatically increased, dealers need more places to expose their inventory, take back some of the market share.

I like Carvana’s strategy of using the auction house as their recon center. I think it has potential and gains operational efficiency, but their focus should be on how to get more gross and more units and less about saving on expenses.

Customer Care

Each example they gave is simply about operational efficiency. I found this baffling in their shareholder letter “Historically, when we were primarily focused on growth, we incorporated the value of future sales, including from repeat customers and word of mouth, into our marketing budget and pricing decisions. As a result, we more frequently acquired sales that were less profitable in the immediate period but were expected to generate higher net present value over time. Currently, as we are primarily focused on profitability, we are intentionally acquiring fewer of these sales.”

What is the problem with this paragraph?

As a dealer, if your least profitable deals are repeat customers you need to examine why it is costing you so much money to keep a client. I have always found the happiest customers are generally the most profitable ones, and repeat business is why OEM’s place such an emphasis on lease penetration rates. As Carvana’s model is uniquely different, I would think people that have already adopted their purchase process would be the easiest to buy another one, unless something went wrong last time.

If your store had to heavily incentivize customers to do business with you again, what methods would you look at internally to improve?

Carvana has seen a drop in customer care calls by 20%, which is positive. They have also been banned to title cars in certain states. They need to do a pareto chart on what is driving low customer satisfaction. This is a major concern that needs to be addressed and coupled with rough financials explains the lack of profitability.

Advertising

I found little breadcrumbs that this is a focus for them, however it is a large expense item for Carvana and all dealers. They offer two key initiatives, which are the same. Optimizing spend by higher efficiency channels. Conversion drivers (Co-signer offering, faster delivery times, lower rescheduling rates.) I find this plan highly basic for a $14M quarterly expense with how many dynamics have changed for consumers. Their conversion drivers do not resonate with buyers except a co-signer offering. Right now, consumers are being squeezed by inflation and are looking to do multiple things: lower their payments, buy cars with updated tech, and gain in either storage space or fuel economy.

How would you adjust your advertising strategy to fit the current needs of clients?

First, you should make sure your inventory is optimized for relevancy searches and shows up on the first page like your website does on google. Gone are the days that clients search from a low to high price. Second with all the makes and models that each brand now offers, clients are now buying by their lifestyle (eco-friendly, commuter, family car, off-road, etc.…) They have so many choices in makes and models, every vehicle seems like the next one. We need to ensure your inventory shows up, and it shows up to the right consumer. Speak to the consumer in the ad for the type of vehicle you are advertising and align the message.

Retailing

It seems they have been heavily focused on increasing vending machines and IRC’s. Carvana does save a considerable amount of money by not delivering vehicles and allowing customers to pick them up. Dealerships still have not adopted a high delivery rate because it is less profitable. However, they have multiple holes for improvements in their retail space other than just more vending machines. They have a solid website, and it is an easy process.

How can they improve their retailing? check VDP, descriptions, inspection, etc.…

An easy value builder is they don’t advertise how much they spend on reconditioning per unit. From their financials it is somewhat extensive, and it is an easy way to build value. They focus heavy on how the vehicle looks on their website, but how does their inventory stand out on third party sites?

If Carvana was to allow customer to finance through other sources, how would it affect their client base?

I understand why they only allow Cash or Carvana financing, but how effective is their finance penetrations and credit score ratings. CarMax outlines this well in their financial statements, and it seems they consistently pick up more business by being open to third party financing. The more eligible buyers you can have, the more customers you will close, and the higher sales price you can charge.