Carvana's House of Cards is falling

Why so many hedge fund managers get caught in the net?

The last few months have not been kind to growth stocks and even less kind to unprofitable ones. ARK's flagship ETF is down 52% YTD and 70% from ATH. Aravt Global, another growth fund, shut down, after significant losses and many of the Tiger funds reported awful results.

One of those unravelling stocks is Carvana. A used car dealer with shady founders and liquidity problems is down 87% and chances are high that they will go bankrupt. Here is a great article that lays out the bear thesis.  Some funds have been caught seemingly with their pants down. Many that describe their strategy as "concentrated value investing" have 8% or more of their portfolio in Carvana, with CAS Investment Partners having a 25% allocation.

Instead of a business deep dive into Carvana, I wanted to look at why these funds were allocated so much into this house of cards.

The Bull Thesis points were laid out by Cliff Sosin, CAS Investment more eloquently than I ever could.

The Bear thesis were the following:

• An incredibly shader founder family that is known to harm shareholders

• Insane Insider Selling -  From 03.11.2020 to 25.08.2021 Garcia Ernest C. II, the father of the founder sold nearly $20m in shares each day!

• No economies of scale (inspection and refurbishment can not be properly scaled)

• Lots of competition

• Valued like the biggest player in the industry by far.

• Lot of related party transaction (graphic taken from clastic's blog on Seeking Alpha)

• Carvana's cash burn will stop them from raising money and they will go bankrupt. That thesis started to play out at the end of April, when Carvana struggled to raise money via junk bonds and Apollo had to step in.

With Carvana now struggling, let's see what we can learn from this situation.

False economies of scale and no moat

One of the main arguments was that Carvana's offer allows them to reduce the costs and be more profitable than their competitors. One look at the used car market should be enough to be sceptical about these claims.No matter what technology one has, similar to real estate (where Zillow lost loads of money) -  not every model of the same car is worth the same or requires the same refurbishment. An offer for a smoker's car will be much less than one in pristine condition, even for the same model and the same mileage. Additionally every seller wants the most out of their car, and every buyer wants a bargain. Carvana's biggest competitor has margins of just 3.5%. In fact one could argue that selling more cars requires more infrastructure and employees, giving them negative economies of scale. This is similar to companies like DoorDash who promised great returns in an industry with already razor-thin margins. The market still prices them as though they have Software margin, so the wakeup call there will unpleasant.

What is questionable is also their moat. Many want to test-drive a car they buy, especially when it is used, and a lot of car dealers already show their inventory on a homepage. Even if their offer is better than that of the competition, is it so good to be valued more than your highest valued competitor by an order of magnitude?

Given their 899 complaints to the Better Business Bureau from Carvana shoppers from Jan.2021- September 2021 while rival CarMax just had 411 and sold 3x as many cars, the experience might not be better. 

Don't confuse a bull market with a great company

Carl Icahn once cautioned to not confuse a bull market with brains. I think the same can be said about the greatness of a business. Over the last decade, we had one of the loosest monetary policies in our modern history. As a result many companies could grow exponentially with debt. But just because something has rapid growth, does not mean it is a great investment.

Looking at the FCF margin of Carvana (2017 FCF Margin -26%, 2018 FCF Margin -23%, 2019 FCF Margin -22%, 2020 FCF Margin -18%), one can easily see -  that they correlate heavily with the change in used car prices. While a slight correlation is understandable, their competitor's do not vary this widely. One could argue that this is due to Carvana's pricing power, but a Seeking Alpha article claims that Carvana also has the highest offer -  meanwhile the company claims $4,000 gross profit per car sold. CarMax and most of their competitors only report half of those profits . Something does not add up here.

Ignoring credits risks and changing times

We like to think that the world we are living in does not recognisably change, yet it does. The low interest rate environment gave rise to many companies that would have long failed beforehand. As with everything, that now comes to an end. Inflation and rising interest rates dry up liquidity for companies, that have negative FCF -  and of course Carvana is one of them. Except for Q2 2021 where the used vehicle price exploded, Carvana has lost money on each and every car they ever sold. Who is gonna lend their money to someone who will likely never pay it back? 

CAS Investment Partners in their recent letter wrote 11 pages about the logistics and market for Carvana. While Clifford Sosin makes valid points, he failed to address the biggest issues: The liquidity problem that Carvana has. Carvana needs debt to survive and operate their business. With their already outstanding $200m debt repayment yearly and their newest $3b debt issue at 10.5%, how will a company with a negative operating margin ever pay that sum back? It looks similar to Bill Miller's mistake in 2008, where he just looked at the valuation of financials and ignored their toxic balance sheet and the liquidity risk. He saw the assets he managed fall from a peak of $77 billion to a humbling $800 million. I hope that Clifford Sosin doesn't have the same decline. 

Times have changed for many companies.

A shady founder family and a high valuation

Warren Buffett has hit the nail on the head with this:

We look for three things when we hire people. We look for intelligence, we look for initiative or energy, and we look for integrity. And if they don't have the latter, the first two will kill you, because if you're going to get someone without integrity, you want them lazy and dumb.

I can understand investing a few percentages in an extremely cheap company that has questionable founders. I also understand concentrating into great companies with remarkable leaders. Carvana never was cheap, trading at crazy multiples compared to their peers and sadly, the founder family Ernest Garcia II and Ernest Garcia III do not possess what Buffett would call integrity. Neither are they lazy or dumb.

I am just leaving the wikipedia article for Ernest Garcia II here:

In October 1990, Garcia, then a Tucson-based real estate developer pleaded guilty to a felony bank fraud charge for his role as a straw borrower in the collapse of Charles Keating's Lincoln Savings and Loan Association. Garcia "fraudulently obtained a $30-million line of credit in a series of transactions that also helped Lincoln hide its ownership in risky desert Arizona land from regulators."Garcia spent three years on probation, and he and his firm filed for bankruptcy.

In 1991, Garcia bought Ugly Duckling, a bankrupt rent-a-car franchise, for under $1 million and merged it with his own fledgling finance company, and turned it into a company selling and financing used cars for sub-prime buyers with poor credit history. Garcia took the company public on the NASDAQ exchange in 1996, trading under the ticker "UGLY". In 1999, Garcia was involved in six lawsuits alleging he had "abused his position to profit" from a real estate deal where he ultimately acquired 17 company properties at a 10% discount. In 2002, Garcia and the former Ugly Duckling CEO, Gregory Sullivan, took the company private and renamed it DriveTime.

Maybe  Garcia has reformed and is a changed man,  but as he sold 3 billions worth of shares over nearly a year, why risk it? It is understandable that founders want to diversify, purchase a house or create a trust for their kids - but when an insider sells billions, while already rich, without giving it to charity -  maybe something is wrong. Given that their 10k of related party transactions feels endless there is another risk that should not be taken without a huge amount of research first.

What upside is left?

At it's peak Carvana was valued at over $68b, at over 65x Book Value and 6x Sales. Meanwhile their competitors were at 4x Book Value and 0.8x Sales. I understand that high growth comes with a high multiple. But how high is too high? What upside is left, when you are already valued like the leader in an industry? 

Pre-pandemic Carvana's highest price was 110, reaching 360 in August 2021. With a 3x, why not sell the initial stake and deploy the rest into fairly valued companies? For me the risk/reward at around 150, is not enticing - at 300 it was just whacky. 

If everything would have gone as many bulls said, the company would have generated around $2-3b in FCF in 2024. The share price was $68b. That is still a valuation higher than 30x FCF. Again, what is the upside?

How to decide if an investment is worth a big position?

I am a fan of concentrated investing and my two idols, Warren Buffett and Stanley Druckenmiller have always run concentrated portfolios. To then decide if an investment is worth a big position, I just ask myself what would they do?

What would Warren Buffett do?

• Is the company cheap? Warren Buffett at heart will always stay a value investor. Apple he bought at 10x PE and back in the day he even had many net-nets.

  • Carvana was never cheap, even if you account for their growth.

• Does the company have a lasting competitive advantage? What stops others from doing the same?

  • Carvana does not have a competitive advantage. The used car market is very competitive

• Do the founders have integrity and the shareholders in mind?

  • Given the history of the founder family and the private placement during the pandemic, which diluted shareholders and enriched the founder family. No

• Is the business profitable?

  • Carvana was never profitable in a single year. 

• Do you understand the business model and how they make money?

  • Carvana's business model is very convoluted and hard to understand. 

• Can the current business operate without investing tons of money?

  • Carvana can't as they always need more debt to fuel the growth. 

As we see, Carvana would have failed all of Buffett's checks. So let's go to Druckenmiller.

What would Stanley Druckenmiller do?

Stanley Druckenmiller is different. He often traded with the aid of technical analysis, riding trends - even when the fundamentals did not look enticing. However we also do know that he often used Technical Analysis to exit his position. Let's assume then, that Druckenmiller allocated a big portion of his portfolio.

Now no matter how you draw your trend-lines or take your exits, this I believe is the latest exit point:

Druckenmiller would have sold after the stock had consolidated for 6 weeks and the 50 day MA crossed the 200 day MA, breaking through the consolidation zone. That sell point would have been at 275. 

Conclusion

Investing is incredibly difficult. There is no lack of fraud, blinders and emotion that we have to battle with. However sometimes it is best to look at two simple questions: What is the remaining upside, and what is the downside.

For me Druckenmiller and Buffett represent those two sides, and trying to understand and use their methods can only make us better investors.