Carvana (NYSE:CVNA) stock has surged by 147% in the past year. But in the last three months, CVNA has failed on multiple occasions to breach the $100 resistance level.
There’s no doubt that Carvana has a sustainable business model with a clear growth visibility. Yet Carvana stock has surged ahead of fundamentals and I believe that a correction is imminent.
Speaking of valuations, Oppenheimer is bullish on Carvana stock and assigned a price target of $95. That implies an 8.7% upside from current levels. Morgan Stanley is also concerned about valuations with a bull case price target of $94, which implies a 7.6% upside from current levels.
If we go by these estimates, Carvana stock currently has 5% to 9% upside potential, but the downside risk seems significant. There are two reasons to be bearish in the near-term.
First, broader markets look stretched, with the S&P 500 trading at a price-to-earnings-ratio of around 24. This is particularly true at a time when the coronavirus outbreak from China is likely to impact global GDP growth.
Second, Carvana has continued to report stellar top-line growth. However, EBITDA for the third quarter of 2019 was worse than expected. For Q4 2019, the company expects wider EBITDA losses. Therefore cash burn will be a concern and the market will react negatively to increased pressure on margins in 2020.
Carvana is certainly on a high growth trajectory and there are compelling reasons to believe that growth will sustain. But Carvana stock is expensive and a correction is likely.
Revenue Growth to Remain Robust
As a quick overview, Carvana is an e-commerce platform for buying and selling used cars. Carvana is among the early digital entrants in this highly fragmented industry with high potential.
To put things into perspective, McKinsey estimates that Americans buy 39.4 million used cars per year, compared to 17.3 million new vehicles. McKinsey also estimates that used vehicle sales will increase faster than new vehicle sales in the next five years.
The used car market is therefore big, but highly fragmented. Even the largest dealer sells less than 2% of used cars. With an increasing number of costumers researching cars online before purchase, Carvana has immense potential for penetration. Not surprising that Q3 2019 was the company’s 23rd consecutive quarter of triple digit revenue growth.
The convenience that Carvana offers compared to traditional dealers will naturally help to sustain healthy growth. For example, via Carvana a consumer could finish purchasing a vehicle in just 10 minutes! In addition, Carvana is already offering next-day delivery in selected markets. With an ever expanding number of cars available for selection, the company’s business model will continue to gain traction.
Carvana is also using data science and investing in technology to tap new markets and enhance consumer experience. From the expansion perspective, Carvana opened in nine new markets in Q3 2019. These factors are likely to translate into strong growth in the coming years as well.
Positive Cash Flow Visibility
Even with the positives, it is worth noting that for the first nine months of 2019, Carvana reported cash used in operations of $435 million. Cash used in operations was $264 million for the comparable period in 2018. Cash burn in the foreseeable future is another reason to believe that Carvana stock might correct in the near-term.
However, as the business expands, the company has the potential to report healthy margins. The company’s EBITDA margin has improved from a negative of 32.2% in 2014 to a negative of 5.1% in Q3 2019. While EBITDA margin in Q3 2019 worsened as compared to Q2 2019, the overall trend is still towards margin improvement.
For Q3 2019, Carvana reported gross margin of 12.6%. In the long-term, the company intends to expand gross margin in the range of 15% to 19%. As SG&A and advertising expenses decline, margin expansion is likely.
Considering the scalability of the business model, I am not worried about negative cash flows in the near to medium-term.
My Final Thoughts on Carvana Stock
Operating in a highly fragmented market, CVNA has the visibility to expand in the coming years. The company’s revenue growth trajectory is a clear indication of the market potential.
However, the stock price seems to have run up too fast, too soon. I therefore believe that investors can wait for some correction before considering fresh exposure to Carvana stock.
With entry into new markets, enhanced consumer experience and a bigger inventory of cars, Carvana is positioned to become bigger.
As of this writing, Faisal Humayun did not hold a position in any of the aforementioned securities.