Stocks that could hit $0 as the Fed hikes rates: Carvana

Time is running out for cash-burning businesses that are kept afloat with easy/cheap access to capital. These “zombie” companies risk going bankrupt if they cannot raise more debt or equity, which is no longer as easy as it used to be.

As the Fed raises interest rates and ends quantitative easing, access to cheap capital is rapidly drying up. At the same time, many companies are faced with shrinking margins and may be forced to pay no interest without the possibility of refinancing. As these zombie companies run out of cash to stay afloat, risk premiums will rise in the market, which could further reduce liquidity and create a growing series of corporate defaults.

This report features Carvana (CVNA), a zombie company with a high risk of seeing its stock drop to $0/share.

Zombie businesses with little money are risky

Companies that consume a lot of cash and have little cash are risky in today’s market. Being forced to raise capital in this environment, even if the company ultimately succeeds, is not good for existing shareholders.

Figure 1 shows the zombie companies most likely to run out of cash first, based on last twelve months free cash flow (FCF) burn and cash on balance sheet (TTM). Each company in Figure 1 has:

  • Negative interest coverage ratio (EBIT/Interest expense)
  • Negative FCF on the TTM
  • Less than 24 months before needing more capital to subsidize FCF TTM burnout rate
  • Been a danger zone choice

Unsurprisingly, the companies most at risk of seeing their stock price fall to $0 are those with a poor underlying business model, which was overlooked by investors during the 2020-2021 stock market frenzy. Companies such as Carvana, Freshpet, Peloton and Squarespace (SQSP) have less than six months of cash on their balance sheets based on their consumption of FCF over the past twelve months. These stocks have a real risk of going to zero.

Figure 1: Inventories in the danger zone with less than two years of cash on hand: as of 1Q22

To calculate the “months before bankruptcy”, I divided the TTM FCF consumption by 12, which is equivalent to a monthly consumption of cash. I then divide cash and balance sheet equivalents through 1Q22 by monthly cash burn.

And overvalued zombie stocks are the riskiest

Stock market valuations that incorporate high expectations for future earnings growth add more risk to owning stocks of zombie companies with only a few months of cash left. For the riskiest zombie companies, not only does the stock price not reflect short term distress facing the company, but it also reflects unrealistic optimistic assumptions about the long term company profitability. With these stocks, the risk of overvaluation is added to the risk of short-term cash flow.

Below, we’ll take a closer look at Carvana and detail the company’s cash burn and how much further its share price could fall.

Carvana (CNVA)

I put Carvana (CVNA) in the danger zone in August 2020, and the stock has outperformed the S&P 500 as a 95% short since then. Even after falling 93% from its 52-week high, 89% since the start of the year and 67% from my April 2022 report, I think the stock has a lot more strength. disadvantages.

Carvana has failed to generate positive free cash flow in a year since its IPO in 2017. Since 2016, Carvana has burned $8.3 billion in FCF, according to Figure 2. Indeed , Carvana’s bonfire roars as the company burns through $4.0 billion. in FCF on the TTM ended 1Q22. With only $247 million of cash and cash equivalents on the balance sheet at the end of 1Q22, Carvana’s cash balance would not have been able to sustain its cash burn until less than a month into 1Q22.

Unsurprisingly, Carvana issued $3.3 billion of senior unsecured notes in April 2022, which bear interest at 10.25%. The interest rate on the debt is considerably higher than the 4.875% rate on the senior unsecured notes issued in August 2021. However, most of this principal is already accounted for, as Carvana uses the proceeds to finance the $2.2 billion acquisition of ADESA’s US auction. Company.

Assuming Carvana pockets the remaining $1.1 billion in cash after the ADESA deal, the company only has three more months of cash left, based on its TTM cash burn rate. Even if the company’s FCF consumption slows to its three-year average, the additional capital would keep the company afloat for only six months. Although it raised capital just three months ago, Carvana will likely need to raise more before the end of this year.

Figure 2: Cumulative free cash flow of Carvana since 2016

The valuation implies that Carvana generates more sales than the two largest used car dealerships

I use my inverse discounted cash flow (DCF) model to analyze future cash flow expectations built into Carvana’s current valuation. Despite fierce competition and negative profit margins when used car prices soared, Carvana’s stock price is valued as if the company would grow its revenue to higher levels than CarMax.
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a feat that has very little chance of materializing.

To justify its current price of $25/share, my model shows that Carvana should:

  • immediately improve its NOPAT margin to 3% (above the 2021 NOPAT margin of -1% but below CarMax at 4%) and
  • grow revenue by 15% per year (1.6 times projected industry growth through 2027) over the next seven years.

In this scenario, Carvana’s 2028 revenues would reach $34.1 billion, or 106% of CarMax’s TTM revenues and 128% of AutoNation’s TTM revenues, the two largest used car dealerships by revenue. .

This scenario implies that the company would sell around 1.2 million vehicles at retail and wholesale in 2028, compared to just over 632,000 sold in the last twelve months. This implication is calculated by taking the implied revenue divided by the implied revenue per vehicle. During the TTM, Carvana generated a total of $14.1 billion in revenue and sold 632,000 retail and wholesale vehicles combined, which equates to approximately $22.2,000 in revenue per unit sold. Assuming inflation of 3.5% per year, revenue per unit sold in 2028 would be approximately $28,300. Such high sales would represent three quarters of the vehicles sold on the TTM by the largest US used car retailer, CarMax. In a mature market, as used cars certainly are, such growth requires taking significant market share from formidable competitors.

This scenario also implies that Carvana increases the NOPAT from -$446 million on the TTM to $1.0 billion in 2028, or 82% of CarMax’s fiscal year 2022 NOPAT.

80% reduction if Carvana grows at the pace of the industry

Below I look at an additional DCF scenario to highlight the downside risk, even if Carvana’s revenue grows at the same rate as the used car industry and margins reach half that of CarMax. .

If I assume that Carvana:

  • NOPAT margin improves to 2% (below 2021 NOPAT margin of -1%, TTM margin of -3% and half of CarMax TTM margin),
  • revenue grows at consensus rates in 2022 and 2023, and
  • revenue grows 9% per year from 2024 to 2028 (equal to the expected industry growth rate through 2027), then

the stock would be worth just $5/share today, an 80% drop from the current price.

In this scenario, the company increases its revenue to $32.1 billion in 2028, and assuming that Carvana generates approximately $28,000 per vehicle sold (using the same assumptions as the previous scenarios), the company would sell 1 .1 million vehicles in 2028, a near doubling of TTM levels and 69% of vehicles sold by CarMax in its 2022 fiscal year.

This scenario implies that Carvana increases the NOPAT from -$446 million on the TTM to $657 million in 2028, or 53% of CarMax’s fiscal 2022 NOPAT.

Figure 3 compares Carvana’s implied future NOPAT in these scenarios to its historical NOPAT. I am also including the NOPAT TTM for CarMax for reference.

Figure 3: Historical and Implicit Carvana NOPAT: DCF Valuation Scenarios

Each of the above scenarios also assumes that Carvana increases revenue, NOPAT and FCF without increasing working capital or fixed assets. This assumption is highly unlikely, but allows me to create best-case scenarios that demonstrate the expectations built into the current valuation. For reference, Carvana’s invested capital grew by 86% compounded annually from 2015 to 2021. If I assume that Carvana’s invested capital grows at a similar rate in the DCF scenarios above, the downside risk is even greater. .

Disclosure: David Trainer, Kyle Guske II, and Matt Shuler receive no compensation for writing about a specific stock, style, or theme.

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