Carvana Co. (CVNA) Earnings Call Transcript & Summary

Great. Good morning, everyone. Thanks for joining. My name is Rajat Gupta, member of the Automotive Equity Research team at JPMorgan. Very pleased to have with us the team from Carvana, Mark Jenkins, Chief Financial Officer; and Mike Levin, Director of Investor Relations. Mike has -- Mike will read the safe harbor statement. And after that, we will dive into Q&A.

Thanks, Rajat. Just real quick for everybody. Today's discussion includes forward-looking statements within the meaning of federal securities laws, which are subject to risks and uncertainties that may cause our actual results to differ materially from such statements. A detailed discussion of the material factors that cause actual results to differ from forward-looking statements can be found in the Risk Factors section of Carvana's most recent 10-K and 10-Q filed with the SEC. The forward-looking statements and risks in this discussion are based on current expectations as of today, and Carvana assumes no obligation to update or revise them, whether as a result of new developments or otherwise. And back to you, guys, for the discussion.

Great. Thanks, Mike. So Mark, maybe just to dive right in, just start off with liquidity. That's been the biggest concern over the last few months in our conversations with investors and also heading into second quarter earnings. You have $4.7 billion right now that you have published. There've also been like other carve-outs in the past that you mentioned with respect to the assets on the balance sheet or related to the market cap, et cetera. Could you remind us like what's your true liquidity bandwidth today in addition to the $4.7 billion? And do you think Carvana has enough capital to grow towards a self-funding operation today, recession or not?

Sure. Yes. Well, thanks, Rajat, first of all, for inviting us to the conference. Very excited to be here talking with you. So I think Carvana sits today in its strongest liquidity position ever. I think we have about $2.7 billion of cash and revolving availability as of June 30. We also, following the acquisition of ADESA, have approximately $2 billion of unpledged real estate assets. These are large and attractive industrial sites spread across the country. So I think that combination puts us on very strong footing from liquidity position perspective as we sit here today. Now as we look forward to operating the business, I think our key operating priorities are really focused on moving the business toward first positive EBITDA and then positive cash flow generation. I think there's a number of key drivers that underlie that. I think the single most important that I would point to and that we have been really focused on over the last couple of months and expect to continue to focus on going forward is driving down operating expenses or SG&A expenses per retail units sold. I think that's a number where we have operated at significantly better than Q1 and Q2 levels in our past, but did have elevated levels of operating expense per unit in Q1 and also Q2, although we made significant improvements quarter-over-quarter due to a significant infrastructure that we built in late '21 and early '22 that wasn't met with the demand both from an industry perspective and also due to some internal constraints that we faced so far this year. And so I think that's our #1 area of focus. I think we have begun that drive toward driving SG&A leverage, driving EBITDA profitability and driving positive cash flow, and have made good steps so far. And we're also starting on that path from a very strong liquidity position with the $4.7 billion of total liquidity resources that you alluded to.

And if there is a recession, what are like the key things to focus on any particular areas of the business that would concern you, that might get hit more and would maybe need an extra draw on that liquidity? Or is that still pretty manageable with the current position that you have?

Sure. So I mean I think if you think about macroeconomic scenario modeling, I think the first point that I would make is Carvana is currently taking meaningful share in an auto industry that is in, or that is seeing meaningful volume declines. I think if you look in Q2 based on various industry data sources, we did see the industry decline on the order of 15% year-over-year compared to a 9% growth rate for Carvana from a unit perspective. And so I think that that's an important starting point because I think it's useful to note that we're already seeing it in the auto industry. Prices are up significantly. But sort of real volume or unit volume is down significantly year-over-year at a level that's even comparable to what we've seen in past, more broad-based across the macroeconomy recession. So I think that's an important consideration in terms of thinking about where we're starting. Now I think a follow-up question to that is, well, how do you respond to changes in the macroeconomic environment, whether that be further industry-wide volume reductions or an industry-wide rebound in volume? And I think on both of those points, I think we're really focused on the various points of flexibility within the business. I think we're very focused on SG&A expense leverage and SG&A flexibility, and have many levers to pull there that we've already begun pulling as we focus on our drive toward profitability. I think we have CapEx flexibility. At the end of the second quarter, we had about 1.2 million units of infrastructure capacity to produce cars to get them up to the website for retail sales. So we have ample excess capacity to grow into, which I think gives us a lot of flexibility in our CapEx plan. And then I think we have numerous other opportunities to flex profitability levers including pricing optimization, for example. And so I think as we look forward, we have a lot of levers for flexibility in the business. But I would say the single most important of those is continuing to stay focused on driving SG&A leverage and driving efficiencies through different parts of the business.

And on the GPU side of things, in that scenario, used car prices are up 40%, 45% above normal levels. Maybe it never goes back to pre-COVID, but probably settles down somewhere halfway through. And if we do have a downturn in during that period of correction, from that 40% to like maybe 20%, are you -- do you think you can manage your retail GPU metrics through that transition? Or how would you manage that? And then also relatedly, on the financing side, in different lending environments or credit environments, how do you manage that as well in a downturn? And what kind of implications could that have?

Sure, yes. So -- you mentioned a couple of intersection points between what's happening in the macro economy and the impacts on GPU for us. And so starting with the first part of your question, we've looked at periods in the past where we've seen periods of -- in terms of the retail used vehicles, either periods of appreciation or depreciation. And over time, either seasonally or cyclically, the period -- the industry goes through periods of either lower depreciation or even appreciation and then it goes through periods of higher depreciation. I think generally, what we've seen in those periods is -- there's some real ballast in retail GPU, because there's a couple of trade-offs that come along with periods of increased depreciation. On the one hand, if used vehicle prices in the retail market are depreciating, that causes more write-downs on the inventory you hold, which can have a negative impact on retail GPU, other things being equal. Then there's a meaningful offset, which is typically wholesale prices fall in advance of retail prices, which lowers your input costs and gives you the opportunity to have lower cost inventory that you can earn a straighter GPU on. And so those are meaningful trade-offs. I think the way we've seen that play out in the industry over time is if you look at some of the large players in the industry, there's been a lot of ballast in retail GPU, even in depreciating environment. So that would be the first point I'd make there. Of course, in an environment where used car prices are normalizing, i.e., declining toward more normal levels, I think that also has a positive impact on affordability and therefore, on demand and sales volume of used cars. And the other part of your question, I think what are some of the impacts of the macro economy on Other GPU. And there, I think those impacts almost take a similar form to some of the things we've seen recently with interest rates moving. As costs move on the -- related to, say, the financing component of Other GPU, I think generally speaking, we try to price appropriately to make sure that those costs are taken into consideration, thereby maintaining some level of stability in Other GPU components. So that would be the way that we think about those things. I think the industry has a lot of ballast in it in general. And we're certainly watching all the trends and want to make sure that we're staying flexible and adapting as the industry adapts.

Got it. Great. That's helpful color. Maybe just double-clicking a little bit on Other in finance GPU. Gain on sale per unit went up sequentially in the second quarter. Did you have any benefit from hedging gains in the quarter? Was it meaningful enough?

So I think -- so our Other GPU, including the financing component went up quarter-over-quarter. I think the single biggest driver of that was an increased spread between our origination interest rates and our cost of funds. Hedging was a small benefit but not a particularly large one. And then I think there were some offsets to those 2 gains that I listed, yes, including sort of industry-wide cost of fund changes, channel mix, things like that.

Got it. I mean the Ally partnership has been a really great partnership for you. But it's still been a bit of a black box in terms of trying to understand the monetization or the margins there. And Ally, on their own earnings call recently mentioned that the quality of paper coming from Carvana was pretty high quality. But how do investors get more insight into the gain on sale dynamics on those loan sales? Particularly during something like last quarter, where we saw spreads blowing up on the ABS side and -- but you still had pretty good margins on the forward flow of the Ally business. If you could dive into that a little bit. And then maybe just on the Ally partnership in general, how real time are those negotiations? How contractual it is? Would it change when you do the next renegotiation once the $3 billion expires? Just -- if you could just help us understand all of those dynamics.

Sure, yes. So I think looking back 5 or 6 years now, we've had a very strong partnership with Ally. I think Ally has been part of our 2-channel strategy for monetizing our loans. And that 2-channel strategy typically is we securitize loans to monetize them and then we sell loans through flow agreements, specifically focused on Ally. And those 2 channels balance better monetization in the securitization market and strong stability through a partnership with Ally. Our partnership has, I think like I said, been going for more than 5 years now. I think we benefit from it. As you alluded to, I think we originate very strong loans, which Ally benefits from as well. And then in terms of the fluidity, I think the best way to think about our partnership with Ally is it's a real partnership, which means we're talking all the time. We're talking about, hey what are we seeing in certain market conditions or how are interest rates moving. I think it's a very fluid ongoing conversation as opposed to a very lumpy conversation where there's a big change here, a big change there. I think it's much -- the best way to think about it is it's a partnership and therefore, a fluid one.

Got it, got it. And so it looks like you have $3 billion left, $3.2 billion left in capacity with them. But in the past, we've also talked about additional partners outside of Ally for those whole loan sales. Any more color you can give us on that? If you don't tap into the ABS markets in 3Q, you probably have half a quarter of capacity left with Ally. So maybe if you could give us a sense of like how those other partnerships work? Are they pretty similar to like the Ally partnership? Are those structured a little differently? Any color you can share on that.

Sure. Yes, so I think we have -- in addition to participating in the securitization market and selling loans through our forward flow agreement with Ally, we have sold pools of loans to other institutional buyers in the past, in particular in the second half of 2020. As we were sort of emerging from COVID, we sold loans to other large whole loan buyers. I think that's an opportunity for us. I think we definitely -- I think we think the 2-channel strategy of having a combination of securitization markets and forward flow partners is the right strategy for the business. And I do think there could be opportunities to expand the set of partners over time.

Got it, great. Moving to retail GPU. You mentioned that you continue to see $600 of incremental logistics and reconditioning headwinds. How much of this is just unutilized costs, overhead, un-absorption, versus just wage inflation and other inflation around logistics and trucks. And how much of this is just one time? Just if you could just decouple that $600 a little bit? And how should we think about those headwinds going away as the year progresses and as we head into 2023?

Sure. Yes. So I mean, I think the -- I think most of that gain is -- or sorry, the increase in cost is really -- it's really all about the rapid growth that we experienced in late 2021, early 2022. I do think there's a component of it that not unlike SG&A, where we just built more capacity including labor capacity than we ultimately needed for production volume. I also think as we rapidly grew, lots of opportunities for process improvement, standardization of processes across IRCs, lots of opportunities for internal benchmarking where we look at what are the best IRCs doing from a performance perspective on speed, cost and quality metrics and then where are the average and the lower-performing IRCs and how do we get all of the lower or average performing ones to look a lot more like the top performing ones. So I think there's a lot of opportunities on things like that that have cropped up as we sort of grew over the course of the second half of 2021 and 2022. There are some other dynamics or -- for example, there's a fixed cost component of that that will -- you would get back with volume, but that's a relatively small component of that overall total. Really, the areas that we're focused are on really capturing efficiency gains in the logistics network and the reconditioning centers, places where we see opportunity relative to where we started in Q1 and Q2.

What are your reconditioning costs today for a car?

So we haven't broken that number out specifically, but we have broken out the, I guess, the year-over-year change. And then I would say on the year-over-year change. The larger portion of that $600 related to reconditioning and the smaller portion related to inbound logistics, but both matter.

Got it. Okay. That's helpful color. I just want to check in, if anyone has a question in the audience. Otherwise, I can keep going. You got one. Jim.

I wanted to go back to your sourcing strategy. I mean, we're in such an unusual environment right now in terms of the inventory and being so lean. And I'm just trying to kind of come back to the public dealers saying they're getting less than like 10% of their used from auctions and they're leveraging their traditional sources. Can you just kind of walk us through where we are today versus where you think we'll be in might be 2 years based on what we're hearing from how long it will take the inventory channels to come back? Any color you can kind of share on that? And just how big of a challenge that's been for you looking back to last year versus maybe some green shoots 12 months from now in terms of sourcing product? And I'm kind of staying away from the whole auction, strategic rationale for that, just for traditional.

Yes. So I mean we've had a lot of success over the past several years, buying cars from customers for our retail inventory. I think it's definitely -- makes up most of our retail inventory today is cars that we bought from customers and then inspected, reconditioned and put up on the site for retail. I think that's something that definitely has moved up over time. And we really launched that product of buying cars from customers in earnest or really started marketing in earnest in early 2019 and then have made a lot of gains. And so we do buy a lot of cars from customers today. It definitely makes up the lion's share of our retail inventory. And I think it's a place where we see continued opportunity to continue buying lots of cars directly from customers. We offer a really great experience. It's very streamlined from a customer's perspective. And at any rate, we think that's -- it's been a big success story in the business and an area where we continue to see opportunity.

[indiscernible]

So I think there is a correlation between buying cars from customers and age. Typically, the cars that you buy from customers are older on average than the cars that you would sell from auction, because auction cars are more heavily weighted toward off-lease, although those are relatively lower volume today in off-rental. But those very new model years, so there is a correlation there. And so yes, I do think average age has climbed to a degree over time.

Kind of a follow-up on that. One of the -- follow-up on that. One of the presenters yesterday was saying that the success you've had in buying cars is due more to the disappearance of negative equity because of rising used car prices. And if the negative equity problem was still there, that would be a huge challenge for you, and more trades would go to the dealers who can play around with things and make the financing available even when there is negative equity. Can you say something about that?

Well, I mean, I think the -- I think one factor that's impacting the industry is their higher used vehicle values means less or more positive equity for customers who might be inclined to sell their car. Now I would just say that's an industry-wide effect. And so I do think that the industry is always going to stay in equilibrium. It will adjust pricing and vehicle value so that the supply of cars coming out will match the demand for cars. But I think all of that's going to affect the industry in general as opposed to any specific player.