Carvana Co. (CVNA) Earnings Call Transcript & Summary

All right. Let's get on with Carvana. Ernie Garcia, CEO; and Mike Levin, Vice President, Investor Relations. Mike, I'm going to give it to you right now because you're [ a champ at it a bit ]. Why don't do your disclosure, do my disclosure. And after we kill your buzz, we'll try to build it back up again.

Here we go. So let's get into it real quick. Today's discussion may include forward-looking statements within the meaning the federal securities laws, which are subject to risks and uncertainties that may cause actual results to differ materially from such statements. A detailed discussion of material factors may 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 the discussion.

You're good at that, Ernie. You've done that before. My disclosure is, talk to a Morgan Stanley salesperson and go to www.morganstanley.com/researchdisclosures. Ernie, there has been a number of years since we were in [indiscernible] the first time I sell a store all the time. It was you, me and your dad.

That's exactly right.

It's an empty road.

You brought one analyst, I get the hell out of here.

And then we just took off our mics and they were like, hey.

It was very awkward.

You think that happened since then, mostly good things, phenomenal things, frankly. But thanks for being here. Key messages at the top for the audience in terms of the investment story or any business update or anything else.

Sure. I don't think anything too material, but just to bring even up to speed, who's not already, I guess, like business context is, I think we came into this year expecting a continuation of 2021, and that's not what showed up. As a result, we shifted our focus from our top priority being growth to our top priority being expense reduction. And I think that's driven pretty much everything that's happening inside the company. I think we've made a ton of progress on that. I think Q2 is a great step forward. I think we have a ton of work left to do, and we're hard at it. I'm sure we'll hit on a bunch more of the detailed points as we go through all this.

All right. So second quarter was about closing the acquisition with the ADESA, starting to integrate that, bolster the balance sheet, match supply and demand, stop the -- slow the burn, give yourself some more runway. Pretty successful, actually. I mean the second quarter seem to hit many of those. Now you have the goal of still controlling what you can control. It seems like a lot of the emphasis is on SG&A to get you back towards your EBITDA breakeven target. So give us an idea of [indiscernible] very right, SG&A is big is probably in the biggest bucket?

Okay.

And so what are you doing to get under $4,500 of SG&A per unit ex SBC?

Yes, sure. Well, so I guess just to motivate it, I think, like I said, we came in expecting a continuation in 2021. That's not what happened. And so then -- as a result, we are way out of balance in Q1 and consuming a lot of capital. And I think the expectation, no one knows exactly what will happen to the economy over the next year or 2, but I think our view is we should prepare for things to be difficult. And so I wanted to get into a position where capital consumption was materially less and ultimately gets positive free cash flow. And when we think about where we consume capital, obviously, you can kind of break it down all the traditional ways. Working capital is not a huge one for us. It is an area generally dominated by our inventory. Our inventory was very large now to balance with where sales were heading as we headed into 2022. So we pulled that back a little bit. CapEx has been a big area for us, our capital consumption over the last 8 years, 9 years as we've expanded to kind of grow very quickly, I think the acquisition of ADESA was basically frontloading a ton of CapEx. And then the remainder of cash generation or consumption is basically is what are we doing with EBITDA inside the business, and that was definitely being dominated in Q1 by expenses on the SG&A side just because we had built for volumes that didn't show up, and we were -- that was the biggest area that was out of balance. So that's become our top priority by a long way. And I think what we've tried to do is take all of our dozens of product teams across the business and get everyone really focused on driving down variable expenses. And so what that basically means is just all those same teams that would have been focused on building the next feature that would have driven additional sales or would have been focused on hiring more people and training more people to support growth, they're now focused on doing all the things that drive down expenses. And so in every part of the business, that takes a different form, but there's literally hundreds of projects going on at any point in time. And I do think that the team has responded exceptionally well. This has not been an easy time for any company. It's been a harder time for tech companies. It's been a harder time still for tech companies that were extremely high growth and found themselves out of balance at the beginning of this year. And I think that there's always a risk that when you kind of have this big public feedback in the form of the stock price that goes way down that, that can kind of derail the morale of people. And I think our team has done a great job coming together and working super hard. And I think that Q2 is a testament to that. I think we made more progress in Q2 across many different parts of the business than we have in a long time. And I think that's continuing today. I do think we have a ton of work left, but SG&A has definitely been the focus and I think we've got a lot of progress that we're making and a lot more to make.

Hundreds of projects. Anything stand out?

So I mean, there's -- they're all over the place. We all have to dive into an operating group. I don't even know where to start. I'll find one that just like pick one that I think is super interesting and kind of somewhat easy to follow is, we started to do paired delivery of retail cars with pickup of cars that we're buying from customers. Historically, our scheduler wasn't kind of aware of 2 different activities that would happen nearby one another. So that's like a multistep process that you have to build in. You have to build awareness of that. You have to try to get the schedules to overlap. You have to build new processes for the advocates to kind of prepare for both a retail drop off and a purchased car pickup at the same time when they leave the hub. You have to kind of build that into your staffing model. You have to kind of create more slots because you can now have any advocate to more activities. That's like the type of thing that is being worked on that in the past would have just been hire more advocates because we're focused on growth and train more advocates and now it's kind of drive that efficiency through improved scheduler and your process.

If I ask you what is a more sensitive, important driver of EBITDA between volume and used car price?

Volume. So look, what I would say is -- if we go back to Q1, our SG&A per unit was probably kind of $2,500 out of bounds versus where it had been in the past. That was an enormous delta and that's because we had built for a volume that was just different. Like the car prices started to go up dramatically at the end of last year. Interest rates started to go up, industry-wide sales started to drop. So that was -- we are significantly out of balance there. If we looked at where like GPU was in any of the line items, whether retail, finance, wholesale, it just -- it wasn't out of bounds by anywhere near that same level. And then I would also say anything can happen. So I don't want to be too confident about where any given line item will go, but I do think that an area where my personal belief, I think the belief of many investors kind of deviate to some degree is kind of what happens to retail GPUs as car prices drop. Certainly, there's room for basically wholesale prices to stay in the same place and retail prices to drop and therefore, for GPUs to drop. But what has traditionally happened is when retail prices drop, wholesale prices also drop and oftentimes wholesale prices lead retail prices. And so you do tend to see across long periods of time and across meaningful changes in retail prices, pretty similar GPUs on the retail side across many dealers. And I do think that's fairly fundamental. Many dealers, they effectively share a cost structure. And so they kind of act in unison as a result of that cost structure and oftentimes, depreciation can be foreseen. And that's what we saw in Q2. We did see more depreciation in Q2, but we saw wholesale retail spreads widen. We've seen wholesale retail spreads continue to widen since Q2. So I think there's generally a little bit more stability in that line item that is oftentimes appreciated, but, of course, time will tell.

Ernie, like August was the largest Manheim -- sequential Manheim drop, exclude COVID. I think you got to go back to the financial crisis, like October '08. How is the used car consumer looking? And would you kind of attribute weakness in the market more to recovering supply or maybe some demand destruction and some pressure on the consumer or both?

I mean I think car prices, depending on what your 2 comparison periods are, in many price segments are up on the order of like 30% interest rates 2-year treasury, which is a good kind of benchmark to look at when you're thinking about what consumer rates are for any given level of credit are up probably 350 basis points in the last 12 months. 350 basis points is a lot.

And [ of course ] the demand.

Yes. Yes, that's going to -- that just dramatically reduces basically how much car a customer can get for any given payment. And so I think those are very real impacts. And then I think cars are discretionary. They're an easier item under uncertainty to pass on. So I think there's clearly been some industry level headwinds over the last 12 months.

A lot of people don't think you can run a used car business without having access to the, say, traditional securitization market, are they wrong?

I don't know that I would want to say there. I mean I certainly think having access to the ABS market is better. I think the ABS market is the most liquid and efficient market for monetizing finance receivables if you have the capacity inside your business to what I call commoditize them, which means basically underwrite them, credit score them, verify them, attach them into servicing and bundle them with historical data so that they can be purchased by a financial buyer instead of someone who has all these capabilities themselves. So I think that's a very important market. I think that market functions pretty predictably on the order of 95% of the time. I think the last time that it was unpredictable for a month was maybe COVID and then before that, you have to go all the way back to 2008 where I think in the subprime kind of credit spectrum, it probably broke down for on the order of a year and on the prime credit spectrum if I broke down for materially less than that. I don't remember exactly how long, but materially less than that. I think it's been choppier over the last several months as we've gone through all these interest rate changes and everything else. So I think trying to have alternative ways to monetize receivables away from the securitization market, we do think is really important. So we like to try to have access to both. I think these numbers won't be exactly right, but I think the ABS market is on the order of $100 billion a year in auto. And doing mental math that may be imperfect, assuming 70% attach rate on financing and $15,000 average car cost. The entire kind of auto market is probably more like $500 billion. So the majority of it does happen away from ABS market, but both markets are very large and very liquid and extremely large compared to any given issuer.

How much is your gain on sale dependent upon participation in the ABS market?

I don't think that's the primary driver. I think the ABS market is generally, in any given environment, it's probably a little bit more efficient way to monetize your receivables because it is such a competitive and liquid market. But I think the primary driver on kind of finance GPU is basically just where our consumer-facing interest rates relative to the sum of investor kind of benchmark interest rate costs plus risk premiums plus expected losses. And I think that in -- there's like this term, interest rates are sticky, which basically means when rates -- when kind of benchmark rates are going up, consumer rates tend to go up more slowly. And when benchmark rates are going down, consumer rates tend to go down more slowly, but they do tend to equilibrate. And I would just -- we've been in a transitionary period now for probably going back to the end of last year that is compressed finance GPU all as constant. I think that's by far and away the biggest driver.

And then tell us what changes you have made and continue to make in terms of your -- managing your credit portfolio, approval rates, higher interest rates to kind of adapt to the recent environment and what's been the demand response to that?

Sure. So I think there's a lot of directions we could go there. I think probably the most important, simplest and easiest to discuss is interest rates themselves. So I do think that we've moved pretty aggressively to raise interest rates. I would say that we are probably simultaneously behind the curve as it relates to the sum of those kind of 3 inputs that we discussed earlier, benchmarks plus risk premiums plus expected losses, which is why finance GPU has compressed over the last several quarters. And we are probably also raising rates faster than the majority of other lenders. I think there's a number of reasons why that could be the case, kind of more exposure to securitization markets, which kind of instantly adapt the fact that we sell our receivables in real time. And so there's a kind of instantaneous visibility in our income statement on kind of where finance GPU is, and therefore, there's kind of more instantaneous, I think, motivation to react. So I think that we probably moved more than most other either kind of dealer issuers or banks. But based on the data that we see, we do see all the other financial institutions also raising rates. They just tend to be a couple of months behind us, I think.

Questions for Ernie from the audience.

And all eyes instantly go to work around.

Some questions for Mike. Okay. So we'll come back to you. I'm not shy. Since the 2Q lows, what's developed worse or better than expected in the market?

I think let's start with one that I think has gone better. I think the ADESA acquisition, both in terms of immediate integration and in terms of, I think, visibility we're getting into long-term potential, I think I'll speak for myself, I'm extremely excited about. I think you never know. I have not been involved in a lot of mergers, but my guess as to why many mergers end up undershooting their intended gains is largely because you have well intended keep on both sides kind of the transaction that believes that they've been doing things in the smartest ways for a long period of time, and it's hard to reconcile those 2 views and get people pushing the same direction. And I think that the ADESA team has been exceptional to work with. They've been extremely open-minded to our views and our thoughts and things they can learn from us. And I think our team has been very open minded to learning from them. And so I think that we've been able to get a lot more done more quickly than I think we could have really expected. And I think that that's exciting. I think those time lines are not instantaneous, but I think they're moving faster than I at least would have expected.

And you've described the ADESA acquisition as kind of like capitalized CapEx or substituting many years' worth of CapEx. Others have talked about, well, you're going to need to have CapEx to integrate ADESA as well. So when you add those 2 things out, what is the CapEx savings from that -- from the run rate?

So I mean, I think a lot of that is timing, and that a lot of that is basically just like how far you're looking out into the future and to what level of sales. But I mean I think we've dramatically pulled back on CapEx because we have built a lot of capacity. And now with ADESA, we have a lot of opportunity to kind of move cars around on those physical footprints and do a lot without having to invest. They have a lot of reconditioning capacity, for example, that was already built out that we're already starting to utilize on the coast. So I do think there's like a -- I think we basically prepaid for a lot of CapEx, and we are in a position now to be able to spend significantly less for potentially a long period of time. I think we'll see how the next year or 2 unfolds and what the right decisions are to be made, but I think we're positioned to not need to spend the time of CapEx for a while. So I think that's great. I also think that the kind of visibility into what we can do with ADESA, I think continues to be exciting, just the power of that footprint and the relationships and the capabilities they have is very high. So I'm excited about that. I think the world around us is not evolving positively. And I say that as it relates to the automotive industry or the economy broadly, we continue to see numbers that aren't great that I think don't bode perfectly for the simplest of environments to operate in over the next 12 months. We'll see how that all unfolds, but I think that's something that probably is going worse than we would have ideally seen since several months ago. And then the other thing I think is going great, I really do think the company is operating at a very fast pace. There's a lot of high-quality work being done very quickly and that's going to show up over the next several quarters, but I'm very excited by that. And I do think that the speed at which we are operating is materially different than the speed at which we were operating 6 months ago, which I think is great.

So you've established growth is more important for the business profitability than, let's say, used car price. There can be some noise there. But in previous conversations, you're adamant that even if you didn't grow, you could be EBITDA positive. I know it's not the objective, and we'll talk about growth. But how is that possible post ADESA? How -- walk me to bridge, how could actually do that in a draconian environment of no growth, which is pretty draconian given you're a low share of the market and your consumer experience?

I would -- we've had several EBITDA positive quarters in the past at lower scale than we're at. And then ADESA, on average, has been a profitable business and in more normal periods, an extremely profitable business. So I don't think that there is -- at least in my mind, there's not a question about the business model's ability to generate positive EBITDA at the scale that we're at or at scale we were at before, we generated positive EBITDA. And I also think that even in those moments, we weren't focused on expenses. And so I think that there's room -- like with the folks that we have today, even at those levels, you could drive down expenses further. So to me, the big question I had the big focus in the business is just where are we putting our energy and then how well are we executing. And I think that's what's most important. And I think that there's always a ton of room for variability and execution quality inside of any real company. And I think that room for variability is bigger if the company is larger. And I think it's bigger if the company is more complex. And I think that we're pretty large and pretty complex, but I think that we're -- I really do believe that we're doing a great job right now, and I'm excited by the progress that we're making. And then I also think this is a place where, again, I'll speak for myself, and [ I'll review ] that may be different than many would have. But in my mind, I think the questions that we faced when we set off to build Carvana was, could we build something that customers like more than the alternative. That was kind of question one. Question 2 was, could we do that in a way where we can kind of monetize the transaction so you had a chance to be profitable? I think that was Question 2. Question 3 was could you drive down our expenses to a level where your overall unit economics would be in a good spot? And then I think Question 4 was, and what scale can you build that to? And I think to get from kind of the seed of inception to the dream, you are going to have to check all those boxes. And I think that when you look back on it, assuming that we get to the end and build the dream that we set out to build, I think the only real question is going to be how quickly did you resolve all those questions. And in my mind, I think we're now focused on a different question than we were focused on 6 months ago, but we're still resolving a question we're always going to have to resolve. And I think that the speed at which we're moving is faster than it's been in a long time. And so in many ways, I think we're marching toward that dream faster than we have.

I do.

It was going to happen, and I think we're marching toward it quickly, and I just think you're in an environment where I think I'll paraphrase and I'll probably get this a bit wrong, but I think [ Truck and Miller ] said something the effect of, when stocks are high, it looks cheap and when stocks are low, it looks expensive. And I think that's because when times are good, people tend to focus on the half of things that are very good. And when times are bad, they tend to folks on the half of things that are very bad. And neither thing is totally true and we're in an environment where times are tougher. But I think that there are a lot of good things happening too that aren't getting as much visibility today, and that's fine. Like the world will judge us as it will, and our job is to just keep building and over time, truth kind of prevails.

I like Stan quotes. I know you admire him, I do as well. I'm a fan, and he's a fan of yours. So the narrative in 2021, I'm paraphrasing was, if we had more cars, we'd grow faster. Now you -- well, do you have cars now? It seems like you have more cars, why aren't you going faster? I mean you're growing, but -- and you're certainly growing -- you outgrow versus the market is, I think, what, last quarter is something like 30% or more versus the market, maybe more, I don't know. What was that growth? How do you define that?

I think it depends a little bit on who you're comparing us to, but we're definitely growing, yes, noticeably faster than the market.

So why some investors are surprised that growth isn't higher, given how well -- that it would be one thing if you had 20% of the market, but you still have a fraction of percent.

Yes. So I would say -- I think it's a fair question. I do think that basically until around November of 2021, I think that it was -- the dramatically simplified version of the story was add car to website sell car. And then [indiscernible] works. Yes. But I think that was basically the story. And then I do think a lot has changed for that. And so I think you need to -- there's many different factors going in there. I think car prices have moved up dramatically. I think interest rates have moved up dramatically. I think consumers have pulled back. And then I think very importantly, we've dramatically shifted our focus because of the previous several factors. And so we talked in Q2, we had sequentially reduced our marketing budgets pretty significantly. We had shrunk our inventory, those trends have continued as we move forward. And then I do think that when you talk about dozens of product teams that were focused on growth first that now focus on expenses, no one of those line items is going to be something that's going to explain more than 0.5% or 1% of change in growth, but you add a lot of those up and there's a big difference. And I think that we think that for the company today, that's the right trade to make because we think driving down expenses is important. But for sure, that's kind of like a transitory like headwind on the level of sales. And so I think our plan and expectation is that as we move through this period and head into 2023 and 2024, that we'll move back to the world where it's add car sell car. And I think our job is to make sure that the engine is as strong as it possibly can be between here and there.

Question here. Can we get the mic?

[ Technical Difficulty] If you sell more, you would cover your fixed expenses more. That would seem to be true, if your variable profit was positive per car. And if it wasn't, then actually, you should sell a lot less and keep profit that way until you get to the right place.

Yes. So I think that brings us to -- so the question is like you've got your variable expenses, the question then just is, do you have like a positive contribution margin? If so, more units is helpful, so unit should be all the matters effectively. It's like may be a reduction of your question, but roughly. I think that, that is correct in theory. And I think the big difference is like what we are focused on is driving down variable expenses. And so then I think where you're kind of trading off is, is it more cash beneficial to drive down variable expenses across all of your sales or to lead variable expenses in a similar spot and add a sale. And I think those -- that's kind of like the trade-off that you're making because variable -- you have to define what variable means. If variable means an unavoidable cost and you can't reduce it, if variable means a function that is variable like logistics or last mile delivery or whatever advocate expenses or any expense in the business, they are variable in function, but they can vary pretty dramatically in cost, depending on the focus you put on them and the efficiency that you get inside of that function. And so I think today, we believe that there's more gain to be had by reducing those variable expenses and just kind of managing like your overall expense level. And so that's where our focus is.

How much of that -- moving from that put car on website, sell car, how much of that got you the just crap business, like business that was just not -- it was negative contributing maybe even incrementally?

Yes.

Or put a strain on the organization and then second derivative that allowed you to either -- that has raise costs in other parts of the business that would otherwise have been profitable?

Sure. So let's make that as like a practical we can. An example of that would be a sale in the Pacific Northwest. A sale in Pacific Northwest because it's very far from inspection centers, you have a much higher expected logistics expense associated with that, right? You have more work that's going to go into that sale. There's more things that can go wrong. So now the question is, is that a good sale or a bad sale? In a world where growth is being supported and you're building an engine and you know that over time, you're going to build an inspection center in the Pacific Northwest and so you think about the long-term value of building a brand in a market out there, it's a good sale. In a world where you're really cash flow focused, it's not a good sale. And so I think that the answer can change a bit. And then I think what's important for a company when you're trying to build towards the long term is that you don't blow too much in the wind because there are many, many things like that where the right choice can change, depending a little bit on your perspective. And so I think we try to kind of change our perspective in those ways as little as we possibly can, but I think that with this out of balance as we were in Q1 and with the markets moving the way that they kind of have and the economy moving the way that it has, we've made several of those moves. And so we have cut out many of those sales that I think in the long run are good sales, but I think in the medium run are not good sales and then we're trying to just maintain the structure that enables us to go get access to those sales again as we feel we can access them more efficiently.

Time for one more question from the audience.

A lot of the inbounds we get from investors relate to the SG&A buckets and break it into 5 or 6 different ones. And where can you guys get costs out of it? Amongst them, where do you guys think there's the most room for you to strip cost out even while growing the business?

And so everyone could hear the question because he was on the mic probably. Okay. So I would say -- I mean I think there's a lot of opportunity everywhere. I think our simple way to think about the path is to break it into 2 steps. I think we tried to do this in our operating report we put on May. Step 1 is just get those line items per unit to a place that we've been in the past, and I think that gives you a pretty good math that gets you to a materially better place where the cash flows of the business itself are -- can be positive again. And then I think step 2 is improve from there by adding these efficiencies like the one that we talked about, which is last mile delivery and pickup matching. And I think that both those things are happening simultaneously. One is about getting in balance, which is trying to balance -- across the company, we have hundreds of locations and in every location, we have many different functions, and we're trying to balance kind of all those function locations with the work that's being done. We're trying to make sure we don't do it too quickly because any given function location can turn into a constraint really quickly if you kind of overdo it in one location and then that can cause you to be more bloated elsewhere in the organization. So I think we're trying to bring that down, and that's about kind of getting into line with where we've been in the past. And then there's a lot of focus on the product teams on driving efficiency to levels that we haven't seen in the past by building new capabilities and new process. And I think that also is across all different line items, and it would be way too long an answer to try to dive into breaking it into each one, but I think there are gains everywhere. A really easy one to see is marketing, which will take time, and there's a lot of interesting dynamics happening today. But we've been in our oldest cohort, we've been in like the mid-$400 per unit range in marketing expense per unit, whereas we probably averaged at the company level like $1,100 would be an example. Then obviously, we don't believe that we were done when we were at those levels. There's all kinds of things happening in like real time today, but trying to kind of get visibility into where the midterm can go. I think that looking at our past is the right first step and then big progress in there across line items is the right second step.

All right. We're warp there. Ernie and Mike, thanks for spending time with us. This concludes the session with Carvana.

Perfect. Thanks, everyone, Adam.

Thank you.