The stock is down because the outcome is far from certain.

Shares of used-car e-commerce company Carvana ( CVNA -6.72%) are down more than 90% from their all-time highs in 2021. However, at $26 per share as of this writing, its collapse hasn’t gone unnoticed. Piper Sandler analyst Alexander Potter believes the stock is “grossly undervalued.”

According to The Fly, Potter gave Carvana stock a price target of $73 per share earlier this month, suggesting around 180% upside. This makes Carvana look like a no-brainer buy. However, Potter also said that “bankruptcy is a real possibility.” These comments vividly illustrate the wildly divergent possibilities with a Carvana investment today. And investors should consider both bullish and bearish opinions before buying the stock. What could go wrong for Carvana

Carvana buys and sells cars by leveraging the power of e-commerce. Consumers can go to one of its select vending-machine locations. But many choose to shop online and have vehicles conveniently delivered.

Acquiring a steady supply of used vehicles is a top priority for Carvana. By the end of this year, the company should have enough infrastructure to acquire and recondition 1.4 million vehicles annually, aided by its recent $2.2 billion acquisition of used-vehicle wholesaler ADESA. This capacity is meaningful considering it’s currently selling more than 100,000 vehicles per quarter.

Growing a low-margin business like this is capital intensive. For example, to annually sell one million vehicles, Carvana must first acquire at least that many. Building inventory is therefore essential and means that more cash goes toward buying cars than cash comes in from selling cars. The company’s cash flows consequently reflect this. Cash from operations is negative, but it has funded its growth by raising cash from financing, as the chart shows. In the current environment of rising interest rates, Carvana’s business plan could be intrinsically problematic. Higher interest rates make car loans more pricey, and values should come down.

Consider that vehicle prices are historically sky high. Prices can be tracked using the Manheim Used Vehicle Value Index. In September 2019, before the pandemic, the index’s value was about 140. The index had climbed every year prior but was only up a total of 15% over the previous five years. However, the index is currently at 206 — a massive 47% two-year increase and a historical anomaly.

The Manheim Used Vehicle Value Index is still high, but it’s fallen about 13% from its peak earlier in 2022, reflecting the effect that higher interest rates are already having on used-vehicle prices. I only expect this trend to continue and accelerate in coming months, potentially leaving Carvana with inventory it will need to unload for a loss. What could go right for Carvana

Back to Potter. He also said Carvana’s value is a “function of market share and profitability.” And it’s smart to consider both of these issues in light of falling used-car values.

Starting with market share, falling prices effect all used-car dealers, including Carvana’s competitors. The fragmented used-car dealership landscape means there are tons of small players with far scarcer resources than Carvana. Therefore, I bet changing economic conditions will deliver a harder blow to weaker companies. And if that’s the case, Carvana may actually gain market share during this time.

Here’s another point to consider: It’s true that Carvana’s gross profit per vehicle sale could go down as car prices plummet. However, the company generates relatively little of its gross profit from car sales in the first place.

In 2021, 54% of Carvana’s gross profit came from its Other segment, which includes financing vehicle sales and providing extended warranties. In theory, the company’s gross profit on vehicle sales could decline dramatically while still retaining the majority of its gross profit.

Moreover, this used-vehicle headwind will be temporary. As used-car prices fall, Carvana will start replacing higher-cost inventory with lower-cost inventory, allowing it to get back on track when prices stabilize. The uncomfortable reality for shareholders

The near term isn’t the most friendly environment for building a used-car powerhouse, but I would put Carvana’s bankruptcy as an extremely low-probability outcome. Consider that on Sept. 22, the company locked in a multi-billion-dollar credit line for managing its inventory. Banks likely wouldn’t be so generous if there was a realistic chance of going under.

However, Carvana is still interested in growing its business at all costs. While its ADESA acquisition gives it capacity for 1.4 million vehicles annually, the company is shooting to build infrastructure to handle three million. And that will cost money.

Few companies can rival Carvana’s revenue growth since […]

source Is Carvana Stock Really “Grossly Undervalued”?

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