When you think about fun shopping experiences, you probably don't think about used cars. Carvana (NYSE: CVNA) is working to change that. The company, which went public last year, takes one of the least pleasant purchases that we make and puts it online. Browse online, buy online, finance online, and get a used car delivered to you -- all without the hours of haggling and physically shopping around.
In this episode of Industry Focus: Consumer Goods, analyst Vincent Shen and Fool.com contributor Asit Sharma dive into the company -- its long-term strategy, where it is now, and the most important numbers and trends from this quarter's earnings report. Tune in and find out what makes Carvana so exciting, what risks investors need to watch, which metrics to focus on each quarter, and more.
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This video was recorded on Nov. 20, 2018.
Vincent Shen: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. I'm your host, Vincent Shen. It's Tuesday, November 20th. Joining me for this show via Skype from beautiful Raleigh, North Carolina is senior Motley Fool contributor, Asit Sharma. Hey, Asit, glad you could join us.
Asit Sharma: Hey, Vince, thank you for having me. I really appreciate it. Great to be here.
Shen: Awesome. I need to start the show off with a few announcements. First, a heads up for listeners that Shannon and Nick will be taking their days off for the Healthcare and Energy and Industrials podcasts this week. Industry Focus will pick back up on Friday with a special episode from Dylan. We'll resume our usual programming schedule next week. Listeners, on behalf of the entire Industry Focus team, our producer Austin, all of our Foolish contributors -- have a wonderful Thanksgiving holiday! We're incredibly grateful for your support. You guys are simply awesome.
This last update is a tough one for me. Today is actually going to be my last day in the studio as a host for Industry Focus. After four fantastic years with The Fool, my wife and I are packing our bags, taking off for a new adventure in Taiwan. As excited as we are about the move, I just want to say I'm really going to miss getting into this chair each week, sharing and learning about new companies together. To everyone who has tuned into the show, whether it was for just one episode or every single week; to everyone who has written in with questions, suggestions, feedback; to all my guests; to our wonderful, wonderful producer, Austin; to Dani and his video team -- thank you so much.
This might be my last day in the studio, but you'll still hear my voice through the remainder of 2018. I've left the IF crew with some shows waiting in the queue. The New Year will come with a new host, but you'll still hear from the Foolish contributors you know and love, like Asit and Dan Kline. And, who knows, maybe I'll be fortunate enough to make a special appearance in the guest chair down the road.
Without getting too sappy, Asit, we have a new name for listeners to consider. Today, we're going to get up to speed on a new way to shop for a car thanks to Carvana, ticker CVNA. I don't have a good reason for why it's taken us so long to introduce this company to Industry Focus. Now that I've had a chance to look through the 10-K, read some earnings calls, this seems like a really cool business. I like how it's changing how people approach what is often one of the biggest purchases they'll make in their lives. Carvana is a pretty young stock. It priced its initial public offering in April 2017. That was a few years after it was spun off by former parent company DriveTime. As a publicly traded company, it had a slow start out of the gate. The IPO priced at $15 per share. In its first couple months, shares actually fell below $10. But then, Carvana reported its fiscal first quarter results that June, and since then, it has enjoyed a steady climb to a peak of $65 per share just a few months ago, before coming down to current levels around $45. That's still more than a 125% gain, and a very impressive performance in 2018.
The excitement investors have for this company is in how it has turned the used car shopping and trade-in experience on its head with a much more tech-focused, e-commerce solution. Asit, can you tell us a little bit, really quickly, about how the buying process works if you're shopping for a car with Carvana?
Sharma: Absolutely, Vince. Before I do, though, I want to quickly say that the last couple of years that I've had the opportunity to be a guest on the show with you, that's been the biggest growth professionally that I've had, is doing this show with you. I want to speak on behalf of investors, listeners, we are going to miss you, your really sharp insights delivered with that calm, rational tone that's so fun to listen to. We look forward to seeing you. Again, you and I had dinner a few weeks ago, I look forward personally to someday heading over to Taiwan and having dinner with you there.
Shen: I appreciate it, buddy!
Sharma: You got it, I appreciate you. To answer your question, a brief overview if you're not familiar with Carvana, this company allows you to complete an entire car buying experience online. This is amazing to me, being somewhat middle-aged, as I often joke about. I have a young friend who I've mentioned on this show before, his name is Brandon Stokes. He's a millennial investor. I learn about these forward-looking companies from him. I first heard about Carvana from Brandon, who had just bought a used car through this service. It's very difficult for someone with my experience of car buying, used to going in and haggling with the salespeople, and then having to go sit at the desk and work out if their financing is better than what my bank has, to think that you can search for a car online using Carvana's technology -- they have a patented 360-degree photo virtual tour of each vehicle. You can look at the car report online, see any spec that you want. Then, you can have financing offers presented to you very quickly online from Carvana. You can finance the used vehicle through them. You can see your contracts within minutes online and sign them, if you want, electronically. Your car can be delivered. Or, if you live in a city in which Carvana has its patented car carousel, you can go for this show, which is quite incredible, it's a car vending machine. We have one in Raleigh, so I drove out there to look at it. Really elegant, transparent building. The car that you've ordered will come out of the car vending machine and you can drive it home.
That's the service in a nutshell. It removes all of the human interaction, except for the touches that you want. You can call up Carvana and get sales assistance. People are very friendly when you go to the dealership to pick up your vehicle. But you can see how this appeals to the millennial mindset. We've talked about so much on this show how millennials, the younger generation, loves to conduct business through an app. It's not that they don't want to interact with other human beings, [laughs] but they appreciate the convenience of being able to do everything in a transaction online. This is a service geared toward a younger generation, which is only going to have more purchasing power as time goes on.
Shen: I'll say that I drove by one of these Carvana Vending towers for the first time, actually, just a few weeks ago. There's a location near D.C., in this area. It's really cool-looking. I didn't realize -- again, not having followed the company at that time -- that these were popping up. I think there's 14 of them currently in the U.S. It looks really cool. I looked up some videos on YouTube of what the pickup process is like if you buy a car and you go to one of these Vending towers. They give you this big coin, you drop it in a slot, and then the car comes down kind of like a conveyor belt. Very cool. Worth checking out on YouTube, get a sense of what that experience is like. I think it's great for building the brand and offering something very unique and fun for car buyers in what is historically a stressful experience, when you're going to a used car lot and doing it that way.
Based on some of the recent acquisitions that the company has made, the key opportunities that management tends to bring up for Carvana, their singular focus here, as you've alluded to, is to streamline the used car buying experience so it's not something people dread. The used car salesman trope is still something people joke about for a reason. With Carvana, you can do all this shopping from your couch. You look through an inventory of over 11,000 vehicles. There's that 360-degree virtual tour of the interior and exterior that you mentioned. They even highlight any defects on the car in that. Once you've made your choice, you can complete the checkout process in as little as ten minutes. Carvana can handle the financing for your used car. They do that for the majority of their buyers. The car can be delivered as soon as the next day, and every car comes with a seven-day money-back guarantee, so you can return it for any reason for a full refund. I've only gone through the car buying process twice so far in my life, but that sounds like a pretty sweet deal, frankly, compared to what it used to be like.
On the flip side of that, I'd like to pivot now to talk about a little bit of the supply chain for Carvana, and how this business model proves out in the financials. The company acquires its inventory from its own customers, from auctions, and from rental companies with these big fleets. In the process, they screen, they analyze these potential units to determine the right pricing, how they fit into their existing inventory. The company mentions that every car they source from an auction to sell to retail customers is purchased sight unseen. This is an example of the company's very strong processes and data at its disposal to make smart purchasing decisions for its inventory supply. For each vehicle, CEO Ernie Garcia said Carvana will put about $1,000 of parts and labor into the car at its inspection and reconditioning centers before capturing photographs, and then the imagery that it uses to list the vehicle on its website. Once a car is sold, we mentioned how it can be delivered directly to you, you can go to the Vending towers, there's some optionality there.
Everything that I've described so far, that's for the retail side of the business, which makes up the lion's share of Carvana's top line. Something to keep in mind is, the company will also sell vehicles via wholesale channel at lower profit margins. Overall, if you've been thinking about how all of this pieces together in terms of the buying experience, in terms of how Carvana operates on its own, you'll notice that from this description, Carvana is a good example of vertical integration. Every step from procurement to fulfillment happens within its own ecosystem. As a result, something that company also mentions is, they gather a lot of data, and they use that to inform how they approach new markets, how they design the online shopping platform experience, and a lot more.
We have a big-picture overview of how the company handles its business and the value that it offers to consumers. Next up, we're going to discuss how that all flows down to the financials and some other things.
With Carvana's latest results, you can probably guess that things are looking pretty good given the way the stock has tripled in the past 18 months' time. But I'm curious, Asit, what has jumped out to you in terms of financial performance or anything else?
Sharma: Several things. One is this record of 19 consecutive quarters of triple-digit unit retail growth and revenue growth. That's a really strong statistic. It also speaks to the fact that this company is still very small. They just celebrated their milestone of 100,000 cars sold. Upon that, actually, CEO Ernie Garcia has given a stock grant to employees, it's worth about $36 million, to celebrate that milestone and keep the troops revved up. The astonishing growth actually presents one thing we see often in companies like this, which are using data and technology to grow very quickly -- the bottom line is, right now, in a loss position.
But before we get to that bottom line, let's look at this most recent quarter, which is the third quarter of 2018. Sales increased 137% over the prior quarter to about $486 million. Gross profit increased 181% to $57 million. We're going to talk about gross margin and the way Carvana cobbles together its gross margin because I think it's very important for investors to grasp this going forward. But before we do that, let's just work down to the bottom line. Selling and general administrative expenses increased 97%. The net loss before income and taxes increased 62%.
I just threw a lot of numbers at you, listeners. The big takeaway here is that revenue is growing at a faster rate than expenses, so the company's creating operating leverage. Even though that net loss grew 62% year over year, from close to $40 million to $64 million, revenue grew at a higher rate, and that allowed gross margin to also grow at a higher rate than expenses, which have kept pace. These are largely selling expenses, general and administrative expenses. And now, the company is spending more on technology.
Let's talk about gross profit, which is one of the really interesting value drivers for Carvana. Their total gross profit per unit, or GPU, is $2,263. The company has a long-term goal of $3,000 GPU. That's a pretty decent gross profit for a used car company, and it should enable that bottom line to come closer to parity over time. The way that Carvana builds this gross margin is extremely interesting to me. The close lion's share of this comes from retail sales. If you take this number of about $2,200, roughly half that comes from the retail used cars it sells.
Another 47% comes from finance receivables. What happens, as Vince told you, when you buy a car from Carvana, you're offered financing, often at attractive rates versus your bank. If you take that loan, the company then has this long-term financing receivable on its books. It's going to collect money from you month after month. Carvana bundles up these car loans, and it sells them at a premium without recourse. That means, if myself or Vince stopped paying on our car loans, that doesn't go back to Carvana. They don't have to make that loss. That belongs with the person who bought that bundle of loans. This is a really lucrative business for the company. As I said, it supplies about half of the gross margin. As Carvana has expanded into over 200 metropolitan areas, that's it's extended reach across the country, it ups the number of cars it's selling each month. That drives this total bulk of finance and receivables that it sells.
So, as a shareholder or prospective investor, keep your eye on this GPU number as it tracks toward $3,000.
Shen: That's awesome, I'm really glad you mentioned that breakdown for the GPU number and some of the mechanics behind that. It's interesting to see that, for the full year, Carvana expects their unit sales to come in at around 95,000, with $2 billion of revenue. Asit, chime in if I'm forgetting something. I know GPU was a big metric that management definitely spoke to quite often. Some other things that listeners should be tracking as they evaluate this business, the big ones that jumped out to me. That unit sales volume, seeing that number continue to track higher. Also, something like average days to sale. Management has mentioned how that factors in, again, to that GPU number. More broadly, you mentioned the runway for the number of markets that Carvana can enter. I'm also going to be following the number of markets Carvana is in. Also, the advertising spend.
To give you some perspective on how this GPU number has tracked over time, that medium to long-term goal of $3,000 has been scaling up so quickly. It's surprising to see. You go back to 2014, when Carvana operated in just three markets. They said they had negative gross profit per unit of $200. Two years later, it's in 21 markets, with gross profit per unit of just over $1,000. Then, another two years later, now, they're starting to work closer and closer to that $3,000 goal.
With all that in mind, in this next part of the show, I'd like to look a little bit ahead to the horizon at some of the growth opportunities for this company. Currently, Carvana is in 82 markets. They have 14 Vending Machines in the U.S. right now. The company says that they should be within reach by the end of 2018 of 56% of the U.S. population. In terms of the runway and the geographic markets that Carvana can tap into, the company's focused on the 200 markets in the U.S. with populations over 200,000 people. Its current footprint, I was looking at the map, seems more concentrated in the South, Southeast, and Mid-Atlantic regions. There's definitely the opportunity for it to expand to other big markets within the United States.
It has a very repeatable model for doing that. Management mentioned how it costs the company just $500,000 to establish a delivery-only market, while a Vending Machine runs $5 million. But, with the Vending Machines, despite that increased investment, they're seeing that the launch of a Vending tower in a market will accelerate the results there. It's brand-building. Brand-building in a location that gets a lot of attention, it builds some buzz in those local markets.
Supporting the triple-digit growth that this company has been able to deliver, Carvana is also building a lot of the infrastructure it needs to accommodate all of this expansion. In the process, they're hoping to also reduce the time and cost of transportation to buyers by expanding the national footprint. There's going to be a new inspection and reconditioning center that'll go live in Indiana in 2019. That'll be the fifth one. It expands the annual capacity for the company to handle about 250,000 vehicles. That's over 2.5X the expected unit sales in full-year 2018. Clearly, management is thinking about, down the road, as they continue to grow their unit sales volume, how they're going to able to accommodate and handle all that inventory.
I like to put into context for this company just how large the market is in terms of vehicle sales, especially used car sales. I pulled these numbers from investor materials that the company provides. Almost $800 billion in used car sales in 2017, and just 7% of the market was claimed by the top 100 largest used auto retailers. The biggest one has less than 2% market share. It's a very fragmented market. That presents a lot of opportunity for companies like this.
There were some interesting comments from CEO Garcia about competition. He said, basically, given the large size of the market, this fragmentation among the competition, even if there are new companies to enter this more e-commerce-focused model for selling cars, it'll basically serve to normalize the concept or the idea of buying a car online. For some people, it still seems intimidating to not be able to see or handle or even test-drive a car that your purchasing, thousands of dollars. Overall, as that becomes normalized, even if there's some competition, that's something that's likely to lift the whole segment before becoming a more traditional fight for market share.
Last couple things that I will mention, used car selling is the main business driver for Carvana, but it's also experimenting with sourcing more of its inventory from customers. The number of vehicles that they will purchase directly from their customers grew over 270% year over year in the third quarter. It made up about 16% of the units the company sold via its retail channel. Something I wanted to get your opinion on, Asit, is all the acquisitions that the company has made in the past few years. I know that they're very focused on acquiring certain talent, certain capabilities that support this platform that they've created. What are your thoughts there?
Sharma: The company is now shifting its focus toward technology. The last acquisition was the purchase of an artificial intelligence company, which will help facilitate more interaction on the site, and also interaction via SMS. Carvana is pretty tech-savvy to begin with, but utilizing the data that they have, they want to be able to anticipate the secondary questions a buyer might have, and be able to resolve those quickly, as well as know the buyer a little better from its data sets and suggest different options. Again, financing is one, if you think back to the GPU.
I think that's a smart move. At some point, the company has to build out some competitive advantages. The thing that it's got going for it, which is going to prevent competition from totally adopting its model, is its inventory doesn't sit on lots. It gets inventory after a customer makes the purchase or it gets it to the distribution point, but the company isn't in the business of buying a gazillion cars and putting those on lots. It's a more streamlined model. That contributes to the gross margin, but it also helps free up capital for the technology, these types of acquisitions that you're mentioning, Vince. I think that's very smart.
I also wanted to say that another inherent advantage going forward for the company is a stat that you just mentioned -- up to 16% of the cars that were sold in the last quarter, it acquired from other customers. This is pointing to a customer lifetime value model. It means that every time I need a new car, I stop going to whoever has the best price, visiting different dealerships. I become this customer who wants to buy and sell every car from one company. This is a long-term advantage if you consider that a competitor like CarMax has that inventory and all the land infrastructure that's tied to that. In the time it would take a larger competitor to adopt this model, Carvana can, over the years, convert people to lifetime customers. That's a very exciting proposition.
I think we'll see additional small acquisitions from Carvana. One of the things on the balance sheet that indicates that it probably is looking in that direction is the issuance of $350 million of unsecured notes just recently. It now has a little more firepower on its balance sheet, not only to patch up some of the losses it's generating, but also make a few small acquisitions. I do think we'll see more in terms of artificial intelligence.
As far as the talent -- that is, the people that it's bringing on -- because the general and administrative expense is relatively lower versus traditional used car companies -- in other words, it doesn't have a lot of sales people standing around lots creating overhead -- it has more money to invest in great people, in engineers, data scientists, etc. This is something we've seen in companies that we've talked about on the show. Analogous, I would say, to Stitch Fix, which is also big on making acquisitions, not just of companies, but of talent, of people who can make the systems more optimized to helping you get to that next purchase.
Shen: Final take, when it comes down to it for you, Asit, is this a yes stock? A no stock? Or something that you're putting on the watchlist?
Sharma: This is actually a yes stock for me. But you have to have a bit of a strong stomach, because the company doesn't have net income, per say. The next-best metric that we often look at is price to sales. I pulled that up this morning, Carvana is selling at 3X forward one-year sales, which actually isn't a sky-high valuation as price to sales ratios go. But it is a lot pricier. I'll bring up CarMax again, which trades that 0.5X forward sales. Of course, that's a much more slowly growing company.
If you purchase this stock today, there's potential for a correction, and we know the general market right now is soft. However, if you are yourself a millennial or middle-aged person like me who wants to buy a great company and hold it for several years, I think it's OK to start taking a position in Carvana. As I said, I do think it has some structural advantages to fend off competition as it begins to adopt some of the better aspects of how Carvana operates.
What about you, Vince?
Shen: I'm in the same boat as you. This is definitely a company that has been really cool to dig into, do that due diligence. I'm really excited about what they're building here, how that's changing the consumer experience. I'm seeing a lot of these core metrics like gross profit go very quickly up and to the right. I'm seeing the potential for all these markets that they can enter. This is definitely, definitely one that I will be, over time, adding and creating a position. Very excited for Carvana. Any final thoughts, Asit?
Sharma: Yes. If you have a chance, before you invest in the company, if you happen to be in a metropolitan area that has one of the Vending Machines, go visit it like I did. It will give you a clearer sense of the kinds of advantages that this company has. I thought it was probably just eye candy, but it creates a bond with the customer, when you vend your car and drive it off the lot, that's different than just stepping in and smelling the new car smell, just seeing the shiny new vehicle. They're onto something which is going to implant in younger people this desire to stick with them for a long time.
Shen: Yeah. To boil it down, it reminds me of the ultimate unboxing experience, which can really change how you perceive a product. A very cool company. Glad we're able to talk about this, especially as I wrap up my time with Industry Focus. Again, thank you so much, Asit!
Sharma: Thank you, Vince!
Shen: Thank you, Fools, for tuning in! People on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against any stocks mentioned, so don't buy or sell anything based solely on what you hear during the program. Fool on!
Asit Sharma has no position in any of the stocks mentioned. Vincent Shen has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends KMX. The Motley Fool has a disclosure policy.