Carvana stock is up 228% on the year, but a new red flag just popped up

One of the hottest stocks this year was Carvan (CVNA 1.82%)which is up over 228% in 2024. The online auto retailer appeared to be on the verge of bankruptcy a few years ago, but has made a solid recovery.

The company posted some strong quarterly results that encouraged investors. However, a new red flag has come up recently. Let’s take a look at the used car sales specialist and why investors may want to avoid its stock right now.

A return to business

Since its initial public offering, Carvana has been a divisive stock, loved by the bulls and hated by the bears. The company grew rapidly in its early days, expanding into new markets at a rapid pace. However, it was also burning through a huge amount of cash in the acceleration process, leaving its balance sheet deep in the red.

Burdened by a pile of debt, the company and its bondholders agreed last year to a debt swap that reduced $5.52 billion in unsecured notes to $4.19 billion in new senior secured notes. By restructuring the debt, the bondholders’ securities were now fully secured by the company’s assets.

As part of the deal, Carvana was able to reduce its cash interest payments by $455 million a year for one year, and possibly two years if it chose, because interest on the bond could be paid in kind ( PIK) in the first two years, meaning that instead of paying in cash, the principal grew. Bondholders have also been able to achieve incredibly high rates of return on their debt: between 12% and 14%. However, the company announced that it plans to start paying some of the bond interest in cash next year and not use PIK with the debt.

After a big slowdown in unit volumes last year, Carvana managed to return to rapid growth in 2024. In the first quarter, retail sales volumes rose 16% year-over-year to 91,878, and in the second quarter by 33%, up to 101,440 units. . Notably, however, revenue growth lagged unit volumes in the second quarter by just 15%. This was largely due to the company selling less expensive vehicles.

Another important area for improvement this year is gross profit per unit (GPPU). Car retail-only GPPU rose 28% year over year in the second quarter to $3,421 from $2,666 a year ago. That compares to the rival GPPU of $2,347 CarMax made in its most recent quarter. In other words, Carvana can make over $1,000 more profit on each vehicle compared to CarMax just from the sale of the vehicle.

Carvana also gives a total GPPU value of $7,049, but that includes wholesale sales of the vehicles it buys and then sells at auction, as well as revenue from issuing loans and selling things like warranties.

Image source: Getty Images

A red flag

While things certainly seem to be looking up, a new red flag for Carvana has come up. As part of its business, it sells the financial claims to third parties for the cars it sells. Since most buyers don’t pay for the cars in cash, but instead finance them, this represents a large percentage of the company’s sales. It generated a high-margin revenue of $317 million from those sales in the first six months of this year.

The biggest buyer is Financial ally (ALLY -1.37%)which agreed to buy $4 billion of Carvana’s financial receivables between Jan. 11, 2024, and Jan. 10, 2025. Earlier this month, Ally shares fell after the company’s chief financial officer warned that it was seeing increased car loan challenges retail. part of his business. Ally said loan defaults in July and August were 20 basis points higher than expected and late-stage delinquencies (61 days or more past due) were rising. The situation is only expected to worsen in the coming months as borrowers continue to struggle with a higher cost of living.

Carvana’s sales to Ally are nonrecourse, meaning it’s not on the hook for the bad-performing auto loans it sells to Ally. However, if these auto loans continue to underperform, there will certainly be changes. Ally could get better terms in the future, wiping out those gains on high-margin finance receivables, or Carvana might even have to keep those loans if Ally no longer wants to service them.

In the second quarter, as mentioned above, Carvana’s unit sales grew much faster than its revenue, indicating that it is selling less expensive cars. At the same time, it was also making a much higher profit per vehicle sale than its rivals. These two factors combined could indicate that the company has stepped up sales of vehicles to buyers with poor credit. This may not affect the company immediately, but it could become a very big problem if its financial debt buyers start to stop.

At the same time, Carvana’s debt problems did not go away. The company still has $5.4 billion in long-term debt on its balance sheet and generated free cash flow of $415 million in the first six months of the year. But if it had to pay interest cash on its debt, its free cash flow would have been just $130 million.

Given the debt it has, the company isn’t really in a position to cut back on selling cars to subprime buyers, who are increasingly taking credit. Eventually, though, something will have to give, which makes Carvana a risky stock to own right now.