Carvana: On The Verge of Step 3
Can they accelerate volume growth while maintaining good unit economics?
A lot has happened since my last Carvana update in Carvana: Feedback Loops. Let’s run through it.
On July 18th, Carvana announced it was moving up its second-quarter earnings release date from August 3rd to the following morning. I thought this unusual move had to be driven by some sort of imminent capital raise and/or debt restructuring announcement.
The following morning the company announced its second-quarter results in conjunction with, sure enough, the launch of a debt exchange offer with the support of over 90% of its noteholders. Essentially, Carvana is issuing new notes with more flexible terms in exchange for most of its current notes and executing a cash tender offer for its 2025 notes. The expiration of the exchange offer was on Wednesday, August 30th, and Carvana announced yesterday morning that it is completing the exchange offers with 96% of its current noteholders participating. With these finalized terms, it is reducing the face value of its notes by $1.325 billion, extending the maturities, and reducing required cash interest payments by over $455 million annually for each the next two years in favor of PIK debt.
In exchange for that additional flexibility, the new notes will be backed by both Carvana and ADESA assets, which provides noteholders with additional collateral, and the new notes will have higher interest rates. As a condition of the debt exchange, management raised $350 million of equity at $46.31 per share, of which $126 million came from the Garcias. The proceeds are being used primarily for additional cash consideration to retire the existing notes.
So what does this mean? Big picture, Carvana is gaining a lot more flexibility by not having to pay any cash interest in the first year and having the option to pay PIK in lieu of cash interest in the second year. In my view—and this is far above consensus, which has been consistently way behind the curve on Carvana’s operational improvements—the company is pretty clearly on the path to generating over $500 million of adjusted EBITDA over the next 12 months. With no required cash interest on the new notes for two years, that level of adjusted EBITDA would easily cover the interest on its inventory and finance receivable facilities plus capex for this period, leading to nicely positive core free cash flow (even after deducting stock-based compensation). Certainly, the face value of the new notes will grow during this 1-2 year period due to the PIK debt. This is akin to kicking the can down the road. But this cash interest holiday gives Carvana two years to ramp retail unit volume—at its now strong incremental unit economics—before the new notes revert to a cash interest requirement.
Two years is a long time. Carvana will likely formally begin Step 3—returning to growth—early next year. Selling more units at its already record-high unit economics through the existing high fixed cost infrastructure is likely to lead to strong growth in adjusted EBITDA from already record levels today. At that point, the business is likely to be in a much stronger position to pay cash interest again. However, the more likely outcome is the stock soars over this two year period, allowing management to eventually issue some new equity at a higher price via their ATM offering in a minimally-dilutive way. That would allow them to retire some of their new debt early before the PIK period ends. Under the terms of their Transition Support Agreement, they can retire the new 2028 notes after only one year at par plus half a coupon and the 2030 notes after two years on the same terms. Management has strongly suggested that is their game plan.
Carvana is clearly on the path out of the woods in terms of its balance sheet and liquidity. Management has plenty of time to finish tweaking the business, return to growth, and start generating serious cash before it would begin to owe cash interest on the new notes.
Operational Improvements
While the debt exchange captured most of the headlines, Carvana’s rapidly improving operating results are the bigger story. The second quarter showed continued progress holding retail units relatively steady while making large, undeniable progress on improving the unit economics. Non-GAAP GPU was an astounding and record-breaking $7,030 in the quarter. Even excluding the $900 of non-recurring items that benefited the quarter—$650 driven by loan sales in excess of originations as they drive down the large backlog of loans held for sale and $250 from a retail inventory allowance adjustment as they sold through cars that had been written down in the fourth quarter—$6,130 of non-GAAP GPU is still a record-breaking number. It is about $2,500 higher than the company reported in the year-ago quarter and almost $1,000 more than it reported in the same quarter in 2021—the previous high water mark.
The single largest driver of this increase in GPU was…
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