Carvana (CVNA -4.00%) has become one of the more surprising turnaround stories in recent years. Two years ago, the company was on the brink of bankruptcy when a debt restructuring deal gave it new life. From that point, its financial performance began to improve and it has consistently reported a profit over the last few quarters.
Nonetheless, despite its turnaround and predictions that its growth will continue, the challenges associated with holding this stock may outweigh the potential gains of owning it. Here's why investors should probably steer clear of Carvana stock.
The state of Carvana
Carvana stood out in the marketplace by taking used car sales online. Instead of dealing with a salesperson, customers would choose from an online selection of inspected and reconditioned cars. From there, they could either pick up the car, sometimes from one of its famous "vending machines," or they can have it delivered. This approach gave Carvana an advantage over a competitor like CarMax, which has higher overhead costs associated with maintaining car lots and employing salespeople.
However, the 2022 bear market took its toll on Carvana's sales, wiping out nearly all of the stock's value. Amid this crisis, a debt restructuring deferred debt and interest obligations, allowing it to return to profitability. Investors responded so well that the stock has risen by 70-fold in about two years as of the time of this writing.
Reason No. 1 not to buy: Valuation
Unfortunately for Carvana bulls, there seems to be little in its financials that justifies a 70-fold increase in two years.
For one, the valuation may give investors pause. Admittedly, the 60 P/E ratio may not seem high for a fast-growth stock.
Nonetheless, while its price-to-sales (P/S) ratio of 3.4 may not appear elevated, it is approaching the record highs experienced in 2021 before Carvana stock began retreating.
Moreover, it sells at a price-to-book value of 52. In contrast, CarMax sells at a book value multiple of only 2. So large is that difference that it could cause investors to question if Carvana's financial performance justifies such a book value multiple.
Reason No. 2 not to buy: Carvana's debt challenges
Investors may also ponder whether Carvana is past its long-term debt struggles. Indeed, only $209 million of its $5.6 billion in total long-term debt will come due over the next year. Also, the debt deal that saved the company in September 2023 postponed debt maturities and saved the company about $455 million in annual interest costs over the next two years.
However, the two years is up in the fall of 2025, which presumably means Carvana will have to resume making interest payments on its debt. In the first nine months of 2024, Carvana reported a net income of only around $131 million. Hence, a resumption of interest payments will likely mean reduced profitability or a possible return to losses.
Additionally, long-term debt levels were about $5.6 billion at the end of 2023, meaning the company has made no headway in reducing this debt.
Carvana's elevated stock price provides a compelling incentive for the company to solve that problem by issuing shares. Right now, Carvana has approximately 129 million outstanding shares. At the current stock price, issuing approximately 22.5 million additional shares (an approximate 18% increase) could pay off that debt.
While that might save the company from a potential debt crisis, such a move would come at the expense of shareholders. Not only would it dilute shareholders, but it could also increase selling if they decide the stock has become overvalued, making Carvana a less desirable holding.
Do not buy Carvana stock
Under current conditions, investors should refrain from buying Carvana shares and close any position they might hold.
The company's plan in early 2023 to restructure debt appears to have saved the company. In fact, it worked so well that the stock is up 70-fold in two years.
Nonetheless, when looking at its price-to-book value ratio, investors must now contend with a possible valuation bubble. In a sense, it is good for the company since it could theoretically issue enough shares to wipe out its long-term debt.
Unfortunately, such a move will almost certainly cost shareholders, and it could cause significant selling if investors question the stock's valuation. That possibility means investors are probably better off staying on the sidelines.
