Buy the Carvana Dip Ahead of Earnings?

Carvana NYSE: CVNA, an e-commerce platform for buying and selling used cars, dipped more than 8% yesterday. There wasn’t any company-specific news. The S&P 500 was down, but by less than 1%.

So, what was the culprit?

Interest rates ticked up. Again. The 10-year Treasury yield is now 1.37%, up from 1.04% on January 27. Stocks are priced based on the present value of their future cash flows, so any increase in interest rates erodes that value. Growth stocks like Carvana got hit a lot harder than value stocks because most of their cash flows are projected to come far in the future.

But this selloff was overdone, particularly for Carvana because:

1. Treasury yields have been increasing since the beginning of the year, slowly and steadily. They went up just 3 basis points between Friday and Monday. Yes, it looks like the $1.9 trillion COVID-relief package will be passed soon, but that was never in doubt.
2. The Fed is expected to keep its benchmark short-term interest rate near zero until at least 2023. That is likely to prevent interest rates from rising too

With Carvana set to report its Q4 earnings on Thursday, this dip should indeed be looked at as a potential buying opportunity.

Carvana’s Growth Story is Still in the Early Stages

There were 40 million used car transactions in the US in 2019, totaling over $700 billion in sales. Carvana accounted for less than one-half of one percent of them.

In fact, less than 1% of used car transactions take place online on any platform. That means that the vast majority of used car buyers are either buying from a dealership or from an individual. Or, in other words, battling high-pressure sales tactics to get a vehicle. Carvana, with its “car vending machines”, takes the stress out of buying a used car.

Buying a car on the internet would have seemed crazy to all but a small subset of the population 20 years ago, but it’s becoming normalized now. According to a survey by CarGurus, 61% of people now think that buying a car online is a good idea, up from 32% pre-pandemic. That’s not to say that 61% of people are rushing out to buy a used car on the internet – but thinking it’s a good idea is one of the first steps to taking action.

Carvana’s Margins Are Improving

Carvana bought 56% of the cars it sold to retail customers from other Carvana customers in the third quarter, which helped the company’s gross profit per unit (GPU) increase by $552 to $1,857. The 56% number is already ahead of the company’s 38-52% long-term target.

The alternative is buying cars at auction, but that can get expensive because it forces Carvana to bid against many others instead of just negotiating a deal with a customer one-on-one. Sometimes, Carvana needs to buy more cars at auction to get enough inventory for its fast-growing business, but it’s good to see this metric moving in the right direction.

Consensus Price Target Has Room for Improvement

Carvana’s consensus price target is $228.27, which is nearly 20% lower than its current share price. The stock has 17 buy ratings, 8 hold ratings, and 1 sell rating.

This sounds bad, but it isn’t really. Most analysts have a favorable opinion of Carvana. They might just be a little behind with raising their price targets. Carvana shares, after all, have increased by nearly 100 points since the beginning of November.

A strong earnings report on Thursday could lead to several upgrades, which could give shares a further boost.

How Should You Play Carvana?

Carvana is trading at 6.1x forward sales and the company is expecting to continue losing money in 2021. Shares are expensive, but this is a company that could see explosive revenue growth deep into the 2020s.

Is Carvana’s market cap of nearly $50 billion reasonable or too high?

We won’t know that for a few more years – at least. What we do know, however, is that the company has a chance to take a big chunk of a $700 billion market. When you look at it like that, the risk-reward on shares is still attractive at these levels.

Carvana shares have been volatile recently. Before yesterday, there had been two sharp pullbacks since the holidays.

But Carvana’s massive long-term upside means that pullbacks qualify as potential buying opportunities.