Carvana - A Vertically Integrated Powerhouse
We are drawn to companies that vertically integrate key parts of their business which enables them to differentiate themselves by sustainably providing faster/better/cheaper products and services to their customers. In fact, it's one of the key components in our Builder Company framework. Vertical integration makes companies more complicated to analyze and often results in higher operating and financial leverage. This can create short-term gyrations in reported results, especially when they are investing in additional fixed capacity and in customer growth simultaneously. However, management teams that invest to build significant advantages in large end markets help position their companies for sustained long-term success.
In this post, we will use Carvana (NYSE: CVNA) as the subject of a study on how vertical integration can create sustainable competitive advantages. For background, Carvana operates a pretty simple business to the consumer: you can go to www.carvana.com to buy and/or sell a used car. With tens of thousands of cars in inventory, they offer a wide selection of vehicles to purchase and a few additional elements that make their retail experience attractive: (1) no price negotiations, (2) integrated financing options, and (3) home pickup and delivery. Customers can purchase a car in less than 20 minutes and it can be delivered as quickly as the same day in some markets. It's a stress-free transaction supported by wide selection, an easy checkout process and a very pleasing delivery experience.
Likewise, customers can sell or trade in their car to Carvana. Customers can get an instant appraisal of their car's value and sell it within 20 minutes if they like the offer (a highlight of Carvana's new ad campaign). Carvana will then schedule a pickup and the driver will bring a check or can wire the money into your account once all the paperwork is completed. Again, an easy and stress-free transaction with full pricing transparency upfront and payment options that settle significantly faster than traditional dealers'.
The consumer experience is simple, but the back-end infrastructure required to complete a transaction is complicated. This is where vertical integration in key areas can create economic and service level differentiation. Let's walk through the workflow of a retail sale. Carvana must:
Acquire the vehicle - from other dealers, from customers, from auctions, or from other channels.
Move the acquired vehicle to an inspection and reconditioning center (IRC) in a region that can most likely sell it quickly.
Repair and recondition the car to prepare it for retail sale.
Photograph the vehicle's interior and exterior, noting all the blemishes and defects to give e-commerce customers confidence in the quality.
List the vehicle for sale on the web site, pricing and promoting it to sell within 60 days (ideally) of acquisition.
Offer the customer a quick and easy checkout process, with financing options and insurance compliance completed seamlessly.
Once sold, transport and deliver the car to the customer within the quoted time frame and keep the customer updated on the car's delivery window as updates arise.
If the customer returns the vehicle within the 7-day risk-free period, Carvana must pick up the car, inspect it again, and start back at #5.
While this is Carvana's e-commerce workflow, all used car dealers must conduct some combination of steps 1 through 5 (acquire inventory, inspect/recondition, list it for sale). Most physical dealers fail miserably at step 6 and they make the price negotiation, financing, and purchasing process stressful and cumbersome for customers, which is a key source of Carvana's differentiation.
It is possible to conduct a transaction like this using third-parties at each step in a very "capital light" way. A company could buy a car from at an auction; lease a space on a truck to reposition that car to a 3rd-party IRC (e.g. Manheim); pay Manheim or others to recondition the car, photograph it, and store it on a lot; and arrange transportation and delivery companies to get the car to the end consumer. In this case, the e-commerce retailer would be responsible for customer acquisition, customer service, and carrying the inventory on its balance sheet, but most other major steps can be outsourced as a variable cost. Let's break down some of these variable costs for third-party services used in a used vehicle transaction.
Transporting a car through a third-party costs somewhere in the $0.60-1.70 per mile range for long haul. 1,000 miles would cost $600-1,700, but it can vary by shipping company, car size, route, and other factors.
Reconditioning costs vary by car, but if we add some reconditioning margin for a third-party to conduct this work, we believe it would average about $1,200-1,500/car.
Parking the car on a lot costs $10/day. If a car takes about 20-25 days to recondition and another 30 days to sell, that is $300-500 of storage costs.
If the car is sold locally, short haul, single bed trucks can cost $5 per mile. 100 miles round trip could cost $500. If the car must be repositioned to another market before local delivery, we would tack on another $0.60-1.70 per mile for another leg of long haul.
If a customer returns the car, there would be another $5/mile of local delivery costs, plus additional storage fees at $10/day while the car is re-listed for sale.
For a perfectly smooth transaction with no repositioning and no returns, variable costs are in the $2,600-4,000 range. Now, how would these compare for a retailer like Carvana, who has invested in vertical integration of transportation, reconditioning, storage, and local delivery? See the chart below for our estimate of the differences, which amount to $1,200-2,600 of savings per unit for a fully vertically integrated unit.
We do not touch on depreciation costs or other elements that are common for both 1P and 3P transactions. We also don't touch on the financing economics, which is a source of significant variance for Carvana vs. other players in the market, but a topic for another day.
Carvana and other vertically integrated auto retailers can reduce the “capital light” variable costs by half or more, as indicated in the Difference column on the right. Despite higher variable costs, a retailer using third-party services to acquire, process, and fulfill a vehicle can still make money on each transaction. If they purchase a car for $20,000, sell it for $25,000, and attach financing to the transaction, they can still make positive gross profit - potentially quite a bit of GP depending on the specific variable costs. However, there are other operating expenses to consider - customer acquisition costs, marketing, G&A, technology, customer service, interest expense, and others. Those costs must be amortized over significant volume to generate positive cash flow. We estimate that when considering fixed and variable SG&A to compete nationally, an e-commerce company utilizing third-party services as outlined above would breakeven at roughly 300-400k vehicles (assume $3,000 all-in GPU, less very lean operating expenses of 15% of revenue), all else equal. However, not all else is equal, which we will touch on below.
If we know the variable unit economics are better with vertical integration, we must consider the costs to achieve those vertical capabilities and variable cost savings. This involves investing in trucks, reconditioning centers, local delivery centers, storage lots, drivers, technicians, and more. Carvana has invested over $2b into PP&E, plus $2.2b for ADESA which brought them a wholesale auction business and significant physical infrastructure that gave Carvana additional IRC capacity and highly complementary local facilities in many markets where Carvana had difficulty building organically. It also has invested in significant operating expenses to support and grow its business, with cumulative adjusted EBITDA losses and interest expense over $3b. Using rough numbers, we estimate that Carvana has invested $8 billion in fixed infrastructure investments and operating losses to build out its vertical capabilities while also developing a leading brand in the market and consummating millions of transactions with customers.
In 2023, Carvana has shown an ability to achieve positive normalized adjusted EBITDA at annual run-rate retail sales volumes in the 310-325k range and retail purchase volumes around 400k. The company expects to continue generating positive adjusted EBITDA while further improving operating efficiencies and unit economics. On its current infrastructure footprint, Carvana has physical facility capacity to recondition 1.6 million cars per year. If we assume $5,000 normalized GPU and $2,000 of normalized EBITDA per unit, Carvana would generate $3.2 billion of adjusted EBITDA and over $2 billion of free cash flow. Relative to the $8 billion of cumulative investment in vertical capabilities to date, this is a pretty attractive return at around 25%. However, Carvana's current production capacity can roughly double by investing another $1 billion of capex into expanding its ADESA-acquired facilities. 3 million cars per year at $5,000 GPU and $2,000 of EBITDA per unit (though fixed cost leverage would likely push this higher), would equate to $6 billion of EBITDA and over $5 billion of free cash flow. That's when the numbers start to pop off the page - $5 billion of cash flow relative to $9 billion of invested capital is a mid-50% annual return on investment, and clearly would be a phenomenal business. It’s also an impressive amount of cash flow relative to the company’s ~$7 billion market cap today.
Why All Else Isn't Equal
A retailer relying on third-party services across all parts of a retail auto transaction may have a business model that can work on paper, but it is structurally disadvantaged and may struggle to achieve profitability and scale due to competitive market dynamics. We believe Carvana can attract significant market share in the used car market and offer sustainably faster/better/cheaper value propositions to consumers across every dimension of the business. As a large-scale, vertically integrated player with only about 1% total market share, the company has plenty of open-ended growth potential and, as noted above, additional capacity to grow into. It can gain share by offering multiple dimensions of value:
Competitive pricing of cars and interest rates, as needed, to turn inventory optimally. Pricing and margins are significantly supported by Carvana's vehicle purchases from customers, which eliminate auction-related fees and increase utilization of its logistics assets, drivers and flatbed local delivery trucks (more dropoff + pickup routes).
Faster and more predictable delivery vs. other e-commerce auto retailers.
Geographic diversification of supply and demand, smoothing out local market supply and demand gyrations over time and offering superior selection to consumers.
In the example above, the retailer using third-party services would be at a structural disadvantage vs. Carvana across most dimensions for an average transaction. Carvana could list its inventory at prices that would significantly threaten the gross profit per unit (GPU) of that company. The scaled, national low-cost operator is able to establish clearing prices for the market and has strong influence on the aggregate profit pool. The NPV-maximizing strategy may evolve over time, from an early-stage strategy of maximizing value to customers to drive higher volume and higher utilization in each area of vertical integration, to a more mature strategy that is less aggressive on price and maximizes EBITDA per unit.
Using some rough numbers, below is an estimate of normalized gross profit per unit, broken out by elements of a transaction. Retail GPU is the gross profit made on the car itself (the "metal margin"). Finance & Other GPU is where most used car dealers make their money - by originating loans and selling extended warranties, service packages, GAP waiver insurance, etc. Wholesale GPU refers to the gross profit generated from acquiring inventory from customers and selling some of it to other dealers or through the auction channel. Because Carvana owns the ADESA auction business and has all the logistics capabilities mentioned in this post, we believe it generates superior wholesale economics.
Of course, most competitors in the market have some elements of vertical integration in their businesses. A local dealer may have mechanics on staff to recondition cars. Carmax has significant assets and capabilities to buy and sell cars nationwide with omnichannel options. However, the market has tens of thousands of dealers that operate at higher variable costs than Carvana because they utilize third-parties for significant portions of the inventory life cycle. Carvana can shine against that large, fragmented base of dealers.
As mentioned above, Carvana controls first-party physical infrastructure with capacity to recondition over 3 million cars per year, once fully expanded. It is currently utilizing only about 10-15% of that long-term capacity (more like 25-30% of the current physical capacity, excluding future expansion capex). Over the last few quarters, the company has demonstrated its ability to generate positive unit economics even at these low utilization rates. It has significant flexibility to optimize its operations for growth or current profitability. The company re-oriented its strategy over the last year to prioritize profitability and highly efficient operations as consumers faced significantly worsening affordability (higher price + higher interest rates), but we believe it is on the cusp of returning to a growth-oriented strategy, supported by significant vertical advantages it has built over its life and optimized over the last 12-18 months. Despite significant current affordability headwinds, Carvana can leverage its superior, vertically integrated model to gain significant share in its market.
Closing
Companies like Carvana can reinvest their variable cost savings into more attractive consumer value propositions (cheaper prices, lower interest rates, faster delivery, more selection, etc.) to ensure that they increase their market share over time. This likely would put pressure on other players to match those terms, which hurts their margins and/or the competitive positioning of their products and services. We have seen this play out with Amazon's logistics and fulfillment network which has conditioned customers to speedy delivery at little to no incremental cost (to consumers). Many other e-commerce companies have had to match those terms without any commensurate increase in revenue, or they risk ceding market share by only offering free slow delivery. It's a difficult choice for those companies, and some are now opting to use Amazon's fulfillment network to fulfill and deliver their parcels. In this way, Amazon has pushed the non-vertically integrated companies to a structurally lower operating margin and has created avenues to monetize the very pressure it created on the market by opening its verticalized assets and capabilities as a service. In this way, it has a visible path to capture additional share of the general merchandise e-commerce profit pool.
We can easily observe that vertically integrated companies are capital intensive through the middle stages of building out their critical infrastructure, but they build cost advantages and capabilities that create competitive separation which sustains and grows over time. That competitive separation manifests in lower variable costs than less vertically integrated competitors, which increases flexibility to optimize price, market share, and volume to become the long-term aggregator of the end market's profit pool. Whether it's Amazon with its FBA capabilities or Carvana with its logistics, reconditioning and delivery infrastructure, we love to find and study businesses where vertical capabilities unlock significant advantages against a field of fragmented, weaker competitors that cannot keep up or catch up with the pace of investment from the market leader.
