Carvana (NYSE: CVNA) has emerged as one of the most talked-about stocks of the year, seeing an impressive rise of over 228% in 2024. Just a few years back, it appeared to be facing bankruptcy, but the company has successfully turned things around.

The firm has reported strong quarterly earnings that have delighted investors. However, a troubling sign has recently come to light. Let’s examine the circumstances surrounding this used car sales expert and why investors may wish to approach its stock with caution at this time.

Business Improvements

Since its IPO, Carvana has sparked mixed feelings among investors, appealing to some while repelling others. The company enjoyed rapid growth in its initial years, aggressively entering new markets. However, it also faced significant cash burn during this period, resulting in a troublesome balance sheet.

Confronted with heavy debt, Carvana and its bondholders reached an agreement last year to swap out $5.52 billion in unsecured notes for $4.19 billion in new senior secured notes. This restructuring ensured that the bondholders’ investments were now secured against the company’s assets.

As part of this agreement, Carvana significantly reduced its cash interest payments by $455 million annually for a potentially two-year period, opting to pay interest through increases to the principal (PIK) instead of cash in the first two years. Bondholders received high yields of 12% to 14% on their debts. Nevertheless, Carvana now plans to start paying some bond interest in cash from next year, moving away from the PIK approach.

After experiencing a slowdown last year, Carvana’s growth resumed in 2024. In Q1, retail sales jumped by 16% from the previous year to 91,878 units, followed by a remarkable 33% increase in Q2, reaching 101,440 units. Yet, revenue growth in Q2 lagged behind unit sales at only 15%, primarily due to a focus on lower-priced vehicles.

Another positive development this year is the increase in gross profit per unit (GPPU). In Q2, GPPU from retail car sales surged 28% year over year to $3,421, up from $2,666 the previous year. In comparison, rival CarMax reported a GPPU of $2,347 in its latest quarter. This demonstrates that Carvana earns over $1,000 more profit per vehicle compared to CarMax in terms of direct car sales.

Carvana also cites an overall GPPU of $7,049, though this figure includes wholesale vehicle sales and revenue from financing and warranty services.

A Concerning Signal

Despite the encouraging signs, a new concern has surfaced for Carvana. The company frequently sells the finance receivables for its car sales to third-party buyers. This is important since most customers finance their vehicle purchases rather than paying in full cash, resulting in this aspect representing a large share of Carvana’s revenue. So far this year, it has generated $317 million in profitable revenue from these transactions.

Ally Financial (NYSE: ALLY) has been the biggest purchaser, having committed to buying $4 billion in Carvana’s finance receivables between January 11, 2024, and January 10, 2025. However, earlier this month, Ally’s shares took a hit when its CFO pointed out rising credit risks in the retail auto sector. The company noted that loan delinquencies in July and August were 20 basis points higher than anticipated, with late-stage delinquencies on the rise. Ally predicts the situation will continue to deteriorate as borrowers find it increasingly tough to manage living expenses.

Carvana’s sales to Ally are non-recourse, meaning that Carvana isn’t responsible for any bad loans sold to Ally. However, if these auto loans perform poorly, changes could occur. Ally might demand tougher terms for future transactions, negating the benefits derived from the lucrative finance receivables, or Carvana may have to retain these loans if Ally decides against purchasing them.

In Q2, Carvana’s unit sales grew at a faster rate than its revenue, suggesting a trend towards selling more affordable vehicles. Meanwhile, the company also recorded higher profits per vehicle than its competitors. These trends could imply that Carvana is beginning to cater to buyers with weaker credit histories. While this issue may not have immediate consequences, it could develop into a significant problem if its finance-receivable partners start to withdraw from the market.

Currently, Carvana is still grappling with significant debt. The company’s long-term debt stands at $5.4 billion, and it produced $415 million in free cash flow over the first half of the year. However, if it had to pay cash interest on this debt, its free cash flow would drop to just $130 million.

Considering its debt load, Carvana can’t afford to reduce sales to subprime buyers, who are increasingly falling behind on their payments. Eventually, some movement is necessary, making Carvana a potentially risky investment at this time.

Ally partners with The Ascent, a Motley Fool company. Geoffrey Seiler does not own shares in any of the mentioned stocks. The Motley Fool has investments in and recommends CarMax. The Motley Fool has a disclosure policy.

The Motley Fool is a content partner of YSL News, providing financial news, insights, and analysis to empower individuals in managing their finances. Its content is created independently from YSL News.

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