Carvana is the worst performing tech IPO of 2017 so far, sitting 34% below its $16 offering price. I haven't built a financial model for the company (like I have for other recent IPOs like MuleSoft, Okta and Cloudera), but I have spent time going through the S-1, and I understand why bankers and investors alike have struggled to value the company. If valuing a SaaS company is like catching a butterfly with a pair of tweezers, valuing Carvana is like spearing a fruit fly with a toothpick. In this post, I'll cover why it is so hard to value Carvana using traditional methods, how that contributed to a choppy public markets debut and wrap-up with two key takeaways for startup founders.
A quick primer on how I value IPOs:
I usually value tech companies using EV/Gross Profit (EV/GP) multiples. I've written a post on why I prefer it to EV/Rev, and Carvana is a case study of why it is important to not treat all revenue as equal. For most public tech companies (especially SaaS companies, the most common breed), EV/GP can be correlated with the sum of the gross profit growth rate and free cash flow margin in an aesthetically pleasing (and intuitive) way:
How Carvana fits in:
Normally when evaluating a company like Carvana which is not SaaS, I use a variant of this EV/GP analysis but assume a healthy discount: after all used cars sales are not "recurring" in the way that SaaS revenues are, and the model is less cash generative due to the need to buy and hold inventory. A nice feature of this approach is it lets us compare low gross margin models like used car retail with high gross margin models like SaaS on a quasi apples to apples basis. Here, however, that is impossible because Carvana is just barely breaking to gross margin profitability, something virtually all other tech companies that are public have already done. It generated an impressive $365m of revenue in 2016, but just $19m of gross profit, a 5% margin, up from 1% in 2015. This compares to the ~14% gross margin earned by the largest used car retailer, Carmax, in 2016. Moreover, Carvana lost $93m in 2016 (and consumed $280m of cash, much of it to buy inventory) on its way to generating that $19m of non-recurring gross profit. That equates to about $.25 of losses for every dollar of revenue. Simply put, Carvana's combination of low gross margins and high losses means it wouldn't even fit on my valuation chart. EV/Rev is tricky because there are few hypergrowth retail comps with similar gross margin profiles, and EV/GP is overly punitive given the company is so far from mature margins.
In all despite its size, Carvana's financial statements look more like those of an early stage start-up than most other public companies. So does its promise. It is operating in an extraordinarily large TAM: It was just over 2% of the size of Carmax was year, and Carmax has only a mid-single digit share of the used car market. Very public companies have a wide-open opportunity in front of them.
Back to the valuation question. How to take even a educated guess at valuing it, given the challenges outlined above?
One way is to assume that in a steady-state scenario its gross margins will normalize slightly above Carmax's, at ~15%. In this analysis, we reallocate Carvana's discounting from that level as higher sales and marketing costs (discounts and sales/marketing are somewhat interchangeable in this case). Looking at the business through this lens, Carvana's financial statements look like this:
This shows ~125% "steady state" gross profit growth against losses greater than that (hypothetical) gross profit number, in a non-recurring revenue business with massive upside if the unit economics work out and network effects kick-in with scale. Even using this modification, the EV/GP multiple investors apply will depend mightily on how optimistic they feel about high growth companies as a group. Today Carvana trades at 14x my estimate of my 2017 "steady state" gross profit, a multiple similar to hypergrowth SaaS companies like MULE and OKTA. To my eye, that feels pretty high, but admittedly I don't have the time to truly study the unit economics of the company. If the math works, there is a chance 14x gross profit is far too low: the market is big and Carmax is an $11bn company. To get to that scale, though, Carvana will require significant additional capital to pursue its model in more and more markets around the country, both for sales and marketing expenses and to acquire inventory (Carmax holds over $2bn of inventory).
Summing it all up, Carvana is the worst performing IPO of 2017 so far because it is incredibly difficult for investors to value, and investors need to build confidence in the unit economics to buy into the longer term story, a process which takes valuable time and attention. It is also quite possible that bankers used EV/Rev multiples to guide the price, which if so was a mistake.
Two takeaways for startups:
1) If gross margin is an issue, valuations will be volatile. EV/Rev is NOT an appropriate valuation approach if long term gross margins are low or uncertain.
2) For capital intensive businesses where valuation is not immediately obvious on traditional metrics, the key is convincing investors that the unit economics of the business justify all of the upfront investment. Without that, capital will be scarce, especially if times get leaner. That is arguably easier to do with private markets investors who take concentrated bets and investing in due diligence than it is with public markets investors, who have a huge menu of investment options and much less time per investment. It may be that Carvana's model works very nicely- but the risk is that very few public markets investors will take the time to comprehend that (as this blog post evidences), complicating future capital raises. Never underestimate the value of investors who will invest their time (not just their money) and do truly deep diligence.
In the interest of full disclosure, I have a small short position in Carvana- not on an fancy short thesis, but because the company's valuation is unusually dependent on the mood of investors, and I am nervous that mood will change. I have long positions in many high-growth tech companies that I have fundamental confidence in/understanding of, but that nonetheless have the same factor exposure to "investor mood," and seek to offset that with countervailing shorts. Further work over time may well prove me wrong, and I advise every investor to do their own diligence before investing either way.