COVID & The Used Car Market

The used car market exploded during the Covid-19 pandemic and is still feeling the effects of the pandemic as the virus continues to dwindle in social relevance. During Covid the global supply chain blew up as shipping routes got backed up and a semiconductor shortage plagued the technology markets. Cars were no exception.

The price of used cars began to rise as the economy rebounded and the pandemic was thought to be under control. There was simply not enough supply to meet the rebounding demand for vehicles. This new demand could not be filled just by new vehicles, in some cases even putting back ups on new cars for months at a time. Even now in June of 2022 ordering the new Ford Bronco could take 6 months to a year to arrive. My dad recently purchased a new car and he was lucky to only have to wait 3 months for delivery.

There was also the added benefit of low interest rates for over a year, boosting the amount of people able to get loans and adding to the overall demand for vehicles. Loans are of course where lots of dealerships, both new and used, make extra money on top of the car sales. Having this high volume of car sales sent many companies’ revenues way up, and as the market begins to stabilize and recession fears grow, the used car market is feeling the effects.

As stabilization continues, interest rates are back on the rise, inflation is at a multi-decade high, and recession fears continue to mount. Gas prices are coming down after being at nearly $5.00 per gallon nationwide, still up almost $2/gallon from a year ago. These economic effects have begun to curb the once booming car market, and as inventories build back up, normalcy is returning. Investors are responding as well.

Background Information

Looking at a few different benchmark statistics across 5 different large used car market companies:

CarMax ($KMX): The clearcut largest used car company across the country, selling thousands of vehicles every week while providing their own financing options for buyers. Carmax has locations across the country, and has technology to keep up with others, ensuring that finding your next car is easy to do.

Carvana ($CVNA): Known initially for their full online purchase and delivery of used vehicles, are now expanding locations and becoming more technology forward as they try to recover recent losses and large debts.

Cars.com ($CARS):Designed to be the one stop in finding your next car, Cars.com searches across all different websites for cars that fit your descriptions to make car shopping easy. Bigger on marketing a few years back, they're website is keeping up with modern technology and their search functionality remains strong.

Autonation ($AN):Similar to Cars.com, Autonation provides an easy car shopping experience, focusing on used cars and adding the functionality to sell your car and get an offer on their website. There are easy search functions to find cars under $10,000, for example. There is also a “service” functionality, to help you find a service center for your car no matter where you are.

CarGurus ($CARG): CarGurus combines a variety of offers including buying, selling, and even financing your car. They, like others, have easy search functions, with the added benefit of getting multiple offers on your car if you are looking to sell. CarGurus has also incorporated easy to find and read vehicle reviews to add to the car shopping experience.

Analysis

Beginning to look at measures of both stability and growth for the different companies, ROA can provide a good and comparable measure. Coming out of the pandemic, with the aforementioned challenges around inventory beginning to ease, there is variety in how each of the businesses performed during, and now post pandemic.

Looking at the comparison between the most current reported ROA (Information from Bloomberg Terminal as of July 12th) compared to last year, three companies, Carvana, Cars.com, and Autonation are doing very well, with Carmax continuing to grow, and CarGurus facing a large decrease in ROA. This level of profitability shows that companies like CarMax have continued to grow positively, while other companies like Carvana are “less negative”. Autonation saw the largest increase, while CaraGurus suffered this past year.

Beginning to look at measures of both stability and growth for the different companies, ROA can provide a good and comparable measure. Coming out of the pandemic, with the aforementioned challenges around inventory beginning to ease, there is variety in how each of the businesses performed during, and now post pandemic.

Looking at the comparison between the most current reported ROA (Information from Bloomberg Terminal as of July 12th) compared to last year, three companies, Carvana, Cars.com, and Autonation are doing very well, with Carmax continuing to grow, and CarGurus facing a large decrease in ROA. This level of profitability shows that companies like CarMax have continued to grow positively, while other companies like Carvana are “less negative”. Autonation saw the largest increase, while CaraGurus suffered this past year.

Looking at the Free Cash Flow (FCF) of the businesses, it shows that despite a positive change to ROA, FCF can trend negatively as changes to working capital in particular can swing FCF negatively. It is also important to look at how FCF has been trending, and it can be seen that industry wide FCF has negatively trended, with the exception of Cars.com that has been bouncing between profitability and slight negativity. Notably, CarMax and Carvana are both deeply in the red, with hundreds of millions of dollars in yearly free cash flow. AutoNation has been the only company to remain profitable, although it has dwindled over the years.

It is not uncommon in this industry to run high debt to equity ratios, however for all with the exception of CarGurus, run extremely high. Carvana in particular has been drowning themselves in debt as they try to rapidly expand and gain market share, with Carmax, AutoNation, and Cars.com all coming in with ratios in the low hundreds as opposed to thousands. This leads to the current ratio of these companies; their abilities to repay their current liabilities (of less than 1 year in maturity) with their current assets. CarMax and CarGuru are the only companies with truly strong Current Ratios, able to pay their maturing debts three times over, with Carvana and Cars.com doing well with 1.69 and 1.56 respectively. AutoNation in this case is the only company of concern, as they are unable to cover all current liabilities. Quick Ratio looks mainly at the cash the business holds to repay their debt. Only Cars.com and CarGurus have maintained a Quick Ratio above 1, while CarMax, Caravana, and especially AutoNation all run with low ratios of cash compared to current liabilities.

It could be argued that these companies with low Quick Ratios are spending their cash to try to grow their businesses, but it is worth noting that cars and inventory they have on hand can be liquidated fairly quickly, and as long as these businesses are able to keep current ratios high, they should not have any problems. Specifically, looking at CarMax, they have a strong Current Ratio despite their low Quick Ratio likely due to the high volume of vehicles in inventory at any given time. Contrasted with Cars.com, with almost identical ratios, means that they do not have as many liquidatable assets, and cash makes up a bulk of their ability to repay debts.

One final piece to debt is the credit ratings being given on bonds issued by these 5 companies. These ratings are not perfect, and distance to default models provided a wide range. Instead, looking at S&P’s ratings, all range from CCC+ to as high as B+. This means that the bonds are not being given the greatest ratings, however not all are junk bonds. Carmax and Cars.com are both given solid BB+ and B+ ratings, securing they are in a better place financially than Autonation, with a lower BBB- junk bond rating and Carvana with an abysmal CCC+ as they drown themselves in debts.

Note: CarGurus does not have much debt currently, and does not have an S&P rating on bonds

EV/EBITDA is a commonly used multiple measure to see the value of companies, comprising enterprise value (Equity Value + Net Debt + Preferred Equity) divided by earnings before interest, taxes, depreciation, and amortization. Generally, the lower this multiple the more undervalued a firm is, however in this industry the range is quite large, including Carvana with massive debt, swinging their multiple negative. Thus, “the lower the better” fails. Instead, looking at Revenue Multiples, which is calculated by dividing market cap over revenue, gives us a measure of how much every dollar of revenue is valued in the company.

This multiple can be used as a more reliable measure to show how the market is looking at the revenue of the companies. Lower means that the company is potentially undervalued, while higher means that the market is potentially overvaluing each dollar of revenue. This follows the principle that the market will eventually find its' average with firms growing in value, and others shrinking in value.

Looking at each firm, CarMax, sits in the middle, with each dollar of revenue being valued at $0.47 in market cap. This multiple appears to be low across the industry, as some technology companies, like Apple, have a multiple over 25. This could mean one of two things, either all of these companies have lots of room to grow up to CarGurus level, or the market does not view revenue very highly in general in the used car market and most revenue multiples will shrink down and stay around the levels they are already. Personally, I see no reason why these multiples won't find a higher average as the technology piece of the industry continues to grow. This could be a reason why CarGurus and Cars.com multiples are higher, as they are centered entirely around the technology of their business compared to others like CarMax and AutoNation that are brick and mortar store based. This of course leaves Carvana floating with a lower multiple than CarMax despite focusing on technology as much as CarGurus. This suppressed multiple is likely due to a variety of the reasons from above and the low faith in the current company to grow, let alone survive.

Conclusion

Based on all of this analysis and data AutoNation appears to be the company in the best state to continue to grow. AutoNation is one of only two companies I looked at to see a positive ROA trend after already being ROA positive. They are also the only FCF positive company, despite the entire industry appearing to trend FCF negatively year over year. Not everything though is positive, $AN does have quite a high D/E ratio, cannot cover their current liabilities, does not have much cash on hand, and has a BBB- bond rating. However, the major upsides include a strong EV/EBITDA and Revenue multiples.

Secondly, Milk Equity currently has a stake in CarMax, and plans to continue to hold for the time being. They too are showing strong signs of being able to continue to grow, with good multiples, strong current and quick ratios, as well as strong ROA trends despite the high D/E levels. As a slight bonus that debt has a good rating of BB+ as well as decent cash on hand to continue to grow. Milk Equity is also hoping that a strong market recovery in the second half of 2022 will lead to positive returns as inflation (hopefully) slows down and the car market reemerges from the covid related issues