Hayden Capital recently released its Q1 2020 Investor Letter, a copy of which you can download below. The fund posted a return of 4.10% for the quarter, outperforming their benchmark, the S&P 500 Index which returned -20.00% in the same quarter. You should check out Hayden Capital’s top 5 stock picks which helped them beat the market by nearly 24 percentage points. There weren’t a lot of funds who could deliver these kinds of returns without shorting the market or using aggressive put options.
In the said letter, Hayden Capital highlighted a few stocks and Carvana Co. (NYSE:CVNA) is one of them. Carvana is an e-commerce platform engaged in the buying of used cars. Year-to-date, CVNA stock gained 6.8% and on May 11th it had a closing price of $100.67. Its market cap is of $16.29 billion. Here is what Hayden Capital said:
“Carvana (CVNA): This quarter, Carvana began trialing an interesting new program involving “Partner Inventory” (note, the company hasn’t publicly commented on this initiative before – we discovered the program only after some sleuthing). The basic idea is that instead of purchasing vehicle inventory outright (and tying up capital in the process), Carvana will list vehicles owned by other dealers on their behalf (similar to a consignment / marketplace model)10.
The vehicles are listed on Carvana’s website, but with pictures taken by the dealer themselves. In 2018, Carvana acquired Car360 for $22 million (LINK) – a technology that allows users to take a high-resolution 360-degree representation of a car, with just a smartphone (LINK; Carvana had historically used expensive DSLR rigs and custom photo-booths to provide this experience. Carvana’s dealer partners are likely using Car360’s technology for this initiative).
So why is Carvana opening up its platform and technology to its competitors? Well for Carvana, it allows them to conserve their capital to increase their competitive advantage in the differentiated aspects of the business, such as logistics, marketing and brand-building, etc.
Used car inventory is one of the most commoditized aspects of Carvana’s business. While Carvana may have a far wider selection of vehicles, on an individual car basis, Carvana’s 2017 Black Honda Accord isn’t going to be significantly different than a local dealer’s. What prompts a customer to choose Carvana over a local dealer, is rather the site’s ease of use and payment, transparency, the fact that they’ll deliver the car to your home, and the trust Carvana’s brand has built where consumers are confident they’ll get the car in the condition they were promised and there won’t be any negative surprises down the line.
This initiative also helps Carvana to scale their inventory diversity without capital. It’s important, since the company’s customer feedback suggests that the #1 reason potential customers don’t buy a car from Carvana, is that they “did not find the car [they] were looking for.” (LINK). So expanding the inventory selection / diversity is a major variable in driving Carvana’s growth further – and a basis for both this program and Carvana starting to aggressively encourage trade-ins / sourcing cars directly from customers a year ago.
In the used car industry, typically half of gross profits (and an even larger portion of net profits) are derived from ancillary services, such as selling the finance receivables, selling extended protection plans, GAP coverage, etc. These are high margin products (compared to single digit margins from selling the vehicle itself), and in Carvana’s case comprised ~52% of total gross profits per unit last quarter. Under the Partner Inventory program, Carvana retains these profits and equally important, retains the customer relationship.
If you look at the example snapshot below, you’ll notice that customers don’t see the dealer partner’s name anywhere. Instead, the process is just as if you were buying directly from Carvana’s own inventory pool, and the order / delivery experience is exact same. Unless customers are reading the fine print, they wouldn’t notice a difference.
For dealers, this program allows them to leverage Carvana’s site traffic and customers to turnover their vehicles quicker. Carvana.com generates 100’s of times the traffic than an independent used car lot would generate on its own11. The dealer is giving up half of their potential profits, but in return, the dealer still makes more money in the end if they can reduce the amount of time it takes to sell a car by more than half 12. And in today’s Coronavirus environment, traditional dealers are more desperate than ever to have an easy mechanism to sell their inventory online. It is a win-win for both parties.
If you think about how Amazon built Prime, it was a very similar roadmap. When ecommerce was nascent and consumers weren’t used to / didn’t trust ordering goods online in the 2005, Amazon had to prove that it was an easy and trustworthy experience13.
The only way to do that, was to control the experience from end-to-end, and develop trust for the Amazon Prime brand. This meant investing heavily in inventory, expanding the number of shopping categories, offering 2-day delivery when competitors took a week, etc. Amazon’s profits suffered as a result – but the goodwill it built with customers allowed them to leverage their brand & infrastructure, and eventually monetize it when they expanded to partnering with 3rd Party merchants.
Note, even though other car marketplaces already exist, the model Carvana is pursuing is very different from peers. Unlike other marketplaces, Carvana is providing a standardized level of service and quality guarantee, similar to what Amazon’s Prime program and Fulfilled by Amazon, did for marketplace sellers. Other platforms like Cargurus, are simply a lead generation tool for dealers and don’t control the offline user experience (which is exactly the part of the buying process used car purchasers dislike).
For example, Ebay already existed (and had a much larger network) when Amazon launched marketplace in 2000, and Fulfilled by Amazon in 2006. But what propelled Amazon Marketplace to over-take Ebay, was their ability to provide a consistent customer experience (quick shipping, simplified shopping experience), regardless of which seller’s inventory it was coming from.
While on Ebay, a customer had to research each individual seller’s ratings and make a judgement as to whether the seller was reliable. Depending on which seller a customer bought from, the Ebay experience could vary drastically (the consumer trust rested with the individual store, not with Ebay’s platform).
However on Amazon Marketplace, the customer just had to trust Amazon, since the places in the supply chain that caused variability (shipping times, customer service response times, hassle-free returns) were all standardized and controlled by Amazon itself. Since the goods themselves were commodities, and multiple sellers of the same item would compete to offer the lowest price / the position in the “buy box”, most of the value and customer trust accrued to Amazon.
Carvana seems to be following a similar playbook. Similar to how Amazon educated the consumer and changed online shopping habits with its own 1P business and Amazon Prime, Carvana is doing the same with its marketing and hassle-free experience. Once they proved the market with their own inventory and built the trust, traffic, and infrastructure, Amazon eventually opened up the platform to 3rd Party sellers and provided them with the tools to succeed.
Fulfilled by Amazon held 3P seller’s inventory in its own warehouses, and provided a seamless delivery experience, while allowing sellers to focus on providing high-quality items procured at low prices. Carvana is at this stage now, opening up its reconditioning centers and logistics network, to provide a consistent experience to its customers. Arguably, these standardized aspects are even more important for Carvana, since the items are so much more valuable – it takes more trust in the platform to buy a $20,000 car online than a $10 laundry detergent. So far, Carvana is doing a great job laying the ground work to become the infrastructure provider, preparing for the day when shopping for a car online becomes mainstream.
As it relates to our investment, infrastructure providers also tend to command higher multiples as well, since they sit in a more valuable part of the industry ecosystem. Revenues become more predictable, as the company moves from just a retailer, to a “tax collector” (I described why these “tax collector” businesses are so attractive in our Q1 2019 letter (LINK)).
This quarter, Carvana also did a $600M equity raise and expanded their loan purchase program with Ally to $2BN. This is on top of the $450M of liquidity Carvana had going into the quarter, mostly in the form of cash and revolvers.
Needless to say, this additional capital gives Carvana plenty of runway – even if they don’t earn a single dollar of revenue for the next several quarters. However, this scenario was a highly unlikely possibility, since data we’ve seen indicates that even during the depths of March, Carvana’s sales weren’t affected nearly as much as their competitors. And in recent weeks, their orders have already returned to January / February levels.
Undoubtedly, this was aided by government “stay at home” mandates, which forced many competitor’s brick & mortar lots to close. If you needed a car during this period, Carvana’s “contactless delivery” was one of the only options available and ready to deliver (LINK).
The equity raise in late March took solvency risk off the table (although as stated before, it wasn’t a big risk to begin with, and there were several cost items that Carvana could have cut back on to conserve capital). The market reacted positively though, since it narrowed the range of outcomes and skewed the equity’s expected value upwards14. It doesn’t surprise me that shares have recovered from ~$22 at the lowest point to ~$90 today.
We had sold some of our Carvana shares in late February, after the stock rose +30% in the span of three days. We bought back some of it in the weeks after, but got much more aggressive as the stock fell during this last drawdown. By now we’ve bought back all the shares we sold and more, with most of the purchases in the $30’s and $40’s.”
As you can see Hayden Capital believes that Carvana is following a similar roadmap followed by Amazon.com, Inc. (NASDAQ:AMZN) and eBay Inc (NASDAQ:EBAY). In Q4 2019, the number of bullish hedge fund positions on CVNA stock increased by about 6% from the previous quarter (see the chart here).
Disclosure: None. This article is originally published at Insider Monkey.
