Barron's Streetwise - The 42% Rise in Used-Car Prices

Episode Date: August 13, 2021

Carvana CEO Ernie Garcia weighs in on what's next for the market. Jackson tries to sell his Subaru. Learn more about your ad choices. Visit megaphone.fm/adchoices

Calling all sellers, Salesforce is hiring account executives to join us on the cutting edge of technology. Here, innovation isn't a buzzword. It's a way of life. You'll be solving customer challenges faster with agents, winning with purpose, and showing the world what AI was meant to be. Let's create the agent-first future together. Head to salesforce.com slash careers to learn more. When you own a car, you kind of like, okay, as long as I get that French fry out from between the seats, I'm good. My car's clean and I'm going to keep moving forward with it. But then when you decide that you want to swap a car with someone else.

I don't want any sign that anyone has ever owned it. I'm going to do a full forensic investigation. I don't want to see even a half a French fry. Exactly. Forensic. That's exactly right. So your expectations change upon kind of this swapping. Hello and welcome to the Barron Streetwise podcast. I'm Jack Howe. The voice you just heard, that's Ernie Garcia. He's the founder and CEO of one of America's fastest growing used car dealers called Carvana. New cars are in short supply right now, so prices for used cars have shot higher, so have sales volumes for Carvana. And its stock price has more than tripled since just before the pandemic.

In a moment, Ernie will walk us through what sets Carvana apart, how big it can become, and what to make of the wild run-up in prices for used cars. This past week, we learned that consumer prices are up 5.4% from a year ago. That's more than double the inflation rate we've gotten used to over the past decade. Now, prices for used vehicles are up more than 40% from a year ago. That's not just unusual, it's unheard of.

Many buyers in Central Ohio are ending up with a case of sticker shock this year. So many people are willing to pay more for a used vehicle than they would pay for a new car. Car manufacturers can't make enough new vehicles, partly because some components like semiconductors are in short supply. We spoke a few weeks ago on this podcast with the CEO of Intel who told us that the chip shortage would probably peak this quarter, but it might take until late next year to fully subside. So if you own a vehicle now, you might be surprised at how much you can get for it. Speaking of which, our own audio producer,

Jackson, has been asking around about his car. Jackson, tell me about this sweet rat of yours. What's the year and model, and how much did you pay for it? It's a 2013 brown Subaru Outback, and I bought it last year for $10,000. Any alterations to the vehicle, hood scoop, racing stripes? No, but I backed around a corner and I scraped it. You've made it your own? Yeah, definitely. So are you looking to sell?

Not exactly, but I'm just curious to see how much it's worth so I can feel a little bit better about myself for paying for it last year. You want to measure your paper profits? It's like checking my retirement account. So you have some clips for us from people you spoke with. Yeah, the first guy I met was John the Leather Guy. Hey, you just say John the Leather Guy. Leather Guy, are we still talking about vehicles? say John the leather guy. Leather guy, are we still talking about vehicles? So John works for himself and he goes to a whole bunch of dealers fixing things like ripped steering wheels, removing coffee stains and that kind of interior stuff. And so many dealerships are calling him these days that he's just turned his phone off.

Everybody that knows me, I don't sell. I don't go out and I don't advertise. You know what I mean? I'm just all word of mouth. Once they see the magic. So John was working at this small used car business in Rhode Island. It's called East Providence Auto Sales. And I spoke with the owner, Joe Cuoto, and he said he's never seen so much demand for cars from customers. The problem, though, is that he's having a lot of trouble finding used cars to buy wholesale himself. I've been seeing dealers paying, you know, five, six, seven thousand over wholesale price, which is over my retail price. But I guess they have customers for those. Joe's Lot is usually filled with luxury foreign cars. So if you look at the Google Street View

of Joe's Lot from a few years back, you'll see 30 or so Porsches, BMWs, Audis, Mercedes. Jack, what's the plural of Mercedes? I think it is Mercedes. But did I hear you say Audis? Because I'm sticking with Audis until I hear different. I think we need Audis. You're okay. Push forward. You'll see 30 or so Porsches, Porsches, Porsches, Porsches. Now you're second guessing every name. Anyways, the point is Joe used to exclusively sell those fancy cars, and now he's just buying anything where the price is right. American cars, Japanese cars, cars between $5,000 to $10,000, and that's what we're selling right now.

Everyone has $5,000, $10,000 to spend cash, and they just keep flying out of the door. I got it. So Joe has gone from dealing in Porsches and Mercedeses to dealing in more workaday vehicles. Yeah. And even though the margins on the fancy cars tend to be much higher, Joe's selling so many of the cheap ones that business is better than ever. And did you ask how much he could get for your car? I thought about it, but then John the Leather Guy said something that made me reconsider. If you got a car you're willing to give up, you know, get him in there now.

The only thing is, you know, you'll have to invest in a good bicycle, I guess, unless you want to pay top dollar for a used car. So what did you decide? Are you going horn or no horn on that bicycle? Yeah, I'm more of a bell guy, but my fiancee uses the car, and I don't think she wants to go from four wheels down to two. But just for informational purposes, I also talked with Bruce Coppola, who's the sales manager at Greco Toyota down the street. Well, I mean, right now there are a lot of people out there that are looking to go from four cars to three in their family, three cars to two, and some from two cars to one and take an Uber.

Now, you know, we don't want that to be the trend. I mean, we're in the automobile sales and service business. So Bruce is at a new car dealership, but he can't get his hands on enough new cars, so he's buying more used ones? Yeah, he wants to keep his sales lot full. more used ones? Yeah, he wants to keep his sales lot full. I use an analogy. I told a client the other day, I said, if you walked into Stop and Shop and they had four boxes of ramen noodles on the shelf and you walked into Dave's and every shelf was completely full, where would you stay? They're not going to stay at Stop and Shop. So you need product to bring customers through the door. And how's the trade-in market looking right now? It's never been stronger.

In some cases, we're offering our clients more than what the MSRP on what the car was new a year, two years, and three years ago. It's a very sparse market right now, so there are not a lot of cars out there. And if you want to take a car and trade, you got to step to the plate and give the people what the car's worth.

And right now, it's thousands more than it's ever been. Jackson, did Bruce have any tips for buyers? He had one. Is it that they should buy from him? Yeah, it is. I would come and see me. I did not see that one coming. I'm the best in the business.

And if I sit down and I give you a number on the car, I can guarantee you that's going to be the best price of any buyer in the industry. To learn more about the outlook for used cars, I spoke with someone who runs what you might call a $60 billion dealership. Hi, Ernie. It's Jack Howe from Barron's. How are you? I'm doing great. How you doing? I was just going through your results and you know it's not a close call. It was a pretty good quarter. Oh well thank you. I asked Ernie to start with the sales pitch. Why should customers buy their used cars from Carvana and sell to Carvana? We've tried to build a completely different business to make the experience way easier to give you a broader selection to give you a better price.

We now have 13 different reconditioning centers around the country that are 50 to 100 acres that have thousands of cars parked at all of them. Every car is going through an assembly line process to get certified prior to sale and getting photographed and getting put up on the website. You can go through the whole purchase process, schedule delivery to your door, and then we'll deliver it to you as soon as the next day. Or you can go pick it up at one of our vending machines. And then from there, you get a seven-day return policy. Yes, Ernie did say you can pick up cars from his vending machines. They're robotic glass facilities the size of buildings, and customers can drop a giant coin into a slot to activate their car delivery. It's gimmicky but fun, and it generates buzz. Also,

if it sounds like Ernie is talking quickly, it might be because Carvana is undergoing such rapid growth. Three years ago, it hadn't yet sold 100,000 vehicles in a single year. Now, it just sold more than 100,000 vehicles in a single quarter. Three years ago, in a presentation to Wall Street analysts, the company pointed out that its gross profit per vehicle had recently topped $2,000. Last quarter, it was more than $5,000. Carvana has a colorful history, or a pretty ordinary history, depending on which parts you focus on. Ernie is Ernest Garcia III, and his father, Ernest Garcia II, was an Arizona land developer who in 1990 pled guilty to fraud connected to a line of credit he obtained at a bank

called Lincoln Savings and Loan, which famously failed during the savings and loan crisis of the 1980s. which famously failed during the savings and loan crisis of the 1980s. He later started a business called Ugly Duckling, which was eventually renamed DriveTime, and which specialized in selling used cars to subprime buyers. There have been dings along the way, like an $8 million regulatory penalty in 2014 for debt collection practices, but the company has also been a financial success, and there have been spinoffs of financing and warranty businesses.

Ernie's son, Ernie III, graduated from Stanford University, joined DriveTime, and began building Carvana in 2012 as what has been called the Amazon.com of used cars. Today, Carvana is headquartered in Tempe, Arizona, just like DriveTime, but they're two separate companies run by two separate Ernie's, and Carvana went public in 2017. So you can look at that story and see some noteworthy missteps in the past, or you can see a fairly ordinary case of a son starting from his father's business and building something new and better. One thing that's different about Carvana is what the company calls its IRCs, or Inspection and Reconditioning Centers. I asked Ernie to walk us through one of those. Cars come in on these big, you know, nine car haulers that you see on the freeway sometimes with a bunch of cars stacked up. And we might have 10 or 15 that come in at the same time. And then those

cars come down off those haulers and they're kind of checked in. They go through a diagnostic process to figure out what we need to fix on that car. And then they go through all these different stations. Many of these stations are, you know, 12 or 13 minute stations where there's literally a clock ticking down and we're going through and we're doing different things that need to be done for the car. And then they get cleaned up and ends with photography and detail. And then it's kind of stored until a customer buys it. Ernie says that traditional dealerships need highly skilled mechanics who know how to fix everything on a car. But Carvana's IRCs separate jobs into simple ones and complex ones and can hire workers who build their skills and careers as they go. That helps

reduce labor costs. Also, dealerships are located in prime retail areas, but Carvana's IRCs can be set up in more remote locations, which keeps real estate costs down. The company just added its 13th IRC near Cleveland, Ohio. It has plans for eight more by the end of next year. By then, it'll be able to process one and a quarter million vehicles per year. I asked Ernie, when do you think used vehicle prices might cool off? It does hinge on this delicate balance of supply and demand. And demand, you know, is a function of domestic COVID and stimulus and all the things going on in our economy. And then the supply side, on the use side of the equation, all the cars are already out there. There's 270 million cars

that people drive every single day. And so there's not fundamentally a limit of supply. But on the new side of the equation, you do have these OEMs that have thousands of parts in every car, and they've got distributed global supply chains. They're oftentimes working with a supplier who's working with sub-suppliers, who's working with suppliers, you know, another level deeper. And all those different components are being built all over the world. I think, you know, probably the deepest fundamental is just recovery in this very complicated supply chain that will lead to normalization of new car production. And then, you know, by extension lead to probably normalization in car prices to some degree. But it's a complicated question. Carvana marks up cars and resells them so it can profit whether prices are high or low to start with. But profit margins now seem quite high.

One of the company's long-term goals has been to reach $4,000 in gross profit per vehicle. Last quarter, as I said, it went over $5,000. Carvana hasn't adjusted its long-term goal yet, so it's reasonable to assume profits won't stay quite this high. Ernie says the long-term trajectory is what matters most. If you go back to 2016, which is the year before we went public, we had about $1,000 of GPU. It was $5,000 last quarter. For the full year, we expect it to be over $4,000. And if you kind of look at000 last quarter. For the full year, we expect it to be over $4,000. And if you kind of look at the graph, I think the most important thing is to just look at the graph over time. We've continually moved that up year after year after year in a way that's almost been

linear. It hasn't quite been linear, but almost been linear. And we've done that through getting better at what we do through efficiencies throughout the business as we take advantage of that big supply chain and the technology that we've built. Und we're in a unique environment. There's just, you know, no two ways about it. And so I think trying to figure out exactly, you know, how much of that $5,000 attributable to this unique environment is not a simple thing to do. But, you know, we think that we've made a ton of progress. We did have a little bit of a tailwind this quarter. We expect to continue making progress. And so the business is in a great spot. Let me say one quick word about gross profit, because it's something that can provide an

important clue for investors. Gross profit is the portion of a company's sales leftover after it subtracts the cost of making or buying the thing that it's selling. There's also operating profit, which further subtracts for things like corporate overhead. And net profit takes out for everything, including taxes. The relationship between the numbers can tell a story. If you show me, let's say, a software company with high gross margins and low operating margins, I'll show you a company with popular products, but also one that's subscale. It doesn't do enough business to justify its corporate costs. The next question becomes, is it growing quickly? If so, leave it alone. The problem will fix

itself. If not, it's a clue that a bigger company could make an offer for that company soon and put those popular products to work in a setting that makes more efficient use of corporate spending. Now, if you show me a company whose gross margins are significantly lower than what they should be for that industry, I'm going to wonder if that company has problems that aren't as easy to fix. Carvana just reached its first quarter of positive net profits. That's something that wasn't expected to happen just yet. Wall Street still doesn't expect it to be profitable on a net basis for the full year, this year or next. But the combination of strong gross profit and fast growth is an excellent sign for future net profits. More than 60% of analysts who cover the stock say to buy it. Nearly all of

the rest rated at hold or the equivalent, with many citing the valuation, saying the share price adequately reflects the company's growth prospects. And that's always a difficult thing to judge for a fast-growing company, how quickly it can grow into or even outgrow its stock price. I asked Ernie about electric vehicles. They're a small part of the market today, but many new electric models are launching over the next few years. And if the experience of Europe is any indication, demand in the U.S. could soon inflect higher, especially once truck-loving Americans have their choice of a few battery-powered pickups. We're excited about that transition because we think we're really well positioned for it. When you look at our customer base, we're now the second largest seller of used cars in the country.

And we've become that in a very short period of time. We're growing really quickly because we're selling to all customer types, but we do have a skew toward younger people. We do have a skew toward electric vehicles. And so I think we're really well positioned to being the destination of choice for those that are looking for electric cars. And because we have these large reconditioning centers, we're in a really good position as well to make sure that we have specialization inside those reconditioning centers. I asked Ernie whether he's been able to get all the workers he needs. He says it's been a strain over the past several months with all the demand, but that Carvana is catching up and that it offers good opportunities for career advancement. I asked whether customers are surprised to learn how much they can get for their cars.

He says, yep, but as we talked about earlier, sometimes they're also surprised at how much they have to pay for a new car. I asked him what his first vehicle was, and he said, a 4Runner with dice hanging from the mirror. Now, I want to leave you with one car finance tip. If you lease a car, there's often a provision that allows you to buy it at the end of the lease, and the price of that buyout might be well lower than what the vehicle is selling for now. In the used car industry, that's called lease equity, and you can capitalize on it by either buying the car and keeping it for longer or using your lease equity as a bargaining chip in negotiating another car transaction. Car dealers might prefer that you just turn the car in without knowing about lease equity.

If you know what stock options are and you know what it means when they're in the money, a car lease now, depending on the model, might be a little like having an in-the-money call option. Now, don't get too excited about lease equity unless you're nearing the end of your lease. Cars are for driving, not flipping, unless you're in the business. Speaking of which, I asked Ernie how big he thinks Carvana can become. Remember, he just reached a milestone of selling more than 100,000 vehicles in a single quarter. You know, we've put out a goal of 2 million plus units. And the 2 million was arrived at a couple of years ago by looking at the scale that we had in some of our older, more mature markets and looking at the trend lines that we saw there and saying, you know, what were we confident that we could extrapolate to? And the plus was arrived

at by saying, you know, there's 40 million transactions nationwide in the U.S. in the used car market alone, 40 million of them. That's a really big number. And at the end of the day, what customers want is the things that we outlined before. It's simple. They want a broad selection. They want the car they're looking for. They want a great experience that's simple, and they want a fair price.

And we think that we've built a business model that delivers those things to customers. So I think trying to precisely quantify how big we can be is hard, but we're going to keep building. We're going to keep trying to deliver the best experiences we can to customers. And we think if we do that, then we'll keep going and we'll see where that takes us. Thank you for listening. Jackson Cantrell is our producer. Subscribe to the podcast on Apple Podcasts, Spotify, or wherever you listen to podcasts. If you listen on Apple, write us a review. And if you want to find out about new stories and new podcast episodes, you can follow me on Twitter. That's at Jack Howe, H-O-U-G-H.

See you next week.