Special Bonus: Carma Deep Dive with special guest, Scott Middleton

0:00I'm Adam Schwab. I'm Adir Shifflin. And this is The Contrarians with Adam and Adir.

0:10And we are back, episode 192, very special guests, one of our most popular, if not our most popular rudder guests in Australia is Warren Buffett in the studio with us live in person. Welcome Scott. The setup for failure keeps getting bigger and bigger, doesn't it? Well you've generated a 30 % return over 25 years, haven't you? Just say yes. Probably. It was a very low base. Roughly. Maybe not financially, but I'm sure you could find something that's generated it. So you had a big couple of months since we last saw you? You know what? Since we last saw you, just the pace of AI has been insane in our businesses and in my own personal day-to-day work.

0:51It's bonkers. I think last week I was doing deep due diligence on a business that we're looking to acquire and my investment associate at our good friend's part capital, Yarn was busy on something and we usually work closely together and I threw it – I've been quietly building up my own like AI thing as an ex-software engineer. I've just been throwing it over to Claude and my financial investment associate and I got done – I got so much done in the space of days. it's quite mind-blowing where we're at. I feel the last couple of months it's accelerated exponentially. I think maybe what's accelerated is what we've learnt to do with it more than the models themselves.

1:40Yeah, I don't think models have changed at all. It's the application. And I find myself now, because I subscribe to multiple models, I find myself with just having them open and engaging on different things with different ones at the same time. As one is thinking and whatever, I just move on to the next one. And so you can have like three completely different engagements simultaneously. Just like get through three tasks at the same time. Like that's really good. When you say that Jensen was talking about last week, it's saying that every business needs an open clause strategy. I think Jensen thinks every business needs a strategy to boost sales.

2:12It's like every baker thinks you're oil and more bread, but yeah. Exactly. No, I never listened to Jensen. I used to love Jensen. When he was making video game cards, there was nothing I loved more than NVIDIA. but now with all of this you know we talk about great business not talking their own book that guy's always talking his own book the circular stuff has got me a bit does the king does a king who's conquered the whole world need to talk about what a great fighter and king he is let other people do the talking that's how I feel about Jensen yeah that's a fair point my big question for you Adam on AI is have you vibe coded a replacement for Jerry yet we haven't yet I'm shocked to hear that the guys are now picking off picking off lots of stuff.

2:55There was one piece of sass that we had. It was like a$10 ,000 all year thing. It wasn't a big thing. And Shy Muscle, so they knocked it off in like an hour. They built the equivalent. So obviously Jira is a bigger build, but they'll get to it. I think Jira's best defense against attack is the fact that it's so cheap. So it's not the highest priority. Except you just got rid of something that was 10K. That's very cheap. As in total 10K, but Jira is cheap, but obviously much more wide. This was a small niche, a really niche thing, whereas Jira is a much bigger thing. so it's less motivation to knock it off because my cost is 500 grand to code it but we save 500 grand year one or no, save 100 grand year one.

3:31It doesn't pay you. On the main episode, I'm going to try and remember every like three months but you have to be honest about this to go back and ask if they're still using the version that they coded up because that will be an interesting test. I'm not saying that cynically because there's maintenance as well, right? And every time the model changes you have to change prompts and so it'll be interesting to see. and if you need well no they've coded something you don't need to change they've built code you don't need to change that the model changes doesn't impact that once code's live it needs love and attention like a garden that's all code and feeding it that's all code except except if you're paying a SaaS provider to do the watering they're doing it yeah that's what I'm saying to you you know what I want to say this I'm not going to rejoice if you end up going back to what you paid for I'm actually more just interested to know yeah I'm curious if it flips back I'll keep you in I might rejoice but I don't want to rejoice because then you won't be honest with me about what's going on.

4:23So I'm going to say I'm going to be sad about it, but don't lie to me about it. So he'll do some good normalised EBITDA accounting and let us know even those guys are maintaining it. Exactly. So we're obviously here for the deep dive but one of our favourite segments of our listeners. And we're talking about a really fascinating business today called Karma, which is an online used car dealer backed by several major venture capital firms and family offices to put on the ASX in November to what has probably been a lukewarm reception. shares I think the Canaccord guys did an incredible job getting this away but shares slid on the first day of trade and since then things have gotten a lot worse dropping from 250 to 90 cents giving the business a market value of about 130 million dollars so not zero but obviously not what it was when it listed Karma is closely based on successful US car dealer Carvana which listed way back in 2017 at$11 a share what do you reckon Carvana hit at its peak it was at 11 it was crazy it was at a crazy valuation We hit$473 a share.

5:22$473. It was a lazy 45 bagger. I was going to say it went up 10x. About 40 something x. Well, that's never good news for a company. Just go and rock it like that. Because then after it comes back down to earth, all anyone talks about is how high it used to be. Well, that said, it's still at 300. So it's still at 25 bagger. It crashed, almost went broke. And then built back up again. And then built back up. This rocketed to 473 more recently. It went up and down and up. and then down a little bit. So it's still trading relatively quite well. It hasn't crashed recently. It's just sort of slid down a little bit.

5:54But I did have a near-death experience. That was years ago, though. Because I spent all my money building car kiosks where I could go and put my credit card in and say, I want that car. And it came out, the thing spun, and it got the car out the bottom. It's a bizarre concept. If it doesn't come out, you have to bang the side of the machine to try and get it out. You might have thought it was cool. I don't think it sold many cars and it cost a lot of money. Yeah, right. The story's actually even better. So it went from its IPO price of 11 bucks, hit in the COVID mania, hit 337s. That was the 30 bagger.

6:28Then dropped down to$4 in 2022. Almost going broke will do that to you. Yeah,$4. So it went from$11 to$300 to$4, then up to basically$440, and now it's still at$300. So even if you could have invested in this three and a half years ago - And made close to 100 times your money. Yeah. Oh, I'm caught 60 times, but either way, that's a pretty incredible return. Can you imagine trying to get options in this and what the Black Shoals would be on the volatility part of his share price? It's capped at$66 billion US now, so almost$100 billion Australian. So a big business. Karma itself, this is the Australian, go back to the Australian version, was founded by a former platinum asset management and a affinity stock picker, Lachlan McGregor, and his co-founder, Yosuke Hall, who was a former Goldman Sachs banker.

7:17so finance people to finance people not car not traditionally car guys Wham is among Karma's heavyweight backers and listed also includes Regal Tiger Global 5V Capital Entree Capital and the wealthy Saunders Family Terrorist Tower Group Frank Lowry's original partner in Westfield the 5V guys took me out to dinner on Wednesday along with some others so I've got to be careful I might not get invited back it's not me it's not me that will get you uninvited from this. I will say a couple of things about what you've just said very briefly. One is 50 % of their market cap is net cash at the moment but that is also because they're churning through it pretty quickly and the second thing I'd say is two finance guys started this business and I would say and we're going to talk about this I don't really think this is a cars business so I don't think it's crazy that two finance guys started it.

8:14Yeah. And so McGregor, one of the co-founders of the AFR, in some ways, a bit like cheating because we could see what was being done overseas. We could see the customers liked it. What was interesting about Carvana is that they are the most profitable business at any time for automotive retail, but are also fast growing. How many people have cheated their way to a 70 % drop from their IPO price? It doesn't feel like a great sales pitch, the cheating part of it. In its most recent financials for the summer half, Karma reported strong revenue growth of 34%, but it's lost widened from 15 to 30 million going to your point on cash.

8:46That's burning a lot of cash. That's pretend, that loss. Yeah. When you adjust for one-offs and con notes and listing, profit is basically flat. So 15 million loss. Yep. So positively gross profit was up 102%. You said profit is flat. As in the loss was flat. But you mean the loss is flat. Sorry. You're correct. Positively gross profit was up 102 % year on year driven by huge margin expansion from 6.1 to 9.2, which is a big positive. one pretty major issue for the business is low take rate it generated 4.7 billion gross profit on sales of 51 million with normalized expenses of 22 so that it's basically the margin on on the cars yeah exactly they buy a car and then they resell it for a little bit of markup and so it makes sense that it's a low and carvana is no different yeah on that part of their business yeah you mean take rate gross profit is that what you're saying yes what you mean by take rate i I call take rate a bit of a different thing.

9:39Okay. Okay. Like attach rate. But anyway, we'll get to that. But yes, they have a low gross margin. Over to you guys. What are your views on this business? Let's dive real deep. So someone was saying it was really interesting to know, what do we do when we get something like this? How do we look through it really quickly? So I thought I'd share my, maybe for me where I immediately go to is the financials. I just opened up. Shocked to hear that. Ignore all the opening section straight to the financials because it tells a bit of a story around business model. and I think we've spoken a bit about revenue and profitability, but they had a flat FY24, FY25 year revenue-wise and then they've picked it up.

10:19And as we're talking about the gross margin for this business is and the way the business works is we buy a car, we've got a great system of buying a car and then we sell the car and we make a little bit on our sale just for everyone listening. And then I think what's interesting is that gross margin is quite small. So even though you might be doing$127 million in revenue or if you're Kavanaugh and you're doing a couple of billion, you're actually only getting a very small clip of that ticket with which to build facilities, software, everything like that. Welcome to selling used cars. That's that business.

10:59You know, it's not sass. Yeah, so what's interesting with the financials then is you start looking at the operating expenses and there's a drop-off. But in the drop-off is some, there's this great, I love these footnotes and I feel like we need to campaign against the accounting standards and start coming up with better standards for how to report on businesses because it's got this great footnote of, and this is just how you have to report by accounting standards. Oh, we've decided to amortize our facilities costs. It's now long-term liability or something. What that means is, is that one of the core costs of this business, running a facility to refurbish.

11:39It's like the leasing, like retailers bring leasing costs. Yeah, yeah, yeah. So like that cost is now below EBITDA. Oh, you mean you say facility, not a finance facility. No, no. You mean a physical, geographical, car refurbishing. Yeah, yeah, yeah. In St. Peter's. Workshop. In St. Peter's in Sydney, there's a big car refurbishment facility. And so that kind of, the cost of looking after that, to come off the P &L, like off your EBITDA, it's still on the P &L, but it comes off EBITDA. So you can look at EBITDA and EBITDA is getting better. Don't worry about EBITDA because the thing is this. EBITDA, this business has got like real depreciation.

12:15Yes, yeah, yeah. I would only look at EBIT on this business. I wouldn't look at EBIT on this business. Well, I think you've just got to – my point before is you've got to come up with your own accounting standard for it and call it operating profit or something. But do you not think – like I think depreciation and amortisation in a business like this, as you've just said, is part of operating expenses. And so I get like, we're not going to go and put the cost of building all of the fit out for this St. Peter's thing straight into the expense line. Fine, put on the balance sheet. But I think that's just operating expenses.

12:45That's why I look at only EBIT on this business. I don't look at EBITDA. Well, I think just on the facility though, one of the key things we'll probably get to is the growth for this. If you want to believe in the share price, you've got to believe in the growth story of this business. And to believe in the growth story, one of the key costs of that is setting up facilities in Newcastle. That's right. You just jack up the operating expenses. Well, yeah, yeah. You can talk about that though, but if you look at its cash flows from operations, $17 million negative, isn't that different to its EBIT?

13:15It's a different problem. Yeah. Yeah, yeah. I think what I'm trying to say is to get a real picture of what's the expenses of the business on a yearly, regular basis. You've got to bring this in because of the growth. I just want to use EBIT though. EBIT has it in. You can use EBIT. I'll use EBIT for that. Your cash problem, that's just a working capital problem. That's not a bad business. That's just a business that needs cash. I tell you what I think about this. Go, you go. Just one more. Also, they're spending$2.7 million a year on software development, which is also getting pulled out of EBITDA.

13:48It's not great. Yeah. They're not a software business, really. You've got to throw that into the... But the amortization of that's going to be in the EBIT. Yep. Remember EBIT? But they wouldn't be amortizing that much. Well, they're going to probably amortize that over three years, aren't they? Whatever it is. I think this is not what's going to determine the success or failure of this business. I'll tell you what I thought about this thing. Number one, you know, you say you look at the financials. I think about it like this. Number one, what are you trying to sell me here? And so can I… You as the investor or the customer?

14:20Yeah, as an investor. Okay. Like, can I buy$1 for 50 cents right now? That would be the best outcome. Once upon a time when stock markets, you used to be able to do that. Now you can buy$1 for$50. That's much – and so this is not$1 for 50 cents in my view. Even with$60 million or$70 million of net cash at a$130 million valuation, this is not a value play. So what I'm buying here is a lottery ticket. And so now I want to work out how much can I win in how long and what are my odds of winning? Because that's what I think I'm buying with this business. Yeah, I agree 100%. And so I think this is a pretty interesting look.

15:02I'd call it an option over a lottery ticket. It's almost an option over their solvency. They stay solvent. It feels like they would do well. This is the Carvana story. Carvana stays solvent at 100x. And keeps growing. Yeah. So then I say, well, this is actually a very prescient comment, solvency. So then I say, what do I think they need to hit EBIT break even? Now, the thing about cash we'll come to, because EBIT break-even is not cash break-even in this business because of the working capital required for cars. But let's put that to the side. So I just did a back-of-the-envelope calculation, which is their expenses today – you have to just make a few assumptions.

15:40Their expenses today, if I just double the half-year, is 45 mil. that's my when I net out bullshit and I put some other stuff in and like they got this 10 million dollar whatever cost of some convertible notes as part of that but basically it looks to me like their expenses are basically do you include the con notes in there or not I got rid of it that really is a one off and so that's 45 mil that was my expense line annualised expense line yeah and so if I think if these guys are going to get to break even like there's no way that fixed cost line is not going to be rising so when I say the expenses, this is the below the line expenses, not including the cost of goods on the cars, right?

16:23Below the line. Because I would say the way I think about this business is simple. I have to sell X dollars of cars and keep a small margin, which is my gross profit. But it's almost like your business where the gross profit margin is almost the revenue and the cost of the car. It's like the total transaction value. Well, if anything, it's worse now. Because what's their GP number effectively? It's like 10 % or something, right? At the moment, it's under 10%. Yeah, ours is like 20%. something yeah it's even worse than us which is saying something so we think those numbers and then i think um then when i talk about it's almost like one of those payments business where you kind of just ignore the gtv because gtv is so ridiculous it'll be very likely to have 10 on a payments business but you know like it's payments like one percent you know what 10 on the payments business is called cab charge yeah remember that 90s yeah um so then i think so i care about that number so like revenue and then gross profit i care about that number a lot and then i just grab everything else together and the question is what percentage of the gross profit can they keep yeah incremental gross profit retention maybe we can call it or attachment rate or whatever you want to call it and so that matters and so i look at 45 mil and i'm like well that ain't going to be the expense line and so then what i go do is be conservative and i say if they have to do part two and three of thisst peters thing and open melbourne and open newcastle and whatever and i get to let's say 75 mil as an expense line and then we have to think in how many years that's uh whatever Whenever they get to break even, I think their cost base is going to be 75 mil.

17:47Okay. And so now we have to say, what gross profit margin – what's their gross profit margin? How many dollars of cars would they have to sell to generate$75 million in gross profit? So now it gets a bit – go on. I was going to say, so my work on that was like you start getting up around$550 million in revenue in order to start generating the expense base. Oh, I think we're in the same place. Yeah, yeah, yeah. So you want to say – The margin goes to 15 % or something. And it's not 15, but do you want to say how you got to your – what number did you get to? What margin? What gross margin? You have to break even on your 75.

18:20Yeah, it's not – Roughly 15. I think it's more like 13. Okay. No, but there's a reason that I got to 13. Okay. So what I did is – What about now? Sorry. What's the current gross margin? I think it was 7 or 8 percent. But it's rising. And there's reasons it's rising. I talked about that before. It actually increased significantly, hasn't it? And I think 13 – 6.1 to 9.2. So it's got a lot. So I think 13 is reasonable based on what other providers are doing. What's Carvana? Much higher than that. Much higher. Yeah, yeah. Because they've got a lot of extra products that they've added to it. Yeah. And they've also got some - Like finance products.

18:55Exactly. Yeah. Finance products. California was running at 25%. So the other thing, that improvement that you're talking about in gross margin for them came over the last year or so from, they were buying cars by doing what you and I would do if we were going to buy a car. They were going on carsales.com.au, Gumtree, Facebook Marketplace, and they were sourcing their cars through that. Wow. Whereas now they've shifted to people are going to their website to sell a car to them. They make a better margin on those. And so if I have to sell… Saving acquisition costs, right. You're saving that, cutting out the middle end.

19:25So if I have to sell$155 million, sorry, if I have to sell$550 million worth of cars, it's probably 20 ,000 cars and that means I need all these facilities but they're not full and so then now I think how fast can this business get to 550 million dollars of sales in its current model because I think the points that you made are interesting but when I say its current model so you say that's 20 ,000 cars a year you reckon yeah 19 or 20 ,000 cars a year and my view is it can get there it's very hard to know because it's currently growing it's actually I think growing like it's forecasting 70 % growth but it won't get there They had 40-something percent and they kind of forecast that again.

20:05Yeah, and I just said, let's imagine it's diminishing to 40 % by like 2031 or something. And let's do it on a slope. And I just approximated. But I reckon it might take them until 2030 to do that. 2.3 million cars are sold secondhand in Australia a year. You're saying you don't need less than 1 % of that market? Yeah, that's right. The TAM's big. Yeah, the TAM's not the problem. Carvana's only doing 1.5 % of the market in the US. Okay. And so basically I think that if this business – If they got to 1%, they were doing really well. So I think if this business – I think this business, if it is – and I'll tell you what I think the opportunities and the risks are, but if it works out in a reasonable way, I think that by 2030, like if by 2030, they probably can get to break even on those types of metrics.

20:55I think it's interesting you tapered back your revenue growth a bit there because when I was looking at that, all right, if this keeps working and they keep executing well, it really feels like 47-plus percent revenue growth is achieved. It could accelerate, actually, as you get scale. Because, yeah, if you start – It could, but we just don't want to – We're buying the lotto and we're trying to work out odds and I don't want to make my odds. Like, I want to look at conservative. Oh, yeah, yeah, yeah. I think the big question is how much cash is needed to raise to get to this. Well, that's another question.

21:32That's the question. No, I don't think that's a the question. That is the question for me. I think they can – actually, if you go back to first principles. If they're growing well, they get the money. And if they're not, they get it heavily diluted. Before you answer the growing well question, answer first principles. Is this a good business? Does this business make sense? Yes, I think it does. I think it's a great idea. I think you've got someone who's bought and sold a car last year. I use CarScout. They're really good. but like you can, the market is terrible for used cars. I think I can't remember when it was when I sold mine two years ago or something and like the amount of hassles of just like messaging back and forth with people.

22:04It's a disaster. So we switched our old BMW for new BMW last year and it was like five and the car deals offer us like a 20 grand for a trade or no, even less, they maybe offer like 15 grand for a trade in and then I went to, I could have sold it myself for 35. So that's a big deal. That's the delta these guys are working in. This is the margins, my opportunity, these guys working in because you get ripped off totally. But people go, I'll just give it to the car dealer. I'm there. I'm buying a new car. It's taking it off. It's easy. I don't have to sell it on car sales myself. I don't know how to do it.

22:33I'll get ripped off. If I'm a female, I've got some random guy coming to my house. You don't want that. So you're paying this massive VIG to the new car dealers who make a fortune off it. So there's clearly a great market there to explore. It's a great business idea. The TAM is great and the model is proven overseas. and there's not enough difference in Australia for the model not to work here, but there are some risks. But let me just finish what I said. Let's say you say 2028. The thing you show is the business model should work. These guys are proven in a small way it works. It takes time for it to work.

23:03That goes to the how much cash is the question, but if you get to before that is, is this a business that should work? And it feels like it should.

23:18Just on Adi, where I think you're going, I went a bit more, when I was then thinking, so it sounds like I went a bit more extreme on my growth case and then I went a bit more conservative on my conservative case of like is the valuation, the entry price, the right price? Because I was thinking about it as, well, I think they're in this spot where they have to grow. It looks like they'll probably grow, like even if you stuff everything up, given the facility they've got given the way the business works they'll grow again a little bit in the next like year or two but that that's interesting because it like they're still loss making in that in that world it's pretty hard to restructure i don't think the valuation matters that's my intake on this yeah well yeah yeah like because the thing is is if i think they're going to get to break even in 2030 but let's say they get there in 2028 who cares like even if I say 2030, it means that by 2032, probably they will do a billion dollars and they might keep 30 mil as EBIT, okay?

24:21But the valuation does matter in the sense that if, like if we're saying, well, 550 mil of revenue is kind of break even when you can say, I think that's where you can go, right, this is a solid business where I'm no longer buying a lottery ticket. Yeah, you're going to pay a lot of money for not buying a lottery ticket. Yeah, but we want to know, like, I would want to know at this price, am I getting in with enough room and enough growth between there and then? Well, I'll answer that question for you. In 2032 – Not financial advice, hashtag. Well, but it's an easy – you just have to make a decision on whether you want to buy this lottery ticket because in 2032, I think it will do a billion dollars, okay?

25:00If this thing succeeds in a 40 % growth way by that point in time, and I think when I do the number, what matters is how much of incremental on its incremental revenue how much is it going to be able to keep now it like different businesses keep different amounts like ap eagers keeps one amount and carmax keeps the least and carvana keeps the most but it's going to keep 25 okay that's what i think it's going to keep 25 of its gross profit and so you'll end up with a place where it'll be making at least 30 mil using the current model on a billion dollars. Now, if I say in 2032, and there's not even the real bull case, but it's still a bull case that they have to do this, and there's some headwinds that they're going to face, but 30 mil on a bill, okay, growing at 40 % a year at a 13 % gross margin, let's say.

25:56Now, that is a car dealer, and car dealers do not get the best valuation, but even if it got 20 times, like I'm talking EBIT, but even if it got 15 to 20 times EBIT on that, which feels pretty reasonable at that growth rate, like you're passing 500 mill as a valuation. And so you just 5X your money between now and 20, 30, 20, 60 years. If it, then we can say, what if they can unlock? That's not an extraordinary bull case either. Because you're not talking about gross margin expansion. Mid bull case, okay? That's survival case. in my mind. But you've also got to factor in dilution to get there because we haven't hit that yet.