Carvana: A Countrywide Auto Stock Promotion: Spruce PointGuest Post
Spruce Point is pleased to issue a critical forensic “Strong Sell” report on Carvana Co. (NYSE: CVNA, Carvana or “the Company”). In our opinion, Carvana is a used car auto dealership masquerading as a high-growth technology-disruptive business. Carvana is majority owned and controlled by the Garcias, notably patriarch Eddie Garcia III, a convicted felon and owner of DriveTime. Given DriveTime's failures to IPO or sell itself, we believe Carvana was incubated as means to unlock value for the Garcias and early investors, at the onerous expense of new public shareholders. Burning >$350m per year and now heavily encumbered with CCC rated junk debt, we believe Carvana is becoming increasingly dependent on aggressive accounting and issuing stock grants to project growth to investors, while stemming employee defections. At best, we believe Carvana is worth $9.60 – $16.00 per share (50%-70% downside), and at worst its equity is worthless under a few plausible scenarios.
Our report will detail that Carvana is extremely dependent on subprime auto lending and origination, along with other questionable business practices that may skirt industry best practices, and the law. Its main financing partner, Ally Capital, appears to be slowly distancing itself, while a trust named Sonoran fills the void. Management has been unwilling to fully disclose the exact parties behind Sonoron, but claims they are independent. Based on our research, it appears that insurance entities tied to Mark Walter (CEO of Guggenheim), a material 9% shareholder, may be supporting Carvana artificially by purchasing loans at above market prices. It has been reported in the press that Guggenheim and Walter have come under SEC scrutiny, and that shares of Carvana were pledged so that Walter and his associates could purchase the LA Dodgers. This would create incentives for Walter to use Guggenheim as a means to keep Carvana afloat.
Spruce Point sees 50%-70% downside risk given our belief that: 1) Carvana will never scale or hit its lofty long-term aspirations, 2) Its technology advantage claims are more likely designed to spin a stock sale story, 3) Its management lacks depth and public company experience running a levered business, 4) Its accounting and financial presentation is becoming more aggressive to provide the illusion of GPU growth, 5) Its Board, including former VP Dan Qualye, who in addition to his son, received political donations from the Garcia, should hardly be considered “independent”, 6) It is heavily dependent on selling subprime auto loans at a time when a key counterparty is reducing exposure, and a blurred line to a related-party appears to be paying noneconomic prices, and 7) Carvana trades at a substantial premium to traditional auto dealers and peers that have both profitable business and reduced subprime auto loan exposure.
Carvana's equity could be entirely worthless if credit conditions change, its business were to come under greater regulatory scrutiny, or if incorrect representations concerning its auto finance loans sold required it repurchase such receivables. If equity investors were unwilling to backstop further losses and such risks, Carvana could face terminal bankruptcy.
Spruce Point Sees At Least 50%-70% Downside Risk In Carvana (CVNA): $9.60 -$16.00 Per Share. In A Deeper Bear-Case Scenario, CVNA Is A Zero.
At best, Carvana (CVNA or “the Company”) is a used car dealership masquerading as a high-growth tech business. At worst, it’s anuneconomical subprime auto loan originator surreptitiously being kept afloat by deep-pocketed early investors with too much skin in the game to let it fail.
Its rapid growth has been built on smoke and mirrors, and it is inevitable that the force of financial gravity will bring it back to the ground.
Billing itself as the “Amazon of cars,” Carvana sells used vehicles through an e-commerce platform which allows customers to browse its inventory, obtain financing, and arrange for delivery / pickup from a home computer or smartphone. Management claims that theinherent scalability of its online-oriented model will support EBITDA margins more than twice those of peers –but, in reality, we believe the cost structure of the business is little different than that of a typical used auto dealer. Perhaps Carvana’s most unique characteristic as an auto dealer isn’t its e-commerce orientation, but the fact that it appears to make an attractive profit on the sale of subprime auto loans. We find thatthe purchasers of these loans have been early investors with a significant stake in the Company, as well as their close associates. Without their provision of attractive financing on uneconomical terms, the economics of the business would collapse.
- Carvana Is An Auto Dealer, Not An Asset-Light Tech Company: Management Is Forecasting Pie-In-The-Sky Margins And Market Share Gains On Unrealistic Scalability Assumptions While Accelerating Cash Burn To The Tune of ~$350M/Yr
- Growing Dependence On Debt Financing As A CCC+ Junk-Rated Borrower: Financing Needs Could Wipe Out The Company If The Credit Cycle Turns And Equity Investors Balk At Backstopping The Cash Bleed
- Closely-Associated Parties Providing Non-Transparent Subprime Auto Loan Financing On Non-Economic Terms: Entities And Individuals Under SEC Investigation For Self-Dealing Providing Vital Financing To Keep Their Investments Afloat?
- Dubious And Unsustainable Sources of Gross Profit Per Unit (GPU): Questionable Refinancing Agreements, Aggressive GAP Insurance Sales, And Warranties Which May Violate Consumer Protection Laws Expose Carvana To Loan Put-Back Risk
- Unseasoned Management And Questionable Governance: CEO’s Father Convicted Of Felony Bank Fraud, A Woefully-Inexperienced C-Suite, A Treasurer Who Filed For Bankruptcy, And A Largely Non-Independent Board Of Directors
- Absurd Valuation: An Overextended, Heavily-Indebted Used Car Dealer / Subprime Loan Originator Valued Like A High-Growth Tech Company, Largely By Mis-Assigned Tech Analysts. Shares Worth $9.60 -$16.00 In The Intermediate Term
Spruce Point Sees 50%-70% Downside In CVNA, And Up To 100% Downside In An Extreme Scenario
Carvana Is An Auto Dealer, Not An Asset-Light Tech Company –And Management Is Forecasting Pie-In-The-Sky Results On UnrealisticScalability
- A Used Car Dealer, Not A Tech Company: Like any other large-scale used car dealer, Carvana buys used vehicles at auction and through trade-ins, reconditions them, maintains inventory, manages a logistics network, and arranges financing for customers. This is not an “asset-light,” highly-scalable internet business. A close look at its PP&E accounts show more money spent on physical assets than on technology.
- Profitability Targets Are Overly-Ambitious: Carvana is targeting medium-term EBITDA margins >2x those of other auto dealers on a below-average target Gross Profit Per Unit (GPU). This suggests that management sees tremendous operating leverage in the business,and that it expects to achieve SG&A efficiency >50% that of CarMax. Carvana’s business model is simply not sufficiently different from thoseof other auto dealers to support such an advantage in scalability. Any cost savings realized from a leaner on-the-ground sales force and smaller brick-and-mortar footprint will be offset by higher IT costs, call center costs, and logistics costs. Intense industry competition andlack of differentiation will undermine any attempts to achieve a materially above-average GPU, as management expects to achieve in the long-term.
- Carvana Outgrowing Shared Service Agreements With DriveTime: Carvana benefits from its special relationship with DriveTime, its former parent, through shared service agreements. As Carvana continues to outgrow its former parent, it will lose the advantage of access to these special arrangements which we believe are struck at a discount to market.
Questionable Accounting And Dubious Sources Of Gross Profit Per Unit (GPU)
- Supporting Profitability With Dubious One-Offs And Other Items: To address high employee turnover without taking a margin hit on higher compensation costs, CEO Garcia recently offered equity incentives from his personal holdings to employees who remain at Carvana for over a year. However, Carvana excludes these costs from adjusted earnings, though they are paid directly by the company first, and thenreimbursed by Garcia. Management effectively sees this as a cost to Garcia, not to Carvana, despite the fact that it represents a real costto the Company if it must increase pay to fight overwhelming employee churn. Meanwhile, it adds the “gift” back abovethe SG&A line, thereby inflating GPU.
- 100% Gross Margin Finance Revenue Driving GPU: Carvana generates an outsized share (~50%) of GPU from 100% gross margin finance and insurance (F&I) sales, vs. <20% for KMX. Underlying GPU on car sales alone are >10% below industry average and less than halfthat of KMX.
- Carvana A Loan Broker?: A questionable refinancing maneuver supported ~7% higher GPU in Q3 FY 18. A similar transaction was completed in Dec 18. We question why the parties chose to pay Carvana a ~2% “brokerage” fee for a transaction in which it assumed zero risk, and why they chose not to employ a third-party financial institution. These gains merit scrutiny and conveniently allowed Carvana to hit its GPU target.
- Questionable Vehicle Service Contract (VSC) Sales Contributing To GPU: Carvana sells extended warranties and GAP waiver insurance, and generates income by selling the VSCs to a related party –perhaps at terms favorable to Carvana. We find evidence that Carvana does not inspect vehicles to standards to which it is obligated by law, and is not transparent with customers about the terms of its warranties. Liability reassignment in the event that consumer protection law violations are proven, could, as a tail risk, wipe out the Company.
Spruce Point Agrees With The Short Side Consensus, But Sees Even More To The Story
Questionable Source Of Financing By What Appear To Be Related Or Closely-Associated Parties Under SEC Investigation
- Returns On Loan Sales Make Little Sense Given Credit Risk Distribution Of Borrowers: Carvana is not transparent about the distribution of its borrowers’ FICO scores. Based on our market intelligence, we believe management has made statements implying that it receiveshigher loan premiums on its sales of subprime auto loans than it receives on its sales of loans of superior quality to Ally Financial. How can this be? Ally recently cut its bulk financing commitment to Carvana, making us concerned that the Company will grow increasingly dependent on non-transparent borrowers which appear to be engaging in loan transactions at non-market rates.
- Evidence Of Closely-Tied Buyers Supporting Irrational Returns On Loan Sales: Management does not disclose the identities of the parties which appear to be purchasing Carvana’s subprime auto loans at non-market premiums. Evidence points to the involvement of Guggenheim Partners CEO Mark Walter, a 9% shareholder of Carvana. We find that insurance companies closely associated with Walter and Guggenheim, yet which have not been disclosed by management as formally “related” parties, have financed Carvana’s loan sales since FY 16. Reports indicate that Walter and Guggenheim have been under SEC investigation for self-dealing, and that he and his associates may have financed their $2B+ purchase of the Los Angeles Dodgers in 2012 using captive insurance companies –entities to which they have since pledged personal assets, including Carvana shares, in response to allegations of improper management. Walter’s strong incentive to keep Carvana afloat may be motivating him to purchase Carvana’s subprime auto loans at a premium to market rates.
Unfit Management Misrepresenting Its Biographies, Questionable Director And Auditor Independence, And Share Structure Favoring Insiders
- A Dubious History: Carvana was incubated by DriveTime, a subprime used auto dealer whose owner and chief executive, Earnest Garcia II, was convicted of felony bank fraud in 1990. The company has been losing money in recent years and replaced Garcia at CEO with RayFidel, another bank fraud felon convicted in a related case. DriveTime abandoned its IPO dreams in 2010, but set its sites on going public with Carvana soon thereafter. Garcia II later installed his son, Ernie Garcia III, as CEO of Carvana. Is Garcia II really the man in charge through super-voting Class B shares, and using Carvana as means to cash out in a way he couldn’t through a DriveTime IPO? Furthermore, management omits from its bios a failed start-up called Looterang (Rewards Systems LLC), material to investors’ ability to assess its history with start-ups.
- Woefully-Lacking Management: No Carvana c-suite executive has prior experience with a public company or in the auto industry (except for Garcia III, who worked for his father for a number of years). The CFO was most recently an economics professor, lacks a traditional CFO pedigree, and is supported by a treasury professional who filed for ch. 7 bankruptcy. While management’s Stanford and Harvardpedigrees are superficially impressive, we prefer seasoned executives with prior auto industry experience for running a levered, money losing enterprise.
- Board Of Directors Lacking Independence: Of the three “independent” directors with prior auto industry experience, two have prior connections to DriveTime. Former U.S. Vice President and current board member Dan Quayle is claimed to be independent, but both Garcia II and his son have donated to Quayle and Quayle’s son’s political campaigns in the past. This calls his independence into question. Spruce Point is wary of companies which grant board seats to well-known and well-connected politicians with limited or no experience in the company’s industry (e.g. Theranos, Kior, Waste Management and WorldCom).
Read the full article here by Spruce Point Capital Management