Let's talk $CVNA

I'm digging around the Q2 2020 10-Q on a Friday night, and I slowly begin to realize that something seems off. Mind you, I'm not an expert, so for me to pick up on something is telling. I begin to realize that 1/

2) Carvana receives a large amount of its revenue from this ambiguous category called "Other Sales". I continue down the income statement and see that these sales are booked at 100% gross margin. In fact, it ends up comprising over 50% over the company's total Gross Profit.

3) Naturally, I start digging into what's going on and the first thing I see are VSC sales (Vehicle Service Contracts). These contracts Carvana sells, where it provides certain services for the vehicle. Except that Carvana isn't truly responsible for servicing the vehicle . . .

4) DriveTime is. Carvana simply takes a commission on the sale, and remits the rest of the proceeds to DriveTime to administer. What is DriveTime? That would be a huge auto dealer and service provider owned by the CEO's father.
Ahhhhhh . . . I understand what's going on

5) DriveTime must be pumping profits into Carvana by agreeing to extremely favorable VSC contracts in order to inflate earnings, and boost the share price. Not something hard to do, when you have family on both sides of the transaction. I begin to run the numbers . . .

6) VSC Revenue increased from $10.1M Q1 2019 to $19.3M Q2 2020, almost double the growth rate of car sales ($). Over the same period, VSC revenue per unit even jumped from $275 to $350.
But there is only one problem . . . .

7) I ran a similar analysis for CarMax, and found that they were selling significantly more per unit for their comparable protection plans. Although Carvana had a steady increase in VSC sales, it isn't out of the ordinary.

8) In fact, even the November 2018 agreement whereby Carvana would receive excess reserves from DriveTime based on the performance of the VSC seemed to be in parallel to what CarMax had established with its plans.

So if it's not VSCs driving this GP, then what's left?

9) Well, that would be financing. YES, FINANCING. Ladies and Gentleman, this is where our story really begins. This is the true genius behind the Carvana story, not shiny glass dealerships and online sales. So let's talk about the basics.

10) When Carvana sells a vehicle, it originates a loan for the vehicle, which becomes an asset called a "finance receivable". In order to receive cash, Carvana has to either hold the receivable and wait for the customer payments, or it can sell the receivable for cash.

11) Carvana usually opts to sell the receivables, and has established several avenue's to offload the billions of dollars of loans it originates. The first agreement is a forward-flow agreement with Ally Financial- the Master Purchase and Sale Agreement (MPSA)

12) In the current agreement, Ally Financial has committed to purchasing up to $2B worth of finance receivables from Carvana from Q2 2020 through Q2 2021. As of month end June, they only have $1.3B worth of capacity left on this agreement. (more on this later)

13) The next avenue Carvana pursues is Securitization Transactions. In this method, Carvana established VIE securitization trusts in order to package up the loans and sell them as asset backed securities (ABS) to the broader market.

14) In this process, Carvana sells the loans to the trust, who sells an ABS. Carvana then books revenue equal to the consideration paid to the company from the ABS sale. Thus, through both methods, Carvana is able to monetize a huge amount of assets into cash.

15) What does this mean for Carvana's financials? Well, it all comes back to "Other Sales". Since Q1 2019, Carvana has booked $189M of "Gain on Loan Sales" from selling its finance receivables to Ally or the trusts. This composed 30% of its total Gross Profit over that time . . .

16) So how does Carvana earn these Gains on Loan Sales? Simple, it sells those finance receivables to Ally and the trusts at "premium prices". The only problem is, no one knows exactly what drives the premium pricing. One theory, is a skillful VIE operator/certificate holder

17) In a document related to the Sonoran Auto Receivables Trust 2017‐1, mgmt is asked about who owns the certificate to the trust:
""The certificate purchaser in our Q3 and Q4 refinancing transactions is an asset manager who has been a partner since prior to our IPO.

18) "The certificate purchaser is not a related party.
We are not able to name the certificate holder due to confidentiality terms in our agreement.
Moreover, we would likely not name the partner absent those terms due to the factors described above."
Hmmmmmm interesting

19) Throughout my research, I have not been able to find out who owns the certificates to any of the trusts in which Carvana is not the primary beneficiary, which poses the question: Why? Were confidentiality terms initially inserted by management or the certificate purchaser?

20) The problem with this theory is that in Q2, the ABS market was under distress and therefore Carvana did sell any ABS's. Meanwhile, the company was still able to post Gain on Loan Sales of $39.3M.

21) This indicates that even during a time when Carvana could not complete a favorable ABS offering, it was still able to generate significant gains on loan sales. This does not make sense from my perspective. With so much pricing pressure in the open market, it would seem

22) purchasers would be better served buying other offerings rather than paying up for Carvana loans, but that's not exactly what happened. This indicates that Carvana has a very loyal group of investors who are willing to pay up for their assets. Which begs the question: Why?

23) Who are these investors willing to buy these Carvana Loans at a seemingly "premium price" even in the midst of the economic uncertainty? I'm not exactly sure. Through my research, I have not seen any lists provided by the company.

24) From my perspective, this makes Carvana's loan monetization program risky. There is information asymmetry as management knows the certificate holder of the trusts, and maybe the purchasers of their loan products too, but I as an investor do not.

25) Although the "loyal" group of investors that I am speculating exist are willing to pay a premium price today. There is no guarantee that this will continue into the future. In fact, as Carvana continues it's growth, I would expect to see these gains decline on a

26) percentage basis, as Carvana's loan origination book moves closer to the market's overall average. Additionally, when we look at the Gain on Loan Sale for the past 6 quarters they have been relatively flat around $40M, so to a certain extent we may already see this happening

27) As it relates to this group of "loyal" buyers, there is also the possibility that they are simply ahead of the curve. Ernie Garcia III has been instrumental in forming Carvana's credit modeling, and their CFO Mark Jenkins was a UPenn professor specializing in auto credit

28) From this perspective, Carvana may simply be originating better loans for their clients and packaging better securities for their end-purchasers. In my mind, there is some credence to this theory . . .

29) At this point, I'm sure you were all waiting for the accusation of fraud, or related party misdeeds. While possible, I didn't see anything truly eye opening. The only problem I found was with the business model itself.

30) In my opinion, the Gain on Loan sales which bolster GP are not a "forever" thing, or at the very least will shrink as a percentage of revenue as Carvana grows, which could scare investors. Used vehicle GPU has been roughly flat over the past 8 quarters, as well.

31) The sheer amount of loan originations and reliance on financing partners and the securitization market scares me, possibly irrationally. I can easily envision a scenario where a loss-making, cash flow negative business goes under in a poor capital market environment

32) So that's it. Carvana reminds me of like the Countrywide of the auto loans, and I think there is structurally too much risk on the financing side for me.

END) I am not an expert *obviosuly* and this is not financial advice. I'm sure I misunderstood and misinterpreted plenty of things here, so do your own research, and don't take what I just said as fact. I also have no position in Carvana.
Feel free to DM me with all complaints

@LSValue FYI. Confirmed that $CVNA books rev equal to the ABS sales. They also receive all of the cash for the sale once ABS is sold (less 5% retained in the trust for risk purposes)