Carvana's Subprime Receivable Problem

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About: Carvana Co. (CVNA)
by: Advantage Investor
Summary

We found a buyer of Carvana subprime receivables, and it has numerous connections to an insider at the company.

Evidence indicates the buyer is massively overpaying for the receivables and thus inflating gross and operating profit at Carvana.

Management messaging on this topic has been misleading and raises concerns regarding credibility.

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Something unique is happening at Carvana (CVNA). Somehow, Carvana sells subprime auto receivables - loans made to low-credit-quality customers in order for them to buy a car - for a profit. This is unique because every used auto retailer we spoke with pays a financing company to take its subprime receivables, whereas Carvana actually gets paid for them. Indeed, sophisticated companies like Carmax (KMX), which has its own captive financing unit and has been in business for 20 years, pays lenders to take its receivables.

Unfortunately, Carvana is not disclosing the entity buying its receivables, so we lack context. What if that entity has motivations other than just making a profit? What if that entity is connected to an insider at Carvana and, as a result, is knowingly overpaying Carvana for those receivables, thereby inflating gross and operating profit? Apparently enough people were inquiring that Carvana voluntarily released an investor FAQ that purports to addresses some of the questions.

The crux of the above FAQ: the only related party that has purchased Carvana’s receivables historically is Delaware Life Insurance Company (“Delaware Life”). Delaware Life is a related party and was disclosed as one because Mark Walter, an early Carvana investor and company insider, also has a substantial ownership interest in it (see page 28 of proxy statement). However, Delaware Life subsequently sold its interests and neither the entity that bought Delaware Life’s notes nor the current certificate holder is a related party to Mark Walter. Therefore, Carvana is not legally required to disclose the identity of the purchaser((s)) under the technical disclosure requirements. Moreover, the company has voluntarily entered into contractual arrangements that purportedly prevent it from disclosing who the purchaser((s)) is even if they wanted to.

Despite the company’s assurances, we wanted to understand exactly how truly unrelated the current purchaser((s)) is. Our approach to determine the buyer was simplistic: if an entity is overpaying Carvana for receivables, it probably had or has some connection to Mark Walter but isn’t technically a “related party” per the company’s FAQ statement. Why did we think the entity would be connected to Mark Walter? Well, self-dealing is an accusation that follows him around, so we searched for fire where there is a lot of smoke. Indeed, Guggenheim, the asset management firm for which Mark Walter currently serves as CEO, has acknowledged in its regulatory filings that it invests in companies in which affiliates have interests (see page 11).

We started searching for companies associated with Mark Walter, albeit not “related” to him from a legal perspective. The easiest and obvious place to start were entities formerly owned by Guggenheim. Based on that criterion, we found EquiTrust Life Insurance Company and Security Benefit Life Insurance Company, two life insurance companies previously owned by Guggenheim. We eliminated Security Benefit Life because Walter serves on the board and, thus, a transaction between Carvana and Security Benefit Life would need to be disclosed as a related party transaction. That left us with EquiTrust Life Insurance. Here is what we found in EquiTrust’s Annual Statement for the year ended December 31, 2017. This information is provided by the National Association of Insurance Commissioners here. (Note that the author is not claiming that the NAIC or any other organization has sponsored or endorsed the use of any copyrighted information in this article.)

Below I have enlarged and focused on the relevant line for readability.

Again, I have focused on the relevant lines for clarity.

In Schedule BA you see something called CAIH LLC. That appears to be the name of the Sonoran Trust which houses Carvana’s subprime receivables. It was in the Carvana Q3 2017 Form 10-Q.

We also noticed that EquiTrust owns some Carvana equity according to Schedule D.

The mystery is partially solved! It appears that the LLC associated with the Sonoran Trust that houses subprime receivables was, at least in part, purchased by EquiTrust.

But, does EquiTrust have any connection to Mark Walter aside from being previously owned by Guggenheim? It sure does. Guggenheim sold EquiTrust in 2015 to Mark Walter’s friend Magic Johnson with whom he currently owns the Los Angeles Dodgers and L.A. Sparks. Furthermore, in an article discussing the purchase of EquiTrust, we find out:

Under MJE's ownership, Guggenheim will continue to manage money for EquiTrust, MJE said. Miller said the company's management team will remain the same under the new ownership and that day-to-day operations ‘will remain largely unchanged.’" [emphasis added]

While EquiTrust may no longer be “related” to Mark Walter under hyper technical SEC disclosure regulations, EquiTrust is formerly owned by the company Walter is CEO of, sold to one of Walter’s friends and current business partners, and according to articles, Guggenheim continued to advise EquiTrust on its investments post sale. If Carvana wanted a closely connected entity that Walter could influence, but one that was technically unrelated for disclosure purposes, it couldn’t have chosen better than EquiTrust.

Rather than providing transparency on these connections, the company has ((a)) referenced the technical definition of a related party and ((b)) cited contractual provisions that require confidentiality of the purchaser’s identity. Keep in mind that contractual provisions are negotiated and voluntarily entered into. Additionally, we question what purpose a confidentiality requirement serves where EquiTrust is regulatorily required to disclose its holdings in detail in its Annual Report. It certainly makes it tougher for investors to learn of the relationship.

Given the fact pattern, we find too many coincidences and extraordinary results to believe Carvana is getting a true market rate for its subprime receivables.

Extraordinary result: Carvana gets paid for subprime receivables.

Subprime auto lenders don’t pay for subprime receivables, they get paid, sometimes thousands of dollars per loan, for taking them. If it were possible to find an entity to pay for subprime used auto loans, wouldn’t Carmax jump at the chance? Conversely, wouldn’t the “unrelated” party buying Carvana loans, EquiTrust, want to purchase some of the Carmax receivables? Where has EquiTrust been for the last 20 years while Carmax has been paying out hundreds or even $1,000 a loan to get a finance company to take its subprime loans?

Coincidence: All identified entities buying subprime receivables are connected to Mark Walter.

The only entities we are aware of buying Carvana’s subprime receivables are Delaware Life, which is a disclosed related party since Mark Walter has a substantial ownership interest, and EquiTrust, which has all sorts of connections to Mark Walter. Is it a requirement to be involved in the purchase of the LA Dodgers to buy subprime receivables from Carvana? Where are all of the other entities buying up these great subprime receivables from Carvana?

Coincidence: Mark Walter has been publicly accused of just the sort of self-dealing that may be going on here.

In November 2017, the Financial Times ran a feature article on Guggenheim and Walter and stated in a relevant part:

The deals saw the $240bn Wall Street asset manager invest at least $1bn of client money in companies where Guggenheim’s top officers and biggest shareholders had personal ties, transactions that were in some cases red flagged by the firm’s own compliance department for a lack of due diligence. … Internally, we were told from people working for the top managers stuff like: ‘Hey, this is a Mark Walter transaction’, or ‘This is a Scott Minerd transaction’, which basically meant don’t ask too many questions and just approve the deal,” says a former senior employee who used to handle conflicts. “We just had to take the boss’s word… That wasn’t the case for other standard transactions.”

Does investing client money in a company where Guggenheim management had personal ties sound familiar? To my ear, it sounds very similar to EquiTrust, a Mark Walter connected entity, investing in Carvana receivables, a company in which Walter has a personal financial stake.

For another example see what Andrew Ross Sorkin wrote in The New York Times's Dealbook:

Mr. Walter, along with his colleague Todd Boehly, Guggenheim’s president, appear to be living out a childhood fantasy using other people’s money, some of whom may not even realize it…Using insurance money — which is typically supposed to be invested in simple, safe assets — to buy a baseball team…

Yet again, using other people’s insurance money, ahem EquiTrust, to invest in personal projects is coincidentally similar to what appears to be happening at Carvana.

Coincidence: Carvana’s controlling shareholder, financer, and the founder’s father, Ernie Garcia II, was convicted of bank fraud.

You’ll never guess the description of his prior criminal conduct.

"This type of white-collar scheme--using 'straw borrowers'--is of particular concern because it is designed to conceal the true nature of the financial transactions involved," said U.S. Atty. Gen. Dick Thornburgh in a prepared statement from Washington. [emphasis added]

Similarly, EquiTrust buying Carvana receivables conceals the buyer’s close connection to Carvana because it isn’t disclosed by Carvana, and we believe conceals the true economics of the receivables.

Perhaps the most concerning aspect of this entire revelation has been management’s lack of frankness. As seen above in the FAQ document, Carvana repeatedly cites the “unrelatedness” of the buyers to any insider at the company, especially Mark Walter. In the words of Shakespeare: “The lady doth protest too much, methinks.” Carvana also acknowledges in the FAQ that colleagues of Mark Walter made the introduction. The reality is that the owner of the entity is a friend and business partner, and the company Walter is CEO of formerly owned the entity and might still advise it on investments. An “introduction” by colleagues doesn’t exactly capture the true nature of the relationship.

The truth of the matter is that substantial evidence points to Carvana getting overpaid for its receivables while management consistently has said the opposite. Rather than cautioning investors that Walter might run out of friends willing to overpay for Carvana subprime receivables, management doubled down and pitched financing opportunities at the analyst day as the largest opportunity for growth in gross profit per unit (see page 54 of slide deck). In this case, rather than rely on management’s promotional analyst day commentary, the company’s risk factor disclosures, buried in its Form 10-K, highlight the true downside risk of the current receivables arrangement:

Our ability to sell automotive finance receivables and generate gains on sales of these finance receivables may decline in the future; any material reduction could harm our business, results of operations and financial condition... Any material reduction in our interest rate spread or gains on sale of finance receivables could have a material adverse effect on our business, results of operations and financial condition.

Carvana is growing like a weed, customers like it, and it might have better long-term economics than traditional dealerships. At this stage though, earnings are negative, it bleeds cash, and there is tremendous execution risk. Consequently, the investor base needs to rely, to some extent, on management explaining what is going on behind the financials. Investors rely on management’s assertion that it isn’t getting preferential prices on shared services with DriveTime, a related company. Investors rely on management to assign costs to COGS and OPEX in a manner that doesn’t misrepresent gross profit. Investors rely on management to characterize the source of financing appropriately. If this is what we find when we are lucky enough to have public documents to fact check their messaging on financing, what is going on in more opaque parts of their business? Rather than minimize and misrepresent relationships, make investors scour insurance filings to get information, and frame a major risk as its biggest opportunity, Carvana needs be fully transparent before it loses its most important asset - management credibility.

Author's note: Earlier this week, I contacted Carvana with some of my findings and allegations and asked the company to respond. At the time of publishing, I have received no response from the company.

Disclosure: I am/we are short CVNA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Disclaimer: The author works at an investment firm that manages one or more investment vehicles that currently maintain investment positions in the common stock of Carvana Co. and CarMax, Inc. that will profit if the price of the common stock of those companies decline. We may change our views about our investment positions in these stocks, for any reason or no reason, and at any time may change the size, form or substance of our investment position in these stocks including within the first several days of the publication of this article, without notice to you. The information and opinions contained herein are the result of extensive research into the used car industry. Although we believe the statements contained herein are substantially accurate in all material respects, these companies and others may dispute the accuracy of them. We make no representation or warrant as to the accuracy or completeness of these statements, and expressly disclaim any liability relating to them. The statements herein are not investment advice or a recommendation or solicitation to buy or sell any securities. The shareholders of these companies and other investors should conduct their own independent research.