Let’s just get right to it: We believe there are flashing red warnings signs that the bad actors involved with Carvana are “at it again.” We believe SEC correspondence and subtle changes management made to its registration statements demonstrates an unequivocally clear intent to mislead investors regarding the company’s most important near-term metric: Gross Profit per Unit (“GPU”). We believe Carvana has misrepresented its GPU by between 24% - 44%.
We have been working on Carvana since its IPO, but we were beaten to the punch – or at least the first punch. Less than two weeks ago, Pluto Research distributed an in-depth report, titled, “Carvana: Looking Under The Hood.” While Pluto’s report received limited distribution or coverage, we believe it did an excellent job identifying some of the inconsistencies in Carvana’s business model, strategic roadmap, and financial metrics. We would strongly encourage any of the “growth” or “story-oriented” investors enamored by Carvana’s “disruptive TAM” balderdash to carefully read Pluto’s report.
One area that escaped detailed scrutiny from Pluto’s research is the pair of felons who are integrally intertwined in the Carvana story and economic model. While there will be a time and place to discuss how history may be rhyming with Ernie Garcia II and Raymond Fidel’s involvement with Carvana, we will simply point out for now that both individuals previously pled guilty to fraud (securities fraud for Mr. Fidel and bank fraud for Mr. Garcia). Mr. Garcia’s criminal scheme may be particularly relevant to consider, which was described as the “type of white-collar scheme--using 'straw borrowers'… designed to conceal the true nature of the financial transactions involved.” (Emphasis ours)
The felonious histories of Messrs. Fidel and Garcia II, and their closely knit association with Carvana, in no way means Carvana, or its management team, must automatically be painted with the same brush. However, we believe there are blatant signs of bad behavior and misrepresentation, which reminds us of the age-old adage, “You are the Company you keep.”
We will defer our analysis of Carvana’s circumspect business model and inferior competitive dynamics – including its structural sourcing disadvantage, asinine assumptions that underpin its financial targets, related-party relationships, inexplicable tax receivable agreement calculation that redirects $900 million from unaffiliated shareholders to insiders, extraordinary cash burn ($280 million in 2016 and $104 million YTD), self-dealing (DriveTime, Mark Walters and Delaware Life), and several other shenanigans - to a later date.
For now, we will simply focus on why we believe Carvana is methodically overstating its most important near-term metric, GPU.
Weeding through the banker’s pitch books, sell-side hoopla, and promotional story, Carvana’s business model is rather straightforward – the company buys used cars at auction, reconditions them, and sells these cars to consumers over the Internet nationwide. When a consumer purchases a car, Carvana will either deliver that car “straight to your driveway” or the purchaser can pick up the car from a Carvana Vending Machine. Importantly, Carvana will even subsidize $200 in airfare for the purchaser to fly-in and pick up the car (as seen below). Seemingly straight forward stuff.
Carvana has delivered vehicles to customers in 48 states and clearly says in its August 16th, 2017, press release that the company provides “free, as-soon-as-next-day delivery to residents in 35 markets.” Considering customers can either pick up their car in person (inclusive of a $200 airfare voucher) or have the car delivered by Carvana for “free,” it would seem indisputable that car delivery fulfillment is an economic cost of revenue.
However, we believe Carvana has meticulously hidden this fulfillment cost below the gross profit line, thus materially overstating its economic GPU metric.
In its SEC filings, Carvana defines cost of sales to include, “costs incurred to transport the vehicles from the point of acquisition to the IRC [Inspection and Reconditioning Center].”
Source: Carvana 10Q
So while Carvana clearly includes the cost of transporting a vehicle from the point of acquisition to its IRC, it oddly makes no mention of the cost to transport the vehicle from its IRC to its end customer or vending machine (nor does it make any mention of its $200 airfare voucher).
We believe Carvana shifted the transportation fulfillment cost of a car sale below the GPU line into SG&A (Logistics), which has the explicit impact of materially overstating the Company’s economic GPU.
Source: Carvana 10Q
Based on ASC 605-45-50-2 guidelines, the classification of shipping costs incurred by a seller is an accounting policy decision. However, according to the SEC, “If an entity elects to present shipping and handling costs outside of cost of sales and the amount is significant, the entity should disclose both the amount and line item on the income statement that includes the amount.”. Assuming a customer takes control of the car after delivery, and delivery was an integral aspect of selling a car, it would seem beyond debate that Carvana’s shipping and transportation costs are fulfillment costs. Because we believe Cravana does not include these fulfillment costs in COGS, GPU is fundamentally overstated.
Regardless of the accounting classification, we believe Carvana’s management team, or somebody close to the management team, was acutely aware of this peculiar reporting structure, and the company appears to have gone to great lengths to limit its disclosure.
You see, we may be the first entity to publicly “cry foul,” regarding Carvana’s shipping fulfillment shenanigans, but the United States Securities and Exchange Commission previously highlighted this exact issue in a comment letter to Carvana. In correspondence with Carvana, which was formally disclosed on 5/25/17, the SEC requested the Company disclose its outbound shipping costs if considered “significant”:
A response letter from Carvana’s attorneys at Kirkland & Ellis to the SEC, dated February 28, 2017, seemed to explicitly confirm these outbound shipping costs are “significant” by agreeing to disclose these expenses in the company’s Prospectus – “In response to the Staff’s comment, the Company has disclosed the amount of outbound shipping and handling costs on page F-16 of the Prospectus.” Unfortunately, it appears the company pulled a switcheroo, as the updated prospectus only included “third party” costs associated with shipments. As is stated in Carvana’s prospectus, we believe the vast majority of the company’s deliveries are by its own employees, and in its own delivery trucks – “In markets where we have launched operations, delivery to the customer is completed by a Carvana employee in a branded delivery truck.” Thus, Carvana’s updated disclosure conspicuously eliminated the vast majority of the company’s delivery expenses.
After the SEC specifically asked the company to disclose shipping fulfillment costs, and Carvana agreed to disclose this metric in a response letter to the SEC, but instead disclosed only a small portion of the expense by changing its composition, the company then proceeded to pull the disclosure entirely from its future filings! Since Carvana’s final prospectus, which was filed on April 28, 2017, the company has inexplicably removed any expense disclosure related to not only the third party transportation fees, but all delivery transportation fees. We believe that not only is Carvana hiding material costs of fulfillment in the SG&A line that the SEC requested the company disclose, but Carvana is now hiding the actual expenses altogether.
In a twist of irony, Carvana’s very own auditor, Grant Thornton, specifically opined in a white paper titled Insights on Revenue Recognition that shipping costs should be disclosed if classified outside of COGS.
Make no mistake, Carvana’s shipping fulfillment costs to customers are a significant and an integral part of the business model (they have no traditional dealerships)… yet these material cost of sales are excluded from GPU and surreptitiously not even disclosed as a component of SG&A. Moreover, the Company appears to be defying the SEC’s basic request for disclosure.
We can understand why Carvana has gone to such great lengths to misrepresent the components of economic GPU. If we include logistics expenses, which are reported in SG&A, as a proxy for transportation and fulfillment expenses, we find Carvana is overstating GPU by an incredible 24 to 44%!
So Carvana, let’s get this straight – the SEC specifically highlights in a letter to you (presumably because it is concerned) that outbound shipping and handling costs are included in your SG&A. The SEC then asks you to disclose this amount if it is considered significant. Your lawyers respond to the SEC stating you will include the amount in your disclosures (again, presumably because it is deemed significant). However, the disclosure is then altered to only report a small subset of the total costs (i.e. third party fees rather than total shipping and handling fees). Finally, after reporting the metric just once in your final Prospectus (again, because it was presumably considered significant), you then completely remove the metric from your future filings, despite the fact your own auditor publicly opined that such costs should be disclosed. Does this really smell like an above board, well intentioned, don’t-paint-me-with-the-same-fraud-brush-as-our-controlling-shareholder situation? What are we missing?
More to come....
Disclosure: I am/we are short CVNA.