Discussing Carvana with my short-seller friends; Seeing wildlife in Kenya
Last Thursday, I shared the debate my friend Marcelo Lima and I had about Tesla and Waymo's autonomous driving. I received overwhelmingly positive feedback from readers and shared some of those responses in yesterday's e-mail.
So today, I'd like to share another discussion – one I've been having with my short-seller friends about used-auto retailer Carvana (CVNA).
I wrote about the stock last Friday, officially adding it to my list of "Stinky Six" stocks to avoid. Then I followed up on Monday and Tuesday to review the company's financials and its bull versus bear case, respectively.
My friends have chosen to remain anonymous for various reasons. But, trust me, they're among the smartest analysts and most successful short sellers I know.
One highlighted management's history and massive insider selling:
How could you NOT mention that the founder's father, bankroller, and largest shareholder is a convicted bank fraud felon (see Wikipedia here)?
And isn't it funny how much the corporate insiders love the stock? Not! Here are the insider sales as filed with the U.S. Securities and Exchange Commission and a chart from Capital (the yellow triangles are sales):
These points were covered by Nate Anderson and others' short pitches as well, which I included in Friday's e-mail.
I shared this e-mail from reader Rick V. with my friends:
I have sold two cars to Carvana, both in the $10,000 to $15,000 range, and they offered me $2,000 to $3,000 more than a dealer trade-in or what CarGurus showed them to be worth.
They didn't even inspect them, other than to make sure they can drive them up the ramp.
I would never try to buy a car from them for this same reason: They must have thousands of lemons that couldn't be sold to anyone else.
In response, one of my friends wrote:
Yeah, the bull thesis assumes the profit margin is genuine. For me, the whole long thesis falls apart when (not if) the subprime market slows or stalls. Carvana can absorb losses through its related parties to juice margins to an extent, but cannot absorb the loan book, especially given that they need to show growth in sales (and therefore loans) to keep the party going.
Another friend added:
The comment he makes about how Carvana can "absorb losses through its related parties to juice margins" is a key to this. They disclose all the related-party relationships – it's the DriveTime entity we think they're using to juice sales.
It's fully owned by the Garcias [a major Carvana shareholder] and is private, so they don't care if it isn't making money or is even losing money. With the massive insider selling of billions in stock, they can afford to feed some money into DriveTime to keep the party going.
Another echoed:
I agree, and if CVNA buys a lemon of a car or one they paid too much for, I think they likely sell it to DriveTime in a "wholesale" transaction. DriveTime then sells it and takes a loss or has thin margin on it.
Also, if, say, they make a loan and the borrower misses the first two payments, then I think they likely sell that loan to an affiliated Garcia entity, which then likely takes the loss. The related party disclosures are pretty broad and likely allow them to do nearly anything.
Reader Brent F. had also mentioned DriveTime in this feedback on my Carvana e-mails:
I looked up the auto-lending performance stats from the Federal Reserve on subprime rates, delinquencies, and spread. The guys who are long CVNA are correct: There's not yet much evidence of problems among subprime auto loans... yet.
Moreover, Carvana is only a few percentage points of the subprime auto market, meaning the loan book they are throwing off may not be reflected in broader market.
Carvana's mix of loans is 44% subprime or worse. Just watch their ads via DriveTime – they are totally targeting subprime borrowers. Given Carvana's dependence on securitizing these loans, the weak link is definitely the subprime borrower.
I would say anyone long or short this stock needs to be following the performance and pipeline of subprime auto loans, watching for any weakness.
As Brent continues, investors should look at history as well:
I think the auto-supply squeeze in 2022 to 2023 left a lot of pent-up demand by subprime borrowers who were priced out of the market, so the last two years might be a reflection of that.
Carvana overpaying sellers in order to get inventory shows they are relying on the profits from selling the loans off. And buyers of these securities aren't necessarily aware of the fact that many of the borrowers are buying overpriced vehicles.
So if delinquencies rise in a recession, the loan losses from repossessions could skyrocket and severely curtail buyers for these securities. Divvying up these securities in various tranches works well until it doesn't. It worked great in the mortgage business until it didn't.
History doesn't always repeat, but always rhymes...
I sent my friends this CNBC article: Tricolor executives charged with "systematic fraud" after subprime auto lender roiled banking sector. And I asked them whether Tricolor's bankruptcy was relevant to their short thesis on Carvana.
They had varied responses. One replied:
Maybe, but not necessarily. It shows industry lending standards are awful, but on the flip side it may be viewed as a competitor being off the market or perceived as a one-off fraud.
But another friend disagreed:
We think so. This is a shady industry. We wouldn't ever want to go on record accusing anyone of fraud, but we are hearing that the senior people at Tricolor are in absolute shock that they went bankrupt, yet CVNA trades at $100 billion, given they are all in the same industry playing all the same games.
There are other similar lenders in trouble right now that are privately held and will be going under. With all of CVNA's related parties, it gives them a ton of flexibility to play games. We think Tricolor was definitely doing fraudulent things, but it's hard to quantify how shady CVNA's behavior is.
He continued with a side note about the used-car market:
In a way, used cars can be compared to banks making loans. It is a commoditized product. If one bank is offering a loan at a cheaper price or more favorable terms that others aren't willing to offer, it might look good in the short term but it never ends well.
There is nothing unique about used cars. It is a competitive market, and whether it's Amazon or someone else, competition will always be there. It's just common sense as CVNA hasn't invented the car or financing for it. They are merely a participant in a very competitive industry.
It reminds us of First Republic Bank, which grew like a weed and everyone said, "This is more than just a bank, it is a service/retail company that has revolutionized banking." Well, they grew like a weed and then look what happened: It went bankrupt in a matter of hours.
He concludes:
At the end of the day, Carvana is a subprime lender masquerading as a car dealer. Even if we assume 100% of what they do is on the up and up and there are no shady dealings, there is still no way the stock is worth what it is trading at or has the growth trajectory that everyone thinks it does.
Thank you, my friends, for sharing your insights!
Overall, I think my friends are right that the used-car market is weakening and competition will be fierce. The latest data point is CarMax's (KMX) earnings report this morning, in which the company acknowledged that it's being forced to cut prices to stay competitive. CarMax's stock has been choppy this morning.
Regarding competition, a friend added amid pre-market trading when the stock was down sharply:
Amazon's entrance into this business isn't great for CVNA. I'm surprised KMX is down today, yet CVNA is up. As we saw with the Whole Foods acquisition, when Amazon goes into something, they don't want to be a small player. I could see them even buying KMX, even though they want more of an online footprint.
Needless to say, Carvana remains squarely on my "Stinky Six" list.
Best regards,
Whitney
P.S. I welcome your feedback – send me an e-mail by clicking here.
P.P.S. While Olepangi Farm – where my family and I are staying in Kenya – doesn't have any wildlife, we saw plenty this afternoon only a short drive away at the Lolldaiga Conservancy:
