$CVNA: Gain-on-sale accounting of Auto Finance Receivables (AFRs) boosts Carvana’s income statement | Dec 2019

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Re: $CVNA Gain-on-sale Accounting of Auto Finance Receivables (“AFRs”)

As @paul_m_Huettner previously pointed out, fully half of $CVNA‘s total gross profit for the three and nine months ended 9/30 came from the ‘Other Sales & revenue’ line item:https://t.co/bKDymcYVBu

— Investor Gator 🐊 (@GatorInvestor) November 30, 2019

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What comprises the ‘Other sales and revenue’ line item?

It “…includes gains on the sales of automotive finance receivables… sales commission on VSCs and sales of GAP waiver coverage”.

— Investor Gator 🐊 (@GatorInvestor) November 30, 2019

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This thread focuses on the first and largest of those three components, the gain on sale from the AFRs, which made up $99.4mm of the $177.2 category total for the 9 months ended 9/30. pic.twitter.com/KGZnQ9ye52

— Investor Gator 🐊 (@GatorInvestor) November 30, 2019

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Here's the punchline upfront: for the purposes of the income statement and therefore reported gross profit, operating profit, [EBITDA] and net income, it's a *non-cash* number.

— Investor Gator 🐊 (@GatorInvestor) November 30, 2019

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So just this one line item, gain on sale of AFRs, created $99.4mm of non-cash revenue which flowed directly through to total reported gross profit of $363.9mm [$99.4mm/$363.9mm = 27.3%]. pic.twitter.com/SDHck8ui68

— Investor Gator 🐊 (@GatorInvestor) November 30, 2019

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CREATION OF AFRs

When $CVNA sells a car, upwards of two-thirds of its customers take financing directly from $CVNA. The installment loan created as a result of this financing is called an automotive finance receivable, or AFR.

— Investor Gator 🐊 (@GatorInvestor) November 30, 2019

7/$CVNA's business model depends on selling these AFRs to other parties and so the AFRs are classified as 'for sale' assets on the company's balance sheet. AFRs on the balance sheet are recorded at the lower of unpaid principal balance or fair value. Fair value is a black box.

— Investor Gator 🐊 (@GatorInvestor) November 30, 2019

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From the company's filings:
"To determine the fair value of finance receivables we utilize industry-standard modeling, such as discounted cash flow analysis, factoring in our historical experience, the credit quality of the underlying receivables, loss trends and

— Investor Gator 🐊 (@GatorInvestor) November 30, 2019

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recovery rates, as well as the overall economic environment." I was not able to find any supporting detail or assumptions for the fair value calculation.

GAIN-ON-SALE ACCOUNTING OF AFRs

Eventually $CVNA sells the AFRs off its balance sheet. The gain or loss from the sale of

— Investor Gator 🐊 (@GatorInvestor) November 30, 2019

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the AFRs is "…an amount equal to the net proceeds received less the carrying amount of the finance receivable." Looking at the cash flow statement, we can see $CVNA reports the *total* proceeds received from AFR sales, including any gain or loss, in operating cash flow,

— Investor Gator 🐊 (@GatorInvestor) November 30, 2019

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annotated as item [3] in the screenshot.

The potentially confusing step created by gain-on-sale accounting is that $CVNA, in the event of a gain, then takes the amount of the proceeds received in excess of carrying value and creates a new entry on the income statement in the pic.twitter.com/EE6tppv5Df

— Investor Gator 🐊 (@GatorInvestor) November 30, 2019

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'Other sales and revenue' account. See screenshot in tweet 5.
Because this other revenue flows through to net income, ignoring tax effects for now, it is now double counted on the cash flow statement because the *total* cash received for the AFR sales, including the gain, was

— Investor Gator 🐊 (@GatorInvestor) November 30, 2019

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already recorded in cash flow from operations. Thus, the gain-on-sale/other sales and revenue amount must be backed out of operating cash flows, annotated as item [2] below: pic.twitter.com/cwttHqM8qe

— Investor Gator 🐊 (@GatorInvestor) November 30, 2019

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The entire amount of gain-on-sale revenue appearing on the income statement is non-cash and it is a significant portion of the company's total reported gross profit for the nine months through 9/30 at over 27%. Furthermore, its amount and timing seems highly influenced by

— Investor Gator 🐊 (@GatorInvestor) November 30, 2019

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management's assumptions given the black box valuation of fair value. These factors clearly have the potential to affect the quality of reported earnings.

As a counterpoint, it's important to note that the gain-on-sale is ultimately a cash source for the company.

— Investor Gator 🐊 (@GatorInvestor) November 30, 2019

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My takeaway is that the income statement for $CVNA is far less important than the cash flow statement. Particularly true give that reported gross profit per unit is a highly touted metric by management.

h/t: @paper_portfolio

— Investor Gator 🐊 (@GatorInvestor) November 30, 2019