Carvana's Financial Engineering: A House of Cards in the Auto Retail Sector?

Carvana (CVNA) has long been a poster child for disruption in the automotive industry, pioneering the “no-haggle, online-first” car-buying experience. Yet beneath its glossy veneer of growth lurks a precarious financial structure, propped up by declining third-party financing, opaque related-party transactions, and a deteriorating subprime lending environment. This article dissects the red flags in Carvana's financial engineering and questions whether its recent earnings improvements are anything more than a temporary illusion.

The Decline of Third-Party Financing: Ally's Exit and the Rise of the “Mystery Buyer”

Carvana's business model relies on a critical financial engine: selling auto loans to third-party investors to free up capital for new inventory. Historically, Ally Financial (ALLY) was its largest buyer, purchasing 60% of Carvana's originations in 2023 ($3.6 billion). By mid-2024, however, Ally's share had plummeted to 35% ($2.15 billion year-to-date through September), as the lender scaled back purchases due to Carvana's subprime delinquency crisis.

To fill the void, Carvana turned to a mysterious “unrelated third party” that purchased $800 million in loans between Q2 and Q3 2024. This buyer accounted for 16-18% of total loan sales during this period. However, lien filings and regulatory red flags suggest this entity is likely a related-party vehicle tied to Cerberus Capital Management, where Carvana's director, Dan Quayle, serves as Chairman of Global Investments. This raises suspicions of shell-game accounting, where related-party transactions are disguised as third-party deals to inflate revenue.

Related-Party Transactions: A Web of Conflicts

Carvana's ties to DriveTime, a private car dealership run by CEO Ernie Garcia's father, Ernest Garcia II, are central to its financial sleight of hand. Here's how the incestuous relationship distorts reported earnings:

1. Warranty Income Manipulation:
   Carvana dumps unreported costs of extended warranties onto DriveTime, inflating its warranty income by an estimated 58%. Former executives describe reimbursements as “pretty generous” to boost reported revenue.

2. Inventory Offloading:
   Carvana sold $105 million in wholesale revenue to DriveTime over three fiscal years. This practice avoids writing down inventory values, masking the true cost of its bloated used-car stockpile.

3. Profit-Sharing Schemes:
   In 2023, $138 million of “other revenue” (8.4% of gross profit) stemmed from DriveTime-related deals, including commissions and profit-sharing. A former director called these agreements a “lever” to inflate earnings, noting they were kept secret to avoid scrutiny (“Fight Club”-style).

4. Loan Servicing Conflicts:
   DriveTime acts as Carvana's loan servicer, enabling it to grant loan extensions to borrowers—a practice that delays recognizing delinquencies. Extensions for Carvana loans doubled in 2024, while peer servicers saw declines, raising questions about artificially inflated performance metrics.

Industry Headwinds: Subprime Loans and a Credit Crunch

Carvana's reliance on subprime borrowers is its Achilles' heel. Over 80% of its non-prime asset-backed securities (ABS) deals involve “deep subprime” borrowers with FICO scores below 600. The fallout is stark:

• Delinquency Rates: Carvana's prime borrowers have 60-day delinquency rates 4x higher than industry averages. Among subprime loans issued since 2022, 44% are underwater, and 80% of its ABS deals have FICO scores in the riskiest tier.

• Used Car Prices: A collapsing used-car market exacerbates losses. Carvana's inventory turnover has slowed, leaving it with a $553 million loan portfolio on its books—a 50% increase since 2021.

• Interest Rate Pressure: With $4.8 billion in net debt and a junk bond rating (B-), Carvana faces $215 million in annual interest payments starting in February 2025. Rising defaults could trigger liquidity crises.

Accounting Tricks and Regulatory Risks

Carvana's financial statements are a masterclass in creative accounting:

• Gain on Loan Sales: Over the past 9 months, $541 million in gains from loan sales accounted for 26% of gross profit and 2.2x net income. This metric is volatile and entirely dependent on third-party buyers—making it a shaky foundation for profitability.

• Off-Balance-Sheet Risks: Carvana claims it doesn't hold credit risk, but its growing loan portfolio (up 50% since 2021) suggests otherwise. The company uses “originate-to-sell” accounting to defer loss reserves, inflating asset values.

• SEC Scrutiny: An undisclosed SEC investigation looms, per Disclosure Insight. Meanwhile, Carvana's auditor, Grant Thornton, has ties to DriveTime and has a history of missing fraud (e.g., Wirecard).

Investment Implications: A Short-Seller's Paradise?

Carvana's recent earnings “improvements” hinge on three pillars that are all in retreat:

1. Third-Party Financing: Ally's commitment expires in January 2025, and the “mystery buyer” may not qualify as a reliable partner. If financing dries up, Carvana's liquidity could collapse.

2. Related-Party Deals: The SEC's focus on related-party transactions and conflicts of interest could force Carvana to unwind opaque revenue streams, eroding reported profits.

3. Subprime Crisis: A 2008-style reckoning for subprime auto loans could trigger defaults that overwhelm its balance sheet.

Investment Thesis: Carvana's model is a house of cards. Short sellers should take note: the stock is a leveraged play on an industry in crisis, with deteriorating fundamentals and regulatory risks. Long-term investors should steer clear until Carvana diversifies its financing, cleans up its accounting, and demonstrates sustainable underwriting standards—a tall order for a company so deeply entrenched in its own web of conflicts.

Final Verdict: Carvana's earnings gains are built on sand. With solvency risks mounting and accounting red flags blazing, this is a stock to avoid unless you're betting on a short-term bounce from desperate liquidity maneuvers. For now, the wheels are coming off.