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Carvana & DriveTime Relationship and Subprime Loan Performance Analysis

The performance of Carvana’s subprime loan portfolio, which represents an estimated ~40% of Carvana’s total loan book, has long been a topic of scrutiny, partly fueled by concerns with its intricate relationship with Bridgecrest, the loan servicer and subsidiary of DriveTime, owned by Ernest Garcia II. 

This connection raises questions about potential conflicts of interest, as Garcia II is the father of Carvana’s founder and CEO, Ernest Garcia III. The overlap between the two entities (Carvana and Bridgecrest) has drawn questions around the extent of the related party transactions, the purchaser of Carvana’s private loan sales, and the underlying commercial relationship between DriveTime and Carvana.

In 2022, we discussed how important subprime loan profitability is for CVNA. Given ~40% of originations are subprime, which are ~50%+ more profitable than prime loans, a significant portion of CVNA gross profit, and therefore group EBIT, is driven from subprime financing.

We've previously explored how there are multiple layers of why CVNA can potentially underwrite subprime loans more effectively than others. CVNA CFO laid out the thesis back in 2018:

In addition to lower costs, the vertically integrated model, we believe, produces better loans. The better loans come from a number of sources. One, we can certify vehicle quality. So we know exactly what cars the customers are buying. They've gone through our 150-point inspection process, our 100-day warranty. That ensures a very high-quality car. Moreover, we operate in a controlled environment, so that reduces adverse selection that can sometimes come from lenders bidding against each other in the traditional indirect model. And the vertically integrated model typically allows for longer-term commitments than dealers are able to achieve in the indirect model, where loans are approved one by one with no long-term commitment underlying it. So in addition to benefits of vertical integration, there's also some significant benefits of the online sales model relative to the brick-and-mortar model. And those come from our lower long-term cost structure, which allows us to provide lower retail sticker prices to the customer, which in turn, provides positive feedback in the lending program through 2 different channels. First, lower retail sticker prices leads to lower monthly payments, everything else equal. And second, lower retail prices leads to lower loan to value ratios, everything else being equal. Both of those facts flow into better loan performance. Now, that is exactly what we are seeing today in our data. - Mark Jenkins, CFO of Carvana, 2018

While it may be possible for CVNA to underwrite higher performing subprime loans, there are a few differences and potential changes worth considering when evaluating CVNA vs peers and the underlying profitability of CVNAs subprime loan book.

This IP Research Analysis shares our learnings from months of studying Carvana's relationship with DT and their partnership in subprime financing. We explore how Bridgecrest services CVNA loans, the cost of servicing, and the net cumulative losses of CVNA subprime loans relative to competitors. We also briefly discuss the recent and historical performance of CVNA ABS issuances as shown in the chart below:

This IP Analysis research goes on to compare LTVs, servicing costs, and credit enhancement of Carvana ABS vs Credit Acceptance, DT, and Exeter. Below is the full contents of the research:

This piece of research can be read alongside our prior work on CVNA financing business:

Howmet Aerospace: Drivers of Operating Margin Improvement

Since Howmet was spun out of Alcoa in 2016, its EBIT margins have increased from ~9% to over 22% today. This interview explores how the company has evolved under John Plant's leadership. One area of focus was on renegotiating contracts with large engine OEM customers:

His view was that capacity was something we could take advantage of, especially in the pre-Covid era when there wasn't enough capacity in the market. I'm specifically referring to aerospace and airfoils, where I have expertise and responsibility. He insisted that we demand a premium from customers. When renegotiating long-term agreements, prices went up with every customer. Previously, customers felt they had the upper hand, expecting suppliers to come up with cost reduction initiatives, leading to price decreases over the long term. Plant flipped that script, insisting that prices go up because we have to allocate capacity for them, and to lock in that capacity, they would pay a premium price. This approach has continued to drive margin improvement. Plant has been there for six years, and every contract negotiation has been approached this way - Former Director at Howmet Aerospace

The interview explores how contracts are typically structured with GE and Rolls, for example:

There are many off-ramps in these agreements. If you ordered too much or didn't provide enough lead time, these factors are negotiated. More time is often spent negotiating terms and conditions, like delivery penalties, than on pricing itself. Companies like PCC and Howmet protect themselves with these off-ramps. However, there are times when Howmet is late and ends up paying several hundred thousand dollars in delivery penalties in a quarter. - Former Director at Howmet Aerospace

The interview also explores how GE brought CPP into the market to offset Howmet and PCC's bargaining power. This can be read alongside various of our previous research covering airfoil and structural investment castings:

Oracle: Gen 2 Cloud Infrastructure

This interview with a Former Director at Oracle explore the history and positioning of Oracle's cloud business relative to AWS, Azure, and GCP:

Oracle decided to design the new Oracle Cloud, called Gen 2, to be different from other cloud platforms by re-architecting everything from the ground up. Other providers, having been around longer, were tied to older architecture and hardware from 20 years ago. Upgrading millions of machines would take years and be costly. For instance, AWS's network cards are quite old, supporting limited bandwidth and computing. This requires a shift of the workload to core compute for faster cycles and upgrades. OCI, by designing from scratch, started with over-provisioned networking to avoid the noisy neighbor problem and used more powerful processors than were available when AWS launched. By the time OCI Gen 2 was developed, data center-class processing power like AMD EPYC and Intel Xeon was available. Another capability they had was providing GPUs. This has become one of the fastest-growing businesses because they were among the earliest and largest customers of NVIDIA before the AI boom. They already had stacks of these computer GPUs available, giving them an advantage on the database side. - Former Director at Oracle Gen 2

Constellation Software, Harris, & Professional Services Techniques

Over 20% of Constellation's revenue is from professional services (PS) including implementation, training, consulting, and other lumpy, typically non-recurring services.

One often overlooked driver of the durability of Constellation's revenue are the techniques used to turn lumpy PS into recurring revenue. This interview walks through techniques Harris uses to improve PS revenue and the challenges in allocating responsibilities and setting targets across PS, customer support, and engineering teams.

For example, assume an on-premise contract with 50% license fee, 50% services, and an 18% maintenance fee. How much revenue is assigned to the PS team to ensure it can meet its profitability target? CSU uses a process called 'bucketing':

Across Harris, once the contract is in place, our finance representative, like the chief financial person for Harris Computer, would review and reallocate some funds to professional services fees or license fees based on the project scope. This is called bucketing. If you had a million dollars in each bucket and determined more implementation costs warrant more funds towards professional services, then we move it to professional services. This is relevant because it dictates how much revenue I have to work with. As the leader of PS, if I underestimate the hours needed to implement a project, my financials will be inaccurate. We use accrual-based accounting, so we only recognize revenue when we do the work. The rate at which we recognize revenue per hour is based on the front-end bucketing process. - Former VP at Harris, Constellation Software

The interview goes on to explore how Harris' government software business operates and how it buckets revenue into cost items to ensure the company drives profitability across each internal team. This can be read alongside other CSU and VMS acquirer research:

Wayfair: Internal Technology Challenges

A former Head of Transportation Execution Tech at Wayfair shares the challenges the company is facing while migrating its legacy monolithic systems to a microservices one and provides inside into the technology culture at the business.

It's a very patched-up system. If someone tries to decouple or detach the system, something would break. So everybody is scared to take that risk. Nobody wants to be the person who might be the fall guy. It's very slow and cautious, and I think it could have been more efficient - Former Head of Execution Tech at Wayfair