Earnings Call Transcript - CVNA Q1 2020

Operator, Operator

Good day, and welcome to the Carvana First Quarter 2020 Earnings Call. All participants will be in a listen-only mode. After today’s presentation, there will be an opportunity to ask questions. Please note, today’s event is being recorded. I would now like to turn the conference over to Mike Levin, Vice President of Investor Relations. Please proceed.

Mike Levin, Vice President of Investor Relations

Thank you, Eric. Good afternoon, ladies and gentlemen, and thank you for joining us on Carvana's first quarter earnings conference call. Please note that this call will simultaneously be webcast on the Investor Relations section of the company's corporate website. The first quarter shareholder letter is also posted on the IR website. Joining me on the call today are Ernie Garcia, Chief Executive Officer, and Mark Jenkins, Chief Financial Officer. Before we start, I would like to remind you that the following discussion contains forward-looking statements within the meaning of the federal securities laws, including, but not limited to, Carvana's market opportunities and future financial results that involve risks and uncertainties that may cause actual results to differ materially from those discussed here. A detailed discussion of the material factors that cause actual results to differ from forward-looking statements can be found in the Risk Factors section of Carvana's most recent Form 10-K and Form 10-Q. The forward-looking statements and risks in this conference call are based on current expectations as of today, and Carvana assumes no obligation to update or revise them. Unless otherwise noted on today's call, all comparisons are on a year-over-year basis. Our commentary today will include non-GAAP financial measures. Historically, we’ve used the non-GAAP measure ex-Gift, which excludes the impact of the 100,000 milestone gift to our employees, but beginning this quarter that program has concluded. And so, any metrics for this quarter referenced on the call today will be inclusive of the 100,000 milestone gift. You can find the 100,000 milestone gift impacts called out in our reported financials. Reconciliations between GAAP and non-GAAP metrics for our reported results can be found in our shareholder letter issued today, a copy of which can be found on our Investor Relations website. And now with that said, I'd like to turn the call over to Ernie Garcia. Ernie?

Ernie Garcia, CEO

Thank you, Mike, and thanks everyone for joining the call. This has been a quarter unlike any we faced as a company. The onset of the pandemic has led to unprecedented changes in our health and behavior, which in turn has significant and currently unquantifiable impact in the economy. Accordingly, we will spend less time than we normally would discussing the specifics of the quarter. I will briefly hit on where we sit today and then spend more time discussing the ways we've reacted so far and the ways we are thinking about and planning for the future. We began to see significant reductions in demand in the back half of March with a sales trough in early April at approximately 30% reduction in sales year-over-year. From there, we have consistently improved week after week with sales in the most recent weeks being up about 20% to 30% year-over-year. It is difficult to get clear visibility into exactly how the industry performed over the last several weeks, but every indication is that Carvana has outperformed the industry quite significantly and grown our market share accordingly over this period. We believe part of this outperformance has been driven by transitory factors and that part of it has been driven by customer preference changes due to the pandemic. We don't yet know how precise these customer preference changes will be, but we are optimistic. Through a medium-term lens, we believe customer behavior shifts are likely to accelerate our progress. Now, let's turn to how we've reacted so far. In early March, it became clear that we were dealing with a very significant event. At that time, we determined that we were fighting a battle on two fronts: health and financial health. Our first priority is the health front, keeping our team and our customers safe. Along those lines, we have enacted work from home for corporate and customer care teams, have reconfigured our inspection centers and field locations to support social distancing, adopted CDC guidance, and implemented a touchless delivery experience for our customers. The second front is the financial health front. Here we've had three primary goals: to align expenses with this new environment, to manage our risks and uncertainties thoughtfully, and to ensure we preserve and continue to progress in those areas that are most important to our long-term success. We came into the pandemic expecting our biggest absolute unit growth year yet, with the business positioned to deliver on those goals. The demand shock we started to see in mid-March has necessitated some significant and difficult changes. To align expenses with the new environment, we eliminated overtime and travel budgets, reduced hours, and paused hiring. Another important component of our strategy for managing through this has been to carefully manage our risks and uncertainties. We view the most important areas of uncertainty during this period to be industry demand levels, the credit and capital market environment, and inventory values. In an effort to manage demand uncertainty, we moved quickly on expense management, rolled out new commercials tailored to this environment, implemented a 90-day payment deferment promotion for our customers, and designed our expense reduction initiatives to be impactful while easily reversible to enable us to adapt to different demand scenarios. We've also been active in managing our credit and capital markets risk. In late March, we tightened credit significantly on the loans generated on our platform. Additionally, we upsized our forward flow purchase agreement with Ally to $2 billion and broadened the set of customers covered under the agreement, and we completed a $600 million common stock offering to fortify our balance sheet. We view inventory values as another area that we want to manage purposefully. We ceased all purchases except for customer trade-ins in late March, which, in combination with our outperformance and sales relative to the industry, have reduced our total inventory by about 30% in just five weeks since the quarter ended. This significantly reduces our exposure to inventory purchased prior to the pandemic. As we bring down expenses and manage our risks, we are also continuing to extend our leadership in the areas that are most important to our long-term success. The single most important area is the quality of our customer experiences. Our customer experiences have three primary drivers: our culture, our technology, and our supply chain. We are continuing to invest in our technology to make buying a car even easier, more fun, and safe for our customers. This in turn enables a different and more efficient supply chain than has traditionally existed in automotive retail. We're also continuing to fill our real estate pipeline while holding off on growth CapEx, so we are prepared to return to rapid growth when the time is right. Culture is at the top of the list of drivers of our long-term success for a reason. Everything we do, all the things that come together to deliver incredible customer experiences are done by our people. People in the relationships and processes that connect them are the fundamental parts of any business. An environment like this is a test for any culture. You learn more about people and more about a culture during these moments of intense pressure. Before I tell you what we've learned so far, I want to share what we hope. In mid-March, we set a goal that we would come out of this stronger. We hoped that our entire team across the country would look back on this time as a period that we came together. To achieve this, we decided to use our values, particularly our value that we're all in this together, as the lens for making tough decisions. We entered the pandemic positioned for tremendous growth, but aligning expenses with this environment was difficult. The only way we could achieve it was to significantly reduce hours for thousands of employees across the company, which was undoubtedly the hardest and most painful decision any member of our management team has ever had to make. It's an unfortunate reality, but the right decision for Carvana was to reduce the hours of the operators that work so hard every day to deliver the customer experiences that define us. That reality did not align with our value of being in this together. So, we set up a fund where employees could voluntarily contribute a portion of their salaries to offset lost wages for those lost hours. We had hundreds of employees, including the board of directors and the executive team, contribute 100% of their salaries. I think there is no clearer expression of our culture than this. In fact, many contributions came from people who lost hours themselves but who knew others needed a hand more than they did. When you think about that, in a time of fear and uncertainty, these people, who were also dealing with reduced income, decided to give more. They did it because they’re incredible people. They did it because they're part of something, and they did it because we're all in this together. The fact that so many did it is something that the entire team at Carvana should be tremendously proud of. This is the strongest memory I'll take from all this. Difficulty rarely leaves things the way they were; it tears groups apart or brings them together. We've been brought together. There are undoubtedly more challenges ahead, but we head into those challenges confidently because of the people standing beside us.

Mark Jenkins, CFO

Thank you, Ernie, and thank you all for joining us today. Q1 was a strong quarter for Carvana in light of the extreme disruption brought on by COVID-19. Retail units sold in Q1 totaled 52,427, an increase of 43%. Total revenue was $1.1 billion, an increase of 45%. Both of these numbers reflect significant gains in market share, which are continuing through April and the first week of May. Total gross profit per unit was $2,640 in Q1, an increase of $232. Our growth in GPU was driven by strong retail GPU, which increased $299 to $1,581, our highest ever, driven primarily by buying cars from customers. Wholesale GPU was $23, a reduction of $60, primarily impacted by declines in industry-wide wholesale prices in late Q1. Other GPU was $1,036, a decrease of $8, which included a $97 reduction in finance GPU to $528, offset by an $89 increase in ancillary products to $508. In March, we completed our first non-prime securitization and sold our prime loans that were originally intended to be part of our securitization program under our existing forward flow agreement. While lower than recent quarters, we believe our Q1 finance GPU demonstrates the resilience of our finance platform during an extremely volatile period. EBITDA margin was negative 12.6% in Q1, a decrease from negative 7.8%. EBITDA margin was significantly impacted by the reduction in demand brought on by COVID-19 during a key selling period in March. Additionally, EBITDA margin in Q1 was impacted by 2.4 percentage points or $26 million due to COVID-19 related non-cash adjustments to asset carrying values that we do not expect to recur in future periods. In late Q1, we took several measures to better align our expenses with customer demand. Following the spread of COVID-19, we immediately paused discretionary growth investments including new hiring, travel, and new facilities and IT investments. We also made the difficult decisions to rebalance staffing and marketing to better match demand. Although we made these decisions early and quickly, lower volume outweighed the expense reductions and led to a 4.6% increase in SG&A as a percentage of revenue. In light of the uncertainty generated by COVID-19, our expansion strategy has shifted to one that prioritizes risk reduction while ensuring that we are prepared for growth when a normalized environment returns. We have paused acquiring new inspection and reconditioning centers and vending machines. However, we are continuing construction on IRCs that were already in process and that have existing sale-leaseback agreements. Additionally, due to the positive customer response to our touchless delivery offering, we plan to open many smaller markets that could be served by our existing logistics and delivery infrastructure with limited incremental investment. Following quarter-end, we completed a registered direct offering of 13.3 million shares, raising $600 million and bringing our total liquidity resources on April 1st to over $1 billion. These liquidity resources provide us with significant flexibility to operate our business under a wide range of operating and macroeconomic scenarios. In addition, we upsized and extended our existing forward flow agreement with Ally, providing additional flexibility to serve our customers. We expect 169 million on a fully exchanged basis in Q2. As we look forward, we're focused on positioning the business to be lean and flexible as we march toward our long-term goals.

Operator, Operator

Thank you. We will now begin the question-and-answer session. Our first question today will come from Zack Fadem of Wells Fargo. Please proceed with your question.

Zack Fadem, Analyst

Hi. I'm curious if you could talk us through the inventory management in a little more detail and how you went about that $500 per unit inventory charge. And then curious if you could talk us through whether the environment has evolved into Q2. And if you see any reasons to believe the GPU environment can improve from here?

Ernie Garcia, CEO

Sure. So I think in general, the way that we assess our inventory and determine its carrying value is based on what our pricing is and what that means for what we're likely to receive in proceeds relative to the value that we acquired inventory at. That's the standard accounting framework for determining that. So that’s how we assess our inventory charges reserve level. In terms of how the situation has evolved, it's been a very dynamic situation with inventory pricing. We saw right when the pandemic hit, volume kind of dried up in the wholesale markets, dropping down to probably 20% of normal levels. It stayed down at those levels for a while. More recently, we’ve seen it climb up closer to 50% of probably pre-pandemic expected levels over the last couple of weeks. We've also seen wholesale pricing move up a little bit recently. We've seen sell-through rates, which is the likelihood of any given car going through auction being sold to a buyer, also go up a little bit. There are signs of stability, but we remain in a highly uncertain environment as it relates to vehicle values. On retail, there's been much more stability in pricing. This progress is something we're really excited about and is something we're paying close attention to.

Zack Fadem, Analyst

Got it. Thanks, Ernie. And then I wanted to talk about the 90-day no payment offer. I'm curious if all customers qualify for that and maybe you could walk through the impact there in terms of top line. And I was also curious how that works in terms of financing those receivables and if there's a delayed impact there on those transactions.

Ernie Garcia, CEO

Sure. So the 90-day promo is something that has qualifying requirements. For many of the customers being sold through our forward flow purchase agreement, most of them are qualifying and they have the option to elect into that or not. For the loans that are not being sold through our forward flow purchase agreement, which is approximately a third of the loans that we’re originating today, a significant minority of the customers are qualifying for that. We do believe that's probably had a positive impact, but quantifying it precisely is difficult in light of the many different things we’ve done recently to ensure that we're providing our best support to customers. The impact on GPU flows through finance GPU, and in the case of being sold to Ally that’s predetermined. We've worked with them given their experience with these kinds of offerings to customers in the past to size it appropriately. So that’s how it's been working.

Zack Fadem, Analyst

Got it. I appreciate the time, guys.

Operator, Operator

Our next question will come from Colin Sebastian with Baird. Please proceed with your question.

Colin Sebastian, Analyst

Great, thanks. And hope everyone there is safe and healthy. I guess one follow up on the April trends. How much have you been able to take advantage of some of the ad pricing deflation? How much has that been a catalyst for your ability to connect with potential buyers? And then looking beyond the current environment, I'm curious on what you think might be liquidity needs incrementally for the balance of the year in different scenarios around the economy. And in general, is the environment changing any of your strategic priorities, whether that's related to market expansions and vending machines, things like that? Thank you.

Ernie Garcia, CEO

Sure. There has clearly been a reduction in advertising costs, and I've noticed an increase in impressions. Consumers are consuming more media than they historically have. So, I think that cost per impressions has fallen pretty dramatically. However, that impact is directionally offset by the fact consumers are purchasing less in this environment across the economy, particularly in automotive. Price reductions have continued over the last month or so. So, we don't know exactly where that will ultimately settle, but there’s clearly been reductions in the cost to get your message in front of consumers. As for liquidity needs, we had about $1 billion in total liquidity resources as of April 1st. This gives us ample resources to operate in even deep stress scenarios. Those deep stress scenarios now appear less likely than they were several weeks ago. We've made several operational changes to adapt to the COVID-19 environment while maintaining capital expenditures and matching our operating expenses to current demand levels. This combination leaves us feeling optimistic about our liquidity position even in challenging scenarios.

Colin Sebastian, Analyst

Thank you.

Operator, Operator

Our next question will come from Lee Krowl of B. Riley FBR. Please proceed with your question.

Lee Krowl, Analyst

Great. Thanks for taking my questions. One I just wanted to get a high-level demand picture on thoughts around lower air travel coming over the holiday season of summer, thoughts on implied demand from more vehicles on the road, and more miles driven. And then also just around this shift in the tax date from April to July.

Ernie Garcia, CEO

There's a lot of uncertainty regarding the new world, both in the immediate term and longer term. Different data suggests that personal ownership could accelerate as a result of all this, increasing due to less desire to take public transportation or partaking in ridesharing. Additionally, people might be traveling less by air and taking more road trips instead. All these scenarios are possible but hard to quantify. We're most excited about the market share we're planning to capture over time. Prior to the pandemic, we were growing rapidly due to our differentiated offering, and we know that the direction of customer preference is leaning towards safety and minimizing contact with others. This preference is likely to push demand toward us. While the impact is uncertain, we expect our market share gains to be significant. Regarding the tax date shift, I believe it will blend in with the much larger impacts from the lifting of shelter-in-place orders and consumers spending again. So, it will be challenging to separate those impacts.

Lee Krowl, Analyst

Got it. Thanks for taking my questions.

Operator, Operator

Our next question will come from Brian Nagel of Oppenheimer. Please proceed with your question.

Brian Nagel, Analyst

Hi. Good afternoon. Thank you for taking my questions. My first question is geared towards Mark, just on the financials. Clearly, Q1 showcased significant disruption, but as we look at that quarter and some of the areas of costs, are there larger callouts that we should think about as we try to normalize earnings expectations for Carvana?

Mark Jenkins, CFO

Sure. The largest expense callout is the adjustment to asset carrying values totaling about $26 million that was referenced in my earlier remarks. It was split between two things: the first portion relates to adjustments in the valuation of finance receivable-related assets held on our balance sheet. The second largest category was significant changes in wholesale trading prices of used vehicles and a significant reduction in demand, which altered our expectations about the days to sale in our retail business. When considering both adjustments, we made changes to our inventory value totaling $26 million, representing a large impact on the expense side. SG&A had impacts as well, particularly advertising and compensation per car sold. This year, we saw significant investments in staffing and marketing during tax season, which we anticipated would be busy. When that demand didn't materialize, we saw elevated compensation and advertising expenses per unit.

Brian Nagel, Analyst

That's very helpful. Thank you. My follow-up question is, as we look at the rebound in sales you mentioned in Q2, are you seeing just a return to normal customer behaviors? Is it a ramping up effect, or is it more of a reset?

Ernie Garcia, CEO

There are different data sources indicating varying estimates regarding industry sales in April and the last several weeks. The estimates suggest a range from down 55% to as little as 45%. In more recent weeks, it's down from 20% to 25%. In April, we trailed at approximately down 30% year-over-year shortly into the month. We then quickly came back to barely down year-over-year at the end and have been up 20% to 30% in recent weeks, demonstrating our ability to outperform the industry. In examining our customer demographics, we find our base was broad before, and while some subtle differences have emerged, they aren't strong enough to warrant commentary. Overall, we have seen broad-based improvement and think the survey data points to a strong desire to buy cars online significantly increasing since the pandemic.

Brian Nagel, Analyst

Got it. That's very helpful. Thank you.

Operator, Operator

Our next question will come from Sharon Zackfia of William Blair. Please proceed with your question.

Sharon Zackfia, Analyst

Hi, good afternoon. Could you provide any perspective on what retail GPU might have looked like for you in April as you were unwinding the inventory? And on the finance business, considering the rough end of March, how should we perceive finance revenue per car as we move through the rest of the year?

Ernie Garcia, CEO

Absolutely. We're pleased with retail GPU, and absent coronavirus, it would likely have been higher. The stop in purchasing inventory in late March had marginal impacts on our retail GPU, freezing our inventory and aging it. When cars age out, the average margin on our income statements may drop. This impact will likely be larger in Q2. We are beginning to reinitiate purchases due to stability in wholesale markets and strong demand. Regarding finance revenue per car, we are extremely pleased with how our finance platform has weathered this environment. We executed our first non-prime securitization during a turbulent market, receiving a solid premium in comparison to what might have been obtained previously.

Operator, Operator

Our next question will come from Armintas Sinkevicius of Morgan Stanley. Please proceed with your question.

Armintas Sinkevicius, Analyst

Sure. Just a follow up on the incremental costs in Q1 as every single line item in SG&A was higher than the prior quarter. Are there any that we should anticipate trending lower ahead of the second quarter?

Mark Jenkins, CFO

Yes. We expect declines on a per car sold basis in those SG&A line items. This decline comes largely from operational changes due to COVID-19. Q1 saw significant investments in anticipation of a busy tax season. As we plan to align with customer demand in Q2, we anticipate a decrease.

Operator, Operator

Our next question will come from Ron Josey of JMP Securities. Please proceed with your question.

Andrew Boone, Analyst

Hi, this is Andrew Boone on for Ron. Thanks for taking our question. With April sales rebounding to that plus 20% to 30% level that you talked about, can you talk about why you aren't leaning into advertising more? Is there a change in ROI, or is there something else there? And secondly, given the fixed cost nature of your model, are you looking to shift more towards variable costs?

Ernie Garcia, CEO

We're very pleased with the demand over the last several weeks, with our performance climbing up to 20% to 30% year-over-year after having been down 30%. This represents a dramatic reversal. Moving forward, we're balancing the uncertainty remaining in the industry with the upside opportunity we recognize. I'm monitoring costs closely and making rapid changes as trends develop. Our business model is designed to swap variable costs for fixed costs compared to traditional models, which has positioned us well for growth.

Operator, Operator

Our next question will come from Rajat Gupta of JPMorgan. Please proceed with your question.

Rajat Gupta, Analyst

Hey. Good evening. Thanks for taking my questions. Can you break out the difference in financial GPU between the forward flow and the non-prime ABS deal in Q1? Are you still planning to monetize the majority of the loans through Ally?

Ernie Garcia, CEO

At a high level, we received a premium on both pools, though it was less than anticipated prior. Historically, we haven’t dove in deeper, so I cannot disclose exact numbers. We expect Ally to continue being a tremendous partner. They upsized our forward flow agreement, and the partnership remains fruitful as we profit from these agreements. Our ongoing efforts to maintain strong lending and credit while being positioned defensively as the market changes are critical.

Rajat Gupta, Analyst

Got it, got it. And just for housekeeping, was the other expense line item related to the loss on beneficial interest in securitization the only material thing to call out?

Mark Jenkins, CFO

Yes, that $17 million related to these financial receivable-related assets, with the majority being the retained beneficial interest in securitizations. The loss I mentioned earlier fits into the larger $26 million adjustment discussed.

Operator, Operator

Our next question comes from Rick Nelson of Stephens. Please proceed with your question.

Rick Nelson, Analyst

Thanks. Good afternoon. I would like to follow up on the shift from sales declines to increases. Could you talk about the impact of stimulus checks on the 90-day promotion and whether you’ve reduced retail inventory exclusively through your website or through auctions as well?

Ernie Garcia, CEO

Those factors are hard to disentangle. We saw rapid demand drops followed by the implementation of the 90-day promotion. Additionally, we’ve had marketing materials tailored to this environment and the stimulus checks have had their own influence. More generally, we are reducing retail inventory exclusively via our website. We maintain a tight inventory during these times.

Operator, Operator

Our next question comes from Nick Jones of Citi. Please proceed with your question.

Nick Jones, Analyst

Hi, thanks for taking my question. I wanted to ask about competition in light of the recent CarGurus survey and whether you believe there’s been a shift in how competitors might be trying to adopt new ways of selling cars?

Ernie Garcia, CEO

We expect e-commerce to outperform across sectors, including automotive, making it likely for more competitors to emerge. The transition in buyer preferences signals a demand for online transactions, which we've specialized in for years. While we anticipate increased competition, our investments and established infrastructure give us a competitive advantage, and we believe this aligns well with evolving customer preferences.

Mark Jenkins, CFO

That view is valid; competition is a concern, but we're optimistic long-term. We continue to execute based on our fundamental beliefs about building the best e-commerce model in the industry.

Operator, Operator

Our next question comes from Mike Montani of Evercore. Please proceed with your question.

Mike Montani, Analyst

Great. Thanks for taking the question. Can you help us understand the magnitude of profit pressure you might expect with the Ally deal on loans? Is this something that would remain over the next year?

Ernie Garcia, CEO

It’s challenging to quantify right now given the various moving parts in today's market. The premium expectations have lowered, contributing to profit pressures. However, we are confident in our credit management and believe we have effectively navigated the current circumstances. Our primary goal is ensuring we remain a flexible and resilient player, and adjustments will be made accordingly.

Mike Montani, Analyst

And what are you seeing on the wholesale pricing front in the past couple of weeks?

Mark Jenkins, CFO

We don't expect adjustments to recur in future periods, however, wholesale GPU may remain lower than normalized levels in Q2 as uncertainty is still prevalent. The wholesale market is recovering but remains at about 50% of what you'd expect. The retail side is stabilizing and with our ongoing efforts, we anticipate better alignment moving forward.

Ernie Garcia, CEO

Regarding sourcing vehicles, the 70% and 40% ratios were trending positively before we paused purchasing continuously. We're focused now on rebuilding those numbers, targeting progress consistent with our long-term goals.

Operator, Operator

Your last question today will come from Brad Erickson of Needham & Company. Please proceed with your question.

Brad Erickson, Analyst

Hi guys. I have a follow-up regarding the functionality of physical auctions. What needs to happen for those auctions to function normally and how critical is that for inventory?

Ernie Garcia, CEO

Currently auctions are active, but volume is only at about half of normal. The majority of auction buyers were already pivoting to online prior to this. Prices are starting to stabilize but we need to remain cautious about potential fluctuations due to uncertainties in supply chains. We are balancing risks and opportunities to ensure effective inventory management.

Brad Erickson, Analyst

Got it. And just one last question for Mark. Can you provide any EBITDA loss expectation for the year under a plausible scenario? What level would the business need to reach for breakeven?

Mark Jenkins, CFO

Looking at Q2, we anticipate GPU to drop significantly compared to Q1. However, we expect expenses per unit to decline as operational changes respond to demand levels. So effectively, we see a path to reducing overall EBITDA losses in Q2 and further improvements after that.

Operator, Operator

Thank you. This concludes our question-and-answer session. I would now like to turn the conference back over to management for any closing remarks.

Ernie Garcia, CEO

I'd like to thank everyone for joining the call. We really appreciate it. I'd like to turn to team Carvana on the line. Thank you for the job you've done over the last six weeks. We’ve made tremendous strides in our business thanks to the hard work of our team. Let’s keep fighting through the rest of this. We’re in a great spot. Thank you everyone.

Operator, Operator

The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.