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Are Nvidia’s Financials Infested With Accounting Fraud?
Note: the following commentary is from the latest issue of my Short Seller’s Journal, a weekly newsletter dedicated to dissecting the latest economic reports and looking for ways to express a bearish view of the stock market. It’s notable that Jensen Huang (CEO) unloaded well over $1 billion worth of shares between June 13th and September 13th.
Nvidia update – (NVDA – $132) – Nvidia and Jensen Huang are no strangers to accouting fraud. Huang has settled with SEC by paying big fines multiple times for revenue recognition and disclosure fraud. Currently it is likely that, on top of revenue recognition fraud, Nvidia is invovled in a quasi-revenue generating Ponzi scheme.
NVDA reported its FY 2025 Q3 numbers Wednesday after the close. Of course it beat estimates across the board. However, while guidance of $37.5 billion in revenues for Q4 “beat” the median consensus of $37.1 billion, it was far below the buyside expectations of $38.8 billion and well below Goldman’s expectations of $39 billion. Also, of note, NVDA’s gross margin declined from 75.1% in FY ’25 Q2 to 74.6% in the latest quarter. The stock initially dropped 5.4% in after hours trading but ended up down 2.5% when the after hours trading closed.
The data center unit, which sells the “coveted” AI chips, represents 86% of NVDA’s revenues (gaming/graphics, professional graphics, auto & other is the rest). However, within the data center segment, the networking revenues declined over 14%. Networking revenues are derived from the sale of networking hardware inter-connectivity components that enable data transfer. Although networking revenue is just 10% of the overall data center, it’s interesting that the revenue in that segment declined because, to the extent that there’s growth in the sale of AI chips, I would think that there should commensurate growth the sale of the high-speed hardware components that transmit data processed by NVDA’s chips.
This is a potential red flag because, as detailed in previous issues, it’s suspected by many – including me – that NVDA is using a Ponzi-like scheme to manufacture a material portion of its revenues. It does this by investing in “hyper-scaler” data center start-ups who use the proceeds from NVDA’s investment to buy chips. However, if these start-ups are not ready to open for business, they might not be purchasing the hardware from NVDA that would be used to enable the data centers to operate and sell cloud computing services. This is just speculation on my part but I’m not the only one who noticed this as some financial media reports noted that networking revenues declined.
The other interesting aspect of NVDA’s numbers is the slowdown in the rate of growth in NVDA’s data center segment (sale of AI chips, mostly). Over the last four quarters, the QoQ growth rate in revenues has been, starting from FY Q2 2024 to present: 26.8%, 22.2%, 16.4% and 17.2%. The growth rate from FY 2025 Q2 to Q3 rose, but the decline in the growth rate from FY Q3 2024 to Q3 this year is dramatic. Furthermore, I can almost guarantee that Jensen Huang used NVDA’s funding of start-ups during the quarter in order to guarantee a small bounce in the QoQ revenue growth rate.
Perhaps the most remarkable aspect of NVDA’s financials since the rate of growth in AI chips soared is the fact that NVDA has been reporting $4 billion +/- in revenue growth since The FY 2024 Q2 – five straight quarters of consistent $4B in revenues growth. This consistency is just too “clean” and thus another red flag pointing toward the potential of profound accounting fraud.
Another interesting metric that potentially points to the revenue generation Ponzi-like scheme that many of us suspect is occurring at NVDA is that fact that the percentage growth in accounts receivable is substantially higher than revenue growth. As an example sequentially from the FY Q2 to FY Q3 revenues grew 17.2% but accounts receivable grew 24.8%. My best guess is that either NVDA engaged in channel-stuffing, in which it ships more chips than were ordered, possibly on the assumption that the orders might fill-in during FY Q4 or it sold chips to NVDA-funded start-ups which were not funded int time to pay at quarter-end. There could be some other reason but the large increase in accounts payable relative to revenue growth is a big red flag.
Jensen Huang triggered a rally in NVDA’s stock price starting in September from $102 to as high as $150 when its Q3 numbers were released by claiming that the demand for NVDA’s H100 (the current hot chip) was “insane” at an investment conference. Funny thing about that, several NVDA’s bearish analysts discovered in early November that H100 chips and racks that were built by SMCI to host the GPUs were being offered for sale on EBAY. Now why would this be this case if demand for the chip was insane? I checked for myself and sure enough NVDA chips and SMCI hardware are freely for sale on EBAY. There’s also this: @DarioCpx
Regardless of whether or not NVDA’s financials are infested with accounting fraud – and I believe it’s a certainty, not a possibility – the slowdown in the rate of growth in revenues at some point will cause a contraction in the stock’s Price/sales and price/earnings ratios. Currently the P/S is an eye-watering 28.7 and the P/E is 52.1. Furthermore, META, GOOG and AMZN are developing their own AI chips in order to wean themselves off of overpaying for NVDA’s GPUs. The contractions in the valuation multiples may have begun after it closed at an all-time high on November 7th ($148.88), backed off for two days and then failed a retest on Novmeber 12th):
When I published the last issue of my Short Seller’s Journal on Sunday, I commented that I wanted to see the stock drop below the 21 dma (light blue ma line), and hold below. It did that Monday and Tuesday and is currently below the 50 dma (yellow ma line). If it holds below the 50 dma, it will seek out the 100 dma (dark blue ma line, $125.98 today). I think, barring a continued slow-motion melt-up in the stock market, that NVDA will fall to the 200 dma (red dma, $111.73 today) by Christmas Eve.
Betting Against Super Micro Computer Is A Good Bet
The following commentary is from the latest issue of my short sellers newsletter. To learn about about it, follow this link: Short Seller’s Journal subscription information.
I’m focusing on SMCI as a short because there’s an increasing number of red flags that suggest a high probability that SMCI is the Hotel California of accounting fraud: you can check-in but you’ll never check-out. I think there’s a strong possibility that SMCI will not be operating in its current form 12-18 months from now. While I think there’s value to SMCI’s business, it’s a matter of determining what’s real and what’s accounting fraud. It’s a low margin business on which SMCI’s c-suite has been imposing accounting fraud to make the sales growth and profit margins appear bigger than reality. The incentive to do this, of course, is to boost the share price.
On Wednesday SMCI filed a Notification of Late Filing with the SEC stating that it is unable to file its FY 2025 Q1 10-Q. It also stated that it needs additional time to find an auditor, for the Special Committee of the Board to complete its review of SMCI’s procedures and controls and for the audit firm that is eventually hired to prepare and complete the FY 2024 10-K and FY ’25 10-Q.
The Nasdaq now must decide if it will delist SMCI or give the Company 180 days to fix the issues listed above. I have no idea how this will unfold but, quite frankly, this stock should not be trading given the complete lack of transparency with its financials for the last 5 quarters. In addition, NVDA pulled a big order for servers last week from SMCI.
SMCI’s shares jumped 16.6% from the close in thin after-hours trading Friday after Barron’s reported that “a person familiar with the matter” told Barron’s that SMCI intends to submit a plan on Monday in an effort to avoid delisting. Details were lacking but as of Friday SMCI had not hired an auditor to replace E&Y.
In fact, the Wall Street Journal published an article Friday morning titled “Is Anyone Crazy Enough to Audit Super Micro Computer?” The article referenced the possibility that E&Y found something missed by the previous accounting firm, Deloitte & Touche. D&T was fired by SMCI at the end of its FY 2023 (June 30, 2023). Thus, E&Y resigned as the auditor just 15 months after Deloitte was fired and before E&Y completed its FY 2024 year-end audit.
In other words, despite SMCI’s denials, there has to be some serious problems with SMCI’s accounting. Prior to E&Y’s resignation, in April a former employee (Bob Luong) who was the Head of Global Services filed a whistleblower lawsuit alleging that SMCI continued to falsify revenue recognition shortly after SMCI settled with the SEC and was relisted on the Nasdaq in 2020.
According to the court filing, Luong was terminated in April 2023 after refusing to comply with SMCI’s repeated requests to implement what Luong believed was revenue recognition accounting that violates SEC accounting regulations between late 2020 and 2022. The court filing has two pages of sordid details. This includes improper revenue recognition, recognizing revenue from incomplete sales and shipping products near quarter-end that SMCI knew had problems and would be returned for exchange after the quarter ended. In addition Luong alleges that SMCI would shift revenue services to hardware sales in order to boost the profit margin reported in the financials from hardware sales. Luong also cited circumvention by upper management of internal accounting controls.
In December 2022 Luong was placed on involuntary administrative leave and fired in April 2023. Note that Deloitte was fired two-and-a-half months later. I suspect that Deloitte was putting up resistance for the same reasons listed by Luong in his lawsuit. Deloitte was SMCI’s auditor when the Company delisted in August 2018 for failing to file financial statements for two consecutive years. After regaining compliance in January 2020, the SEC charged the Company with widespread accounting violations in August 2020. SMCI settled with the SEC shortly there-after.
I find it quite interesting that E&Y quit as SMCI’s auditor before it completed what would have been its first FY year-end audit in connection with the preparation of the 10-K to be filed with the SEC. Clearly E&Y discovered huge problems with SMCI’s accounting and controls and was unwilling to put its name on the Auditor’s Report which precedes the presentation of the financials in a 10-K.
In my opinion the writing is on the wall for SMCI. This Company is riddled with accounting fraud based on all of the “footprints in the snow.” I continue to believe that SMCI will be trading under $10 within six to twelve months. The problem with using puts right now to express this view is that if the stock is delisted the options cease trading. That said, I think the after-hours report that SMCI is filing a plan of compliance with the Nasdaq (though I don’t see how the report has substance since an audit firm has not been hired).
I hope the stocks pops this week because I would love to establish a longer-dated, OTM put position in this stock. I’ll be watching the price-action in the stock Monday at the open and I hope the stock runs into the mid-high $20’s.
As an aside, there’s still the potential for this stock to get delisted. If you take a bearish view on SMCI with puts, there’s delisting risk, meaning that the options cease trading if there’s a delisting. However, if you short the stock, that short position can be carried over into the OTC market, likely under the symbol “SMCIQ.” I really believe this stock is a no-brainer short.
NOTE: On Monday SMCI filed an 8-K in which t announced that it hired a new audit firm, BDO, and intended to file a Plan of Compliance. There’s just two problems. The 8-K contained a paragraph which would lead a discerning reader to conclude that the BDO engagement is contingent on BDO getting comfortable with the issues that led to the firing of Deloitte and the resignation of E&Y. Note that E&Y quit before it completed what would have been its first annual audit of SMCI’s numbers. As it turns out, BDO is a shady “mid-tier” audit firm. The Public Accounting Oversight Board issued a report in which is stated that 86% of the audits by BDO that PCAOB insspected were deficient. This means that BDO had failed to collect evidence to support at least part of its audit conclusion.
I don’t know how this saga might play out in the near-term. But longer term, as the market figures out that the value-added of AI does not justify the massive market caps given to the AI-related companies. This is particlularly true with the SMCI, which sports an operating margin that is below 10% – to the extent that operating margin can be trusted – and clearly does not command pricing power for what is basically a commodity product.
The Sell-Off In The Precious Metals Sector May Be Winding Down
The sell-off in the precious metals sector since the election has nothing to do with Trump’s victory. That thesis is based on the price-action in the precious metals sector when Trump was elected in 2016. But the sell-off that year followed a move straight up starting in January 2016 that lasted nearly eight months. The sector began heading south in late August that year. It was going to at least undergo a correction in spite of Trump. There’s some other factors back then that are not present currently.
The current sell-off has more to do with the fact that, after a big move higher since the beginning of August the sector had become extremely overbought technically. The Comex banks were shorting a massive amount of gold and silver contracts to feed the appetite of the momentum-chasing hedge funds and CTAs. The bank short position became extreme as did the managed money long position. It was the perfect set-up for the banks to implement what I call a Commitment of Traders open-interest liquidation operation. Using a technically overbought condition in the sector, along with a torrid rally in the dollar, the banks coerced selling by the hedge funds/CTA. The sell-off was almost exclusively during Comex floor trading hours – almost none of the downside price action occurred during physical market trading in the eastern hemisphere.
Last Friday the COT report showed that the banks covered 15k+ contracts in an amount that was nearly identical to the decline in the managemed money long postion. Unfortunately the big move lower Wednesday won’t show up in the COT numbers until November 22nd (Tuesday is a cut-off day). But I suspect this Friday’s COT report will show that the banks covered more shorts and the managed money puked more longs.
I discuss the market action and dispel the Trump/gold misinformation in a podcast with Arcadia Economics
The mining stocks are extremely oversold now. As well, the dollar is extremely overbought and may be topping. In response to a flood of emails from my subscribers, I included a shopping list of my favorite mining stocks in today’s new issue of my newsletter to buy in order to take advantage of the sell-off and the next move higher. I also updated five stocks that I cover and recommend that I believe could be anywhere from doubles to 5-baggers over the next six to twelve months. To learn more about my newsletter and get these stock picks, follow this link: Mining Stock Journal
Mining Stocks Haven’t Been This Undervalued Since 2001
Tom Bodrovics invited me back onto this Palisades Gold Radio podcast to discuss the election, the economy, the national debt and mining stocks. We also discuss the existence or non-existence of the U.S. Treasury’s gold bars, which are allegedly held in custody by the Fed but for which there has not been an indepedent audit since the mid-1950’s (note: the gold was moved from Fort Knox to “deep storage” in various locations quite some time ago; any gold Fort Knox is for display purposes only). With respect to our discussion about minining stocks follow this link to learn about my Mining Stock Journal
Housing Market Update – DR Horton Is Down 13%
NOTE: DR Horton (DHI) reported its FY Q4 numbers this morning. It missed Street consensus across the board and warned about FY 2025. The stock is currently down 12.5 but it has a long way to fall just to reset to its valuation at the peak of the first big housing bubble this century.
Existing home sales fell 1% in September from August and 3.5% YoY. The 3.84 million seasonally adjusted, annualized rate is the lowest since October 2010. On a not-adjusted, monthly basis, existing sales plunged 12.6% from August and 4.9% YoY. At the current SAAR the months’ supply of listings jumped to 4.3, the highest since the pandemic. First-time buyers represented 26% of the closings, which matched an all-time low.
Existing home sales are based on closings. It’s possible that existing sales in October could undergo a small bounce because the mortgage purchase index rose during September and contracts signed will show up as closings in October and part of November.
The prospects for a sustained turnaround in home sales will not improve anytime soon, however, as the weekly mortgage purchase index plunged 5.8% from the previous week. The purchase index is down 12.1% from September 27th. The purchase index had been rising since mid-August as mortgage rates declined in anticipation of the Fed rate cut. The index started to reverse sharply three weeks ago with the 10yr Treasury yield up 60 basis points and the baseline 30yr fixed mortgage rate jumping to 7.26% from 6.6%.
New home sales were said to have risen 4.1% in September from August and 6.3% YoY. August’s 8.7% decline from July was revised even lower, from a 716k SAAR to a 709k SAAR. And July’s alleged 751k SAAR, or 18.4% jump from June’s originally reported 681k SAAR. June’s number was revised down to a 672k SAAR and the July number was revised down to a 726k SAAR.
See the pattern here? The Census Bureau’s data surveying and statistical calculus is completely unreliable. New home sales are based on contracts signed. So, while the Census Bureau’s estimate is likely inaccurate, it’s entirely possible that there was an increase in new home contracts given that the mortgage purchase index rose 9.5% during September. That said, the CB does not adjust its data for canceled contracts. Given the jump in mortgage rates since mid-September, I would bet there will be a jump in contract cancellations.
I can’t say with certainty that the market will start to reprice tech or small caps anytime soon, though I think it will, I am confident that the homebuilders and related stocks will are starting to feel the gravitational pull of fundamentals-based reality. Higher rates eventually will force a hard downward valuation adjustment in the housing stocks.
Pulte Homes reported its Q3 numbers on Tuesday before the open. Despite what looked like decent headline numbers, the stock plunged 7.2% and dragged the entire sector with it. This is despite the fact that PHM beat the revenue and EPS consensus. I’ll get to my rationale for the sharp sell-off in the stock shortly.
In terms of the prima facie numbers, on a YoY basis closings were up 12%, revenues rose 12% and EPS increased 16%. Gross margin declined and SG&A as a percent of sales increased. Both metrics do not surprise me because the Company no doubt had to offer huge incentives to coerce contract signings and the cost of that would be allocated both to the cost of revenues and SG&A.
Here’s where it gets interesting. To begin with, forward guidance was notably absent from the earnings press release, the earnings presentation and the conference call. Although new orders increased YoY, the dollar value of the backlog declined 5.3% YoY and roughly the same amount from Q2 2024. Despite the Fed rate cut, along with a decline in mortgage rates during July and August in anticipation of the rate cut, PHM’s cancellation rate increased in Q3 vs Q2 (it was about the same – 15% – as Q3 2023).
Here’s PHM’s comment about mortgage rates: “with mortgage rates hovering around 6.5% to begin the third quarter, buyers were generally less inclined to sign a purchase agreement.” Actually, the current baseline (20% down, 740+ FICO) 30-yr fixed mortgage rate is now 7.26%, which means buyers will be even more “less inclined” to sign a purchase agreement now. This means it will become more difficult to move inventory. In addition, the jump in mortgage rates will likely cause an increase in cancellations.
Speaking of which, Pulte management said that 43% of the homes in its inventory are “spec” homes. In all likelihood, I would bet 50% of those spec homes are from canceled contracts. I would love to ask about that on the earnings call, but corporate earnings calls are highly curated and no sycophantic Wall Street analyst would would dare ask a tough question. It’s a great bet that the percentage of spec homes in PHM’s inventory will continue to climb. I suspect the same is true for all of the homebuilders.
Here’s the money-shot. At the peak of the housing bubble in the first decade of this century, PHM peaked at a little over 2.4x the dollar value of its backlog. Currently, the stock is valued at 3.6.x the value of the backlog. On this basis, despite the big drop earlier this week, PHM is at least 50% overvalued based on market cap to backlog value.
As with the entire sector and the stock market in general, PHM has been rising relentlessly, albeit irrationally, since mid-October 2022. It was triggered by the market’s anticipation of the eventual rate cut that occurred in September. Unfortunately for the perma-bulls, the rate cut triggered a sharp increase in the 10-year Treasury rate and mortgage rates. In addition, new home sales home sales have been on a downward trajectory since October 2020. The phony SAAR for September is down 28.3% from October 2020 – and the numbers do not include contract cancellations.
Of the homebuilders I analyze and present in SSJ, only TOL and PHM look like this:
While I think both TOL and PHM are fantastic shorts, the charts of KBH, BZH, DHI and LGIH appear have formed a top and are poised to head lower:
LGIH, along with BLDR, are my two favorite homebuilder shorts. They both report numbers on November 5th. DHI reports Tuesday (Oct 29). In my opinion, all three are shorts (or put plays) ahead of earnings.
Russia proposes to put the Comex and LME out of the market-rigging business (GATA)
Bingo! I’ve been wondering for over 20 years when this would happen. It’s not like Russia and China don’t understand the degree to which western Central Banks, led by the Fed, manipulated the prices of gold and silver using the banks on the Comex and LBMA as their agents.
MOSCOW, Oct 24 (Reuters) – Russia is in talks with other BRICS members about creating an international precious metals exchange to ensure fair pricing and trade growth, the country’s Finance Minister Anton Siluanov said in a statement on Thursday…”The mechanism will include the creation of price indicators for metals, standards for the production and trade of bullion, and instruments for accrediting market participants, clearing, and auditing within BRICS,” Siluanov said.
The BRICS precious metals exchange would rival Western trading platforms, such as the London Metal Exchange, and would protect trade from sanctions imposed by the West on BRICS members Russia and Iran.
Earlier, BRICS leaders expressed support for efforts to increase trade in precious metals among the group’s countries in a joint communique issued on Oct. 23.
Here’s the link for the entire article: REUTERS
And here’s the link for the GATA Dispatch: GATA.org
Silver Looks Explosive To The Upside
That’s the title from the latest issue of my Mining Stock Journal, which I released yesterday. Silver is up nearlly 4% as I write this. Here’s the title from the September 19th issue: “The Mining Stocks Remain Historically Undervalued.” GDX is up 4% as I write this. Several of the micro-cap, project development stocks that I recommend are up over 20% since mid-September. Some of them, like Cabral Gold, have potential 10-20x returns ahead of them. I updated Cabral in yesterday’s issue with a couple of imminent catalysts that could trigger a 25% to 35% move in the stock before Christmas. Follow this link to learn more about my newsletter: MSJ information
The left “rim” of the cup goes back silver’s all-time high in 1980. The right “rim” of the cup formed in 2011, when silver peaked just $1 below the 1980 all-time high. The “handle” has been forming over the last 13 years. Perhaps, most interesting, a 5-year chart shows that part of the handle is an upside-down head and shoulders technical formation.
The point here is that silver looks potentially explosive. Since April, silver has been banging its head on $32.50 (Comex front-month contract price basis). In my opinion, if it breaks over $33 and holds, it will trade towards $40 very quickly.
This view is supported by the fundamental set-up in the silver market. It’s been well circulated that the Silver Institute of America is forecasting a 215 million ounce silver supply/demand deficit for 2024. Several factors will likely increase the size of that deficit in 2025. First, Russia announced in its Draft Federal Budget release that it plans to significantly increase the holdings in precious metals in its State Fund (sovereign wealth fund). This includes plans to acquire gold, platinum, palladium and, for the first time, silver.
In addition, China recently announced that its build-out of a national solar grid will continue through 2030. This endeavor requires a massive amount of silver. Though China does not publish official silver import numbers, I recall that when the program was underway it was consuming more than all of the annual amount of silver produced in China. India also has a similar program in place, which is part of the reason it has been importing large amounts of silver. In fact, earlier this week India announced another $109 billion in grid investments for renewable energy sources. This will also require large quantities of silver.
Finally, at some point – as occurred in the late 1970’s and again leading up to the 2011 top in silver – the “poor man’s gold” attribute of silver will become a large factor in driving a massive amount of investor money into silver as a cheap substitute for gold. This demand would be coming from the greater public beyond the precious metals “bugs” who have been stacking silver for years.
I believe that in the next 12 to 18 months, silver will make a move higher that will shock just about everyone except the most ardent silver bulls. I don’t like to make price forecasts based on a specific point in time, but I think $40 silver within the next year has a high probability. Furthermore, the primary silver producer stocks will soar and the junior silver project development stocks will soar x 5. This is likely why both Coeur Mining announced the acquisition of Silvercrest Metals and First Majestic announced the acquisition of Gatos Silver. Six months to a year from now the cost to acquire these companies might have doubled.
Biggest Stock Bubble In History
The stock market, though maybe not by some GAAP accounting-based measures, is at its all-time high valuation. In other words, this is a bigger stock bubble than 1929, 1987, 2000, 2008 and 2022. Using “hold the accounting accountable” numbers, like market cap to free cash flow, the valuations are at all-time highs. To be sure, the stock market could be in a “Weimar” phase. As discussed in the podcast, the Fed has actually been printing money per the M2 statistics.
How to make money from this. The precious metals sector has been the best performing sector this year. The micro-cap project development stocks have lagged by a considerable amount. As long as the bull market in precious metals continues, it’s a good bet that many micro-cap junior mining stocks have, minimally, 3-5x potential. I cover – AND OWN – 4 stocks that I think have minimally 10-20x potential. I’ll note that I pounded the table on Silvercrest Metals at 16 cents in 2016. Coeur Mining just acquired Silvercrest for over $11 per share. Not a bad ROR.
The KE Report invited me to discuss the macro economy plus we drilled down to the precious metals sector. In addition to my outlook for the sector, I mention a few stocks that I think will be home runs.
I publish the Mining Stock Journal every two weeks. Unlike most Seeking Alpha Einsteins, I chat with and have relationships with every company I follow and recommend. I also put my money where my mouth is. You can learn more about the Mining Stock Journal here: LINK
Carvana (CVNA) Is Insanely Overvalued
The following analysis of Carvana is from the September 29th issue of my Short Sellers Newsletter. You can learn more about this here: LINK
Carvana update (CVNA – $187) – Originally I was going to keep this brief. And I apologize to those who are tired of hearing about what a great short CVNA is only to watch the stock relentlessly levitate higher. But once I started re-digging into CVNA’s Q2 numbers and the footnotes in the most recent 10-Q, I believe CVNA ultimately will prove to be one of the best shorts in the next 12 months.
Recall that ALLY Financial announced earlier this month that auto delinquencies and charge-offs jumped considerably more in July and August than its internal risk-control model led management to believe would occur. “Higher than its risk-control model” projected. That is a key phrase.
Risk control models at sophisticated algorithms designed to predict the percentage of loans that will fall delinquent, thereby enabling management to determine its willingness to take lending risks plus how much to charge (loan rate) for each given tier of risk. When the actual outcome jumps “outside” of the guard rails established by the model, it means that a fundamental shift occurred in the ability or willingness of borrowers to make loan payments. Whatever that shift was, in all probability, it’s worse than ALLY’s management represented.
I bring this up because ALLY is the bank that finances the loans underwritten by Carvana. CVNA has a “Master Purchase and Sale Agreement” with ALLY in the amount of $4 billion which enables CVNA to sell the loans it originates to ALLY, subject to certain underwriting criteria.
Given the disclosure by ALLY, it’s a good bet that a material percentage of the loans sourced from CVNA is part of the problem for ALLY. The current agreement expires on January 10, 2025. It’s also a good bet that ALLY likely will tighten the underwriting standards on the auto loans it is willing to buy from CVNA. In turn, this will adversely affect CVNA’s sales volume.
Further to this point, not all of CVNA’s loans (“finance receivables”) go to ALLY. It has also issued $14 billion worth of Asset Backed Securities (ABS) – in this case bond trusts securitized by the CVNA auto loans. In aggregate, the delinquency rates for the loans in these ABS trusts are beginning to soar.
The graphic on the next page is from CVNA’s Q2 10-Q. It was prepared by and posted on Twitter by @Bluechip, someone with whom I share ideas and analysis. I believe he’s a professional investor and analyst. He’s also a fellow CVNA bear. As it turns out, and not surprisingly, the delinquency rate on CVNA underwritten auto loans is escalating:
12.6% of the total loan balance in these trusts is in some degree delinquency. The total 31-day+ delinquency rate jumped from 7.71% in June 2023 to 8.71% in June 2024. The 61-day+ delinquency rate jumped from 2.39% at the end of 2022 to 3.373% at the end of 2023 to 3.97% as of the end of June. The big jump in all delinquencies means that the 61-day+ delinquency rate will be considerably higher by year-end. CVNA has balance sheet exposure to these trusts in the form of variable interest entities. If enough of the tranches above CVNA’s investment in equity tranche become distressed, CVNA’s interest will be wiped out and it will have to recognize the loss on its income statement.
In its latest ABS pool, the weighted average interest rate is nearly 14% with an average remaining term of 71 months. The average principal balance is $24,504. But I noticed something interesting. The average selling price for a CVNA vehicle YTD in 2024 is $23.7k (per the latest 10-Q):
Because the average loan balance in the loans that went into CVNA’s latest ABS deal are below the average selling price of the vehicles, it means there’s a meaningful percentage of these loans that were made with negative equity.
In other words, the car buyer was underwater on the trade-in and CVNA loaned enough to buy the new used car and pay off the loan on the old used car. Those are also likely loans extended to the bottom half of the FICO range in this loan pool (576 to 894), which means the loans carry an interest rate substantially higher than the average rate for the pool (13.69%). It also means that a material percentage of the loans will eventually default.
As with ALLY, as the rate of distress and defaults rise, the market will be less willing to invest in CVNA ABS bonds, which means CVNA will either be forced to retain a higher percentage of the loans that it dishes off to ALLY and the ABS market or curtail the number of loans it underwrites. The latter issue will adversely affect sales.
Here’s also why that matters. In Q2 2024, buried in its income statement (but disclosed in its footnotes), CVNA recognized non-cash $173 million in gains on from the sale of finance receivables. It’s hard to tell where CVNA stashes this number but it is supposed to be an entry below the operating income line item. It’s probably in the “other expense (income), net” line. Regardless CVNA’s net income before taxes was $49mm in Q2.
See the problem? Excluding the non-cash gain on loan sales of $173mm in Q2, CVNA’s NIBT would have been a $124mm loss. Moreover, given that the “other expense/income net” line item was $124mm lower than the gain from loan sales, it likely was because CVNA had to write-off bad loans of that amount or close to that amount.
But there’s more. Recall that CVNA “restructured” its debt and replaced a large amount of cash pay bonds with PIK bonds (payment-in-kind, meaning the interest is paid with more bonds). The bonds PIK for two years then revert to cash-pay. The restructuring temporarily reduced CVNA’s total debt outstanding but if CVNA PIKs the bonds for the fulld two years, it will be saddled with the same amount of debt as before the “restructuring” and the interest rate on the bonds will be even higher (12-14%). The bonds revert to cash pay in 12 months.
CVNA would have trouble making cash interest payments right now on that debt. As the economy gets worse and used car sales decline, CVNA will have no ability to make cash interest payments on that debt.
The bottom line is that CVNA remains insanely overvalued. It trades at 54x trailing earnings and 123x the consensus 2025 earnings. Those metrics are based on just the market cap. Including the debt, CVNA is trading at an enterprise value of 34.2x the last six months’ operating income annualized. But CVNA’s operating income likely will decline over the next six months. For point of comparison, Carmax – which is also overvalued – trades at a trailing P/E of 29x and a forward P/E of 21x.
An argument can be made that CVNA is not even worth the amount of debt on its balance sheet, which is $5.4 billion right now and will be over $5.6 billion when the PIK bonds go cash-pay. Using the Street estimate for 2025 net income, which invariably will turn out to be too high, that “p/e” for the debt is 34x. Using the last six months’ net income annualized that debt is 52x net income. But CVNA’s net income declined from Q1 to Q2. Using the Q2 net income annualized, the debt is 75x net income. Compare those valuation ratios to the ones for KMX above. When CVNA eventually has to restructure its debt, the shares theoretically are thus worthless because that debt will be worth far below par value in bankruptcy.
The short interest as of mid-September has declined by a considerable amount. For most of the last few years, CVNA’s short interest has been over 30% of the share float but it has declined to 12.6% of the float. That’s still fairly high but it makes it more difficult for Street trading desks to engineer short-squeezes, particularly since the founder, Ernest Garcia II has been a habitual seller of shares, including dumping over one million shares this month.
CVNA’s move higher is truly puzzling. It’s reminiscent of the trading action of the dot.com stocks in late 1999/early 2000. If the pattern remains consistent, it would appear that CVNA is getting ready to sell-off down to the $130-$140 area. The next earnings report is at the end of October. I think CVNA will move lower ahead of earnings, particularly if there’s any type of material move lower in the stock market. This is likely why Ernest Garcia II has been one of the most prolific insider sellers in the entire stock market.
Half Of A Percent Rate Cut? It’s Worse Than We Thought
The following commentary is from the September 15th issue of my Short Sellers Journal. For more information on this bear newsletter follow this link: Short Sellers Journal Information
“The US economy is in a good place and our decision today is designed to keep it there.” – Jay Powell at his post-FOMC press conference
Here’s the opening sentence to the latest FOMC policy statement: “Recent indicators suggest that economic activity has continued to expand at a solid pace.” Think about it for a moment: why does the Fed need to cut rates at all given that the alleged unemployment rate is low relative to history, the stock market is at a record high and housing prices are at all-time highs? As the global head of Deutsche Bank’s economic research (Jim Reid) wrote: “the interest rate cut of a half-percentage-point to kick off its easing cycle looks harder to justify than those in 2001 and 2007.” I qualify that by saying “at least on the surface.”
The Fed only cuts 50 basis points at the start of a rate cut cycle as it did in 2001 and 2007 after there’s been a severe deterioration in the markets or the economy. We know the economy is not expanding at a “solid pace,” unless the Fed’s definition of “solid” is the opposite of the dictionary definition. Manufacturing has been in a recession for well over a year, the Dallas Fed Manufacturing index has been negative for 22 consecutive months. Housing hit a wall in May/June and homebuilders have slowed down the rate of housing starts by quite a bit. If it weren’t for a record level of Government deficit spending, the economy would be in a severe recession.
I’ve always maintained that you need to watch what the Fed does, not what it says. If the economy were “in a good place” the Fed would not have needed to start a rate-cut cycle with a 50 basis point cut. In fact, given that the Fed has access to better data than the public, it’s likely that the economy is in worse shape than is discernible from the private sector reports.
We know the Government economic data is manipulated to belie reality by reflecting stronger economic activity and lower inflation than is otherwise factual. During the post-FOMC meeting presser, Powell used the word “recalibration” in reference to the Fed’s level of policy rate being out of sync with the lower inflation rates and rising unemployment. As Rabobank ranted: “Powell had trouble clearly explaining the reason for the large cut because he did not want to admit that the ‘recalibration’ was needed because the FOMC had fallen behind the curve.”
Furthermore, it’s likely that the big bank balance sheets, along with the regional banks, are in worse shape than can be determined with publicly available data. The Fed has been slowly pumping reserves into the banking system since October 2023, which why M2 has risen by $364 billion since October 2023. That number is likely larger now as there’s a two-month lag in the data (the latest number is through the end of July).
The bottom line is that the economy is in trouble both with respect to the declining level of economic activity and the overall level of debt at every level of the economy – public, corporate and house-hold. Furthermore, an increasing percentage of that debt is becoming distressed.
With respect to that latter point, the Government Accountability Office (GAO) estimates that about 10 million borrowers – or 25% – of student loans are behind on payments as of the end of January. About two-thirds of them were more than three months behind. These borrowers are currently protected by a one-year moratorium ordered by the Biden administration that expires next month. There’s currently $1.6 trillion in outstanding student loan debt. The Biden Government has already forced taxpayers to eat $168.5 billion by forgiving it. Of course, that puts more stress on the record spending deficit.