Coverage Initiation: Vroom’s UACC Unit Ends 2023 With $34M of Reorg-Calculated Simple Cash Flow; Continued Progress on Net Interest Margin Depends on Credit Quality Enhancements to Maintain Sustainable Delinquencies as It Expands Serviceable Portfolio

Relevant Documents:
Q4 2023 Earnings Presentation
S-1
Q3 2023 10-Q
UACC 2022-1 Securitization Press Release
S&P UACC 2022-2 Securitization Summary

On Jan. 22, e-commerce-enabled used car dealer Vroom announced its plans to completely wind down its used vehicle dealership business in order to “preserve liquidity … [and] maximize stakeholder value through its remaining businesses.” This followed the company’s inability to raise additional capital to fund the extension of its vehicle floorplan facility. Vroom CEO Thomas Shortt added that the company plans “to sell its current used vehicle inventory through wholesale channels, halting purchases of additional vehicles, and executing a reduction-in-force commensurate with its reduced operation.”

The company said it will focus its efforts on the remaining business units, which include United Auto Credit Corp., or UACC, an automotive financing company focusing on serving nonprime customers, which Vroom acquired in February 2022, and CarStory, an analytics and digital services business unit focused on serving retail automotive customers.

The wound-down e-commerce and wholesale operations accounted for approximately 75% of 2023 sales. Cash flows at UACC, the remaining principal entity, are highly dependent on the spread between the interest income it earns and the cost of its borrowing, which tightened significantly from 2021 to 2023, falling from 24% to 11%. UACC was acquired halfway through this period, and the gross serviceable portfolio expanded significantly, from $636 million in 2021 before the acquisition to $973 million at the end of 2022. At the same time, interest income from the portfolio as a function of the gross portfolio fell from 27% in 2021 to nearly 18% at the end of 2023, potentially indicating delinquencies within the portfolio, which play an important role in maintaining an adequate spread to cover fixed and one-time expenses. The company addressed delinquencies in its latest presentation, indicating that it sought to improve underwriting standards as delinquencies ballooned in 2022.

Initial indications of a potential wind-down were initially provided in the third-quarter 10-Q, in which the company stated, “The 2022 Vehicle Floorplan Facility has a borrowing capacity of $228.1 million as of September 30, 2023, of which $15.6 million was unutilized and … mature(s) on March 31, 2024. The Company has commenced discussions with its floorplan lender [Ally Bank and Ally Financial] … [which] recently indicated its willingness to extend the floorplan facility beyond June 2024 would be contingent upon the Company raising additional capital. … In the event that a capital raise is required by Ally or another lender, there can be no assurance that such additional capital would be available in the required amount or on terms acceptable to the Company, if at all. Failure to secure floorplan financing beyond the expiration of the 2022 Vehicle Floorplan Facility would have a material adverse effect on the Company’s ability to finance its inventory and operate its core used automotive sales business” (emphasis added).

Capital Structure

Cash Flow Analysis

As shown below, UACC’s total interest income and net interest income dropped in 2022 to $107 million and $95 million, respectively, from reported highs of $162 million and $148 million, respectively, in 2021. The reduction reverberates down to simple free cash flow, before working capital adjustments, as calculated by Reorg, and with 2022 at approximately $19 million, less than a quarter of the simple cash flow generated in 2021.

The table below using Reorg calculations shows the sensitivity of UACC’s simple free cash flow to the size of the gross serviced portfolio and the net interest margin the company generates, assuming that cash operating expenses as a function of the gross serviced portfolio remain at their historical level of approximately 8%.

The company provided a stand-alone income statement for UACC as shown below.

Reorg’s methodology is similar to how we have analyzed other companies with similar revenue models, such as Curo, looking at net interest margin, or total interest income, or income derived from interest gained through securitization lending less interest expense, or the cost of sales for a finance company. The difference is net interest income, essentially a gross profit. This figure should be large enough to cover operating expenses and other miscellaneous expenses, such as a $31.5 million one-time expense as part of the value maximization plan. As indicated above, as of Dec. 31, 2023, the company had approximately $287 million of unsecured convertible debt with a 75 bps coupon and over $400 million of warehouse line floating-rate debt, both of which are included in the interest expense line item added back to arrive at company-reported adjusted EBITDA.

Delinquencies: A Key Underlying Driver to Results

Keeping in mind that Vroom acquired UACC in February 2022, the storyline with the changing trajectory of simple cash flow (before working capital impacts) and tightening spreads pertains to increasing interest rates from 2022 and 2023 as well as changes in credit quality of the customer base that affected delinquencies and ultimately implied interest income rates.

In 2021, UACC had a net interest spread of 24% with a portfolio size of only $636 million and a 27% implied interest income rate. However, in 2022 the company increased its serviceable portfolio base by over 50% but lost more than 50% of its net interest spread; this cut simple cash flow, before working capital, by more than 75% to $19 million from a Reorg-calculated high of $86 million for the historical period. The sharp decline in net interest spread in 2022 as interest expense as a function of the average portfolio size fell indicates this was likely driven by an increase in delinquencies.

Comparing 2022 and 2023, UACC suffered a more than doubling of its average interest rate expense to 6.3% in 2023 from 2.3% in 2022. UACC added $124 million in serviced loans to its portfolio in 2023, ending the year with $1.1 billion, which may have contributed to an increased implied interest rate. The chart below provided by the company indicates that this may have been driven by tightening underwriting standards.


UACC’s Debt Includes Warehouse Lines and Securitization Debt

Warehouse Facilities

The company relies on warehouse facilities to provide liquidity to finance third-party auto financing. UACC draws on the warehouse lines and provides auto financing to subprime customers who elect to purchase a vehicle through a dealership that relies on UACC for customer financing. As the company accumulates loans to customers, it aims to move the loans off balance sheet via a securitization process (see below), repaying the warehouse lender using proceeds received from the issuance of asset-backed securities, or ABS. However, UACC still maintains the assets and securitization debt for three of its securitization variable interest entities, or VIES, on its balance sheet, because of specific issues associated with the deals.

While the warehouse lines are drawn, the facility is secured by the finance receivable generated from the loan extended to the purchasing customer.

Securitization Debt

When the company has enough loans, it creates a securitization vehicle funded with loans from the ABS market, which may allow the company to move both the assets and the liabilities off its balance sheet. However, the securitization may not successfully clear the market, or the company may elect to hold the loans on its balance sheet as secured borrowings. For example, in January 2023, UACC marketed 2023-1 ABS. However, because of unfavorable pricing in the market, the company had to hold on to the non-investment-grade tranche, and as a result it was required to capitalize the entire ABS on its balance sheet as secured borrowing. The non-investment-grade bonds were eventually sold off, but as UACC is still considered the “primary beneficiary” of these VIEs, it is required to consolidate the entire ABS on its balance sheet under secured debt.

Financing of Beneficial Interests in Securitizations - Offloading the Retained Risk

Regulations for sponsoring ABS transactions require the sponsor to retain at least 5% of the securitized assets, known as “risk retention.” However, sponsors can seek financing to provide liquidity for the 5% of assets that can be locked in the ABS securities. UACC, for example, recently sought financing for $24.5 million of its retained beneficial interests, accounting for UACC’s shared risk for all of its securitizations, because the $24.5 million was essentially locked into a fixed and long-term payment timeline.

In exchange for the $24.5 million of collateral, UACC received proceeds of $24.1 million, and the securitization trusts wire the risk retention proceeds directly to the lender that underwrote the financing of UACC’s beneficial interests. The balance as of Dec. 31 was $15.4 million.

Convertible Notes

In June 2021, the company issued $625 million in convertible bonds due July 2026. However, given trading prices of the bonds, the company has been aggressively repurchasing the bonds. Since 2022, the company has repurchased $328.5 million of the bonds for $126.7 million, using balance sheet cash primarily generated from the company’s IPO in June 2020.

Cash

The company noted in its fourth-quarter presentation that it expects to end 2024 with $35 million to $65 million of cash and cash equivalents, compared with $136 million at the end of 2023.

Below is a summary of the drivers of cash burn during the fourth quarter of 2023:


Shuttered Businesses Accounted for 75% of 2023 Revenue

Risks

Hung Deals

As of 2022, the auto asset-backed securities market was approximately $111 billion, with subprime $37 billion in the same year. While there exists a large market for subprime ABS credit, exogenous factors such as interest rates still play a critical role in determining successful marketing efforts. For example, there still exists the risk that UACC’s securitizations get “hung” - the market refusing to finance the structure in full, potentially because of unfavorable market dynamics and pricing. As a result, UACC would retain the subprime receivables on the balance sheet and the associated warehouse facility, which would likely be more expensive than the securitization financing.

This risk materialized in January 2023 when the company attempted to sell UACC 2023-1 securitization, but “as a result of market conditions at the time, which led to unfavorable pricing, [Vroom] retained the non-investment grade securities and residual interests in UACC's 2023-1 securitization, requiring that the transaction remain on balance sheet pending the sale of the additional retained interests.” When the company is not able sell the notes or residual interests, it is not able to recognize a sale and must maintain the notes on its balance sheet under secured borrowings.

Excessive Losses Due to Customer Delinquencies

UACC can take outsized losses when customer delinquencies rise amid failure to pay principal and interest. For example, from January to March 2023, UACC waived its servicing fee on the 2022-2 securitization, because of higher-than-expected losses, which transferred more than an insignificant portion of the corresponding risk of loss from the VIE back to UACC and effectively to Vroom. In other words, as the sponsor and the equity, or certificate holder, UACC, has significant authority to direct the VIEs’ activities and as a result must absorb the loss and record the entire securitization on its balance sheet as secured debt.

Vroom notes in its recent 10-K that “[a]s a result of high interest rates, the current inflationary environment and vehicle depreciation in the used automotive industry, UACC is experiencing higher loss severity (emphasis added). The increased loss severity could lead to reduced servicing income if UACC elects to waive monthly servicing fees going forward as it did in the first quarter of 2023. The waiver of monthly servicing fees related to the 2022-2 securitization transaction resulted in consolidation of the related finance receivables and securitization debt on our financial statements.”