Item 1. Business
Unless otherwise indicated, the terms “DriveTime,” the “Company,” “we,” “our” and “us” refer to DriveTime Automotive Group, Inc. and its consolidated subsidiaries.
Business Overview
We are the leading used vehicle retailer in the United States with a primary focus on the sale and financing of quality vehicles to the subprime market. Through our company owned dealerships, we provide our customers with a comprehensive end-to-end solution for their automotive needs, including the sale, financing, and maintenance of their vehicles, by offering our DriveCare® limited warranty. Over our company history, we have sold and financed over 900,000 vehicles. As of December 31, 2012, we owned and operated 97 dealerships and 17 reconditioning facilities located in 44 geographic regions throughout 19 states. On average we have over 7,500 vehicles available for sale at our dealerships. For the year ended December 31, 2012, we sold 59,930 vehicles, generated $1.2 billion of total revenue, and generated $160.1 million of Adjusted EBITDA. As of December 31, 2012, our loan portfolio had a total outstanding principal balance of $1.6 billion.
Over the past 20 years, we have developed an integrated business model that consists of vehicle acquisition, reconditioning, sales, underwriting and finance, loan servicing, and after sale support. We believe our model enables us to operate successfully in the underserved subprime market, and provides a platform which allows us to systematically open new dealerships in existing and new markets throughout the United States.
The DriveTime Brand
In recent years, the DriveTime brand has evolved from a traditional buy-here, pay-here dealership model to a comprehensive retail experience. Our dealerships are retail focused and facilitate the sale of our vehicles through dealerships with a customer centric focus. We have opened 21 new dealerships over the past two years under this model. We have also remodeled all of our existing dealerships and branded them with a spacious contemporary design, unique signage and flooring, and modern furniture and color patterns. We believe our branded dealership facilities are essential to our customer experience and help promote our image as a courteous, transparent, respectful and trustworthy business.
Our website focuses on the approval process, vehicle inventory selection, and the unique features of the DriveTime brand. It provides customers with comprehensive information about available inventory, including pictures of dealerships, pictures of vehicle inventory, vehicle pricing, and specifications of each vehicle. The website also educates customers on how to complete a credit application and schedule a visit at a dealership. Our internet call center is available for customers to ask questions, discuss financing, inquire about our warranty, and schedule an appointment prior to visiting one of our dealerships. These features are focused on helping customers get comfortable with our straightforward sales approach and obtain information on our differentiation within the subprime used vehicle market prior to and without having to physically visit a dealership. This approach is intended to provide customers peace of mind when dealing with sensitive credit issues. After purchasing a vehicle, our customers also have access to www.mydrivetime.com, which allows them to manage their account, sign up for ACH payments, make one time payments, and see their account balance. We believe that www.mydrivetime.com adds clarity and enhances our customer relationship throughout the life of the customer's loan.
As of December 31, 2012, information regarding the regions in which we operate is as follows:
(1) New region for the Company for 2012.
Integrated Business Model
Our integrated business model is focused on giving our customers the ability to acquire quality used vehicles through the following key activities:
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Vehicle acquisition. We acquire inventory primarily from used vehicle auctions. Our centralized vehicle selection strategy takes into account many factors, including the retail value, age, and costs of buying, reconditioning, and delivering the vehicle for resale, along with buyer affordability and desirability. Our supply chain analytics and centralized purchasing strategy are integrated with our distribution of vehicles in order to maintain the optimum mix of vehicle inventory at each dealership based on specific dealership demand in each market. It also factors in pricing and deal structure for the finance component of our business, enabling us to quickly adjust vehicle acquisition and pricing in light of market conditions and to ensure affordability at all of our dealerships.
Using our proprietary models and real-time data, we deliver weekly buy targets to our buyers based on current inventory levels, projected sales volumes, inventory turn times, and targeted vehicle pricing. We acquire inventory from used vehicle auctions, daily rental agencies, and commercial fleets. Approximately 88% of our inventory is acquired through on-line or live auctions, with the remainder purchased through fleet purchases and other sources. On-line purchases account for approximately 20% of our auction purchases.
At December 31, 2012, we employed 39 buyers who averaged over five years of experience with us. For the year ended December 31, 2012, we purchased 78,190 vehicles from over 120 auctions nationwide, with over 70% of those purchased from two national wholesale auction companies.
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Vehicle reconditioning and distribution. Subsequent to acquisition, vehicles are transported to one of our regional reconditioning facilities, where we recondition the vehicles and perform a rigorous multi-point inspection for safety and operability. The inspection process assists us in evaluating the extent of repairs required
for each vehicle and helps in evaluating profitability of vehicle sales. We centrally determine the distribution of vehicles to our dealerships based on current inventory mix and levels, along with sales patterns at each dealership. We utilize our proprietary inventory management system to determine and monitor labor, parts, and other costs associated with reconditioning each vehicle. Reconditioned vehicles are distributed to our dealerships based on real-time projected inventory turn times and levels at each dealership.
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Vehicle sales. Our sales process is designed to facilitate the delivery of a vehicle to a customer, educate our customer on financing terms and payment options, educate the customer on our warranty, and choose the right vehicle for the customer's needs. The sales process often starts with customers visiting our website and setting an appointment at a dealership. Our inventory and inventory pricing is available on-line and we have recently released a mobile website that allows customers to search vehicle inventory on their smartphones. Our no-haggle vehicle pricing is displayed on each vehicle's sticker and on our website. Prices are determined centrally for all dealerships and all regions.
We employ proprietary inventory management and pricing systems which are integrated with and into our credit scoring system to facilitate the optimum vehicle for our customers' needs. Sales and credit grade are generally down payment sensitive. Down payments can take the form of cash or vehicle trade-in.
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Marketing. We utilize targeted television, radio, and online advertising programs to promote our brand and encourage customers to complete an online credit application and visit one of our dealerships.
We have refined our advertising campaign to emphasize more information about our sales process, including the following: lower down payments than our competition, the option to be approved on our website, in person, or through a mobile device, and extra benefits included as part of the purchase price, such as our DriveCare® limited warranty. Our current TV advertising strategy features the tag line “We Bring People and Cars Together.” Our new TV advertisements focus on the availability of our inventory to fit our variety of customer needs, whether their needs call for a family vehicle, economy car, SUV or pick-up truck.
A vital component of our lead and sales generation is web-based marketing and online assets. Approximately 57% of our sales are generated by customers who complete an online application prior to visiting one of our dealerships. Credit applications are submitted via www.drivetime.com. In addition to our websites, we generate leads and sales through search engine optimization, pay-per-click marketing, targeted e-mail, third-party, and affiliate marketing.
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Underwriting and finance. Using information provided as part of the credit application process, our centralized proprietary credit scoring system determines a customer’s credit grade and the corresponding minimum down payment and maximum installment payment. We monitor the performance of our portfolio and close rates on a real-time basis, allowing us to centrally adjust pricing and financing terms to balance sales volumes and loan performance. For more information on underwriting, see "Underwriting and Credit Scoring Models" below.
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Loan servicing. We perform all servicing functions for our loan portfolio, from collections through the resale of repossessed vehicles. Customers can make cash payments through an electronic payment network at over 3,900 Wal-Mart stores and more than 17,000 other locations nationwide. Customers also can make payments through traditional payment methods such as check, money order, bill-pay, and ACH. Our experienced collection staff utilizes our proprietary collection software, which we developed specifically for subprime auto loans. We use behavioral models designed to predict payment habits, as well as automated dialer and messaging systems to enhance collection efficiency. We utilize our vehicle acquisition and sales expertise in representing our vehicles at auction in order to maximize the recovery value of repossessed vehicles.
Beginning in 2012, each of our vehicles is equipped with an anti-theft GPS device that not only assists in tracking and recovering vehicles if stolen, but in many cases helps to lower auto insurance rates. This device is also used by our collections team in the event we need to recover the vehicle post-charge-off. The device does not contain a starter interrupt feature.
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After sale support. After-sale support consists of our DriveCare® limited warranty. In the majority of the states in which we operate, the warranty is included with each vehicle we sell as part of the sales price. In certain states, the warranty is sold as a separate service contract. During the fourth quarter of 2012 we began a pilot, whereby we're offering the DriveCare® warranty as a separately priced product, apart from the price of the vehicle. We both self-administer our warranty program through our in-house team of customer service representatives, as well as use a third party warranty administrator. Our DriveCare® limited warranty includes a 36 month/36,000 mile warranty which covers major mechanical and other electronic components of the engine block, the transmission, climate control, and drive axles.
Dealership Operations
Each of our dealerships features a wide selection of makes and models to satisfy the preferences and budgets of our potential customers. Our dealerships generally maintain an inventory of approximately 75 vehicles and we offer a broad spectrum of brands. Over 75% of our inventory is comprised of vehicles from Chevrolet, Ford, Dodge, Chrysler, Nissan, Toyota, Pontiac, Hyundai, Kia and Mitsubishi. To a lesser extent, our current inventory also features brands such as Honda, Audi, BMW, Mercedes, Volvo and Infiniti. Our newly renovated and branded dealership facilities feature a contemporary, open floor plan that provides customers with a degree of transparency throughout the buying experience that is uncommon in the subprime market. Spacious floor plans are supplemented with interactive workspace, no "back-office," and a customer friendly atmosphere.
Customers are guided through the retail process by our personnel. Our retail process is designed to be transparent and to let the customer “drive” the process. Customers are provided with information on the purchase process and transactions move at the customer’s pace. Our dealerships are generally located in high traffic commercial districts and showcase our DriveTime logos and color schemes.
Each dealership is operated by a general manager, who has responsibility for the operations of the dealership facility and is compensated in part based on overall dealership profitability and other operating metrics. Our dealerships also typically employ between one to three sales managers, seven to ten sales advisors, and administrative support personnel. Sales advisors' primary compensation is comprised of a base salary and incentive bonus programs focused on dealership profitability, as well as the achievement of monthly sales targets.
Underwriting and Credit Scoring Models
We provide financing for substantially all of the used vehicles we sell at our dealerships through retail installment sales contracts. The foundation for underwriting these loans is our proprietary credit scoring models.
We have dedicated, and will continue to dedicate substantial resources to developing, maintaining, and updating our proprietary credit scoring models that are focused on predicting the credit risk of our customers. Many companies use FICO scores as a standard metric to assess the credit risk of customers. Our scoring models provide a substantial improvement over traditional FICO scores in rank-ordering the likelihood of credit risk default within the subprime auto segment. Our scoring models utilize alternative data sources along with traditional credit bureau data to enhance the ability to separate the credit risk levels of the subprime auto segment into different categories. Our alternative data sources span hundreds of different metrics and are utilized to enhance the predictability of loan performance through additional behavioral statistics and external reference data. Our centralized proprietary credit scoring models are currently used to classify customers into various risk grades that are linked to financing parameters. We have over ten years of experience in developing credit scoring models that are more finely tuned to the nuances within the subprime auto segment. Our internal scoring model is comprised of eight credit grades ranging from A+ to D-, with A+ being the highest and D- being the lowest credit grade. Approximately 93% of our portfolio is graded C and above, with just 7% scored C- and below. We believe our ability to quantify a customer's risk profile based upon historical data, breadth of data, and sophisticated modeling techniques, allows us to better predict loan performance, manage the blended quality of our portfolio of loans, and obtain more appropriate risk adjusted returns than relying on more generic predictors such as FICO scores.
Our scoring models are periodically updated to account for changes in loan performance, data sources, economic cycles, and business processes. We deployed our first credit scoring model in July 2001. Since then, we have implemented seven subsequent generations of credit scoring models. We generally update and enhance our models on an 18-24 month rotation. The credit scoring models have evolved over time to better leverage data collected from additional data sources than in prior models, resulting in improvements in identifying differences in the credit risk of our customers and in our ability to more accurately predict loan performance.
Prior to each sale, we require our customers to complete a credit application. Upon entering the customer information into our origination system, our proprietary credit scoring system determines the customer's credit grade. The credit grade and down payment generates the selection of vehicles that meet the customer's needs and are within the parameters of the available financing terms. The customer's credit grade and type of vehicle determine the term, maximum installment payment, and minimum payment amounts. The annual percentage rate (APR) charged is a function of the customer's credit grade, down payment, and model year of the vehicle along with state mandated limits. Our centralized risk management and pricing departments set these terms and they cannot be altered by dealership personnel.
Our centralized risk management group manages the credit mix of our loan portfolio on a company-wide basis. This group is also responsible for monitoring the origination and underwriting processes, providing underwriting training to the dealerships, monitoring loan servicing, and static-pool tracking of portfolio loss performance and profitability. The static-pool tracking of portfolio loss performance is also monitored by our internal credit grade. Over the past several years, the unit loss
rate results by credit grade have been relatively consistent through economic cycles and across different generations of scoring models.
We actively monitor our portfolio performance and the credit grade mix of originations. We regularly analyze the grade mix of originations through the financing terms provided to our customers, which are established centrally. We have higher minimum down payments and lower maximum installment payments for our lower credit grade customers, resulting in lower close rates for our lower credit grade customers. Our loans have an average original term of approximately 57 months and an average life of 31 months, due to charge-offs and pay-offs. Due to the fact that our loans have a relatively short average life, we are able to closely monitor credit trends and make appropriate adjustments to both the grade mix and pricing of our originations.
Monitoring and Collections
After completing a sale, each loan is automatically added to our comprehensive loan servicing and collection system. Our proprietary collection system was developed specifically for subprime auto loans and provides the transparency and tools necessary to effectively and efficiently service our loan portfolio. We use a centralized collections approach and do not have collectors residing in dealership locations.
Our early delinquencies are managed through the use of an automated dialer and messaging system to provide optimum collection efficiency for early delinquencies. The early delinquencies (one to 16 days past due) are managed by our offshore collections partner, and are actively overseen by domestic collections management.
Our delinquencies 17 to 43 days past due are managed by our Dallas, Texas collection facility personnel utilizing a manual and dialer effort. Delinquencies 44 to 60 days past due are managed by our Mesa, Arizona collection facility personnel. These collections are primarily manual (non-dialer) and are managed through daily queues of delinquent accounts for each collector to manage based on the customer's delinquency status.
Our back-end collections (generally 61+ days past due) are all handled through our Mesa collections facility primarily through our strategic manual process. The Mesa facility also manages our specialty groups such as new loans, bankruptcy, repossession, insurance, and military programs.
Collectors focus their efforts on obtaining customer payments, educating our customers on payment options and explaining our warranty (for vehicles in need of repair). All collector calls are recorded and recorded calls are randomly selected for quality review. Calls are evaluated based on (i) respect - listening to the customers and showing that we understand their situation; (ii) transparency - empowering customers with information to help them be successful; and (iii) options - being solution focused and helping to educate customers about different tools and programs available to them.
During 2011, we began installing anti-theft/GPS units on our vehicles. For collection purposes, these units are used to locate vehicles and assist us in repossessing vehicles more effectively when collection efforts have been exhausted. These units can also assist the customer in locating a stolen vehicle. These units do not include starter-interrupt functionality.
We also employ a recovery team that utilizes an extensive network of qualified third-party repossession agents throughout the country. These agents are assigned repossession rights to recover the vehicles at our direction and transport recovered vehicles to vehicle auctions. All repossessed vehicles are then sold at auction to establish a fair market recovery value. We utilize our vehicle acquisition and sales expertise in representing our vehicles at auction in order to maximize the recovery value of repossessed vehicles.
Indirect Lending - GO Financial
In December 2011, we launched a new indirect lending line of business, GFC Lending, LLC dba GO Financial (“GO Financial” or "GO"). GO provides subprime auto financing to third-party automobile dealerships. The third-party automobile dealerships originate retail installment sales contracts to finance purchases of vehicles by customers with demographics similar to DriveTime. GO enters into a dealer servicing agreement with each of the third-party automobile dealerships whereby, subsequent to verification of a qualifying customer loan, GO advances funds to the dealership through a non-recourse loan (“dealer advance”). Once originated, GO performs the loan servicing of both the dealer advance to the dealership and the underlying customer loan to the end customer. Another subsidiary of DT Acceptance Corporation ("DTAC") (“DTCC”) serves as the servicer of the underlying customer loans, on behalf of GO. GO generally does not have recourse to the dealerships with respect to customer loan performance. GO has a secured interest in each customer loan and the underlying collateral (the vehicle) and receives priority repayment of customer loans from cash flows collected by GO from customers.
The amount of each dealer advance from GO to a dealership is dependent upon the vehicle, our credit rating of the dealership and the credit quality of the customer, and is a percentage of the amount financed. GO provides the third-party dealership with a credit scoring model and underwriting guidelines. The dealer advance amount generally ranges from sixty
percent (60%) to eighty percent (80%) of the customer loan. The exact amount of each dealer advance from GO to the dealership varies from loan to loan, based on a predetermined set of risk characteristics. Each individual dealership builds discrete pools of loans and dealer advances are repaid by the dealerships based on cash flows collected by GO from the pool of underlying customer loans. Based on certain qualifications, GO offers a pool-closing advance, which provides dealers incentive to originate the minimum number of loans required to close a pool.
In general terms, each dealer agreement is a form of cash flow sharing arrangement. The dealer agreement assigns the responsibilities for administering, servicing, and collecting the amounts due on customer loans from the dealership to GO. The dealer agreement states that as cash payments are received from the underlying pool of customer loans, twenty percent (20%) of the cash is allocated to GO as a return, covering both GO’s interest income on the dealer advance and a servicing fee related to the customer loan. Cash collections are then allocated to repayment of incremental and direct servicing expenses incurred by GO and then allocated to the pay down of the dealer advance. Once all dealer advances within a pool have been paid in full, the future payments received from customers continue to be allocated twenty percent (20%) to GO and the remaining cash, net of any incremental and direct servicing expenses, is allocated and remitted to the dealership.
We believe this indirect lending program provides an opportunity for independent dealerships to sell additional vehicles to customers with subprime credit, and provides us with incremental profitability to supplement our existing operations. At December 31, 2012 and 2011, we had $41.0 million and $24.0 thousand, respectively, in dealer finance receivables outstanding.
GO's capital to date has been generated by contributions from its parent, DTAC. For the year-ended December 31, 2012, DTAC contributed approximately $41.7 million to GO for its funding needs and for general corporate purposes. GO does not currently have a third party lending arrangement and is seeking to obtain its own warehouse lending facility apart from that of DriveTime.
With the introduction of the indirect lending line of business through GO, we have determined that we have two reportable business segments, one for our core DriveTime operations and one for GO. See Note 20 to our consolidated financial statements under “Item 8 - Financial Statements and Supplementary Data” for financial information regarding our operating segments.
On-Line Auto Sales - Carvana
In January 2013, we launched Carvana. Carvana, LLC is a new sales channel that enables a customer to buy a car, from click to delivery, 100% online over the internet. Carvana's target customer demographic is not specific to credit, and is geared to attract a broader credit spectrum and income classification than that of DriveTime and GO Financial. Carvana (www.Carvana.com) is a 360-degree, integrated used car buying experience that enables consumers to purchase used vehicles online through a highly efficient and transparent process. Initially launching in Georgia, with plans to expand regionally, then nationally, Carvana’s business and operations will fully integrate all steps of the vehicle sales process, including: (a) vehicle search (b) vehicle tour and detail (c) credit scoring (d) customer financing (e) eContracting (f) verification of customer data (g) electronic down payment, and (h) vehicle delivery. Carvana is not expected to have a significant net impact to our consolidated results for 2013. To a certain extent, Carvana will utilize DriveTime's existing infrastructure, with customized aspects of each component of the DriveTime business process.
Intellectual Property
We have an ongoing program under which we evaluate our intellectual property and consider appropriate federal and state intellectual property related filings. We believe that there is significant value in our trademarks, but that our business as a whole is not materially dependent on our trademarks. We believe we have taken appropriate measures to protect our proprietary rights.
Employees
At December 31, 2012 we employed 2,530 people, consisting of 1,820 people in our retail operations, 440 people in our portfolio operations, 230 people in our corporate operations and 40 in our indirect lending operations. None of our employees are covered by a collective bargaining agreement and we generally believe that relations with our employees are good.
Competition
We operate in a highly fragmented and competitive industry. Our primary competitors include a number of used vehicle departments of franchise dealers, “buy-here, pay-here” dealerships, and independent used vehicle dealers that operate within the subprime segment of the used vehicle sales industry. We also compete with a broad range of financial institutions and independent finance companies offering financing in the subprime segment and the banks and finance companies that purchase their loans. We continually strive to successfully distinguish ourselves from our competitors and compete in this
industry in a cost-effective manner. In addition, periodically larger companies with significant financial and other resources have entered or announced plans to enter the used vehicle sales and/or finance industry, or relax their credit standards and compete with us, at least at the upper end of our customer segment. These dealerships also compete with us in areas such as the purchase of inventory, which can result in increased wholesale costs for used vehicles and lower margins. These dealerships and finance companies could also enter into direct competition with us at any time at the lower end of the subprime market.
While traditional financial institutions have not consistently serviced subprime borrowers, the high interest rates and margins of companies involved in subprime financing have, at times, encouraged certain of these traditional institutions to enter, or to contemplate entering, this market. During the past economic downturn, many finance companies reduced or eliminated subprime auto financing. More recently, however, companies have re-entered our market presenting new competition, which has resulted in increased subprime auto originations nationwide. Traditional lenders have also increased their subprime auto finance originations.
Integrated Information Systems
We manage the operations of our reconditioning facilities, dealerships, loan servicing centers, and our accounting and reporting functions with an integrated information system. When we purchase a used vehicle, our purchasing group records the purchase in our system, and the system adds the vehicle to inventory and makes the appropriate accounting entries for vehicle cost. Reconditioning costs are also tracked for each vehicle. When a sale occurs and a loan is generated, the system adds the loan to our loan servicing and collection systems. We use both local and wide-area data and voice communication networks that allow us to account for all purchase and sale activity centrally and to service large volumes of contracts from our centralized collections facilities. We also have internally developed comprehensive databases and management tools, including credit scoring models, static pool analyses, behavioral scoring, and predictive modeling to set inventory acquisition and underwriting guidelines, structure contract terms, establish collection strategies, and monitor underwriting effectiveness.
Our systems and databases are maintained in secured data centers. Our data centers are configured with redundant power, cooling, and network access. Fire protection systems, including passive and active design elements, are installed. We utilize multiple backup systems in an effort to ensure uninterruptible power. Our network features multiple wide area network connections using a redundant routing architecture and multiple access points to public networks. Systems and databases are configured for high availability and disaster recovery. We have a comprehensive disaster recovery plan in place to cover intermittent or extended periods of interruption in one or more of our critical systems and we periodically test our disaster recovery procedures.
Industry
We operate in the large and highly fragmented used vehicle sales and financing markets. According to CNW Research, for 2012, used vehicle sales were generated from 54,000 franchise and independent dealers nationwide.
Used vehicle sales. The market for used vehicles is among the largest and most highly fragmented retail markets in the United States, with no single used vehicle retailer holding more than 1% of market share. Although the number of industry-wide dealerships has contracted in recent years, due to the recessionary environment and franchise terminations, unit sales of used vehicles have recently increased. According to CNW, in 2012 there were 40.5 million used vehicle sale transactions, representing 73.7% of the overall vehicle market by unit sales. Sales typically occur through one of three channels: (i) the used vehicle retail operations of the approximately 16,000 manufacturer-franchised new car dealerships, which represented 37.0% of industry sales in 2012, (ii) approximately 38,000 independent used vehicle dealerships, which represented 34.6% of industry sales in 2012, and (iii) individuals who sell used vehicles in private transactions, which represented 28.4% of industry sales in 2012.
Vehicle financing. The industry is generally segmented by credit characteristics of the borrower (prime versus subprime). According to CNW, originations for customers within the subprime used vehicle market averaged $29.1 billion per annum over the last five years ending December 31, 2012, and increased to $43.1 billion in 2012, a $2.5 billion increase over 2011.
The used vehicle financing segment is highly fragmented and is served by a variety of financing sources that include independent finance companies, “buy-here, pay-here dealers,” and select traditional lending sources such as banks, savings and loans, credit unions, and captive finance subsidiaries of vehicle manufacturers. Many traditional lending sources have historically avoided the subprime market due to its relatively high credit risk and the associated collection efforts and costs, however, in recent years traditional lending sources have increased their subprime lending.
Our market. Within the subprime market, we cater to customers who have the income necessary to purchase a used vehicle, but because of their impaired credit histories, cannot qualify for financing from traditional third-party sources
generally because they do not have the required down payment. Our average customer is 30 to 45 years of age, has an annual income of $35,000 to $50,000, and has a FICO score between 475 and 550. A customer with a FICO score below 620 is typically considered to have subprime credit.
Regulation
Our sales, finance, and collections operations are subject to ongoing regulation, supervision, and licensing under various federal, state, and local statutes, ordinances, and regulations. Among other things, these laws require that we obtain and maintain certain licenses and qualifications, limit or prescribe terms of the contracts that we originate, provide specified disclosures to customers, limit our right to repossess and sell collateral, and prohibit us from discriminating against certain customers.
Our financing activities with customers are subject to federal truth-in-lending, fair credit reporting, and equal credit opportunity laws and regulations, as well as state and local motor vehicle finance laws, installment finance laws, usury laws, and other installment sales laws. Our debt collection activities with customers are subject to federal fair debt collection practices and fair credit reporting laws and regulations. We are also subject to federal and state consumer protection, privacy, and related laws and regulations. We charge fixed interest rates in excess of traditional prime and non-prime finance companies on the contracts originated at our dealerships. Some states regulate finance fees and charges that may be paid as a result of vehicle sales.
The Dodd-Frank Wall Street Reform and Consumer Protection Act, which was signed into law on July 21, 2010, established a new regulator, the Consumer Financial Protection Bureau, to oversee consumer financial products and services, including mortgage, credit card, payday lending and auto finance. The Bureau’s authority includes rule making, enforcement and an array of enforcement tools ranging from fines to legal action. The Bureau is also establishing cooperation agreements with various agencies including the Federal Trade Commission and State Attorneys General. The Federal Trade Commission retains certain of its rule making and enforcement authority, including enforcement authority over the Federal Debt Collections Practices Act and for warranty issues, and under the new law it is required to prescribe rules addressing unfair and deceptive practices by auto dealers.
Environmental
We are subject to a complex variety of federal, state, and local laws, regulations, and permits relating to the environment and human health and safety. These requirements change frequently and tend to become more stringent over time, and are a significant consideration for us as our operations involve the use of storage tanks, the disposal of wastewater, and the emission of hazardous substances to the air, as well as the use, storage, recycling, and disposal of hazardous materials, such as motor oil and filters, transmission fluids, antifreeze, refrigerants, paints, thinners, batteries, cleaning products, lubricants, degreasing agents, tires, and fuel. If we violate or fail to comply with these laws, regulations, or permits, we could be fined or otherwise sanctioned by regulators. Pursuant to such requirements, we have made and will continue to make capital and other expenditures.
Item 1A.
Item 1A. Risk Factors
You should carefully consider the following risks and the other information contained in this report, including our consolidated financial statements and related notes and “Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations.” The risks described below are those that we believe are the material risks we face. Any of the risks described below, and others that we may not anticipate, could significantly and adversely affect our business, prospects, financial condition, results of operations, and liquidity.
We require substantial capital to finance our business.
We have borrowed, and will continue to borrow, substantial amounts of capital to fund our operations and we periodically refinance such debt. If we cannot obtain the financing we need, or cannot do so on a timely basis and on favorable terms, our liquidity could be materially adversely affected.
At December 31, 2012, we had approximately $1.4 billion in aggregate principal amount of indebtedness outstanding, which includes $57.2 million under portfolio warehouse facilities that are due to expire between 2013 and 2014, depending on the facility. The portfolio warehouse facilities contain term-out features resulting in final maturities between 12 and 24 months from their expiration dates, depending on the facility.
We historically have restored capacity under our portfolio warehouse facilities from time to time by securitizing portfolios of finance receivables and/or obtaining bank term financing. The volatility of the securitization market and our ability to successfully and efficiently complete securitizations and bank term financings are affected by the condition of the financial markets generally, conditions in the asset-backed securities market specifically, the performance of our securitized portfolio and the macro-economic environment generally.
Since the disruption in the securitization markets at the onset of the financial crisis a few years ago, we have obtained alternative financing through a variety of debt instruments, including bank term financing through which we entered into private securitization transactions, securing over $800.0 million in portfolio financing, $60.1 million in third party junior secured notes, $200.0 million in senior secured notes, and $75.0 million in shareholder financings.
There is a risk that in the future, we may not be able to secure similar additional financing, execute securitizations, or renew loans and facilities if lenders and counterparties are also facing liquidity and capital challenges. Such an inability to obtain or renew financing could adversely affect our liquidity, financial condition, and results of operations.
Our substantial debt could have adverse effects on our business and we may incur additional indebtedness in the future.
For the year ended December 31, 2012, we paid $73.0 million in cash for interest charges associated with our debt obligations. We may incur additional debt in the future, causing our cash payments for interest to increase. The degree to which we are leveraged, and to which we may become leveraged, could have adverse effects on our business, including as follows:
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Our ability to obtain additional financing in the future may be impaired.
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A significant portion of our cash flow from operations must be dedicated to the payment of interest and principal on our debt, and related expenses, which reduces the funds available to us for our operations.
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Some of our debt is and will continue to be at variable rates of interest, which may result in higher interest expense in the event of increases in market interest rates.
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The agreements that govern our indebtedness contain, and any agreements to refinance our indebtedness likely will contain, financial and restrictive covenants, and our failure to comply with such covenants may result in an event of default, decrease in advance rate, or increase in interest rate, which, if not cured or waived, could result in the acceleration of that indebtedness and trigger an event of default under other indebtedness.
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Our level of indebtedness will increase our vulnerability to general economic downturns and adverse industry conditions.
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Our debt service obligations could limit our flexibility in planning for, or reacting to, changes in our industry.
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Our leverage could place us at a competitive disadvantage vis-à-vis our competitors who have less leverage relative to their overall capital structures.
Interest rates affect our profitability and cash flows and an increase in interest rates will increase our interest expense and lower our profitability, cash flows, and liquidity.
Much of our financing income results from the difference between the rate of interest that we pay on the funds we borrow and the rate of interest that we earn on the finance receivables in our portfolio. While we earn interest on our finance receivables at a fixed rate, we pay interest on certain of our borrowings at variable rates. When interest rates increase, our
interest expense increases. Increases in our interest expense that we cannot offset by increases in interest income could have a material adverse impact on our profitability and liquidity. Correspondingly, a significant reduction in our average APR could have a material adverse impact on our profitability, if not offset by a corresponding reduction in our loan losses, borrowing costs, or increases to gross margin on vehicles sold.
Reduction in the credit rating of our senior secured notes due 2017 ("Senior Notes") could restrict our access to the capital markets and adversely affect our liquidity, financial condition and results of operations.
Credit rating agencies evaluate us, and their ratings of our Senior Notes and creditworthiness are based on a number of factors. These factors include our financial strength and other factors not entirely within our control, including conditions affecting the financial services industry generally. There can be no assurance that we will maintain our current ratings. Failure to maintain those ratings could, among other things, adversely limit our access to the capital markets and affect the cost and other terms upon which we are able to obtain financing, which may adversely affect our liquidity, financial condition and results of operations.
We may not be able to generate sufficient cash flow to meet our debt service obligations.
Our ability to generate sufficient cash flow from operations to make scheduled payments on our debt obligations will depend on our future financial performance and cash flows, which will be affected by a range of economic, competitive, and business factors, many of which are outside of our control. If we do not generate sufficient cash flow from operations, we may have to undertake alternative financing plans, such as refinancing or restructuring our debt, selling assets, reducing or delaying capital investments, or seeking to raise additional capital. The terms of the agreements that govern our indebtedness contain limitations on our ability to incur additional indebtedness. We cannot assure you that any refinancing would be possible, that any assets could be sold, or, if sold, of the timing of the sales and the amount of proceeds realized from those sales, or that additional financing could be obtained on acceptable terms, if at all, or would be permitted under the terms of the agreements governing our indebtedness then outstanding. Our inability to generate sufficient cash flow to satisfy our debt obligations, or to refinance our obligations on commercially reasonable terms or at all, would have a material adverse effect on our business, financial condition, and results of operations, as well as on our ability to satisfy our debt obligations.
Our failure to comply with the agreements relating to our outstanding indebtedness, including as a result of events beyond our control, could result in an event of default or limits on our ability to borrow funds to finance our business.
The agreements that govern our indebtedness (including the indenture governing the notes) contain, and any agreements that govern future indebtedness may contain, covenants that impose significant operating and financial restrictions on, among other things, our ability to:
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incur additional debt;
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incur liens;
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sell or otherwise dispose of assets;
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make investments, loans, or advances;
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engage in merger and acquisition activity;
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pay dividends, redeem capital stock, or make certain other restricted payments or investments;
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engage in certain sale and leaseback transactions;
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enter into new lines of business; and
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enter into transactions with our affiliates.
The agreements that govern our indebtedness also contain certain covenants relating to the performance of our portfolio, which ultimately impacts the manner in which we operate our business. The advance rates on our portfolio warehouse facilities may be reduced if our portfolio does not perform as expected, we exceed certain extension limits, term limits, delinquency limits, or fail to meet the required collateral levels. The agreements governing any future indebtedness could contain financial and other covenants more restrictive than those that are currently applicable to us.
Failure to comply with the agreements governing our indebtedness could result in an event of default under one or more such agreements, cause cross-defaults on other agreements governing our indebtedness, including the Senior Notes, and prevent us from securing alternate sources of funds necessary to operate our business. Any of these events could have a material adverse effect on our results of operations and financial condition. From time to time in the past, we have breached technical or other covenants under the agreements governing our indebtedness, and have obtained waivers from the applicable lenders in such instances. In a future event of default, there can be no assurance we will be able to receive waivers, and our inability to obtain these waivers may have a material adverse impact on our business.
Our ability to obtain certain financings in the future is restricted by the fixed charge coverage ratio of the debt incurrence test under the indenture relating to the Senior Notes. We do not currently meet these requirements nor do we anticipate meeting
these requirements for the foreseeable future, which will limit our ability to obtain certain financings, especially the incurrence of senior unsecured debt.
There is a high degree of risk associated with borrowers with subprime credit. The allowance for credit losses that we have established to cover losses inherent in our loan portfolio may not be sufficient or may need to be increased, which could have a material adverse effect on our results of operations and the value of your collateral.
Substantially all of the sales financing we extend and the loans that we service are with borrowers with subprime credit. Loans to borrowers with subprime credit have lower collection rates and are subject to higher loss rates than loans to borrowers with prime credit. Although we have extensive experience in subprime auto lending, there can be no assurance that our collections and loss rates will not increase over time.
We maintain an allowance for credit losses to cover losses on an aggregate basis at a level we consider sufficient to cover estimated losses inherent in our portfolio of receivables. On a quarterly basis we review and may make upward or downward adjustments to the allowance. However, our allowance may not be sufficient to cover losses inherent in our portfolio, and we may need to increase our allowance for reasons related to, among other things, the continued weak economic environment and uncertainty in the housing market, or significant increases in delinquencies or charge-offs. A significant variation in the timing of or increase in credit losses in our portfolio or a substantial increase in our allowance or provision for credit losses would have a material adverse effect on our results of operations.
In addition, because a portion of the collateral securing the notes consists of receivables, the remaining residual property rights in receivables securing other financings (and the value of which are therefore determined by the value of receivables sold or otherwise pledged) or the remaining residual value of special purpose entities that have themselves put in place financings secured by receivables (and the value of which are therefore determined by the value of receivables owned), the value of the collateral securing the notes will be sensitive to the performance of the underlying receivables.
Our focus on customers with subprime credit may raise concerns on the part of future business partners, lenders, counterparties, and regulators, which may adversely affect our business.
We focus solely on the subprime segment of the used vehicle sales and financing market and provide loans to borrowers with subprime credit who, as a class, have lower collection rates and are subject to higher loss rates than prime and near prime borrowers. In addition, the subprime industry has been the subject of extensive media attention, enhanced regulatory scrutiny, and Congressional hearings as a result of what has been characterized as inappropriate consumer practices by subprime lenders in the mortgage industry.
These issues may raise concerns on the part of future business partners, lenders, counterparties, and regulators. As a result, we are unable to assess whether, and to what extent, they may have an adverse effect on our business in the future, including on our reputation, revenues and profitability. In particular, we cannot predict whether these issues may negatively affect our ability to obtain new financing to support our operations or any necessary regulatory approvals or business licenses in connection with our plans to expand our business, either of which could have a material adverse effect on our business.
Our proprietary credit scoring system may not perform as expected and fail to properly quantify the credit risks associated with our customers, which could have a material adverse effect on our financial condition and results of operations.
We have developed, and revise from time to time, complex proprietary credit scoring models that use traditional and non-traditional variables to classify our customers into various risk grades that are linked to loan parameters. There is no guarantee that our credit scoring models will perform as intended or that they will perform in future market conditions. Failure of our credit scoring models to properly quantify the credit risks associated with our customers could have a material adverse effect on our results of operations and financial condition.
We depend on the accuracy and completeness of information furnished to us by or on behalf of our customers. If we and our systems are unable to detect any misrepresentations in this information, we could experience a material adverse effect on our results of operations and financial condition.
Our typical customers have limited or no credit histories. In deciding whether to extend credit to customers, we rely heavily on information furnished to us by or on behalf of our customers, including employment and personal financial information. If a significant percentage of our customers intentionally or negligently misrepresented any of this information, and we and our systems did not detect such misrepresentations, this could have a material adverse effect on our ability to effectively manage our credit risk, which could have a material adverse effect on our results of operations, cash flows, and financial condition.
Our proprietary vehicle pricing system may not perform as expected and fail to properly set the retail price and effective margin associated with our used vehicle inventory for sale.
We have developed, and revise from time to time, a complex pricing engine that utilizes several variables in determining the retail price of our vehicles, including cost of vehicle, cost of reconditioning, relative market prices, and other external data to price our vehicles competitively. The failure of our pricing engine to properly calculate a retail price for each vehicle could have a material adverse effect on our results of operations and financial condition.
General economic conditions and their effect on automobile sales may adversely affect our business.
Vehicles sales historically have been impacted by economic factors. Many factors affect the industry, including general economic conditions, consumer confidence, the level of personal discretionary income, interest rates, the price of fuel, and credit availability. Deteriorating economic and market conditions throughout the United States or within a region in which we do business could result in a decline in vehicle sales, a decrease in collectability of our finance receivables, or an increase in vehicle pricing. We cannot assure you that the industry will not experience sustained periods of decline in vehicle sales in the future. Any future decline could have a material adverse effect on our business.
We are subject to significant governmental regulation, and if we are found to be in violation of any of the federal, state, or local laws or regulations applicable to us, our business could suffer. We are also subject to legal and administrative proceedings which, if the outcomes are unfavorable to us, could adversely affect our business, operating results, and prospects.
The automotive retail and finance industries are subject to a wide range of federal, state, and local laws and regulations, such as local licensing requirements, and retail financing, debt collection, consumer protection, environmental, health and safety, creditor, wage-hour, anti-discrimination, and other employment practices laws and regulations. The violation of these or future requirements or laws and regulations can result in administrative, civil, or criminal sanctions against us, which may include a cease and desist order against the subject operations or even revocation or suspension of our license to operate the subject business. As a result, we have incurred and will continue to incur capital and operating expenditures and other costs to comply with these requirements, laws, and regulations. Further, over the past several years, private plaintiffs and federal, state, and local regulatory and law enforcement authorities have increased their scrutiny of advertising, sales, financing, and insurance activities in the sale and leasing of motor vehicles. In addition, many state attorneys general have been increasingly active in the area of consumer protection. We are also subject, and may be subject in the future, to inquiries and audits from state and federal regulators. There can be no assurance that such activities will not continue in the future or have a material adverse effect on our business.
From time to time, we may be involved in various legal and administrative proceedings. We are also currently the subject of investigative inquiries from the Consumer Protection Division of the Office of Texas Attorney General. See “Item 3 - Legal Proceedings.” It is not feasible to predict the outcome of these proceedings or any claims made against us, and the outcome of any such proceedings or claims could adversely affect our reputation, results of operations, or financial condition.
We are also subject to the Dodd-Frank Act of 2010, which represents a comprehensive overhaul of the rules and regulations governing the financial services industry. Although the regulatory decisions regarding its implementation continue many parts of the Dodd-Frank Act are now in effect, including the establishment and operation of the Consumer Financial Protection Bureau (the “CFPB”), as an independent entity within the Federal Reserve. The CFPB has the authority to promulgate consumer protection regulations applicable to all entities offering consumer financial services or products, including non-bank commercial companies in the business of extending credit and servicing consumer loans. Although the CFPB has begun operations and now has a director, the exact scope and substance of the regulations that may be adopted by the CFPB, particularly as they relate to our operations, are still unknown at this time. However, on April 12, 2012, the CFPB delivered a Civil Investigative Demand to DriveTime Automotive Group ("DTAG") requesting that DTAG produce certain documents and information and answer questions relating to certain components of the business of DTAG and its affiliates. The CFPB has not alleged a violation by DTAG of any law and DTAG is cooperating with the CFPB's requests for information. We are currently in the process of providing the documents and information requested by the CFPB. It is not feasible to predict the outcome of this investigation, and although no assertions or claims have been made against us, an adverse action by the CFPB could adversely affect our reputation, results of operations, or financial condition.
The Dodd-Frank Act contains numerous other provisions affecting financial industry participants of all types, including third parties that we deal with in the course of our business, such as rating agencies, insurance companies, and investors. Its implementing regulations have had, and likely will continue to have, the effect of increasing the compliance costs of operating our business. Additionally, its continued implementation may further impact our operating environment in other substantial and unpredictable ways that could have a material adverse effect on our financial condition and results of operations.
Changes in laws, regulations, or policies may adversely affect our business.
The laws and regulations governing our lending, servicing, debt collection, and insurance activities or the regulatory or enforcement environment at the federal level or in any of the states in which we operate may change at any time and may have an adverse effect on our business. For example, the CFPB is currently conducting studies on and reviewing consumer lending related regulations that affect our industry. The CFPB has also commenced the examination of banks and non-banking institutions, with a focus on consumer lending compliance. These activities may lead to changes in laws and regulations governing these activities that apply to our business.
In addition, the Patient Protection and Affordable Care Act of 2010, as it is phased in over time, will significantly affect the administration of health care services and could significantly impact our cost of providing employees with health-care insurance.
We are unable to predict how these or any other future legislative or regulatory proposals or programs will be administered or implemented or in what form, or whether any additional or similar changes to statutes or regulations, including the interpretation or implementation thereof, will occur in the future. Any such action could affect us in substantial and unpredictable ways and could have an adverse effect on our results of operations and financial condition.
Our inability to remain in compliance with regulatory requirements in a particular jurisdiction could have a material adverse effect on our operations in that market and on our reputation generally. No assurance can be given that applicable laws or regulations will not be amended or construed differently or that new laws and regulations will not be adopted, either of which could materially adversely affect our business, financial condition, or results of operations.
Due to the most recent economic recession and continued uncertainty in capital markets, we have in the past, and could be required in the future to reduce the scope of our operations, which could have a material adverse effect on our results of operations, cash flows, and financial condition.
During 2008 and early 2009, we contracted our operations in response to the economic crisis. While we expanded our operations and opened new dealerships during 2010, 2011, and 2012, if we again experience economic uncertainty or economic deterioration, we could be required to reduce the scope of our operations. If we choose to close dealerships and/or reduce portfolio originations in the future, we will face certain additional risks, including risks related to:
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an inability to obtain anticipated cost reductions;
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legal and regulatory risks related to closed stores and lay-offs, including the risk of lawsuits;
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vandalism, theft, or other damages to vacant stores;
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diversion of management's attention from normal business operations; and
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failure to generate sufficient cash flows to help fund our operations.
If we were to lose the right to service our portfolio of receivables, we could experience a decrease in collections, which could have a material adverse effect on our results of operations and financial condition.
We retain the right to service all receivables that we finance, including those pledged as collateral to our portfolio warehouse facilities and those sold to securitization trusts. We are entitled to a fee for our servicing activities, which generates cash flow for operations. Subject to certain conditions, if we experience an event of default under the agreements governing our financing arrangements, we may lose the right to service our receivables. Loss of this right could have a material adverse effect on our cash flows. In addition, if we lose our servicing rights, transitioning servicing activities to a third party could result in interruptions in collections, which could decrease the likelihood that the receivables will be repaid. Moreover, a replacement servicer might lack the requisite experience in servicing such subprime receivables. As a result, we may experience decreased collections, which could have a material adverse effect on our results of operations and financial condition and on the value of the collateral securing the notes.
Our operations and the finance receivables we generate are concentrated geographically, and a downturn in the economies or markets in which we operate could adversely affect vehicle sales and collections.
As of December 31, 2012, we operated our dealerships in 19 states. Approximately 50% of our portfolio is concentrated in three states, Texas, Florida and North Carolina. These states also account for approximately 45% of our sales volume. Adverse economic conditions, natural disasters, or other factors affecting any state or region where high concentrations of our customers reside could adversely affect vehicle sales and collections. If adverse economic conditions, natural disasters, or other factors occur that affect the regions in which we do business, or if borrowers in these regions experience financial difficulties, a significant number of borrowers may not be able to make timely loan payments, if at all, or may be more prone to filing for bankruptcy protection, which could have a material adverse effect on our results of operations and financial condition.
We may experience seasonal and other fluctuations in our results of operations.
Sales of motor vehicles historically have been subject to substantial cyclical variation characterized by periods of oversupply and weak demand. We believe that many factors affect the industry, including consumer confidence in the economy, the level of personal discretionary spending, interest rates, fuel prices, credit availability, and unemployment rates. A recession or an industry or general economic slowdown could materially adversely impact our business.
Historically, we have experienced higher revenues in the first quarter of the calendar year than in the last three quarters of the calendar year. We believe these results are due to seasonal buying patterns resulting in part because many of our customers receive income tax refunds, which are a primary source of down payments on used vehicle purchases, during the first quarter of the year. Our loan performance also has historically followed a seasonal pattern with delinquencies and charge-offs being the highest in the second half of the year. Accordingly, our results in any quarter may not indicate the results we may achieve in any subsequent quarter or for the full year. A significant portion of our general and administrative expenses do not vary proportionately with fluctuations in revenues. We expect quarterly fluctuations in operating results to continue as a result of seasonal patterns. Such patterns may change, however, due to factors affecting the automotive industry or otherwise.
Our failure to effectively manage our growth could harm our business, we may not be able to access the additional financing required to fund our growth, and our plans to expand our operations will expose us to increased legal and regulatory risks that may adversely affect our business.
We continually evaluate expanding our operations by opening new dealerships and reconditioning centers, some of which will potentially be located in existing DriveTime markets and some of which are expected to be located in markets in which we do not currently operate. This growth may result in the incurrence of additional debt and operating expenses, which could adversely affect our profitability and liquidity. Moreover, growth and expansion of our operations may place a significant strain on our resources and increase demands on our executive management team, management information and reporting systems, financial management controls and personnel, and regulatory compliance systems and personnel. We may not be able to expand our operations or effectively manage or integrate our expanding operations, or achieve planned growth on a timely or profitable basis. If we are unable to achieve our planned growth or manage our growth effectively, we may experience operating inefficiencies and our results of operations may be materially adversely affected.
In addition, expansion into new states will increase our legal and regulatory risk. Our failure or alleged failure to comply with applicable laws and regulations in any new jurisdiction, and ensuing inquiries or investigations by regulatory and enforcement authorities, may result in regulatory action, including suspension or revocation of one or more of our licenses, civil or criminal penalties, or other disciplinary actions, and restrictions on or suspension of some or all of our business operations. As a result, our business could suffer, our reputation could be harmed, and we could be subject to additional legal risk. This could, in turn, increase the size and number of claims and damages asserted against us, subject us to regulatory investigations, enforcement actions, or other proceedings, or lead to increased regulatory or supervisory concerns. We may also be required to spend additional time and resources on any necessary remedial measures, which could have an adverse effect on our business. We cannot predict the timing or form of any current or future regulatory or law enforcement initiatives, and any such initiatives could have a material adverse effect on our results of operations and financial condition.
We operate in a highly competitive environment, and if we are unable to compete with our competitors, our results of operations and financial condition could be materially adversely affected.
Our primary competitors are the “buy-here, pay-here” dealerships, independent used vehicle dealers, and used vehicle departments of franchise dealers that operate in the subprime segment of the used vehicle sales industry, and the banks, finance companies and indirect lenders that purchase their loans. There is no assurance that we can successfully distinguish ourselves from our competitors or compete in this industry in a cost-effective manner or at all. Moreover, if our competitors grow and strengthen through consolidation in the industry while we are unable to identify attractive consolidation opportunities, we could end up at a competitive disadvantage and experience declining market share and revenue. In addition, larger companies with significant financial and other resources have periodically entered or announced plans to enter the used vehicle sales and/or finance industry, or relax their credit standards and compete with us, at least at the upper end of our customer segment. These dealerships also compete with us in areas such as the purchase of inventory, which can result in increased wholesale costs for used vehicles and lower margins, and the dealerships and finance companies could also enter into direct competition with us at any time at the lower end of the subprime market.
Increased competition may cause downward pressure on the interest rates that we charge on finance receivables originated by our dealerships, or lower margins, or may cause an increase in our operating costs, all of which could have a material adverse effect on our results of operations and financial condition.
If we are unable to obtain sufficient numbers of used vehicles for our inventory in a cost-effective manner, our operations and financial results will be adversely impacted.
We require a large number of quality used vehicles for our dealerships. We acquire most of our used-vehicle inventory through auctions, and primarily through two auction companies. To a lesser extent, we also acquire used vehicles from wholesalers, franchised and independent dealers, and fleet owners, such as leasing companies and rental companies. The sources from which we can purchase vehicles of a quality and in a quantity acceptable to us are limited, and there is substantial competition to acquire the vehicles we purchase. Consequently, we may not be able to obtain sufficient inventory in a cost-effective manner or at all. Any decline in the number of or increased competition for quality vehicles could diminish our ability to obtain sufficient inventory at a price that we can reflect in retail market prices and would adversely affect our business.
If our inventory or other costs of operations increase and we are unable to pass along these costs to our customers, we may be unable to maintain or grow margins.
Our inventory and other costs are variable and dependent upon various factors, many of which are outside of our control. A rise in vehicle acquisition cost could erode our sales margins and negatively affect our results of operations. Rising auction prices have also led to the acquisition of a higher mileage and older age vehicle, which could cause an increase in reconditioning and warranty costs, both of which would also negatively affect our sales margins and overall profitability. If we incur cost increases, we may seek to pass those increases along to our customers. However, the income of our average customer limits the maximum monthly payment our customers can afford, and we may be unable to pass these costs along to our customers in the form of higher sales prices, which would adversely affect our ability to maintain or increase margins. Recently, used vehicle values have continued to increase.
We rely heavily on logistics in transporting vehicles for delivery from auctions to reconditioning facilities and to our dealerships. Our ability to manage this process both internally and through our network of transportation partners could cause a rise in inventory costs and disruption in inventory supply chain and distribution. Further, any disruption in the vehicle transport industry or the cost of transport could adversely affect our results of operations.
A failure of or interruption in our communications and information systems could adversely affect our revenues and profitability.
Our business is highly dependent on communications and information systems and is exposed to many types of operational risks, including the risk of fraud by employees or other parties, record-keeping error, errors resulting from faulty computer or telecommunication systems, computer failures or interruption, and damage to computer and telecommunication systems caused by internal or external events. We periodically update or change the integrated computer systems and other components of our operating systems. Any significant failure of such systems, whether as a result of third-party actions or in connection with planned upgrades and conversions, could disrupt our operations and adversely affect our ability to collect on contracts and comply with legal and regulatory requirements. Additionally, our systems are vulnerable to interruption or malfunction due to events beyond our control, including natural disasters and network and telecommunications failures. Our systems may also be vulnerable to unauthorized access, computer hackers, computer viruses, and other security problems. A user who circumvents security measures could misappropriate proprietary information or cause interruptions to or malfunctions in operations. As a result, we may be required to expend significant resources to protect against the threat of these security breaches or to alleviate problems caused by these incidents. We have backup systems and we periodically test disaster recovery scenarios; however, this may not prevent a systems failure or allow us to timely resolve any systems failures. Any interruption to our systems could have a material adverse effect on our results of operations and financial condition.
Reliance on our outsourced business functions could adversely affect our business.
We outsource a portion of our collections and internet sales functions to companies located outside the contiguous United States. While we believe there are benefits to these arrangements, outsourcing increases our operational complexity and decreases our control. We rely on these service providers to provide a high level of service and support, which subjects us to risks associated with inadequate or untimely service. For example, the outsourcing of collection functions could result in lower collection rates than we would have achieved had we performed the same functions internally. In addition, if these outsourcing arrangements were not renewed or were terminated or the services provided to us were otherwise disrupted, we would have to obtain these services from an alternative provider or provide them using our internal resources. We may be unable to replace, or be delayed in replacing, these sources and there is a risk that we would be unable to enter into a similar agreement with an alternate provider on terms that we consider favorable or in a timely manner. In the future, we may outsource other business functions. If any of these or other risks related to outsourcing were realized, our financial position, liquidity and results of operations could be adversely affected. We are also subject to work strikes and work stoppages in the countries/regions in which we operate, which could adversely affect our collections.
Anti-outsourcing legislation, if adopted, could adversely affect our business, financial condition and results of operations.
Outsourcing services and corporate functions to organizations operating in countries outside the U.S. is a topic of political discussion in many countries, including the United States. Federal and state legislation has been proposed, and enacted in some states, that could restrict or discourage U.S. companies from outsourcing their services to companies outside the United States in order to address concerns over the perceived association between offshore outsourcing and the loss of jobs domestically. The enactment of additional such legislation could broaden existing restrictions on outsourcing and impact private industry with measures that include, but are not limited to, tax disincentives, fees or penalties, intellectual property transfer restrictions, mandatory government audit requirements, and new standards that have the effect of restricting the use of certain business and/or work visas.
The personal information that we collect may be vulnerable to breach, theft, or loss, the occurrence of any of which could adversely affect our reputation and operations.
Possession and use of personal information in our operations subjects us to risks and costs that could harm our business. We collect, use, and retain large amounts of personal information regarding our customers, employees, and their families, including social security numbers, tax return information, personal and family financial data, and credit card numbers. Our computer networks and the networks of certain of our vendors that hold and manage confidential information on our behalf may be vulnerable to unauthorized access, employee theft or misuse, computer hackers, computer viruses, and other security threats. Confidential information may also inadvertently become available to third parties when we integrate systems or migrate data to our servers following an acquisition or in connection with periodic hardware or software upgrades.
Due to the sensitive nature of the personal information stored on our servers, our networks may be targeted by hackers seeking to access this data. A user who circumvents security measures could misappropriate sensitive information or cause interruptions or malfunctions in our operations. Although we use security and business controls to limit access and use of personal information, a third party may be able to circumvent those security and business controls, which could result in a breach of privacy. In addition, errors in the storage, use, or transmission of personal information could result in a breach of privacy. Possession and use of personal information in our operations also subjects us to legislative and regulatory burdens that could require us to implement certain policies and procedures, such as the procedures we adopted to comply with the Red Flags Rule that was promulgated by the Federal Trade Commission under the federal Fair Credit Reporting Act and that requires the establishment of guidelines and policies regarding identity theft, and could require us to make certain notifications of data breaches and restrict our use of personal information. A violation of any laws or regulations relating to the collection or use of personal information could result in the imposition of fines against us. As a result, we may be required to expend significant resources to protect against the threat of these security breaches or to alleviate problems caused by these breaches. A major breach, theft, or loss of personal information that is held by us or our vendors, or a violation of laws or regulations relating to the same, could have a material adverse effect on our reputation and result in further regulation and oversight by federal and state authorities and increased costs of compliance.
New business ventures could expose us to business risks not previously encountered.
In the fourth quarter of 2011, we introduced an indirect lending line of the business through our wholly-owned subsidiary GO Financial. This line of business is a complement to our other operations, and does not replace DriveTime vehicle sales or financings. Although we have leveraged much of the knowledge and resources of our existing infrastructure, the third party nature of GO transactions exposes GO's portfolio to risk that has not been traditionally present in the DriveTime portfolio. We will continue to monitor and make changes to our business plan to minimize risks to the GO portfolio; however, the following risks are inherent in GO:
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GO relies on third party dealers, not owned or operated by DriveTime, for its originations; the quality and accuracy of the loans originated, including customer fraud, vehicle quality, and the presence or absence of warranties or extended services contracts covering vehicle repair, will impact the quality of receivables in our GO portfolio.
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GO deals have customer payment terms different from our traditional arrangements, but which are customary in the indirect lending business.
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The infrastructure we built to facilitate GO transactions could fail, resulting in substantial write-offs to capitalized software projects.
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GO may experience operating difficulty in certain states in which we are operating due to regulatory restrictions specific to subprime lending.
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Loan portfolio performance may prove to be unprofitable if loss rates of the GO portfolio exceed our expectations.
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The GO brand could negatively impact the DriveTime brand.
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As GO grows, it may end up with a concentration of third-party dealers in a state or states increasing credit quality and dealer risks.
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Third parties administer ancillary product offerings, such as vehicle service contracts, and if they fail to perform our loans may perform worse than anticipated and we will have the cost and risk of finding competent, cost effective alternatives in a timely manner.
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Our third-party dealers must also comply with credit and trade practice statutes and regulations. Their failure to comply with these statutes and regulations could result in consumers having rights of rescission and other remedies.
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The sale of vehicle service contracts and other products by our third party dealers in connection with loans assigned to us is also subject to state laws and regulations. As we are the holder of loans that may, in part, finance these products, some of these state laws and regulations may apply to our servicing and collection of the loans. Although these laws and regulations do not significantly affect our business, there can be no assurance that insurance or other regulatory authorities in the jurisdictions in which these products are offered will not seek to regulate or restrict the operation of our business in these jurisdictions.
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A number of risks related to DriveTime also apply to GO, including capital to finance the business, our substantial debt, cash flow, compliance with our agreements with our lenders, the risk of being in the subprime segment of the market, interest rates, efficacy of our credit scoring model, servicing of our loans, key personnel, confidentiality of customer information, and regulatory changes and concerns.
There can be no assurance that GO will be successful, and it could have unintended consequences which would have an adverse effect on our results of operations or financial condition. GO also involves numerous other risks, including the diversion of management's attention from other business concerns.
In the first quarter of 2013, we introduced a new on-line used vehicle sales channel through Carvana, LLC, which is a wholly-owned subsidiary of DTAG. The Carvana business model is designed to facilitate the sale of a used vehicle through a sale process that is 100% on-line. Carvana is a complement to our other operations, however, and does not replace our core DriveTime businesses of vehicle sales and financings. Although we have leveraged much of the knowledge and resources of our existing infrastructure, the prospect of this new business venture presents risks to our core operations. We will continue to monitor and make changes to our business plan to minimize risks to DriveTime. However, the following risks, among others, are inherent in Carvana:
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The infrastructure we built to facilitate Carvana transactions could fail, resulting in substantial write-offs to capitalized software projects.
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Carvana may experience operating difficulty in certain states in which we are operating due to regulatory restrictions.
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The Carvana brand could negatively impact the DriveTime brand.
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Operating the Carvana business could divert excessive time and attention of DriveTime management and personnel away from core DriveTime businesses.
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Carvana is initially concentrated in Atlanta, Georgia. Any economic disruption, geographic natural disaster, or other negative impact in the local area could cause a negative financial impact to DriveTime.
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Third parties may administer ancillary product offerings, such as vehicle service contracts, and if they fail to perform our loans may perform worse than anticipated and we will have the cost and risk of finding competent, cost effective alternatives in a timely manner.
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A number of risks related to DriveTime also apply to Carvana, including capital to finance the business, our substantial debt, risks to operating cash flow, compliance with lender agreements, interest rates, efficacy of our credit scoring model, our reliance on key personnel, confidentiality of customer information, and regulatory changes and concerns.
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Carvana's business focus as an on-line retailer could be significantly affected by internet fraud, identity theft, credit card, debit card and ACH fraud.
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Carvana will rely heavily on logistics in transporting vehicles for delivery. Our ability to manage this process both internally and through a potential network of transportation partners could cause a disruption in business. Further, any disruption in the vehicle transport industry or the cost of transport could adversely affect both Carvana and DriveTime.
There can be no assurance that Carvana will be successful, and it could have unintended consequences which would have an adverse effect on our results of operations or financial condition.
We are dependent on the services of certain key personnel and the loss of their services could harm our business.
We believe that our success depends on the continued employment of our senior executive management team, including our Chief Executive Officer and President, Raymond C. Fidel, our Chief Financial Officer, Mark G. Sauder, and our Executive Vice President and General Counsel, Jon D. Ehlinger. The unexpected loss of the services of any of our key executive management personnel or our inability to attract new management when necessary could have a material adverse effect on our operations. We do not currently maintain key person life insurance on any member of our executive management team.
Additionally, our success depends on the key management personnel at our corporate offices and the dealerships in our local markets. The market for qualified employees in the automotive and finance industries and in the markets in which we operate, particularly for qualified general managers, loan managers, and collections personnel, is highly competitive and may
subject us to increased labor costs during periods of low unemployment. We also believe that our competitors pursue many of our managerial and collections and sales and service personnel from time to time. The loss of a group of key employees in any of our markets could have a material adverse effect on our business and results of operations in that market or across many or all markets in which we operate.
If all or some portion of our employees elect to collectively bargain or join a union, these actions could adversely affect our operations.
As of December 31, 2012, none of our employees were represented by a labor union. The automotive industry is historically an industry in which there is a high degree of labor union participation. If all or some portion of our employees elects to join a labor union, we could experience increased operational costs, work stoppages or strikes, and/or barriers to communication between management and employees. These factors could lead to inefficiencies in the operation of the affected facilities or groups and could cause us to experience a material adverse effect.
We are subject to environmental laws, regulations, and permits that could impose significant liabilities, costs, and obligations.
We are subject to a complex variety of federal, state, and local laws, regulations, and permits relating to the environment and human health and safety. If we violate or fail to comply with these laws, regulations, or permits, we could be fined or otherwise sanctioned by regulators. These environmental requirements, and the enforcement thereof, change frequently, have tended to become more stringent over time, and may necessitate substantial capital expenditures or operating costs. Under certain environmental laws, we could be responsible for the costs relating to any contamination at our or our predecessors' current or former owned or operated properties or third-party waste disposal sites. We cannot assure you that our costs and liabilities relating to environmental matters will not adversely affect our results of operations, business, financial condition, reputation, or liquidity.
We could also be responsible for costs relating to any contamination at our current or formerly owned or operated properties or third party waste disposal sites. This liability may be imposed even if we were not at fault. In addition to potentially significant expenses to investigate and remediate contamination, such matters can give rise to claims from governmental authorities and other third parties for fines or penalties, natural resource damages, or personal injury or property damage.
States impose limits on the interest rates we can charge on the installment sales contracts we provide to our customers, and new or lower limits may harm our ability to offset increased interest expenses and can adversely affect our profitability and liquidity.
We operate in states that impose limits on the contract interest rate that a lender may charge, and laws or regulations that limit the interest rates that we can charge can adversely affect our profitability and liquidity. When a state limits the amount of interest that we can charge on our installment sales contracts, we may not be able to offset an increase in interest expense caused by rising interest rates or greater levels of borrowings under our credit facilities. In addition, no assurance can be given that we will not be prohibited by new state laws from charging the interest rates we are currently able to charge on our installment sales contracts or from raising interest rates above certain desired levels. Therefore, these interest rate limitations can adversely affect our profitability and liquidity.
A change in state laws, or the application thereof, relating to the extent to which we can obtain a refund of sales tax for customer defaults could have a material adverse effect on our business.
In general, we are required to collect and remit state and local sales tax on each vehicle we sell. Subject to certain requirements, certain states allow us to collect a refund of prior sales taxes paid to the extent that the receivable becomes uncollectible. If state laws change with respect to the extent to which we can claim a refund for sales tax in such situations, or state taxing authorities change their position with respect thereto, we could experience a material adverse effect. In this regard, on February 24, 2011, we received an unfavorable ruling from the Nevada Supreme Court with respect to the efficacy of certain sales tax refunds we requested for prior tax years. While only applicable to 2002 and 2003, this ruling could affect subsequent tax years as well.
Reliability and safety of vehicle manufactured products could have a material adverse effect on our results of operations.
Manufacturer recalls, product reliability, safety issues and overall vehicle quality could adversely affect the demand for used vehicles at our dealerships and adversely affect loan performance. Such issues could also expose us to litigation and negative publicity related to the sale of the vehicles in question, which could have an adverse material effect on our sales, reputation, and results of operations.
We may be adversely affected by product liability exposure claims.
DriveTime, and the automotive industry generally, is exposed to product liability claims in the event that the failure of our products to perform to specifications results, or is alleged to result, in property damage, bodily injury, and/or death. In connection with such product liability claims, we may incur significant costs to defend such claims and we may experience material product liability losses in the future. We cannot assure you that we will have sufficient resources, including insurance to the extent it is available, to cover such product liability claims, and the outcome of various legal actions and claims could have a material adverse effect on our results of operations and financial condition.
We have programs for our customers to provide insurance covering our collateral in the event of theft or an accident. If our customers do not maintain insurance, it could negatively impact our operations and/or profitability.
Certain of our customers have difficulty obtaining and maintaining affordable insurance for their vehicles. We offer a separate collateral protection insurance program. Under this program, we offer customers dual interest collateral protection insurance administered through a third party with whom we have a contractual relationship. We do not offer a liability insurance product. There is a risk customers will not maintain collateral protection insurance, which could adversely affect our recoveries.
Failure to register our dealership sales business subsidiary in the relevant jurisdictions would cause a severe disruption in our operations.
In connection with our applications for renewal of the relevant license or registration, a state licensing authority could decide to withhold or delay approval of the relevant license or registration and prohibit DriveTime Car Sales, a subsidiary of DTAG, from operating one or more of our dealerships until certain requirements are met. We cannot anticipate what these requirements might entail or whether we will be able to comply with any such requirements in a timely manner. If the relevant license or registration is not granted for DriveTime Car Sales to operate in any state, it would cause a severe disruption in our operations in that state, which could have a material adverse effect on our business, financial condition and results of operations. We have recently expanded our operations into new states and intend to continue our expansion. A failure to attain the proper licensing and registration requirements for our expansion could disrupt our ability to further expand our business.
We could suffer a material adverse effect if the IRS challenged our position on intercompany sales of receivables.
We generally recognize losses for U.S. federal income tax purposes on the intercompany sales of receivables from DTAG to DTAC. This practice is standard within our industry and our interpretation is not meaningfully different from other companies in our industry. However, the IRS may challenge our position and seek to defer our recognition of such losses. If the IRS were able to successfully challenge our position, there could be a material adverse effect on our results of operations and financial condition.
Our Chairman and principal shareholder can direct our management and policies through his right to elect our board of directors and to control substantially all matters requiring a stockholder vote.
Ernest C. Garcia II, our Chairman and principal shareholder, beneficially owns the majority of our outstanding common stock. Certain agreements to which we are a party, including the indenture governing the notes, the agreements governing our other indebtedness, and our origination agreement with DTAC pursuant to which DTAC purchases all of the auto loan receivables we originate, limit the control Mr. Garcia otherwise could exercise over our business and operations. Mr. Garcia has the power to elect our entire board of directors and determine the terms and outcome of any corporate transaction or other matters required to be submitted to shareholders for approval, including the amendment of our certificate of incorporation, mergers, consolidations and the sale of all or substantially all of our assets. Because his interests as an equity holder may conflict with the interests of holders of the notes, he may cause us to take actions that, in his judgment, could enhance his equity but may be prejudicial to the holders of the notes.
Conflicts of interest may arise as a result of affiliations that our directors or executive officers have with Verde Investments, Inc. or other companies with which we have material relationships.
Ernest C. Garcia II, our Chairman and controlling stockholder, is also the owner of Verde Investments, Inc. ("Verde"), a company with which we have historically had material leasing and financing relationships. See “Item 13 - Certain Relationships and Related Transactions, and Director Independence.” In addition, there may occur future transactions between us and Verde which could give rise to a conflict of interest on the part of Mr. Garcia. While transactions that we enter into in which a director or officer has a conflict of interest are generally permissible so long as the material facts relating to the director's or officer's relationship or interest as to the transaction are disclosed to our Board of Directors and a majority of our
disinterested directors, or a committee consisting solely of disinterested directors, approves the transaction, any such conflict of interest could have a material adverse effect on our business, results of operations or financial condition.
Changes in accounting policies could adversely affect our reported results of operations.
We have identified several accounting policies as being “critical” to the fair presentation of our financial condition and results of operations because they involve major aspects of our business and require management to make judgments about matters that are inherently uncertain. Materially different amounts could be recorded under different conditions or using different assumptions.
Additionally, the U.S. based Financial Accounting Standards Board is currently working together with the International Accounting Standards Board on several projects to converge certain accounting principles and facilitate more comparable financial reporting between companies that are required to follow U.S. GAAP and those that are required to follow International Financial Reporting Standards (“IFRS”) outside of the U.S. These efforts may result in different accounting principles under GAAP, which may have a material impact on the way in which we report financial results in areas including, but not limited to, potential changes in accounting for leases, revenue recognition, and impairment of financial assets. The U.S. Securities and Exchange Commission (the “SEC”) may make a determination in the future regarding the incorporation of IFRS into the financial reporting system for U.S. based companies. A change in accounting principles from U.S. GAAP to IFRS, or the implementation of these or other converged or new accounting requirements, could adversely affect our reported results of operations and financial condition, and cause us to restate prior period reported results under the proposed guidance.
Item 1B.
Item 1B. Unresolved Staff Comments
None.
Item 2.
Item 2. Properties
Dealerships and Facilities
As of December 31, 2012, we operated 97 dealerships and 17 reconditioning facilities in 44 geographic regions in 19 states. Select information regarding these dealerships is as follows:
Item 3.
Item 3. Legal Proceedings
We are involved in various claims and actions arising in the ordinary course of business. In the opinion of management, based on consultation with legal counsel, the ultimate disposition of these matters will not have a material adverse effect on us. We believe appropriate accruals have been made for the disposition of these matters. In accordance with ASC 450, Contingencies, we establish an accrual for a liability when it is both probable that the liability has been incurred and the amount of the loss can be reasonably estimated. These accruals are reviewed monthly and adjusted to reflect the impact of negotiations, settlements and payments, rulings, advice of legal counsel, and other information and events pertaining to a particular case. Legal expenses related to defense, negotiations, settlements, rulings, and advice of outside legal counsel are expensed as incurred.
In August 2008, we received a Civil Investigative Demand from the Texas Office of Attorney General, Consumer Protection Division, asking for the production of certain materials. The demand indicates it is the subject of an investigation of possible violations of the Deceptive Trade Practices Act, Sections 17.46(a) and (b) in the marketing, advertising, financing, and selling of used vehicles. We provided the Texas Office of Attorney General with all requested information in August 2008. At that time, we met with the state’s Attorney General’s Office to provide an overview of the Company and discuss the requested materials. In addition, the Attorney General’s Office indicated that it would review the materials we provided to it and if there were any concerns, contact us to meet, discuss and resolve the concerns. The Texas Attorney General has requested additional information and documentation from time to time, most recently in February 2010, when it requested clarifying information limited to vehicle inspections, after sale repairs, warranty, loan servicing, and consumer concerns. We believe the request is routine in nature and we have responded accordingly. We believe we are in compliance with all applicable state laws and regulations and we intend to continue to cooperate with state officials, and we will continue to fully cooperate with the Texas Attorney General’s Office in responding to the demand and any follow up discussions. We believe we do not have loss contingencies related to this matter.
On April 12, 2012, the Consumer Financial Protection Bureau (the “CFPB”) delivered a Civil Investigative Demand to DTAG requesting that DTAG produce certain documents and information and answer questions relating to certain components of the business of DTAG and its affiliates. The CFPB has not alleged a violation by DTAG of any law and DTAG is cooperating with the CFPB's requests for information. We have provided the documents and information initially requested by the CFPB. On February 21, 2013, we also received a limited request to clarify and supplement certain information provided to the CFPB. Such information has since been provided.
On March 4, 2013, Credit Acceptance Corporation filed a patent infringement complaint against DTAG, DTAC and GO in the U.S. District Court for the Central District of California, Western Division. In its complaint, the plaintiff alleges infringement of its U.S. Patent No. 6,950,897, entitled “System and Method for Providing Financing.” The complaint seeks injunctive relief as well as awards of damages and attorneys' fees. We have not yet answered the complaint but we believe we do not have loss contingencies related to this matter.
Additionally, in the ordinary course of business, we are a defendant in various other types of legal proceedings. Although we cannot determine at this time the amount of the ultimate exposure from these lawsuits, if any, based on the advice of counsel management does not expect the final outcome to have a material adverse effect on us.
Item 4.
Item 4. Mine Safety Disclosures
None.
Part II
Item 5.
Item 5. Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
There is no established public trading market for our common equity. Approximately 98.3% of our common equity is beneficially owned by our Chairman and principal shareholder, Ernest C. Garcia, II. The remaining 1.7% is held by our Chief Executive Officer, Raymond C. Fidel, subject to vesting as described more fully under “Item 11 - Executive Compensation- Compensation Discussion and Analysis-Chief Executive Officer Restricted Stock Grant.” See also Note 12-Shareholders’ Equity & Dividends to our consolidated financial statements for information regarding cash dividends.
Item 6.
Item 6. Selected Financial Data
The following table sets forth our selected historical consolidated financial and operating data as of the dates and for the periods indicated. The consolidated statements of operations for the years ended December 31, 2012, 2011, and 2010, and data from the consolidated balance sheet as of December 31, 2012 and 2011, have been derived from our audited financial statements, which are included elsewhere in this report. The consolidated statements of operations for the years ended December 31, 2009 and 2008, and the consolidated balance sheet data as of December 31, 2010, 2009 and 2008, have been derived from our audited financial statements, which are not included in this report. Our historical results are not necessarily indicative of our results for any future period.
The following selected financial and other data should be read in conjunction with “Item 7
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis of our financial condition and results of operations and our liquidity and capital resources should be read in conjunction with our consolidated financial statements and related notes that appear elsewhere in this report. In addition to historical financial information, the following discussion contains forward-looking statements that reflect our plans, estimates, and beliefs. Our actual results could differ materially from those discussed in the forward-looking statements. Factors that could cause or contribute to these differences include those discussed below and elsewhere in this report, particularly in “Item 1A - Risk Factors” and “Special Note Regarding Forward-Looking Statements.”
Overview
We are the leading used vehicle retailer in the United States with a primary focus on the sale and financing of quality vehicles to the subprime market. Through our branded dealerships, we provide our customers with a comprehensive end-to-end solution for their automotive needs, including the sale, financing, and maintenance of their vehicles. As of December 31, 2012, we owned and operated 97 dealerships and 17 reconditioning facilities located in 44 geographic regions throughout 19 states. For the year ended December 31, 2012, we sold 59,930 vehicles, generated $1.2 billion of total revenue, and $160.1 million of Adjusted EBITDA. As of December 31, 2012, our loan portfolio had a total outstanding principal balance of $1.6 billion. We maintain our loan portfolio and related financings on our balance sheet.
Fiscal 2012 Highlights
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Total revenue increased 9% to $1.2 billion in 2012, from $1.1 billion in 2011.
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Unit sales increased 7% to 59,930 in 2012, from 56,109 in 2011.
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Originations increased 11% to $917.1 million, compared to $829.2 million in 2011.
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GO Financial increased its active dealer base to 191 dealers and funded $45.4 million in advances.
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We opened 10 stores in nine new geographic regions including: Pensacola, Florida; Little Rock, Arkansas; Columbus, Ohio; Montgomery, Alabama; St. Louis, Missouri; McAllen, Texas; Tallahassee, Florida; Huntsville, Alabama, and Myrtle Beach, South Carolina.
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We completed two securitizations by issuing an aggregate of $482.2 million of asset backed securities.
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In December 2012 we executed a $350.0 million bank term financing secured by $458.0 million of finance receivables.
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Entered and terminated definitive agreements to sell DTAG and DTAC in two separate transactions - See "Termination of Material Definitive Agreements" immediately following.
Termination of Material Definitive Agreements
On September 11, 2012, DTAG and DTAC entered into definitive agreements to sell DriveTime in separate
transactions. Pursuant to the definitive agreements, DTAC agreed to sell its finance receivable portfolio, which consists of vehicle related installment sales contracts, certificates representing its residual interests in securitizations of finance receivables, and certain other assets to Santander Consumer USA Inc. Immediately thereafter, a group of third-party investors was to purchase all of the outstanding stock of DTAG and DTAC, effectively acquiring DTAG's used vehicle dealership operations, including its owned and leased dealerships and reconditioning and other facilities located throughout the United States. In connection with the pending sale of DriveTime, on September 24, 2012, we commenced an offer to purchase and consent solicitation with respect to our outstanding Senior Notes.
On November 14, 2012, we terminated the definitive agreements entered into on September 11, 2012 to sell DriveTime due to certain unsatisfied conditions to the closings of the transactions contemplated therein. We also terminated and withdrew the offer to purchase and consent solicitation commenced on September 24, 2012.
Statement of Operations-Line Item Descriptions
Revenue
Sales of used vehicles
We derive a significant portion of our revenue from the sale of used vehicles. Revenue from sales of used vehicles is derived by the number of vehicles sold multiplied by the sales price per vehicle. Sales revenue is reported net of a reserve for
returns, and net of deferred service contract revenue, where applicable. Factors affecting revenue from sales of used vehicles include the number of used vehicles we sell and the price at which we sell our vehicles.
The number of used vehicles we sell depends on the volume of customer applications received and the conversion rate from customer application to sale. Application volume is a function of the number of dealerships, advertising, customer referrals, repeat customer volume, other marketing efforts, competition from other used car dealerships, availability of credit from other subprime finance companies, and general economic conditions. The conversion rate from customer application to sale is a function of our underwriting standards, customer sales experience, customer affordability, vehicle inventory, and warranty provided. The price at which we sell our vehicles is dependent on base inventory cost, reconditioning costs, and our pricing strategy.
Interest income
Interest income consists of interest earned on finance receivables, net of amortization of loan origination costs, plus late payment fees and interest earned on investments held in trust. We write-off accrued interest on charged-off loans as a reduction to interest income. Interest income is affected by (i) the principal balance of our loan portfolio, (ii) the average APR of our loan portfolio, and (iii) the payment performance by our borrowers on their loans.
Dealer Finance and Other Income
Dealer finance and other income consists of revenue recognized from GO Financial's dealer finance receivables under the effective interest method and income from other ancillary products offered by GO Financial, respectively.
Costs and Expenses
Cost of used vehicles sold
Cost of used vehicles sold includes the cost to acquire vehicles, reconditioning and transportation costs associated with preparing the vehicles for resale, vehicle warranty, and other related costs. The cost to acquire vehicles includes the vehicle purchase price, auction fees, wages, and other buyer costs. A liability for the estimated cost of vehicle repairs under our DriveCare® limited vehicle warranty program is established at the time a used vehicle is sold by charging cost of used vehicles sold.
The cost of used vehicles sold is affected by a variety of factors, including the following: (i) the cost of vehicles purchased at auction, (ii) the supply and demand of vehicles purchased at auction, (iii) the quality, make, model, and age of vehicles acquired, (iv) transportation costs, (v) reconditioning parts and labor costs along with costs to operate our reconditioning facilities, and (vi) warranty costs.
Provision for credit losses
Provision for credit losses is the charge recorded to operations to maintain an allowance adequate to cover losses inherent in the portfolio. We charge-off the entire principal balance of receivables that are contractually 91 or more days past due at the end of a month unless the customer has made a qualifying minimum payment within the previous 30 days from month-end, in which case the customer loan would not charge-off until 121 days contractually past due. At time of charge-off, we record a receivable for estimated recoveries on charged-off receivables, which is included in other assets. The allowance for credit losses varies based on size of the loan portfolio and the expected performance of the loans. Loan performance is a function of the underlying credit quality of the portfolio, the effectiveness of collection activities, auction values for repossessed vehicles, other ancillary collections, and overall economic conditions.
We anticipate the allowance for credit losses to grow as we increase origination volume and grow our portfolio. However, the allowance as a percentage of portfolio principal may increase or decrease based on the underlying performance of loans originated, value of collateral, and the change in credit grade mix of loans originated.
Interest expense
Portfolio debt interest expense consists of interest and related amortization of debt issuance costs on our portfolio warehouse facilities, securitizations, bank term financings, and term residual financings.
Non-portfolio debt interest expense consists of interest expense and related amortization of discounts and debt issuance costs on our senior unsecured notes payable, inventory facility, real estate mortgage financing, and an equipment note payable. Non-portfolio debt interest expense is dependent on the amount of indebtedness and the interest expense associated therewith, both of which are dependent on the financial markets and economy as a whole.
Senior secured debt interest expense consists of interest expense and related amortization of discount and fees on our 12.625% Senior Secured Notes due 2017.
Selling and marketing
Selling and marketing expenses are generally affected by sales volume, cost of advertising media, and our marketing strategy. Selling and marketing expenses include advertising and marketing related costs.
General and administrative
General and administrative expenses include compensation and benefits, property-related expenses, collection expenses on our portfolio, store closing costs, and other ancillary expenses, such as professional fees and services.
General and administrative expenses increase and decrease primarily as a result of costs associated with expansion and contraction of our dealership base. As we grow our portfolio, certain collection related costs may increase as we manage a larger servicing platform.
Loss on extinguishment of debt
Loss on extinguishment of debt represents the difference between the carrying value of the debt we repurchased and the purchase price at which we repurchased the debt, net of the write-off of unamortized debt issuance costs and discounts.
Critical Accounting Policies
The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with United States generally accepted accounting principles (GAAP). The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets and liabilities, revenue and expenses, and related disclosures of contingent assets and liabilities at the date of our financial statements. Actual results may differ from these estimates under different assumptions or conditions, impacting our reported results of operations and financial condition.
Certain accounting policies involve significant judgments and assumptions by management, which have a material impact on the carrying value of assets and liabilities and the recognition of income and expenses. Management considers these accounting policies to be critical accounting policies. The estimates and assumptions used by management are based on historical experience and other factors, which are believed to be reasonable under the circumstances. The significant accounting policies which we believe are the most critical to aid in fully understanding and evaluating our reported financial results are described below.
Revenue Recognition - DriveTime
Revenue from the sale of used vehicles is recognized upon delivery, when the sales contract is signed, and the agreed-upon down payment or purchase price has been received. Sales of used vehicles include revenue from the sale of used vehicles at the contractual sales price, net of a reserve for returns and excludes sales tax. The reserve for returns is estimated using historical experience and trends and could be affected if future vehicle returns differ from historical averages. A 10% increase in our rate of returns would result in a $0.2 million and $0.1 million increase in our sales return allowance (and corresponding decrease in revenue) for the years ended December 31, 2012 and 2011, respectively. Revenue is recognized at time of sale since persuasive evidence of an arrangement in the form of an installment sales contract exists, we have delivered the vehicle to the customer, transferred title, the sale has a fixed and determinable price, and collectability is reasonably assured.
Interest income consists of interest earned on finance receivables, net of amortization of loan origination costs, plus late payment fees and interest earned on investments held in trust. Interest income is recognized on the accrual basis, when earned, based on a simple interest method. Finance receivables continue to accrue interest until repayment or charge-off. Customer loans may be prepaid without penalty. Direct loan origination costs related to loans originated at our dealerships are deferred and charged against interest income over the life of the related loans using the effective interest method.
Revenue Recognition - GO Financial
We recognize revenue for dealer finance receivables (Dealer Finance Income) under the effective interest method, by applying a loss adjusted forecast of cash flows for each dealer pool, such that revenue is recognized on a level-yield basis. Open pools establish an effective yield at either their first fiscal quarter, or upon maturation of the pool. The effective yield established is held constant for an open pool until pool closure, unless circumstances warrant a yield adjustment or impairment assessment prior to pool closure. For each accounting period subsequent to pool closure, expected cash flows are re-estimated. Deterioration in expected cash flows, both in the open and closed pool stage, is reflected as a provision for loan loss and corresponding allowance for credit losses, at the pool level. Any subsequent improvement in expected cash flows of the impaired pool(s) will first reverse any previous allowance for credit loss and be prospectively reflected as an increase in the pool yield. For closed pools, if the re-estimation of expected cash flows results in a higher effective yield, an increase in the pool yield is reflected prospectively.
Allowance for Credit Losses
DriveTime maintains an allowance for credit losses on an aggregate basis at a level we consider sufficient to cover probable credit losses inherent in our portfolio of receivables as of each reporting date utilizing a loss emergence period to cover estimated losses. The allowance takes into account historical credit loss experience, including timing, frequency and severity of losses. This estimate of existing probable credit losses inherent in the portfolio is primarily based on static pool analyses by month of origination based on origination principal, credit grade mix and deal structure, including down payment and term. The evaluation of the adequacy of the allowance also considers factors and assumptions regarding the overall portfolio quality, delinquency status, the value of the underlying collateral, current economic conditions that may affect the borrowers’ ability to pay, and the overall effectiveness of collection efforts.
The static pool loss curves by grade are adjusted for actual performance to date, and historical seasonality patterns. The forecasted periodic loss rates, which drive the forecast for estimated gross losses (before recoveries) are calculated by factoring amortization speed and origination terms. Charge-offs have a natural seasonality pattern such that they are typically lower during the first and second quarters of each calendar year because customers tend to have additional money from tax refunds to apply to their loans, compared to the third and fourth quarters when charge-offs tend to increase. Recoveries are estimated using historical unit and dollar static pool recovery activity to forecast recoveries for estimated charge-offs at the balance sheet date. The forecasted recovery rates (on a per unit basis) are based on the historical unit recovery trend by recovery type and adjusted for the estimated impact of economic and market conditions.
The allowance model is sensitive to changes in assumptions such that an increase or decrease in our forecasted net charge-offs would increase or decrease the allowance as a percentage of principal outstanding required to be maintained. The amount of our allowance is sensitive to losses within credit grades, recovery values, deal structure, the loss emergence period and overall credit grade mix of the portfolio. In the event loss assumptions used in the calculation of the allowance for credit losses were to increase, there would be a corresponding increase in the amount of the allowance for credit losses, which would decrease the net carrying value of finance receivables and increase the amount of provision for credit losses, thereby decreasing net income. A 5% increase in our frequency loss assumption would increase the allowance for credit losses and our provision for credit losses by $11.0 million and $10.4 million as of December 31, 2012 and 2011, respectively. Also, a 5% decrease in our assumed recoveries per loan charged-off, would result in an increase to the allowance for credit losses and provision for credit losses of $6.1 million and $6.0 million as of December 31, 2012 and 2011, respectively. Our ability to forecast net charge-offs and track static pool net losses by month of origination are a critical aspect of this analysis.
Although it is reasonably possible that events or circumstances could occur in the future that are not presently foreseen, which could cause actual credit losses to be materially different from the recorded allowance for credit losses, we believe that we have given appropriate consideration to the relevant factors and have made reasonable assumptions in determining the level of the allowance. Our credit and underwriting policies, adherence to such policies, and the execution of collections processes have a significant impact on collection results, as does the economy as a whole. Changes to the economy, unemployment, auction prices for repossessed vehicles, and collections and recovery processes could materially affect our reported results.
See “Revenue Recognition - GO Financial” for a description of allowance for credit losses on GO finance receivables.
Recovery Receivables
Recovery receivables consist of estimated recoveries to be received on charged-off receivables, including proceeds from selling repossessed vehicles at auction, along with insurance, bankruptcy and deficiency collections. The recovery amount from selling repossessed vehicles at auction is a forecast of vehicles to be recovered from loans previously charged-off and vehicles currently in our possession. Based on our extensive experience and historical database of auction recoveries, we estimate the number of units we will recover and the value that we will receive for these vehicles at auction. Our forecast utilizes historical data with respect to recovery rates, values, and time from charge-off to repossession. In order to estimate auction recoveries we utilize historical static pool unit recovery rates, as adjusted for recent market trends, to arrive at the forecasted recovery dollars by static pool month of charge-off. Insurance, bankruptcy and deficiency collections are estimated using historical trends adjusted for changes to recovery practices.
Valuation of Inventory
Inventory consists of used vehicles held-for-sale or currently undergoing reconditioning and is stated at the lower of cost or market value. Vehicle inventory cost is determined by specific identification. Direct and indirect vehicle reconditioning costs including parts and labor, costs to transport the vehicles to our dealership locations, buyer costs, and other incremental costs are capitalized as a component of inventory cost. Determination of the market value of inventory involves assumptions regarding wholesale loss rates derived from historical trends and could be affected by changes in supply and demand at our retail locations and at the auctions. A 1.0% decrease in the valuation of our inventory at December 31, 2012 would result in a decrease in net income of approximately $2.7 million.
Secured Financings
We sell loans originated at our dealerships to our bankruptcy-remote securitization subsidiaries, which, in turn, transfer the loans to separate trusts that issue notes and certificates collateralized by these loans. The notes (asset-backed securities) are sold to investors, and we retain the certificates. We continue to service all securitized loans. We have determined that the trusts are variable interest entities and that DTAC is the primary beneficiary of those trusts. Therefore, loans included in the securitization transactions are recorded as finance receivables and the asset-backed securities that are issued by the trusts are recorded as a component of portfolio term financings in the accompanying consolidated balance sheets.
Limited Warranty
A liability for the estimated cost of vehicle repairs under our DriveCare® limited warranty is established at the time a used vehicle is sold by charging costs of used vehicles sold. The liability is evaluated for adequacy through an analysis based on the program’s historical performance of cost incurred per unit sold, management’s estimate of frequency of vehicles to be repaired and severity of claims based on vehicles currently under warranty, the make, mileage, and age of vehicles under warranty, which are based on the program’s historical performance and our expectation of future usage. These assumptions are further affected by mix, mileage, and age of vehicles sold and our ability to recondition vehicles prior to sale. A 5.0% increase in our warranty frequency assumptions related to warranty usage and a 5.0% increase in our warranty severity assumptions would result in a $0.9 million increase in our warranty accrual at December 31, 2012, and a corresponding reduction in net income.
Factors Affecting Comparability
We have set forth below selected factors that we believe have had, or can be expected to have, a significant effect on the comparability of recent or future results of operations:
Revenue Recognition
Beginning in the fourth quarter of 2012 we began offering our DriveCare® limited warranty as a separately priced service contract in our dealerships located in Tennessee, Virginia and Ohio. As a result, the revenue and costs of the sale of these service contracts is deferred and recognized over the life of the warranty contract, in relation to the usage and expected duration of the contracts. At December 31, 2012, the amount of deferred revenue (and revenue recognized) on the consolidated balance sheet and consolidated statement of operations, was immaterial. An increase in the number of locations where we offer the warranty as a separately priced product will have a direct material impact on our gross revenue and gross margin of vehicle sales in future periods compared to historical results.
GO Financial
In December 2011, we launched GO Financial. GO provides indirect subprime auto financing to non-DriveTime dealers. This business line was launched during our fourth quarter of 2011 and was not material to our financial results for the fiscal year ended December 31, 2011. However, at December 31, 2012, GO Financial had $41.0 million in dealer finance receivables and $42.4 million in total assets, combined with $41.7 million of equity on a stand-alone basis. GO has generated $3.0 million in total revenue during fiscal 2012, with a pre-tax loss of $1.9 million for the year. We expect that GO’s originations of dealer financings will continue to grow during 2013, thereby increasing our total revenue, portfolio size, and operating expenses as GO hires personnel, organizes and registers in various states with various regulatory authorities, and incurs other costs of doing business.
New Business Line - Carvana
In January 2013, we launched Carvana. Carvana, LLC is a new sales channel that enables the customer to buy a car, from click to delivery, 100% online over the internet. Carvana's target customer demographic is not specific to credit, and is geared to attract a broader credit spectrum and income classification than that of DriveTime and GO Financial. Carvana (www.Carvana.com) is a 360-degree, integrated used car buying experience that enables consumers to purchase used vehicles online through a highly efficient and transparent process. Initially launching in Georgia, with plans to expand regionally, then nationally, Carvana’s business and operations will fully integrate all steps of the vehicle sales process, including: (a) vehicle search, (b) vehicle tour and detail, (c) credit scoring, (d) customer financing, (e) eContracting (f) verification of customer data (g) electronic down payment, and (h) vehicle delivery. Carvana is not expected to have a significant net impact to our consolidated results for 2013, though it will incur operating expenses as it hires personnel, obtains state licensing and registers with regulatory agencies and incurs other costs of doing business, thereby increasing our general and administrative expenses. To a certain extent, Carvana will utilize DriveTime's existing infrastructure, with customized aspects of each component of the DriveTime business process.
Transaction Costs
We incurred certain legal, accounting, tax consulting, and other professional service fees in connection with a planned sale of DTAG and DTAC in 2012 (see Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations - Termination of Material Definitive Agreement for more information). The aggregate expense paid to third parties associated therewith of approximately $3.9 million was recorded in General and administration expenses for the year ended December 31, 2012. We have incurred all costs associated with this transaction in the 2012 fiscal year and do not expect these costs in the future, nor did we incur such costs in 2011.
Results of Operations - DriveTime
Comparison of years ended December 31, 2012 and 2011
The following table sets forth our results of operations for the periods indicated:
Sales of used vehicles
Revenue from sales of used vehicles increased for the year ended December 31, 2012 compared to 2011 primarily due to an increase in sales volume of 6.8%, coupled with a 2.8% increase in the average sales price per vehicle net of sales returns and allowances. The increase in sales volume is primarily attributable to an increase in the average number of stores in operation as a result of opening 10 new stores and closing two in 2012. The increase in average sales price per vehicle sold is attributable to an overall increase in the average cost of used vehicles sold, both as a result of an increase in wholesale used vehicle prices causing our acquisition cost to increase, and an increase in reconditioning costs, as a result of acquiring vehicle inventory with higher mileage and age, year over year. See also “-Cost of used vehicles sold” below.
Interest income
Interest income increased for the year ended December 31, 2012 compared to 2011 primarily due to an increase in our average portfolio principal outstanding year over year, partially offset by a decrease in average portfolio yield. Average portfolio principal outstanding increased as a result of an increase in originations over portfolio run-off. Average portfolio yield decreased slightly, as a result of a decrease in average APR of loans originated during the period. See “Originations” below for further discussion.
Cost of used vehicles sold
Total cost of used vehicles sold increased for the year ended December 31, 2012 compared to 2011 as a result of an increase in the number of vehicles sold and an increase in the per unit average cost of vehicles sold. Our cost of vehicles sold per unit increased primarily as a result of higher acquisition costs at auction and an increase in vehicle reconditioning costs. Acquisition costs have increased as a result of an appreciation in wholesale used vehicle prices. Wholesale used vehicle prices increased throughout most of 2012, with prices starting to soften at the end of the fourth quarter. Price appreciation was caused by increased demand for used vehicles, coupled with a decrease in supply of used vehicles nationwide. In an effort to maintain overall affordability for our customers, we purchased vehicles with a higher average age and mileage to limit our base cost of vehicles acquired at auction. As a result, reconditioning costs have also increased.
Gross margin
Gross margin as a percentage of sales revenue decreased for the year ended December 31, 2012 compared to 2011. The decrease in gross margin is primarily attributable to an increase in our “Cost of used vehicles sold” as described above, while only a portion of these costs were passed on to our customers through an increase in sales price due to competitive pressure, and to maintain affordability for our customers. As we experience wholesale pricing pressure, our ability to pass on cost to our customers is limited, because our customers are generally down payment and monthly payment sensitive.
Provision for credit losses
Provision for credit losses increased for the year ended December 31, 2012 compared to 2011 primarily as a result of an increase in the principal balance of loans outstanding in conjunction with an increase in allowance for credit losses as a percentage of loan principal. Portfolio principal increased as a result of an increase in originations, mostly driven from an increase in dealership growth.
Net charge-offs as a percent of average outstanding principal increased to 13.9% from 13.1% for the year ended December 31, 2012 compared to 2011, as a result of an increase in gross charge-offs, coupled with a decrease in our recovery rate. Gross principal charged-off increased to 23.4% for the year ended December 31, 2012, compared to 23.0% in 2011. Influencing gross loss rates are general economic conditions including unemployment and underemployment rates and wholesale vehicle prices, which have resulted in the sale of older, higher mileage vehicles and longer financing terms to maintain customer payment affordability. Recoveries as a percentage of principal charged-off decreased to 40.3% from 42.8% for the year ended December 31, 2012, compared to 2011. However, auction values continue to be near historical highs.
Our allowance as a percent of principal outstanding increased from 15.1% at the end of 2011 to 15.7% at December 31, 2012. The increase in the allowance rate is driven by our expectation that recovery values will continue to decline during 2013, combined with an increase in gross charge-off expectations as a result of an increase in average term.
Portfolio debt interest expense
Total portfolio debt interest expense decreased for the year ended December 31, 2012 compared to 2011. This decrease is a result of a decrease in the overall cost of funds of portfolio debt to 4.5% for the year ended December 31, 2012, compared to 5.1% for 2011, partially offset by an increase in the average balance of portfolio debt outstanding. The decrease in our costs of funds is attributable to lower borrowing costs of our recent securitizations, bank term financing, and a decrease in borrowing costs of our warehouse facilities. We utilize our warehouse facilities for our origination growth. Therefore, our average debt outstanding increased as a result of an increase in finance receivable originations during the year.
Non-portfolio debt interest expense
Total non-portfolio debt interest expense increased for the year ended December 31, 2012 compared to 2011. The increase was primarily due to increased borrowings on our inventory line as a result of increasing the capacity of that facility from $50.0 million to $130.0 million (excluding a $10.0 million seasonal increase) as of October 2011. In addition, we added a real estate facility in 2012 with average borrowings of approximately $8.0 million. As a result, the average balance outstanding of non-portfolio debt increased $38.6 million from 2011 to 2012, which was partially offset by a decline in the average cost of funds for non-portfolio debt.
Senior secured debt interest expense
The weighted average effective rate on the Senior Notes was 13.2% and 13.3% for the years ended December 31, 2012 and 2011, respectively, which includes amortization of discount and deferred financing costs. In June 2010 we issued $200.0 million of 12.625% Senior Notes due 2017. The Senior Notes were issued with an original issuance price of 98.854%. Interest on the Senior Notes is payable semi-annually in arrears on June 15th and December 15th of each year.
Selling and marketing expense
Selling and marketing expenses increased for the year ended December 31, 2012 compared to 2011. This increase was primarily a result of an increase in our advertising expenses, primarily related to our television and internet marketing strategy, an increase in television commercial production, and an increase in advertising associated with operating in new geographic locations as a result of expansion of our dealership base into several new geographic regions.
General and administrative expense
General and administrative expenses increased for the year ended December 31, 2012 compared to 2011. This increase was primarily the result of the increased number of dealerships and reconditioning centers in operation year over year, and a
corresponding increase in salaries and wages as we increased the number of employees in conjunction with our overall expansion. Lease expense increased due to the increased number of facilities in operation combined with an increase in the per facility location costs as our new locations have a larger footprint than legacy locations. In addition, we incurred approximately $3.9 million in transaction-related costs associated with the potential sale of the Company that was terminated in the fourth quarter of 2012 and approximately $3.1 million in initial costs associated with the CFPB requests for information.
Depreciation expense
Depreciation expense increased for the year ended December 31, 2012 compared to 2011. This increase was primarily the result of an increase in capital expenditures associated with the expansion of our dealership base, the addition of a reconditioning facility and improvements to our information technology infrastructure.
Net income
Net income for the year ended December 31, 2012 decreased compared to 2011. The decrease in net income is primarily attributable to increases in general and administrative expenses associated with our retail expansion, one time sale transaction costs and initial CFPB costs, an increase in marketing and advertising expenses, and an increase in provision for loan losses, partially offset by increases in interest income and gross margin dollars from increased sales volume.
Originations
The following table sets forth information regarding our originations for the periods indicated:
(1)
Represents the dollar amount originated divided by the dollar amount of revenue from sales of used vehicles.
We originate loans in conjunction with each vehicle we sell, unless the sale is a cash transaction. The balance on these loans, together with accrued interest and unamortized loan origination costs, comprises our portfolio of finance receivables. Our receivables are then financed through securitizations, bank term facilities, and warehouse facilities in order to generate liquidity for our business. See “-Liquidity and Capital Resources” below.
The increase in origination volume and number of loans originated were due to an increase in the number of used vehicles sold and an increase in the average amount financed per loan originated as a direct result of an increase in the average sales price per vehicle sold and a decrease in the average down payment per loan originated. Average APR decreased and average term increased for the year ended December 31, 2012 compared to 2011. These changes are a result of our overall interest rate and financing/underwriting strategy, which is designed to optimize affordability to our customers, while considering the effects of retail costs and vehicle pricing. The increase in the percentage of sales revenue financed is primarily a result of a lower average down payment combined with a higher average sales price.
Receivables portfolio
The following table shows the characteristics of our finance receivables portfolio for the periods indicated:
Finance receivables principal balance, average principal balance and the number of loans outstanding period over period increased as of and for the year ended December 31, 2012, compared to 2011, due to origination volume exceeding portfolio run-off (regular principal payments, payoffs, and charge-offs).
Delinquencies
As a percentage of total outstanding loan principal balances, delinquencies over 30 days increased year over year. The increase in delinquencies is the result of our change in collection strategy for early delinquencies aimed to improve customer experience while reducing cost of servicing, centralization of collection efforts for early delinquencies, which includes the use of off-shore services. As a result of the proposed sale of the portfolio in the latter half of 2012, turnover of collections personnel increased, we enacted a collections hiring freeze, and experienced a general disruption of our collections operations, all which adversely impacted delinquencies. We also closed our regional collection centers in Orlando, Florida and Richmond, Virginia, which temporarily impacted delinquencies. Since the termination of the transaction and closure of our regional facilities, we have taken necessary steps to increase collections personnel and supplement our closed regional centers, to our normal staffing levels.
Results of Operations- DriveTime
Comparison of years ended December 31, 2011 and 2010
The following table sets forth our results of operations for the periods indicated:
Sales of used vehicles
Revenue from sales of used vehicles increased for the year ended December 31, 2011 compared to the same period during 2010. This increase in revenue was primarily due to an increase in sales volume of 6.9%, coupled with an increase in the average sales price per vehicle of 3.1%. The increase in sales volume is primarily attributable to an increase in the average number of stores in operation as a result of opening a net of four new stores in 2011. The increase in average sales price per vehicle sold is attributable to an overall increase in the average cost of used vehicles sold, primarily as a result of an increase in wholesale used vehicle prices causing our acquisition cost to increase. See also “-Cost of used vehicles sold” below.
Interest income
Interest income increased for the year ended December 31, 2011 compared to 2010. This increase is primarily due to an increase in our average portfolio principal outstanding for the year ended December 31, 2011, partially offset by a decrease in average portfolio yield. Average portfolio principal outstanding increased $91.0 million during the year ended December 31, 2011, compared to 2010. This increase was the result of an increase in originations over portfolio run-off. Average portfolio yield decreased slightly, as a result of a decrease in average APR of loans originated during the period. See “Originations” below for further discussion.
Cost of used vehicles sold
Total cost of used vehicles sold increased for the year ended December 31, 2011 compared to 2010. This increase is due to an increase in the number of vehicles sold and an increase in the average total cost of vehicles sold of 5.9%. Our cost of vehicles sold per unit increased primarily as a result of higher acquisition costs at auction and an increase in vehicle reconditioning costs. Acquisition costs have increased as a result of an appreciation in wholesale used vehicle prices. Wholesale used vehicle prices increased during the year ended December 31, 2011, compared to 2010, as a result of increased demand for used vehicles, coupled with a decrease in supply of used vehicles nationwide. Vehicle reconditioning costs have increased as a result of an increase in the average age and mileage of vehicles sold, in an effort to maintain overall affordability for our customers.
Gross margin
Gross margin total dollars increased for the year ended December 31, 2011 compared to 2010, however gross margin as a percentage of sales revenue decreased. The increase in gross margin dollars is attributable to an increase in total units sold year
over year. The decrease in gross margin percentage is primarily attributable to an increase in our “Cost of used vehicles sold” as described above, while only a portion of these costs were passed on to our customers through an increase in sales price. In an effort to maintain affordability for our customers, our total cost per vehicle sold increased 5.9% during the year ended December 31, 2011, while our average price per vehicle sold only increased 3.1%, for the year ended December 31, 2011, compared to the same period in 2010.
Provision for credit losses
Provision for credit losses increased for the year ended December 31, 2011, compared to 2010. The increase is primarily the result of an increase in the principal balance of loans outstanding as a result of an increase in originations over portfolio run-off, in conjunction with a slight increase in allowance for credit losses as a percentage of loan principal.
Net charge-offs as a percent of average outstanding principal decreased to 13.1% from 13.5% for the year ended December 31, 2011 compared to the same period in 2010 as a result of an increase in gross charge-offs which was more than offset by an improvement in our recovery rate. Gross principal charged-off increased to 23.0% for the year ended December 31, 2011, compared to 22.0% in 2010. Influencing gross loss rates are general economic conditions including unemployment and underemployment rates and wholesale vehicle prices, which have resulted in the sale of an older, higher mileage vehicle and longer financing terms to maintain customer payment affordability. Recoveries as a percentage of principal charged-off increased to 42.8% from 38.5% for the year ended December 31, 2011, compared to 2010. The improvement in recoveries is due primarily to higher auction values stemming from appreciation in the wholesale used vehicle market.
Portfolio debt interest expense
Total portfolio debt interest expense decreased for the year ended December 31, 2011 compared to 2010. This decrease was a result of a decrease in the overall cost of funds of portfolio debt to 5.1% for the year ended December 31, 2011, compared to 8.2% for 2010. The decrease in our costs of funds is attributable to lower borrowing costs of our securitizations in 2011 and a decrease in borrowing costs of our warehouse facilities. The original duration weighted average coupon of our three most recent securitizations as of December 31, 2011 was 3.03% for 2011-1, 2.88% for 2011-2, and 3.97% for 2011-3. In addition, our warehouse facility renewals and additions in 2011 were at lower interest rates than in 2010.
Non-portfolio debt interest expense
Total non-portfolio debt interest expense decreased for the year ended December 31, 2011 compared to 2010. This decrease was primarily due to the exchange of $60.1 million junior secured notes and $40.0 million of subordinated debt (with effective rates of 22.4% and 12.2%, respectively) for equity, and the exchange of $2.0 million junior secured notes and $35.0 million in subordinated debt for an equal principal amount of Senior Notes, both of which occurred in conjunction with the offering of our Senior Notes in June 2010. As a result, the average balance of non-portfolio debt decreased $64.8 million for the year ended December 31, 2011 compared to 2010. Further, the average cost of funds of non-portfolio debt decreased to 4.7% for the year ended December 31, 2011, from 11.6% for the same period in 2010, as a result of these transactions.
Senior secured debt interest expense
Senior secured debt interest expense increased during the year ended December 31, 2011 compared to 2010. This increase was a result of the issuance in June 2010 of our Senior Notes. As a result, we incurred a full year of interest expense in 2011 versus a partial year in 2010. The weighted average effective rate on these notes is 13.3%, which includes amortization of discount and deferred financing costs.
Selling and marketing expense
Selling and marketing expenses decreased for the year ended December 31, 2011 compared to 2010. This decrease was primarily a result of a decrease in sales commissions as we completed the transition from a 100% commission structure to a base salary plus team and individual bonus compensation structure for sales personnel. This transition began in 2010 and was fully complete in 2011. This decrease was partially offset by an increase in our advertising expenses, primarily related to our television and internet marketing strategy, an increase in television commercial production, and an increase in advertising associated with operating in new geographic locations as a result of expansion of our dealership base into seven new geographic regions.
General and administrative expense
General and administrative expenses increased for the year ended December 31, 2011 compared to 2010. This increase was primarily the result of the increased number of dealerships and reconditioning centers in operation year over year and a corresponding increase in salaries and wages as we increased the number of employees in conjunction with our overall
expansion. Salaries and wages expense also increased due to the new salaries and wages structure of sales personnel. See “-Selling and marketing expense” as described above. Lease expense also increased due to the increased number of facilities in operation.
Depreciation expense
Depreciation expense increased for the year ended December 31, 2011 compared to 2010. This increase was primarily the result of an increase in capital expenditures associated with the expansion of our dealership base and information technology infrastructure.
Net income
Net income for the year ended December 31, 2011 increased compared to 2010. The increase in net income for 2011 is a result of an increase in total revenue of 9.3%, primarily as a result of an increase in the volume of vehicles sold and a larger average loan portfolio. Partially offsetting the increase in total revenue was an increase in provision for credit losses and general and administrative expenses, as discussed above.
Originations
The following table sets forth information regarding our originations for the periods indicated:
(1)
Represents the dollar amount originated divided by the dollar amount of revenue from sales of used vehicles.
We originate loans in conjunction with each vehicle we sell, unless the sale is a cash transaction. The balance on these loans, together with accrued interest and unamortized loan origination costs, comprises our portfolio of finance receivables. Our receivables are then financed through securitizations and warehouse facilities in order to generate liquidity for our business. See “-Liquidity and Capital Resources” below.
During 2011, the number of loans and principal balance of loans we originated increased as compared to 2010. These increases were due to an increase in the number of used vehicles sold and an increase in the average amount financed per loan originated as a direct result of an increase in the average sales price per vehicle sold and a decrease in the average down payment per loan originated. Average APR decreased for the year ended December 31, 2011 compared to the same period in the prior year. The average term increased for the year ended December 31, 2011, compared to the same period in 2010. These changes are a result of our overall interest rate and financing/underwriting strategy, which is designed to optimize affordability to our customers, while considering the effects of retail costs and vehicle pricing.
Receivables portfolio
The following table shows the characteristics of our finance receivables portfolio for the periods indicated:
Finance receivables principal balance, average principal balance and the number of loans outstanding period over period increased as of and for the year ended December 31, 2011, compared to 2010, due to origination volume exceeding portfolio run-off (regular principal payments, payoffs, and charge-offs).
Delinquencies
As a percentage of total outstanding loan principal balances, delinquencies over 30 days were 11.2% and 9.1% at December 31, 2011 and 2010, respectively. The increase in delinquencies is the result of our change in collection strategy for early delinquencies, including utilizing dialer technology, coupled with our modification in charge-off policy (see “Factors Affecting Comparability, Modification to Charge-off Policy”). Further influencing delinquencies is the effects of the current economic environment, including high unemployment and underemployment. In conjunction with our centralization of collections during 2010, we are utilizing messaging and dialer technologies for early delinquencies in order to achieve a more cost effective collections process. As a result, we anticipate delinquencies to be relatively higher than our historical rates. We will continue to monitor portfolio performance and delinquencies in an effort to balance cost effectiveness and efficiencies based on the current economy.
Seasonality
Historically, we have experienced higher revenues in the first quarter of the calendar year than in the last three quarters of the calendar year. We believe these results are due to seasonal buying patterns resulting, in part, because many of our customers receive income tax refunds during the first quarter of the year, which are a primary source of down payments on used vehicle purchases. Our portfolio of finance receivables also has historically followed a seasonal pattern, with delinquencies and charge-offs being the highest in the second half of the year.
Seasonality of Earnings
To illustrate the seasonality in total revenue, costs and expenses, and income before taxes, a summary of the quarterly financial data follows:
(1)Includes net gains / losses on extinguishment of debt.
Seasonality of Vehicle Sales
To illustrate the seasonality of retail sales units, a summary of quarterly data has been provided:
Seasonality of Loan Performance
This table represents the performance of our entire loan portfolio outstanding for each period shown, and does not represent static pools based on origination year. As is evident from the table below, the seasonality in our business results in net charge-offs typically being the highest in the third and fourth quarter of each year and the lowest in the first and second quarter of each year.
Net Charge-Offs as a Percent of Average Portfolio Principal Balance:
Results of Operations - GO Financial
GO Financial began operations in December of 2011. The year ended December 31, 2012 is GO's first full year of operations. The following table sets forth our results of operations for the periods indicated:
Dealer Finance Income
GO recognized $2.2 million of finance income for the year ended December 31, 2012. Finance income represents revenue for dealer finance receivables recognized under the effective interest method, by applying a loss adjusted forecast of cash flows for each dealer pool.
Other Income
GO recognized $0.8 million of other income for the year ended December 31, 2012. Other income consists of revenue generated from ancillary products sold by participating dealers such as service contracts and GPS units.
Operating Expenses
GO's total operating expenses for the year ended December 31, 2012 were $4.8 million. The primary component of operating expenses is salaries and wages. At December 31, 2012, GO employed 40 people, including personnel in the areas of sales, verifications, information technology, account representation, and senior management.
The following table summarizes information related to the GO portfolio of dealer finance receivables, originations, collections, portfolio performance, and other key operating metrics:
Liquidity and Capital Resources
General
We require capital to provide financing to our customers, for the purchase of vehicle inventory, for capital improvements to open new dealerships and reconditioning facilities, and for general corporate purposes, including the purchase of property and equipment and to fund operations.
We historically have funded our capital requirements through operating cash flow, portfolio warehouse facilities, securitizations, bank term financing, residual cash flow, term facilities, inventory and other revolving debt facilities, real estate mortgage financing, and other notes payable (including senior secured notes, junior secured notes, senior unsecured notes, and subordinated notes).
Financing sources
We currently fund our capital requirements through the following:
•
Portfolio term financings including asset-backed securitizations, which offer fixed rate secured financing for our receivables portfolio.
•
Bank term financings.
•
Portfolio warehouse facilities including agreements with three different institutional lenders.
•
Senior Secured Notes due 2017.
•
A term residual facility.
•
Operating leases for the majority of our dealerships, reconditioning centers, operations facilities and our corporate offices.
•
Other secured notes payable including an inventory facility, a mortgage loan for our operations call center in Mesa, Arizona, and other notes and capital leases secured by property and equipment.
For additional details and terms regarding these debt instruments, see Note 8-Debt Obligations to our condensed consolidated financial statements included in Part II, Item 8 of this report.
Our warehouse facilities include certain favorable terms and conditions, including (i) the inability of the lender to subjectively lower collateral values and effectively lower advance rates; (ii) limited recourse; and (iii) limited foreclosure rights upon a default.
We actively manage utilization of our various funding sources as we seek to minimize borrowing costs through drawing on our lower cost facilities and minimizing unused line fees, while at the same time balancing the effective advance rates and liquidity generated by each of the credit facilities in order to meet our funding needs. The effective advance rates on our portfolio warehouse and term financings are based on the outstanding principal balance of the loans we originate. However, our initial investment in the loans we originate is lower than the original principal balance of the loans.
Recent financing and cash flow transactions
•
In December 2012, we amended our $100.0 million portfolio term residual facility and extended the maturity date to December 2019, decreased the interest rate and provided the ability for borrowing base credit (under certain conditions).
•
In November 2012, we entered into a $350.0 million portfolio term facility with Wells Fargo, collateralized by $457.5 million of finance receivables. This agreement is substantially similar in structure to a securitization.
•
In October 2012, we paid $6.4 million in dividends to shareholders, relating to third quarter 2012 earnings.
Operating leases
Operating leases are a significant component of our financing sources. At December 31, 2012, we leased the majority of our dealership and reconditioning center locations. We also lease our corporate office in Phoenix, Arizona, and an operations collections facility in Dallas, Texas. As each lease matures, we evaluate the existing location to determine whether the dealership should be relocated to another site in the region closer in proximity to new car franchises and/or higher traffic retail areas. As of December 31, 2012, we had approximately $70.3 million in aggregate operating lease obligations.
Shareholder distributions
Income from S-corporations flows through to the individual shareholders, who report income/losses on their individual income tax returns. We have made distributions to shareholders to fund the tax paid by the shareholders related to S-corporation income of DTAG and DTAC, in addition to general distributions to the shareholders. The following table summarizes distributions to shareholders since January 1, 2003.
Liquidity
The following is a summary of total available liquidity, consisting of unrestricted cash and current availability under our portfolio warehouse and inventory facilities for the periods indicated:
The following table presents a summary of our access to liquidity under our portfolio warehouse facilities and our inventory facility based on collateral pledged as of December 31, 2012 and 2011:
(1)
Represents amounts that can be drawn upon as long as the amount drawn does not exceed the borrowing base for the credit facility.
(2)
Borrowing base is determined by the collateral currently pledged to the respective facilities. The borrowing base calculation for the portfolio warehouse facilities uses a blended 58% advance rate for December 31, 2012 and 57% for December 31, 2011. Borrowing base includes collection and reserve amounts on deposit which are assumed to be used to pay down amount drawn on the RBS warehouse. Warehouse borrowing base excludes the amounts in the collection accounts for the Deutsche Bank warehouse and the Wells Fargo warehouse per the borrowing base definition for these warehouses. Borrowing base for the inventory facility is capped at our facility amount of $140.0 million, however, if we had a larger facility, availability would increase by $35.3 million at December 31, 2012.
(3)
Includes $79.3 million and $123.7 million as of December 31, 2012 and 2011, respectively, of unpledged qualifying receivables that can be pledged immediately and bring total borrowing to our maximum capacity. The borrowing base is the lesser of total eligible collateral multiplied by the applicable advance rate and the facility amount.
Changes in liquidity
Changes in liquidity are affected by increases and decreases to our operating cash flow, changes in advance rates on our portfolio warehouse facilities, capacity of our portfolio warehouse and inventory facilities, portfolio term financings, and changes in other notes payable. The following is a summary of changes in liquidity for each period presented:
Change in liquidity during the year ended December 31, 2012. Our liquidity for the year ended December 31, 2012 decreased $91.9 million, from $230.3 million at December 31, 2011 to $138.4 million at December 31, 2012. This decrease was primarily the result of the origination of $45.0 million of GO Financial dealer finance receivables, which were not eligible for borrowing base, and higher inventory levels resulting in borrowing base in excess of facility capacity.
Change in liquidity during the year ended December 31, 2011. Our liquidity for the year ended December 31, 2011 increased $84.4 million, from $145.8 million at December 31, 2010 to $230.3 million at December 31, 2011. This increase was primarily the result of increased liquidity from our revolving inventory facility and increased portfolio warehouse availability.
Increased portfolio warehouse availability was primarily the result of higher advance rates on our warehouse facilities and securitizations.
Change in liquidity during the year ended December 31, 2010. Our liquidity for the year ended December 31, 2010 increased by $105.4 million. This increase was primarily the result of the net proceeds from the sale of our Senior Notes in June 2010, which were used primarily to pay down amounts outstanding under our warehouse facilities, plus the addition of a residual term loan in May 2010.
Cash flows
Operating activities
For the year ended December 31, 2012, net cash used in operating activities increased compared to 2011. The increase in cash used in operating activities was primarily due to a decrease in net income, and an increase in loan originations over collections and recoveries of principal balances received. The decrease in cash was partially offset by a smaller increase in inventory and other assets.
For the year ended December 31, 2011, net cash used in operating activities was $25.2 million as compared to net cash provided by operating activities of $5.9 million for 2010. The decrease in cash provided by operating activities was primarily due to an increase in loan originations, an increase in inventory levels, and a smaller increase in accrued expenses. The decrease in cash was partially offset by an increase in collections and recoveries on finance receivable principal, and an increase in net income (inclusive of an increase in provision for credit losses).
For the year ended December 31, 2010, net cash provided by operating activities decreased as compared to 2009. The decrease in cash provided by operating activities was primarily due to an increase in loan originations, an increase in inventory levels as compared to 2009, and increase in other assets in 2010 compared to a decrease in 2009. This decrease was partially offset by an increase in collections and recoveries on finance receivable principal, and an increase in accounts payable, accrued expenses and other liabilities in 2010 compared to a decrease in 2009.
Investing activities
For the year ended December 31, 2012, net cash used in investing activities increased as compared to 2011. The increase in cash used in investing activities was primarily due to the origination of dealer finance receivables for Go Financial. This increase was offset by a decrease in cash used to purchase dealership facilities and equipment for new dealerships and to remodel existing dealerships. The decrease in cash used for facilities was driven by the rebranding of several facilities in 2011 that did not occur in 2012. We also opened ten dealerships and one inspection center, and relocated three dealerships, in 2012, as compared to eleven dealerships, three inspection centers, and one inspection center relocation in 2011. Of the new and relocated facilities, we purchased one dealership and no inspection centers in 2012, as compared to two dealerships and three inspection centers in 2011.
For the year ended December 31, 2011, net cash used in investing activities increased as compared to 2010. The increase in cash used in investing activities was primarily due to eleven new dealership openings in 2011 and one dealership relocation. We also opened three new inspection centers in 2011 and had one inspection center relocation. Of the new and relocated facilities, we purchased three inspection centers and two dealerships. We also completed remodeling our existing dealerships, and increased information technology infrastructure equipment to support our operations.
For the year ended December 31, 2010, net cash used in investing activities increased compared to 2009. The increase in cash used in investing activities was primarily due to ten new dealership openings in 2010, one of which was a purchased property, combined with two reconditioning facilities under development, remodeling our existing dealerships, and an increase in the addition of information technology infrastructure equipment to support our operations.
Financing activities
For the year ended December 31, 2012, net cash provided by financing activities increased as compared to 2011. This increase was primarily due to a net increase in portfolio term financings as a result of executing two securitizations in 2012 along with the bank term financing aggregating $832.2 million compared to three securitizations in 2011 totaling $708.0 million. We also borrowed and repaid less on our portfolio warehouse facilities in 2012 as a result of the term financings. In addition, other secured notes payable, net, increased less in 2012 than 2011 as a result of borrowing and repaying more under our inventory facility as a result of expanding our inventory borrowing base and expansion of our inventory available for sale.
For the year ended December 31, 2011, net cash provided by financing activities increased as compared to 2010. This increase was partially due to three securitizations during the course of 2011, in which we issued $708 million in asset-backed securities as opposed to one securitization in 2010 for $228.0. This increase was partially offset by the pay-down of our
warehouse facilities. We also increased the amount borrowed under our inventory line when we amended and restated the inventory facility and increased the facility capacity.
For the year ended December 31, 2010, net cash provided by financing activities increased as compared to 2009. This change was a result of an increase in net borrowings under our warehouse facilities, which was a result of executing three new warehouse facilities and terminating one of our bank term financing agreements with one of our lenders, resulting in the pay-down of such financing while increasing warehouse borrowings. In addition, we issued $200.0 million of Senior Notes in June 2010, which provided net proceeds to the Company of $155.9 million (as $37.0 million principal amount of the notes were exchanged for existing debt), which was used to pay down amounts outstanding under warehouse facilities and pay-off a portion of junior secured notes and subordinated notes payable to our principal shareholder.
Contractual Obligations
The following tables set forth the aggregate amounts of our significant contractual obligations and commitments with definitive payment terms:
(1)
Securitization obligations and bank term agreements do not have a contractual termination date. Therefore, all collections on the contracts collateralizing the securities are used to repay the asset-backed security holders based on an expected duration of the securities.
(2)
On the termination date of the facilities, amounts outstanding at termination are not due and payable immediately. All collections on the contracts collateralizing these facilities are used to pay down the facilities until they are paid in full because these facilities contain term-out features.
(3)
Generally and historically, we have renewed or replaced facilities expiring in less than one year.
(4)
Total contractual obligations exclude future interest payment obligations.
Senior Secured Notes Collateral
Our Senior Notes due June 15, 2017 contain a collateral coverage ratio covenant which requires the Company to maintain a collateral coverage ratio of 1.5x the outstanding Senior Notes. The following is the calculation of the collateral coverage ratio as of December 31, 2012 and is not meant to portray a GAAP summary of collateral but rather a summary of collateral as it resides legally within the Guarantor Subsidiaries, Non-Guarantor Subsidiaries, and Co-Issuers.
(1)
Net Receivables Value equals 85% of the finance receivables (including accrued interest and capitalized loan costs) minus debt (exclusive of Senior Notes) collateralized by finance receivables (including accrued interest) plus cash equivalents securing such debt. The Senior Notes are excluded from this calculation.
(2)
Net Inventory Value equals 85% of the book value of inventory pledged as collateral minus debt obligations (including accrued interest) secured by inventory. The Senior Notes are excluded from this calculation.
(3)
Cash equivalents equal cash and equivalents pledged directly to secure the 12.625% Senior Secured Notes.
Impact of New Accounting Pronouncements
For a discussion of recent accounting pronouncements applicable to us, see Note 17-Recent Accounting Pronouncements to the consolidated financial statements as of December 31, 2012, included in Part II, Item 8 of this report.
Off-Balance Sheet Arrangements
We do not have any off-balance sheet arrangements that have or are reasonably likely to have a material effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures, or capital resources.
We lease the majority of our dealership and reconditioning facilities under operating leases. See “-Liquidity and Capital Resources-Operating Leases” for more information.
Impact of Inflation
Inflation generally results in higher interest rates on our borrowings, which could decrease the profitability of our existing portfolio to the extent we have variable rate debt and could decrease profitability of our future originations if we are not able to pass the increase on to our customers. We seek to limit the risk of increasing borrowing costs:
•
through our fixed rate portfolio term financings, which allowed us to fix a portion of our borrowing costs and generally match the term of the underlying finance receivables, and
•
by increasing the interest rate charged for loans originated at our dealerships (if allowed under applicable law) while maintaining affordability of the customer's payment.
The used vehicle market has experienced strong appreciation in used vehicle wholesale prices over the past couple of years. The appreciation resulted, in part, from a reduced supply of used vehicles in the market due to a decline in new car industry sales coupled with a decrease in used vehicle trade-in activity compared with pre-recession levels. Higher wholesale values increased our vehicle acquisition and related costs. In addition, we increased the age and mileage of vehicles we sell in order to maintain affordability for the customer. These increased costs led to an increase in our average selling price for used vehicles; however, we chose to pass only a portion of these costs to our customers in order to maintain affordability for our customers. Higher wholesale values also improved our recovery values as a percentage of principal charged-off.
Non-GAAP Discussion
EBITDA and Adjusted EBITDA, which we refer to as the non-GAAP financial measures, are supplemental measures of our performance that are not required by, or presented in accordance with, generally accepted accounting principles in the United States (“GAAP”). The non-GAAP financial measures are not measures of our financial performance under GAAP and should not be considered as an alternative to GAAP net income (loss) or any other performance measures derived in accordance with GAAP. See the footnotes to the tables in “Item 6 - Summary Financial Data” for definitions of the other non-GAAP financial measures.
We present non-GAAP financial measures because we consider them to be important supplemental measures of our operating performance. All of the adjustments made in our calculation of the non-GAAP financial measures are adjustments to items that management does not consider to be reflective of our core operating performance. Management considers our core operating performance to be that which can be affected by our managers in any particular period through their management of the resources that affect our underlying revenue and profit generating operations during that period.
However, because these non-GAAP financial measures are not recognized measurements under GAAP, when analyzing our operating performance investors should use these non-GAAP financial measures in addition to, and not as an alternative for, net income, operating income, or any other performance measure presented in accordance with GAAP, or as an alternative to cash flow from operating activities or as a measure of our liquidity. Because not all companies use identical calculations, our presentation of these non-GAAP financial measures may not be comparable to similarly titled measures of other companies.
Because of these limitations, EBITDA and Adjusted EBITDA and other non-GAAP financial measures should not be considered as discretionary cash available to us to reinvest in the growth of our business. You should compensate for these limitations by relying primarily on our GAAP results and using these non-GAAP financial measures on a supplemental basis.
EBITDA represents net income (loss) before income tax expense, total interest expense (secured and unsecured) and depreciation expense. Adjusted EBITDA represents EBITDA plus store closing costs, non-cash compensation expense, Nevada sales tax liability, restricted stock compensation expense, IPO expense, gain on extinguishment of debt, CFPB Expense, and Transaction Costs.
In evaluating EBITDA and Adjusted EBITDA, you should be aware that in the future we may incur expenses similar to the adjustments described above. Our presentation of EBITDA and Adjusted EBITDA should not be construed as an inference that our future results will be unaffected by expenses that are unusual, non-routine, or non-recurring. EBITDA and Adjusted EBITDA have limitations as an analytical tool, and you should not consider it in isolation, or as a substitute for analysis of our results as reported under GAAP. Some of these limitations are that it does reflect:
•
cash expenditures for capital expenditures or contractual commitments;
•
changes in, or cash requirements for, our working capital requirements;
•
interest expense, or the cash requirements necessary to service interest or principal payments on our indebtedness;
•
the cost or cash required to replace assets that are being depreciated or amortized; and
•
the impact on our reported results of earnings or charges resulting from items accounted for in the GAAP measure from which EBITDA and Adjusted EBITDA is derived.
The following table presents data relating to EBITDA and Adjusted EBITDA, which are non-GAAP measures, for the periods indicated:
(1)
Store closing costs represent costs to close stores in 2008 and 2009 related to downsizing (and do not include dealerships closed in the normal course of business). Typically, expense relates to rent paid on continued lease obligations and fees associated with required storage of original dealerships records. Additionally, 2012 included the loss on disposal of fixed assets for a closed dealership and a lease liability for a closed reconditioning facility. Credits in store closing costs are the result of negotiating lease terminations more favorable than amounts accrued.
(2)
Non-cash compensation expense related to an agreement directly between Mr. Garcia and Mr. Fidel (not between the Company and Mr. Fidel), which expired in June 2010.
(3)
In December 2010, our chief executive officer, entered into a Restricted Stock Agreement with DTAG and DTAC pursuant to which we awarded a specified number of shares of restricted stock to Mr. Fidel. Such shares will become vested over a three-year period based on the achievement by the Company of certain income before income tax targets. See “Item 11 - Executive Compensation- Compensation Discussion and Analysis-Chief Executive Officer Restricted Stock Grant.”
(4)
Represents non-cash adjustments to sales tax refunds related to loans charged-off in prior periods.
(5)
IPO expense represents costs incurred related to our withdrawn initial public offering in 2010.
(6)
Loss on extinguishment of debt is a result of repurchasing outstanding indebtedness.
(7)
Represents initial direct costs incurred in responding to the CFPB's request for information.
(8)
Represents directs costs incurred in conjunction with the terminated sale of the Company in 2012.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures about Market Risk
Our financial instruments are exposed to market risk from changes in interest rates. We do not use financial instruments for trading purposes. We use fixed rate securities to manage risk. Our earnings are substantially affected by our net interest income, which is the difference between the income earned on interest-bearing assets and the interest paid on interest-bearing notes payable. Increases in market interest rates could have an adverse effect on profitability.
Our financial instruments consist primarily of fixed rate finance receivables and fixed and variable rate notes payable. Our finance receivables are classified as subprime loans and generally bear interest ranging from 3.6% to 29.9% or the maximum interest rate allowed in states that impose interest rate limits. At December 31, 2012, the remaining scheduled maturities on our finance receivables ranged from one to 75 months, with a weighted average remaining maturity of 45.4 months. The interest rates we charge our customers on finance receivables have not changed significantly as a result of fluctuations in market interest rates. We may increase the interest rates we charge in the future if market interest rates rise. The affordability of our customers’ payments is an important component of the structure of our transactions. Because of these affordability concerns for our customers and interest rate limits imposed by some states, we may not pass on the entire portion of future rate increases to our customers.
Approximately $900 million of our total debt of $1.4 billion at December 31, 2012, consists of fixed-rate collateralized asset-backed securities issued under our securitization program, a term residual financing, Senior Notes payable, and other notes with a fixed interest rate. Our securitization program has allowed us to mitigate our interest rate risk by periodically replacing variable rate borrowings under our portfolio warehouse facilities with fixed rate borrowings during the year.
The table below illustrates the impact that hypothetical changes in interest rates could have on our interest expense for the years ended December 31, 2012 and 2011. We compute the impact on interest expense for the period by first computing the baseline interest expense on our debt with interest rate risk, which includes the variable rate revolving credit lines and the variable rate notes payable. We then determine interest expense based on each of the interest rate changes listed below and compare the results to the baseline interest expense. The table does not give effect to our fixed rate receivables and borrowings.
In computing the effect of hypothetical changes in interest expense, we have assumed that:
•
interest rates used for the baseline and hypothetical net interest expense amounts are on a monthly basis and in effect for the entire month;
•
interest for the period is calculated on monthly average debt balances during the applicable periods; and
•
there is no change in average balance outstanding as a result of the interest rate changes.
Our sensitivity to interest rate changes could be significantly different if actual experience differs from the assumptions used to compute the estimates.
Item 8.
Item 8. Financial Statements and Supplementary Data
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Report of Independent Registered Public Accounting Firm
Board of Directors and Shareholders
DriveTime Automotive Group, Inc.
We have audited the accompanying consolidated balance sheets of DriveTime Automotive Group, Inc. and subsidiaries (collectively the “Company”) as of December 31, 2012 and 2011, and the related consolidated statements of operations, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2012. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of DriveTime Automotive Group, Inc. and subsidiaries as of December 31, 2012 and 2011, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2012, in conformity with accounting principles generally accepted in the United States of America.
/s/ GRANT THORNTON LLP
Phoenix, Arizona
March 28, 2013
DRIVETIME AUTOMOTIVE GROUP, INC. AND SUBSIDIARIES
Consolidated Balance Sheets
(1) Refer to Note 18 for Consolidating Financial Information and discussion regarding non-controlling interest.
See accompanying notes to Consolidated Financial Statements.
DRIVETIME AUTOMOTIVE GROUP, INC. AND SUBSIDIARIES
Consolidated Statements of Operations
(1) Refer to Note 18 for Consolidating Financial Information and discussion regarding non-controlling interest.
See accompanying notes to Consolidated Financial Statements.
DRIVETIME AUTOMOTIVE GROUP, INC. AND SUBSIDIARIES
Consolidated Statements of Shareholders’ Equity
(1) Refer to Note 18 for Consolidating Financial Information and discussion regarding non-controlling interest.
See accompanying notes to Consolidated Financial Statements.
DRIVETIME AUTOMOTIVE GROUP, INC. AND SUBSIDIARIES
Consolidated Statements of Cash Flows
DRIVETIME AUTOMOTIVE GROUP, INC. AND SUBSIDIARIES
Consolidated Statements of Cash Flows - (Continued)
See accompanying notes to Consolidated Financial Statements.
DRIVETIME AUTOMOTIVE GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(1) Description of Business, Ownership, Basis of Presentation, and Principles of Consolidation
Description of Business
DriveTime Automotive Group, Inc. (“DTAG”) (referred to herein as “we,” “our,” “the Company,” and “us”), through its subsidiaries, owns and operates used automobile dealerships in the United States focusing on the sale and financing of used vehicles to the subprime credit market. The subprime credit market is comprised of customers with modest incomes who have experienced credit difficulties, have very limited credit histories, and/or do not have access to obtain their own source of financing from third-party finance companies. Therefore, we provide financing for substantially all of the vehicles we sell. Since many of our customers may be unable to obtain financing to purchase a vehicle from another company, financing is an essential component of the services that we provide our customers. We fund this portfolio primarily through portfolio warehouse facilities, securitizations, and other portfolio term financings.
In December 2011, as a supplement to our core operations, we launched a new indirect lending business segment, GO Financial ("GO"). GO provides indirect auto financing to third-party automobile dealerships collateralized by pools of subprime auto loans and is a separate operating segment.
Ownership
DTAG and DTAC are sister companies, generally with DTAG directing our retail vehicle sales operations and DTAC directing our financing and collections operations. As of December 31, 2012 and 2011, the shareholders of DTAG and DTAC were Ernest C. Garcia II (Chairman) and the Garcia Family Trusts (collectively, herein also referred to as “Principal Shareholder” or “Mr. Garcia”) owning 100.0 shares, or 98.3% of each of DTAG and DTAC, and Raymond C. Fidel (President and CEO) owning 1.8 shares or 1.7% of each of DTAG and DTAC.
Basis of Presentation
We have determined that DTAC is a variable interest entity (“VIE”) and DTAG is the primary beneficiary of DTAC. Therefore, the accounts of DTAG and DTAC are consolidated and intercompany transactions between DTAG and DTAC are eliminated in consolidation. We determined DTAG is the primary beneficiary of DTAC because DTAG has both (1) the power to direct the activities of DTAC that most significantly impact DTAC’s economic performance and (2) a potentially significant variable interest that carries with it the obligation to absorb the losses or the right to receive benefits of DTAC. DTAG has the power to direct the activities of DTAC because it originates and sells 100% of the loans DTAC is required to purchase, sets underwriting standards and origination terms, sets servicing and collection policies administered by DTAC, as well as the fact that DTAC was created and designed by DTAG to obtain third party financing for DTAG’s originations. DTAG also has potentially significant variable interests in the form of debt capital provided to DTAC through various debt issuances, guarantees of DTAC’s debt, as well as operational liabilities owed to DTAG, all of which carry the obligation to absorb losses or receive benefits of DTAC. Creditors of DTAC generally do not have recourse to the general credit of DTAG, except that the special purpose entity ("SPE") related to our term residual facility entered into a demand note with DTAC. The demand note is guaranteed by DTAG. (See Note 8-Debt Obligations for further information.)
Total assets of DTAC consolidated into DTAG are comprised primarily of net finance receivables, cash and cash equivalents, restricted cash, investments held in trust, and deferred financing costs. Total liabilities consolidated into DTAG are comprised primarily of portfolio warehouse, portfolio term, and senior secured debt. Total revenue of DTAC consolidated into DTAG is comprised of interest and dealer finance income. DTAC expenses are comprised of provision for credit losses, interest expense and general and administrative expenses.
Also included in the consolidated financial statements are SPEs of DTAC, which are all bankruptcy remote entities formed in conjunction with our securitizations, warehouse facilities, residual facility, real estate financing, and bank term financing transactions. We have determined that these SPEs' are VIE's and DTAC is the primary beneficiary. Therefore, all intercompany accounts and transactions have been eliminated in consolidation for all periods presented. We determined DTAC is the primary beneficiary of these SPEs because DTAC has both (1) the power to direct the activities of the SPEs that most significantly impact the SPEs' economic performance and (2) a potentially significant variable interest that carries with it the obligation to absorb the losses or the right to receive benefits of DTAC. DTAC has the power to direct the activities of these SPEs because it services the loans in each of the securitizations, warehouse facilities and other lending arrangements. DTAC also has potentially significant variable interests in the form of holding the residual certificates for securitizations and rights to residual cash flows of the warehouse facilities. Creditors of the SPEs generally do not have recourse to the general credit of DTAC, except through servicing performance guarantees.
For more information regarding DTAC's financial position and results of operations and the SPEs' financial position and results of operations consolidated into DTAG and DTAC, respectively, see Note-18 Supplemental Consolidating Financial Information.
The consolidated balance sheets have been adjusted to reflect Mr. Garcia's basis in the Company through the application of push-down accounting, as it relates to his acquisition of the Company in March 2002 when he acquired our predecessor, Ugly Duckling Corporation. Although not material, certain prior period amounts have been reclassified to be consistent with the current period financial statement presentation.
(2) Significant Accounting Policies
The following accounting policies pertain to DriveTime's core operations. Accounting policies specific to GO Financial are specifically noted within each section if they vary from DriveTime's policies.
Cash & Cash Equivalents
We consider all highly liquid investments with original maturities at the date of purchase of three months or less to be cash equivalents. Periodically we maintain cash in excess of the amounts insured by the federal government.
Finance Receivables - DriveTime
Finance receivables consist of the aggregate principal balances of all auto loans in our active portfolio, which are collateralized by used vehicles sold, plus accrued interest receivable and direct loan origination costs. Finance receivables are comprised of loans related to used vehicles sold by us, all of which are simple interest loans which may be prepaid without penalty. We do not place loans on nonaccrual status, nor do we classify loans as impaired, since accounts are charged-off when the loans are contractually past due, at 91 days (or later, if the customer makes a qualifying payment in accordance with the terms of our charge-off policy).
Dealer Finance Receivables - GO Financial
Dealer finance receivables consist of the aggregate carrying value of amounts advanced to dealers ("dealer advances") participating in our indirect lending program through DTAC's subsidiary, GO Financial, plus direct loan origination costs. We account for dealer finance receivables in a manner consistent with loans acquired with deteriorated credit quality, using the effective interest method. Third party independent dealerships build discrete pools of loans and dealer advances are repaid by the dealerships, on a pool level, based on cash flows collected by GO from the pool of underlying customer loans. Each dealer pool is treated as a discrete unit of account, both during the open phase and during the closed phase for purposes of recognizing revenue and evaluating impairment. Dealer finance receivables are evaluated for impairment subsequent to pool closure and at the end of each quarterly accounting period. A decrease in expected cash flow, deriving a decrease in pool yield, results in pool impairment, which is recorded as a charge to provision for GO credit losses and a credit to allowance for GO credit losses. Subsequent improvement in expected cash flows, deriving an increase to pool yield, is treated first as a recovery of previously recorded allowance.
Charge-off Policy
For DriveTime receivables (excluding GO), the accrual of interest is discontinued and any accrued but unpaid interest is reversed and written-off along with any unamortized loan origination costs when the loans are charged-off. Accounts which have been charged-off have been removed from finance receivables. Net charge-offs consist of finance receivable principal balances charged-off, net of any amounts received from vehicles recovered and sold at auction, sales tax refunds, where applicable, and any subsequent collections on the charged-off accounts, as well as an estimate of recoveries on loans previously charged-off (recovery receivables).
Prior to December 2011, loans were charged-off at 91 days contractually past due. In December 2011, we made a modification to our charge-off policy, which was treated as a change in accounting estimate. Under our new charge-off policy, we charge-off the entire principal balance of receivables that are contractually 91 or more days past due at the end of a month, unless the customer has made a qualifying minimum payment within the previous 30 days from month-end, in which case the customer loan would not charge-off until 121 days contractually past due. This change was made as a result of a change in delinquency patterns, partially resulting from a fully centralized collections environment, and an analysis which indicated that loans which have made a qualifying payment within 30 days, are collectible, and therefore, should not be charged-off.
If this change was not executed, for the year-ended December 31, 2011, net charge-offs would have been $2.6 million higher than reported, provision for credit losses would have been $2.0 million higher than reported, interest income would have been $0.1 million lower than reported, and net income would have been $2.1 million lower than reported.
Underlying customer accounts in the GO program follow the same charge-off policy as DriveTime, except that upon charge-off, the loans are not removed from the dealer pool. However, expected cash flow of the pool is affected, thereby affecting effective yield and carrying value of the GO dealer finance receivables.
Allowance for Credit Losses
DriveTime maintains an allowance for credit losses on an aggregated basis. We accrue for estimated losses when it is probable that the amount will not be fully collectible and the amount of the loss can be reasonably estimated. The evaluation of the adequacy of the allowance for credit losses considers such factors as performance of the loan portfolio by month of origination (“static pool analysis”), the portfolio credit grade mix, our historical credit losses, the overall portfolio quality, delinquency status, the value of the underlying collateral, current economic conditions that may affect the borrowers’ ability to pay, and the overall effectiveness of collection efforts. This estimate of existing probable and estimable losses is primarily based on static pool analyses prepared for various segments of the portfolio utilizing historic loss experience, adjusted for the estimated impact of current economic factors. In management’s judgment, the allowance is maintained at a level that is adequate to provide for the estimate of probable credit losses inherent in our finance receivable portfolio. Charge-offs are recorded as a reduction to the allowance for credit losses at the time of charge-off. An estimate of recovery proceeds is recorded as an other asset, see (“Recovery Receivables” below,) until such time as the vehicle or other recovery proceeds are received. For previously charged-off accounts that are subsequently recovered, or portions thereof, the amount of such recovery is credited to the allowance for credit losses. On a quarterly basis management reviews the allowance for credit losses for reasonableness and adequacy. Adjustments to the allowance for credit losses as a result of our allowance analyses are recorded through the provision for credit losses.
See "Revenue Recognition - GO Financial" for a description of allowance for credit losses on GO dealer finance receivables.
Recovery Receivables
Recovery receivables represent estimated recoveries to be received on charged-off finance receivables, including proceeds from selling repossessed vehicles at auction, along with insurance, bankruptcy and deficiency collections. The recovery amount from selling repossessed vehicles at auction is a forecast of vehicles to be recovered from loans previously charged-off and vehicles currently in our possession. We estimate the number of units we will recover and the value that we will receive for these vehicles at auction. Our forecast utilizes historical data with respect to recovery rates, values, and time from charge-off to repossession. Changes in recovery receivables are treated as increases or decreases to net charge-offs and ultimately the allowance for credit losses. At December 31, 2012 and 2011, recovery receivables amounted to $37.0 million and $34.5 million, respectively, and are included as a component of other assets on the accompanying consolidated balance sheets.
Inventory
Inventory consists of used vehicles held-for-sale, or currently undergoing reconditioning, and is stated at the lower of cost or market value. Vehicle inventory cost is determined by specific identification. Direct and indirect vehicle reconditioning costs including parts and labor, overhead, costs to transport the vehicles to our reconditioning centers and dealership locations, and other incremental costs are capitalized as a component of inventory cost.
Property and Equipment
Property and equipment consists of land, buildings, leasehold improvements, furniture, software, and repairs and maintenance costs that extend the life of an asset. Property and equipment is stated at cost and is shown net of accumulated depreciation. Depreciation is computed using the straight-line method over the estimated useful life of the assets, which range from three to 15 years for equipment, three to five years for furniture, three years for software, five to ten years for building improvements, and thirty years for buildings. Leasehold improvements are depreciated using the straight-line method over the lesser of the lease term or the estimated useful lives of the related improvements.
Capitalized Internally Developed Software
We capitalize direct costs of materials and services consumed in developing or obtaining internal use software. We also capitalize payroll and payroll-related costs for employees who are directly associated with and who devote time to the development of software products for internal use, to the extent of the time spent directly on the project. Capitalization of costs begins during the development stage and ends when the software is available for general use. Amortization of these costs is computed using the straight-line method over the estimated economic life of the software.
Deferred Financing Costs
Costs relating to obtaining debt financing and capital leases are capitalized and amortized over the term of the related debt using the effective interest method. Unamortized deferred financing costs at December 31, 2012 and 2011 were $15.0 million and $15.8 million, respectively, and are included as a component of other assets on the accompanying consolidated balance sheets. Amortization of deferred financing costs is recorded as component of interest expense, and was $8.2 million, $11.9 million and $17.8 million for the years ended December 31, 2012, 2011, and 2010, respectively.
Limited Warranty
A liability for the estimated cost of vehicle repairs under our warranty program is established at the time a used vehicle is sold by charging costs of used vehicles sold. The liability is evaluated for adequacy through an analysis based on the program’s historical performance of cost incurred per unit sold, and management’s estimate of frequency of vehicles to be repaired and severity of claims based on vehicles currently under warranty, which are based on the program’s historical performance and our expectation of future usage.
Revenue Recognition - DriveTime
Revenue from the sale of used vehicles is recognized upon delivery, when the sales contract is signed and the agreed-upon down payment or purchase price has been received. Sales of used vehicles include revenue from the sale of used vehicles, net of a reserve for returns and excludes sales tax. The reserve for returns is estimated using historical experience and trends. Our reserve for returns at December 31, 2012 and 2011 was $5.3 million and $1.5 million, respectively. Revenue is recognized at time of sale since persuasive evidence of an arrangement in the form of an installment sales contract exists, we have delivered the vehicle to the customer, transferred title, the sales have a fixed and determinable price, and collectability is reasonably assured.
Interest income consists of interest earned on finance receivables, net of amortization of loan origination costs, plus late payment fees and interest earned on investments held in trust. Interest income is recognized on the accrual basis, when earned, based on a simple interest method. Finance Receivables continue to accrue interest until repayment or charge-off. Customer loans may be prepaid without penalty. Direct loan origination costs related to loans originated at our dealerships are deferred and charged against interest income over the life of the related loans using the effective interest method.
Revenue Recognition - GO Financial
We recognize revenue for dealer finance receivables (Dealer Finance Income) under the effective interest method, by applying a loss adjusted forecast of cash flows for each dealer pool, such that revenue is recognized on a level-yield basis. Open pools establish an effective yield at either their first fiscal quarter, or upon maturation of the pool. The effective yield established is held constant for an open pool until pool closure, unless circumstances warrant a yield adjustment or impairment assessment prior to pool closure. For each accounting period subsequent to pool closure, expected cash flows are re-estimated. Deterioration in expected cash flows, both in the open and closed pool stage, is reflected as a provision for loan loss and corresponding allowance for credit losses, at the pool level. Any subsequent improvement in expected cash flows of the impaired pool(s) will first reverse any previous allowance for credit loss and be prospectively reflected as an increase in the pool yield. For closed pools, if the re-estimation of expected cash flows results in a higher effective yield, an increase in the pool yield is reflected prospectively.
Cost of Used Vehicles Sold
Cost of used vehicles sold includes the cost to acquire vehicles, standard production costs, and the reconditioning and transportation costs associated with preparing the vehicles for resale. Direct and indirect vehicle reconditioning costs, including parts and labor, overhead, costs to transport the vehicles to our dealership locations, warranty costs, and other incremental costs which are allocated to inventory via standard costing, are included in cost of used vehicles sold. The cost of used vehicles sold is determined on a specific identification basis.
Accounting for Transfers of Financial Assets
Securitizations. We periodically sell loans originated at our dealerships to our bankruptcy-remote securitization subsidiaries, which, in turn, transfer the loans to separate trusts that issue notes and certificates collateralized by these loans. The notes (asset-backed securities) are sold to investors, and we retain the residual certificates. We continue to service all securitized loans. We have determined that the trusts are variable interest entities and that DTAC is the primary beneficiary of those trusts, therefore, loans included in the securitization transactions are recorded as finance receivables and the asset-backed securities that are issued by the trusts are recorded as a component of portfolio term financings in the accompanying consolidated balance sheets. The bankruptcy remote securitization subsidiaries are owned and controlled by DTAC.
Additional credit enhancement is achieved via over collateralization and a cash reserve account is established for the benefit of the Asset-Backed Security note holders. The reserve accounts are classified as restricted cash and investments held in trust in the consolidated balance sheets.
Warehouse facilities. We utilize portfolio warehouse facilities in order to fund our finance receivable originations. Loans originated are pledged to the warehouse lenders to create borrowing base. The pledge of collateral is accomplished through a sale from DTAC to the bankruptcy-remote entity (an SPE) formed for each warehouse facility. Although these sales are treated as true-sales for legal purposes, we have determined these SPEs to be VIEs, for which DTAC is the primary beneficiary, therefore, DTAC consolidates the VIEs and finance receivables pledged to the SPEs and the associated debt of the warehouse facilities are consolidated into our financial statements.
Other Portfolio Term Financings. As with our traditional securitization program, under our bank term financings, we pooled loans originated at our dealerships and sold them to either (i) a special purpose entity which transfers the loans to a separate trust which, in turn, issues a note collateralized by the loans; or (ii) we sold the pooled loans, in a secured financing transaction, directly to a third-party financial institution to yield a specified return with the right to repurchase these loans at a specified date. We retained all servicing. Both types of transactions are accounted for as secured financings, either due to our right to repurchase the loans sold at a specified date or due to certain restrictions placed on the trusts. Therefore, the loans included in these transactions remain in finance receivables and the debt is reflected as a component of portfolio term financings on the consolidated balance sheets.
Provision for Credit Losses
Provision for credit losses is the charge recorded to operations in order to maintain an allowance for credit losses adequate to cover losses inherent in the DriveTime and Go Financial portfolios.
Advertising
All costs related to advertising and marketing are expensed in the period incurred. Advertising costs related to production are capitalized, and expensed once the media is aired. We had no capitalized advertising costs as of December 31, 2012 and $0.8 million as of 2011. Total advertising costs for the years ended December 31, 2012, 2011, and 2010 were $28.0 million, $22.3 million, and $16.5 million, respectively.
Income Taxes
DTAG and DTAC are both S-corporations for federal and state income tax purposes. There is no provision for income taxes, except for any amount of entity level state tax in certain jurisdictions, and federal income taxes related to a wholly-owned subsidiary of DTAG, which is a C-corporation. Income or losses of an S-corporation flow through to the individual shareholders, who report such income or loss on their individual income tax returns.
Impairment of Long-Lived Assets
We own some of our used vehicle sales facilities, a reconditioning facility, and an operations call center building. These long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future undiscounted net cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets. Assets to be disposed would be reported at the lower of the carrying amount or fair value less costs to sell, and would no longer be depreciated. At December 31, 2012 and 2011, there were no indications of impairment pertaining to these assets.
Business Segments
Business segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker in deciding how to allocate resources and in assessing operating performance. With the introduction of the indirect lending line of business through our wholly-owned subsidiary, GO Financial, we have determined that we have two reportable business segments, one for our DriveTime operations, and one for GO Financial. The DriveTime segment is a vertically integrated platform which enables us to both sell and finance used vehicles to customers with subprime credit. We finance substantially all of the vehicles sold at our DriveTime dealerships in a single sales/finance transaction and decisions regarding allocation of resources and assessing operating performance are reviewed by the CFO and CEO of DriveTime (chief operating decision maker function). Our GO Financial segment provides subprime auto financing to third-party automobile dealerships. The third-party automobile dealerships originate retail
installment sales contracts to finance purchases of vehicles by their customers who have modest incomes and who have experienced credit difficulties or have a limited credit history (subprime customers). Operating metrics, financial performance, and bonus levels for management and employees for GO are assessed by the President of GO who serves as the chief operating decision maker for GO. See Note 20-Segment Information for additional information regarding our business segments.
Use of Estimates
The preparation of the consolidated financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amount of assets and liabilities. Certain accounting estimates involve significant judgments, assumptions, and estimates by management that have a material impact on the carrying value of certain assets and liabilities, disclosures of contingent assets and liabilities, and the reported amounts of income and expenses during the reporting period which management considers to be critical accounting estimates. The judgments, assumptions, and estimates used by management are based on historical experience, management’s experience, and other factors, which are believed to be reasonable under the circumstances. Because of the nature of the judgments and assumptions made by management, actual results could differ materially from these judgments and estimates, which could have a material impact on the carrying values of our assets and liabilities and our results of operations.
Significant items subject to estimates and assumptions include the allowance for credit losses, inventory valuation, fair value measurements, certain legal reserves, our reserve for sales returns and allowances, our recovery receivables, and our warranty accrual. Estimates used in deriving these amounts are described in the footnotes herein. Actual results could differ from these estimates.
Stock-Based Compensation
We record compensation expense for awards of restricted stock granted to employees in accordance with ASC 718, “Compensation-Stock Compensation”. Under the fair value recognition provisions of ASC 718, stock-based compensation cost is measured at the grant date based on the fair value. We utilized a third party financial and economic appraiser to assist us in determining the grant-date fair value of the award. The value of the portion of the award that is ultimately expected to vest is recognized as an expense over the requisite service periods using graded vesting (see Note 12-Shareholders’ Equity & Dividends to our consolidated financial statements included herein).
Reclassifications
Certain prior period amounts have been reclassified to be consistent with current period financial statement presentation. For the year ended December 31, 2010, we reclassified a total of $15.0 million from selling and marketing to general and administrative expense.
(3) Restricted Cash and Investments Held in Trust
We maintain various cash accounts, which are pledged as collateral under our debt agreements. We are permitted to invest funds in these accounts in short-term, high quality liquid investments. The following is a summary of restricted cash and investments held in trust:
Restricted Cash
Restricted cash consists of cash collections related to loans held in securitization trusts, pledged to our portfolio warehouse facilities, and included in bank term financings, which have been collected from customers, but have not yet been submitted either to the lenders or the securitization trustee, as appropriate.
Investments Held in Trust
We maintain cash reserve accounts on behalf of Asset-Backed Security investors in our securitizations and certain bank term financings as a form of credit enhancement. At the time loans are transferred to a trust, a portion of the proceeds from
sales of notes are deposited into a reserve account that is pledged to the trusts. We may be required to make additional deposits to reserve accounts from collections on the loans to fund the reserve account to the required target percentage. Balances in the reserve accounts totaled $33.6 million and $20.0 million at December 31, 2012 and 2011, respectively. Investments held in trust also include collections related to loans held in securitization trusts and loans included in bank term financing transactions, which have been collected from customers, and submitted to the trustee, but have not yet been paid to the lenders, as appropriate.
(4) Finance Receivables
The following summarizes the components of finance receivables:
Our finance receivables are defined as one segment and class of loan, which is the sub-prime consumer auto loan. Therefore, the disaggregation of information into portfolio segment and classes for assets with different risk characteristics is limited, and the level of risks inherent in our financing receivables are managed as one homogeneous pool and further segmented with our proprietary credit scoring system as described below -Credit Quality Indicators. We have chosen our internal customer credit scoring model as our key credit quality indicator because it has a direct and prominent impact in managing our portfolio receivables and monitoring its performance.
Finance receivables pledged as collateral associated with liabilities in our warehouse facilities, asset backed securitizations, and bank term financings, are provided in Note 8-Debt Obligations. We do not place loans on nonaccrual status, nor do we classify loans as impaired, since accounts are charged-off when the loan becomes contractually past due under our charge-off policy. We do not have loans that meet the definition of troubled debt restructurings.
Credit quality information for our finance receivables portfolio is provided as of the dates indicated below:
Age Analysis of Past Due Finance Receivables
An account is considered delinquent if a substantial portion of a scheduled payment has not been received by the date such payment was contractually due. Delinquencies may vary from period to period based upon the average age or seasoning of the portfolio, seasonality within the calendar year and economic factors. Delinquencies are presented on a Sunday-to-Sunday basis, which reflects delinquencies as of the nearest Sunday to period end. Sunday is used to eliminate any impact of the day of the week on delinquencies since delinquencies tend to be higher mid-week.
Credit Quality Indicators
We monitor our portfolio performance and the credit grade mix of originations. Our proprietary credit grading system segments our customers into eight credit grades. We control the grade mix of originations through the finance terms provided to our customers, which are established centrally by our risk management team, and applied consistently throughout our dealership network. Our loans have an average original term of approximately 57 months and an average life of 31 months, due to charge-offs and pay-offs. The average life of our loans enables us to closely monitor credit trends and make appropriate adjustments to both the grade mix and pricing of our originations.
Many companies use FICO scores as a standard metric to assess the credit risk of customers. Our internal scoring models include the use of alternative data sources along with traditional credit bureau data which allow us the ability to separate the credit risk levels of the subprime auto segment into different categories. Our centralized proprietary credit scoring models are currently used to classify customers into various risk grades that are linked to financing parameters. The scoring models are periodically updated to account for changes in loan performance, data sources, geographic presence, economic cycles, and business processes.
Prior to each sale, we require our customers to complete a credit application. Upon entering the customer information into our origination system, our proprietary credit scoring system determines the customer’s credit grade, which is used by the dealership to help select vehicles that fit the required finance terms and the customer’s needs. The customer’s credit grade and type of vehicle determine the term, maximum installment payment, and minimum down payment amounts. The annual percentage rate (APR) charged is a function of the customer’s credit grade, down payment, and model year of the vehicle. Our centralized risk management and pricing departments set these terms. The static-pool tracking of portfolio loss performance is also monitored by credit grade. Our scoring model is comprised of eight credit grades ranging from A+ to D-, with A+ being the lowest risk credit grade and a D- being the highest risk credit grade. Generally, the lower the risk grade, the lower the unit loss rate.
Concentration of Credit Risk
At December 31, 2012, a summary of our portfolio by our internally assigned credit risk ratings was as follows:
At December 31, 2011, a summary of our portfolio by our internally assigned credit risk ratings was as follows:
(1)
Average FICO score is provided as an external metric of credit quality, but is generally not utilized to determine internal credit grade. Our internal scoring model is the primary driver of our internal credit grade. Average FICO presented excludes originations with no FICO.
Our portfolio concentration by state was as follows:
Allowance for Credit Losses
We maintain an allowance for credit losses on an aggregate basis at a level we consider sufficient to cover probable credit losses inherent in our portfolio of receivables as of each reporting date. The allowance takes into account historical credit loss experience, including timing, frequency and severity of losses. This estimate of existing probable credit losses inherent in the portfolio is primarily based on static pool analyses by month of origination based on origination principal, credit grade mix and deal structure, including down payment and term. The evaluation of the adequacy of the allowance also considers factors and assumptions regarding the overall portfolio quality, delinquency status, the value of the underlying collateral, current economic conditions that may affect the borrowers’ ability to pay, and the overall effectiveness of collection efforts.
The static pool loss curves by grade are adjusted for actual performance to date and historical seasonality patterns. The forecasted periodic loss rates, which drive the forecast for estimated gross losses (before recoveries) are calculated by factoring amortization speed and origination terms. Recoveries are estimated using historical unit and dollar static pool recovery activity to forecast recoveries for estimated charge-offs at the balance sheet date. The forecasted recovery rates (on a per unit basis) are based on the historical unit recovery trend by recovery type as adjusted for estimated impacts of economic and market conditions.
The allowance model is sensitive to changes in assumptions such that an increase or decrease in our forecasted net charge-offs would increase or decrease the allowance as a percentage of principal outstanding required to be maintained. The amount of our allowance is sensitive to losses within credit grade, recovery values, deal structure, the loss emergence period and overall credit grade mix of the portfolio.
The following table sets forth the rollforward of the allowance for credit losses for the periods indicated:
(5) Dealer Finance Receivables
The following is a summary of the activity in dealer finance receivables for the periods presented:
Accretable yield represents the amount of revenue expected over the remaining life of existing pools, but is not part of the carrying value of these receivables at period end. Changes in accretable yield were as follows:
Non-accretable yield represents the difference between the total contractual net cash flows of dealer finance receivables and the expected cash flows. This difference is neither accreted into income nor recorded on our balance sheets since it represents the portion of cash flows not expected to be received. Contractual net cash flows are comprised of the underlying contractual cash flows from consumer loans aggregated with the total accretable yield to be earned on dealer finance receivables over the life of the dealer pool. Expected net cash flows represent the loss adjusted contractual cash flows, including earnings thereon. Components of non-accretable yield are as follows:
Credit Quality Indicators - GO Financial
We monitor dealer portfolio performance and the credit grade mix of dealer originations. We use the same proprietary credit grading system for GO Financial that we employ for DriveTime originations, which segments dealer customers into eight credit grades. Dealers have access to an internet portal to utilize our credit scoring system and to price each customer finance arrangement.
Our internal scoring models include the use of alternative data sources along with traditional credit bureau data which allow us the ability to separate the credit risk levels of the subprime auto segment into different categories. Our centralized proprietary credit scoring models are currently used to classify customers into various risk grades that are linked to financing parameters. The scoring models are periodically updated to account for changes in loan performance, data sources, geographic presence, economic cycles, and business processes.
Prior to each sale, we require dealer customers to complete a credit application and provide various other documentation for underwriting such as proof of income, residence, and employment. Upon entering the customer information into our origination system, our proprietary credit scoring system determines the customer’s credit grade, which is used by the dealership to help select vehicles that fit the required deal terms and the customer’s needs. The customer’s credit grade and type of vehicle determine the term, maximum installment payment, and minimum down payment amounts. The annual percentage rate (APR) charged is a function of the customer’s credit grade, down payment, and model year of the vehicle. Our centralized risk management and pricing departments set these terms. The static-pool tracking of portfolio loss performance is also monitored by credit grade. Our scoring model is comprised of eight credit grades ranging from A+ to D-, with A+ being the lowest risk credit grade and a D- being the highest risk credit grade. Generally, the lower the risk grade, the lower the unit loss rate.
Concentration of Credit Risk
The following is a summary of GO Financial's portfolio by our internally assigned credit risk ratings as of December 31, 2012:
(1)
Average FICO score is provided as an external metric of credit quality, but is generally not utilized to determine internal credit grade. Our internal scoring model is the primary driver of our internal credit grade. Average FICO presented excludes originations with no FICO.
(6) Property and Equipment, Net
A summary of property and equipment follows:
We have commitments under capital leases, consisting primarily of software, computer equipment, and reconditioning center equipment classified in Equipment and Software included in the above table. As of December 31, 2012, assets under capital leases had a cost of $5.4 million and accumulated depreciation of $3.1 million. As of December 31, 2011, assets under capital leases had a cost of $5.4 million and accumulated depreciation of $1.7 million. Depreciation expense for capital leases is recorded as a component of depreciation expense on the consolidated statements of operations.
For the years ended December 31, 2012, 2011, and 2010, we capitalized $2.8 million, $2.6 million, and $1.9 million, respectively, of payroll and payroll-related costs for employees who are directly associated with and who devote time to the development of software products for internal use, to the extent of the time spent directly on the project.
(7) Other Assets
A summary of other assets follows:
(8) Debt Obligations
Portfolio Term Financings
The following is a summary of portfolio term financings:
Securitization debt
The following table is a summary of securitization transactions with outstanding balances for each period presented:
(1) These rates represent the original duration weighted average rates of the outstanding asset-backed securities.
Asset-backed securities outstanding are secured by underlying pools of finance receivables (collateral) and investments held in trust (cash reserve). Asset-backed securities outstanding have interest payable monthly at fixed rates. These rates represent the original duration weighted average rates of the outstanding asset-backed securities. Credit enhancement for the asset-backed securities consists of a reserve account, over collateralization, and subordination of certain classes of notes in each trust to more senior classes of notes in such trust. Over collateralization represents finance receivable principal balance in excess of the face value of asset-backed securities issued. Cash reserves are funded with proceeds from the sale of asset-backed securities and through cash collections. Asset-backed securities outstanding have interest payable monthly at the fixed rates represented in the table above. The 2012-2, 2012-1, 2011-3, 2011-2, 2011-1 and 2010-1 securitizations were rated in tranches with credit ratings from AAA to BBB by Standard and Poor's (S&P) and DBRS, and the 2009-1 securitization was rated in tranches with credit ratings from AAA to A by DBRS.
Individual securitization trusts are not cross-collateralized or cross-defaulted. Additionally, we have the option to purchase the remaining loans in a trust when the remaining principal balances of the loans reach 10% of their original principal balance.
Portfolio term residual financing
At December 31, 2012, our term residual facility with Santander Consumer USA Inc. ("Santander") was secured primarily by residual interests in our warehouse facilities. We amended the terms on this facility on December 31, 2012 to extend the term through December 31, 2019, reduce the interest rate, and allow for GO Financial collateral to be included as eligible borrowing base on the facility provided the collateral is approved to be eligible in our warehouse facilities. The interest rate on this facility changed from 8.62% to LIBOR + 3.50% or LIBOR + 6.00%, depending upon whether certain conditions are satisfied. We borrowed the remaining $75.0 million available on this facility on January 4, 2013.
Bank term financings
Bank term financings are secured by underlying pools of finance receivables and in certain cases, a cash reserve account. In November 2012, we executed a $350 million bank term financing with Wells Fargo bearing interest at LIBOR plus 2.0% (2.20% at December 31, 2012). This facility includes overcollateralization and a cash reserve similar to a securitization transaction, but consists of only one class of bonds and is unrated. At December 31, 2011, interest rates on our outstanding bank term financings were at a fixed rate of 8.0%. The net advance rate on the receivables ranged from 55.9% to 67.1% of the principal balance for transactions outstanding at December 31, 2011.
Portfolio warehouse facilities
The following is a summary of portfolio warehouse facilities:
(1) Collateral represents underlying pools of finance receivables pledged to each facility.
(2) Interest rate at period end equal to contractual benchmark plus index.
(3) Facility was renewed in March 2013. See Note 16 - Subsequent Events for information on renewal of this facility.
Deutsche Bank Warehouse Facility
We have a revolving warehouse facility with Deutsche Bank AG, New York Branch (Deutsche Bank). On December 21, 2012 we executed amendment No. 2 on this facility to extend the term of the facility through December 21, 2014. The amounts outstanding under the facility bear interest at LIBOR plus 2.25% as of December 31, 2012 and 2011. At December 31, 2012, we were in compliance with all financial covenants of this facility.
Wells Fargo Warehouse Facility
We have a revolving warehouse facility with Wells Fargo Bank, N.A. (Wells Fargo). The amounts outstanding under the facility bear interest at LIBOR plus 2.25% as of December 31, 2012 and 2011. At December 31, 2012, we were in compliance with all financial covenants of this facility.
RBS Warehouse Facility
We have a revolving warehouse facility with The Royal Bank of Scotland PLC (RBS). The amounts outstanding under the facility bear interest at LIBOR plus 1.4% and 1.5% as of December 31, 2012 and 2011, respectively. At December 31, 2012, we were in compliance with all financial covenants of this facility.
In March 2013, we renewed and extended this facility with RBS. See Note 16 - Subsequent Events for further information.
UBS Warehouse Facility
We had a revolving warehouse facility with UBS Real Estate Securities Inc., which expired and we paid off in August 2012. Prior to expiration, amounts outstanding under the facility bore interest at LIBOR plus 1.90%.
Collateral
The finance receivables pledged as collateral to each of the warehouse facilities is established for the benefit of the note holders, and the respective carrying amounts of the finance receivables pledged as collateral are disclosed above. These facilities contain a borrowing base which requires us to pledge finance receivables in excess of the amounts which we can borrow under the facilities. The aggregate balance of finance receivables are presented on our consolidated balance sheets included herein, and we do not separately classify those assets serving as collateral since the creditors in each of the warehouse facilities do not have the right to sell or re-pledge the collateral, except in certain cases upon an event of default.
Warehouse Facility Structure
We formed individual limited liability companies that serve as the sole borrowers under our existing portfolio warehouse facilities, our portfolio term residual financing and our portfolio term financing. Each of these LLCs is an SPE established specifically for the purpose of the applicable lending relationship, with assets and liabilities distinct from the remainder of DTAG and DTAC. We have determined these SPE's are VIE's with DTAC as the primary beneficiary. These facilities do not contain mark-to-market clauses that would otherwise enable the lenders to reduce advance rates based on market conditions, limit recourse of the respective facility amounts, and limit the lenders’ ability to sell or otherwise dispose of the underlying collateral upon certain termination events. In addition, on the termination date of the facilities, (i) failure to pay amounts outstanding at termination do not immediately give rise to the applicable lender’s right to foreclose on the applicable collateral, (ii) all collections on the contracts collateralizing these facilities would be used to pay down the facility until they are paid in full, and (iii) we would continue to service the contracts that are pledged under the facility, for which we would receive an annualized service fee of up to 7.0%.
The SPE related to our term residual facility with Santander has entered into a demand note with DTAC. The demand note is guaranteed by DTAG. Prior to the termination date under the term residual facility, under certain circumstances, the lender can require DTAC to fund the demand note, and apply the proceeds to pay down the facility with the SPE. After the termination date, the lender can require DTAC to fund the demand note, at its sole discretion, and apply the proceeds to pay down the facility with the SPE if, and only if, any of the following occurs: (i) the termination date occurs as a result of an Event of Termination (as defined in the agreement), (ii) the SPE fails to maintain borrowing base compliance after the termination date, (iii) an Event of Termination occurs after the termination date and is continuing.
Senior secured notes payable
A summary of Senior Secured Notes payable follows:
In June 2010, DTAG and DTAC jointly issued $200.0 million of Senior Notes. The notes were issued with an original issuance price of 98.854%, resulting in an effective yield of 12.875%. Interest on the Senior Notes is payable semi-annually in arrears on each June 15th and December 15th. In August 2012, Verde Investments, Inc. ("Verde") purchased $5.0 million of the DriveTime Senior Notes on the open market, at a purchase price of 111.0%. Subsequent to this transaction, Mr. Fidel purchased $0.5 million of the notes from Verde at an identical purchase price.
At both December 31, 2012 and December 31, 2011, the Senior Notes are shown net of unamortized discount of $1.7 million and $1.9 million, respectively.
Guarantees
The Senior Notes are unconditionally guaranteed by certain of our existing and future domestic restricted subsidiaries. The guarantees rank senior in right of payment to all existing and future subordinated indebtedness of these subsidiaries and equal in right of payment with all existing and future senior indebtedness of these subsidiaries.
Security
The collateral for the Senior Notes consists of a (i) first lien on (a) finance receivables held by the issuers, (b) equity interests held by certain of DTAC’s wholly owned subsidiaries (“Pledged SPSs”), and (c) residual property rights in finance receivables securing other financings, in each case subject to certain exceptions, and a (ii) second lien, behind one or more secured credit facilities, on inventory owned by certain guarantors. If, following a payment default under the exchanges notes, the holders of Senior Notes exercise their rights under the pledge agreement with respect to the Pledged SPSs, a third-party paying agent will direct all cash flows from the Pledged SPSs to their respective defined sets of creditors, with the residual to be paid to the collateral agent for the Senior Secured Notes. Therefore, a first-priority lien on the equity interests of the Pledged SPSs is effectively a second-priority lien on the underlying collateral held by such Pledged SPSs.
Maintenance covenants
We are required to comply with certain maintenance covenants relating to minimum net worth and minimum collateral coverage. As of December 31, 2012, we were in compliance with such covenants.
Other secured notes payable
A summary of other secured notes payable follows:
(1) Interest rate at period end equal to contractual benchmark plus index.
(2) Advance rate is based on qualifying vehicle cost and is secured by our entire inventory.
(3) Inclusive of a $10.0 million seasonal increase in the months of November through the end of January.
Revolving inventory facility
We have a revolving inventory line with Wells Fargo, Santander and Manheim Automotive Financial Services, Inc. The facility has an advance rate of 85% of qualifying vehicle costs and is secured by our entire vehicle inventory. The interest rate
on the facility is based on the Daily One Month LIBOR rate plus 3.5%. At December 31, 2012, we were in compliance with all financial covenants of this facility.
Mortgage note payable
We have a mortgage note payable which is secured by our operations call center building in Mesa, Arizona (a commercial property). Terms of the note agreement provide for monthly principal and interest payments with a final balloon payment. At December 31, 2012, we were in compliance with all financial covenants of this loan.
Real estate facility
We have a seven year fully amortizing real estate facility with Wells Fargo. The amounts outstanding under the facility bear interest at LIBOR plus 4.0% as of December 31, 2012. At December 31, 2012, we were in compliance with all financial covenants of this facility, and the line was collateralized by nine properties.
Equipment note payable
We have an equipment note payable, which is secured by an aircraft and bears interest at the Prime rate plus 1.5%. Terms of the note agreement provide for monthly principal and interest payments with a final balloon payment. At December 31, 2012, we were in compliance with all financial covenants of this loan.
Future minimum principal payments
The following table represents the future minimum principal payments required under our debt obligations and capital leases as of December 31, 2012:
(1)
Securitization obligations and bank term financing agreements do not have a contractual termination date. Therefore, all collections on the contracts collateralizing the securities are used to repay the asset-backed security holders based on an expected duration of the securities.
(2)
On the termination date of the facilities, amounts outstanding at termination are not due and payable immediately. All collections on the contracts collateralizing these facilities are used to pay down the facilities until they are paid in full because these facilities contain term-out features.
(3)
Generally and historically, we renewed or replaced facilities expiring in less than one year.
(4)
Total contractual obligations exclude future interest payment obligations.
(9) Extinguishments of Debt
During the year ended December 31, 2010, we repurchased outstanding indebtedness in the form of bank term debt for which we paid a fee of $3.4 million. The fee was recorded as loss on the extinguishment of debt.
(10) Related Party Transactions
During the years ended December 31, 2012, 2011, and 2010, we recorded related party operating expenses as follows:
Relationship with Verde Investments, Inc.
Verde is an Arizona corporation that is wholly-owned by Mr. Garcia. Verde engages in the acquisition, development, and long-term investment in real estate and other commercial assets. Mr. Garcia is the principal stockholder, president and director of Verde. Transactions between us and Verde, as well as other related parties, are described below.
Property lease expense
Included in property lease expense are costs of operating leases with Verde for certain dealership and reconditioning facilities which the Company operates, and certain dealership closing costs. For the years ended December 31, 2012, 2011, and 2010, we leased an average of 13, 14, and 15 vehicle dealership facilities, respectively, three reconditioning facilities, our former loan servicing center (which is currently being subleased to third-party tenants), and our corporate office from Verde and another affiliate of Mr. Garcia (the Garcia Family Limited Liability Partnership, LLP). Three of these facilities were closed locations as of December 31, 2012 and 2011. During the year ended December 31, 2010, we also leased one vehicle sales facility and one reconditioning center, from a director of DTAC, Steven Johnson, who is also Mr. Garcia’s brother-in-law. As of December 31, 2012 and 2011 we had no remaining leases with Steven Johnson. For the years ended December 31, 2012, 2011, and 2010, we rented one vehicle sales facility from Stephen Fidel, the brother of Mr. Fidel, our President and CEO. At December 31, 2012, the maturity of these related party leases range from 2013 to 2023. Future minimum lease payments required under related party leases are disclosed in Note 13-Commitments and Contingencies.
During the year ended December 31, 2011, we paid $0.4 million in lease termination fees on two of our closed properties to terminate the leases with Steven Johnson. During the year ended December 31, 2010, we paid $0.4 million in a lease termination fee on one of our closed properties to terminate the lease with Verde.
Restricted stock compensation expense and non-cash compensation expense
Restricted stock compensation expense represents stock compensation expense under a restricted stock agreement between DTAG, DTAC and Mr. Fidel. See Note 12-Shareholders' Equity & Dividends for further information.
Non-cash compensation expense represents compensation expense associated with an employment agreement entered into in connection with a stock purchase agreement between Mr. Garcia and Mr. Fidel, in which Mr. Garcia agreed to purchase Mr. Fidel’s 5% interest in DTAG and DTAC for $17.5 million. The terms of the purchase were such that Mr. Garcia paid Mr. Fidel $6.25 million in cash and $11.25 million in a promissory note bearing interest at 8.0% per annum. The term of the note was five years with annual installment payments required. For the years ended December 31, 2012, 2011, and 2010, Mr. Garcia made annual interest payments to Mr. Fidel of $0.1 million, $0.3 million, and $0.5 million, respectively. The note was paid off in June 2012 with the payment of the fifth and final installment to Mr. Fidel.
Aircraft operating and lease expenses
We are party to a lease agreement for an aircraft with Verde under which we agreed to pay monthly lease payments of $150,000 plus taxes and are responsible for paying all operating costs and repairs and maintenance related to the aircraft. The lease expires in August 2015.
Salaries and wages, general and administrative and other expenses
Certain general and administrative expenses and salaries and wages of Verde and Verde employees who are enrolled in our health plan are reflected in our general and administrative expenses-related party.
Reimbursement of general and administrative expenses
For each of the periods presented, we received reimbursement of certain general and administrative expenses incurred by us on Verde’s behalf.
Interest Expense
During the years ended December 31, 2012, 2011, and 2010, we recorded related party interest expense as follows:
In August 2012, Verde purchased $5.0 million of the Senior Notes on the open market, at a purchase price of 111.0% to par, plus accrued interest. Subsequent to this transaction, Mr. Fidel purchased $0.5 million of the notes purchased by Verde at an identical purchase price.
During the year ended December 31, 2011, we recorded related party interest expense associated with our June 2010 issuance of $200.0 million of the Senior Notes, an aggregate of $49.0 million of which were held by Verde and Mr. Fidel. In June 2011, Verde purchased Mr. Fidel's portion of Senior Notes, and Verde sold the Senior Notes it held on the open market. As a result, at December 31, 2011, none of the Senior Notes were held by a related party and interest expense during 2011 is related to the period they held the notes.
During the year ended December 31, 2010, we recorded related party interest expense associated with junior secured notes, senior unsecured notes, subordinated notes, and Senior Notes as depicted above.
(11) Income Taxes
The consolidated financial statements consist of DTAG (S-corporation status elected in 2004) and DTAC (an S-corporation since inception). Since DTAC and DTAG are flow through entities for Federal income tax purposes, there is no Federal income tax expense related to the income of DTAC and DTAG, other than for one of DTAG’s wholly-owned subsidiaries, which is a C-corporation. The taxable income flows through to our shareholders who are responsible for paying the associated taxes. Although most states follow the Federal recognition of S-corporation status, some states do impose an entity level tax on that income; therefore, the tax expense is adjusted accordingly. Income tax liability was $0.2 million and $0.5 million as of December 31, 2012 and December 31, 2011, respectively.
A reconciliation between expected taxes computed at the federal statutory rate of 35% and the effective tax rate on income before income taxes follows:
Components of income tax (benefit) expense are as follows:
DTAG and DTAC, along with a wholly-owned C-corporation subsidiary of DTAG, file a federal and various state income tax returns. For federal purposes, the 2009 to 2011 years remain subject to examination, while for state purposes, the 2008 to 2011 years remain subject to examination. We do not have any open federal income tax examinations, but were notified in January 2013 that we will have one state income tax examination commencing later in 2013.
As of December 31, 2012 and December 31, 2011 we had not recorded any liabilities for unrecognized tax benefits, nor have we recorded any liability for interest or penalties related to such positions in our financial statements.
(12) Shareholders’ Equity & Dividends
Share Information
DTAG - par value $0.001 per share, 1,000 shares authorized, 101.8 shares issued and outstanding; DTAC - no par value, 1,000,000 shares authorized, 101.8 shares issued and outstanding.
Non-controlling Interest
Because DTAG and DTAC are consolidated for financial reporting purposes, we are required to separately present the non-controlling equity interest of the VIE (DTAC) on the consolidated balance sheets and consolidated statements of operations for all periods presented. The non-controlling interest is DTAC's U.S. GAAP equity and income for the periods presented and there are no third-party competing interests in DTAC. For the amounts of assets, liabilities, revenue, and income of DTAC consolidated into DTAG at December 31, 2012, see Note 18-Supplemental Consolidating Financial Information.
Dividends
Certain of our debt facilities place restrictions on the amount of cash dividends we are permitted to pay to our shareholders. We are permitted to pay cash dividends limited to an amount not greater than the percentage of S-corporation taxable income for such quarterly period equal to the highest combined federal, state, and/or local tax rate for individuals, plus 50% of the difference between net earnings less amounts paid for tax.
During the years ended December 31, 2012 and 2011, we paid $51.2 million and $51.8 million in dividends. We did not have any approved but unpaid dividends at December 31, 2012 or 2011, however, we had approximately $4.9 million in dividends available for distribution at December 31, 2012.
Chief Executive Officer Restricted Stock Grant
In December 28, 2010, Mr. Fidel entered into a Restricted Stock Agreement with each of DTAG and DTAC, pursuant to which he was issued an award of 2.8595 shares of restricted stock in each of DTAG and DTAC, subject to certain vesting restrictions. Mr. Fidel made an election under Section 83(b) of the United States Internal Revenue Code of 1986, as amended,
to be taxed on the fair market value of the entire restricted stock grant as of the award date. In connection therewith, the fair market value of shares sufficient to satisfy Mr. Fidel's federal and state income tax obligations with respect to the entire award was deemed to be vested in full as of the award date. However, only those shares of a value equal to the minimum statutory federal and state withholding due from Mr. Fidel on the grant were repurchased by DTAG and DTAC, and the proceeds from such repurchases were delivered to the relevant tax authorities. The remaining unvested shares of restricted stock will vest one-third each year over a period of three years based on Mr. Fidel's continued employment with us and on the achievement of certain income before income tax targets for the consolidated results of DTAG, measured for the preceding twelve months as of June 30, 2011, 2012 and 2013. For income tax purposes, Mr. Fidel was deemed to own 2.8595 shares at the grant date, and immediately thereafter the Company repurchased 1.0899 shares resulting in Mr. Fidel owning 1.7696 shares in each of DTAG and DTAC as of December 31, 2010, 2011, and 2012. A shortfall in the performance target measured at June 30, 2011, 2012, and 2013 (and therefore a failure of one-third of the unvested shares to vest at such date) may be made up at a subsequent date if the consolidated results of DTAG exceed the relevant income before income tax target applicable to such subsequent period. Shares of restricted stock that would otherwise vest at June 30, 2013 will only become vested shares if Mr. Fidel's employment with us continues until December 31, 2013. In connection with the execution of the Restricted Stock Agreement, Mr. Fidel also entered into a Shareholders' Agreement with our principal shareholder and DTAG and DTAC, which, among other things, restricts his ability to transfer his shares of restricted stock and grants him certain tag-along rights in the event of a sale by our principal shareholder and certain piggy-back registration rights in connection with a public offering of our shares or any successor entity.
In December 2010, we obtained a valuation of the Company and Mr. Fidel's 2.78% ownership from a third party appraisal firm resulting in a $9.5 million grant date fair value of the award. As the terms of the Agreement do not meet the specific criteria for liability classification as set forth in ASC 718 Compensation - Stock Compensation, we have determined the awards to be equity based stock compensation awards, therefore recognizing the expense over the requisite service periods based on a graded vesting. As DriveTime's Restricted Stock Agreement requires the achievement of a service and a performance condition, the Company would only recognize compensation expense for those periods in which the service is rendered and the performance condition is met. In addition, as the number of shares and purchase price are known by Mr. Fidel at the time of grant, compensation cost is fixed and measured as of the grant date.
As a result of this transaction, we recorded $3.9 million in share-based compensation expense in 2010 for the 1.1721 shares which vested on December 31, 2010. The remaining 59.0% of the shares vest over the following 36 months based on various vesting periods as set forth in the Agreement and are being recognized as compensation expense over the requisite service periods based on a graded vesting. The vesting is dependent upon achieving a predetermined performance ratio. The following is a summary of the vesting schedule:
Pursuant to the Restricted Stock Agreement, Mr. Fidel would be entitled to the vesting in full of all of the then-unvested shares of restricted stock granted under such agreements if at any time during the terms of the agreements there is a change in control of the company or if his employment is terminated by the company without cause or if he terminates his employment for good reason, as each such term is defined in the restricted stock agreement. In addition, in the event of Mr. Fidel's death, only those shares that have previously vested under the restricted stock agreements shall remain vested shares and Mr. Fidel's estate (or any beneficiary named by him) shall be entitled to the proceeds of an insurance policy on Mr. Fidel's life with a death benefit in the amount of $10.0 million. The premium on such policy will be paid by the company, and the benefit amount will reduce in proportion to the amount that any vested shares on a vesting date bear to the unvested shares.
For the years-ended December 31, 2012, 2011 and 2010, we recorded $1.5 million, $2.8 million and $3.9 million, respectively in share-based compensation expense for the shares which vested in association with the restricted stock agreements. The non-cash share-based compensation of $1.5 million, $2.8 million and $0.3 million was credited to Paid-in-Capital for the years ended December 31, 2012, 2011 and 2010, respectively.
Non-Cash Compensation
In January 2008, Mr. Garcia entered into an agreement with Mr. Fidel to purchase Mr. Fidel’s 5% interest in DTAG and DTAC for $17.5 million. The terms of the purchase were such that Mr. Garcia paid Mr. Fidel $6.25 million in cash and $11.25 million in a promissory note bearing interest at 8.0% per annum. The term of the note was five years with annual installment payments required. The agreement contained an employment condition, requiring Mr. Fidel to remain employed with the Company through June 30, 2010. In the event Mr. Fidel voluntarily terminated his employment as the President and Chief Executive Officer of the Company at a time prior to June 30, 2010, one-half of the principal balance of the note would have
been waived and no longer payable by Mr. Garcia. Accordingly, one-half of the $11.25 million note was deemed compensation expense recognized over the term of the employment condition, which expired in June 2010. As a result, $1.1 million of non-cash compensation expense was recorded for the year ended December 31, 2010, as an increase to general and administrative expenses-related party and an increase to paid-in capital on the accompanying consolidated statements of operations and balance sheets. For the years ended December 31, 2012, 2011, and 2010, Mr. Garcia made annual interest payments to Mr. Fidel of, $0.1 million, $0.3 million, and $0.5 million, respectively.
Prior to June 30, 2010, Verde was the holder of all of our outstanding $75.0 million 12% subordinated notes and the holder of $60.1 million of our junior secured notes. In conjunction with our offering of our 12.625% Senior Secured Notes due 2017 issued in June 2010, Verde transferred to Mr. Garcia and Mr. Garcia received and contributed to equity an aggregate of $100.1 million of debt, comprised of $40.0 million in subordinated notes and $60.1 million in junior secured notes. As a result of this agreement, paid-in capital was increased by $100.1 million in June 2010.
As a result of the exchange of debt for equity by Mr. Garcia, we wrote-off unamortized deferred financing costs associated with the subordinated notes and junior secured notes. The portion of the unamortized costs associated with related party debt and the discount associated with the issuance of the Senior Notes owned by Mr. Garcia were treated as capital transactions and resulted in a net decrease to paid-in capital of approximately $0.2 million during the year ended December 31, 2010.
Intercompany Loan Transfers
DriveTime Car Sales Company, LLC ("DTCS"), a wholly-owned subsidiary of DTAG, has a contractual commitment to sell all loans it originates at its dealerships to DTAC. Under ASC 805-50 “Business Combinations,” these transfers of loans from DTCS to DTAC are accounted for as a sale (and not a secured financing), at carryover basis since DTCS and DTAC are entities under common control. Therefore, the difference between book value and purchase price is accounted for as a debit to retained earnings on DTAG and credit to retained earnings on DTAC. These amounts are shown as “Intercompany Transfers of Loans” on the accompanying consolidated statements of shareholders’ equity for each period presented.
(13) Commitments and Contingencies
Limited warranty
Our DriveCare® limited warranty accrual is recorded as a component of accrued expenses and other liabilities on the accompanying consolidated balance sheets for each year presented. The following table reflects activity in the warranty accrual for the periods indicated:
Lease commitments
We lease used car sales facilities, reconditioning centers, our former loan servicing center, our corporate office, an aircraft, and certain other office/computer equipment from unrelated and related entities under various operating leases that expire through January 2025. The leases provide for periodic rent increases and many contain escalation clauses and various renewal options from one to ten years. In certain instances, we are also responsible for occupancy and maintenance costs, including real estate taxes, insurance, and utility costs. We recognize rent expense on a straight-line basis over the length of the lease term. Rent expense, including store closing costs, totaled $17.5 million, $16.6 million, and $16.9 million for the years ended December 31, 2012, 2011, and 2010, respectively.
A summary of future minimum lease payments required under non-cancelable operating leases with remaining lease terms in excess of one year as of December 31, 2012 follows:
We have properties where we ceased operations and still remain obligated under the lease agreements, some of which we have sub-leased to third party tenants. A summary of future minimum sub-lease income under non-cancelable operating leases with remaining lease terms in excess of one year as of December 31, 2012 follows:
Prior to and during 2012, we closed dealerships and reconditioning centers and incurred store closing costs and recorded lease termination liabilities in accordance with ASC 420 “Exit or Disposal Activities” (ASC 420). At December 31, 2012 and 2011, approximately $1.2 million and $1.4 million, respectively, remain in accrued expenses and other liabilities on the accompanying consolidated balance sheets for these lease obligations. In accordance with ASC 420, we recorded an aggregate amount of $0.2 million, $0.1 million, and $0.4 million in lease obligations associated with these closures for the years ended December 31, 2012, 2011, and 2010, respectively. At December 31, 2012, the expiration of these leases range from 2013 to 2018.
Legal matters
We are involved in various claims and actions arising in the ordinary course of business. In the opinion of management, based on consultation with legal counsel, the ultimate disposition of these matters will not have a material adverse effect on us. We believe appropriate accruals have been made for the disposition of these matters. In accordance with ASC 450, Contingencies, we establish an accrual for a liability when it is both probable that the liability has been incurred and the amount of the loss can be reasonably estimated. These accruals are reviewed monthly and adjusted to reflect the impact of negotiations, settlements and payments, rulings, advice of legal counsel, and other information and events pertaining to a particular case. Legal expenses related to defense, negotiations, settlements, rulings, and advice of outside legal counsel are expensed as incurred. At December 31, 2012, we do not have any material accruals for legal contingencies.
In August 2008, we received a Civil Investigative Demand from the Texas Office of Attorney General, Consumer Protection Division, asking for the production of certain materials. The demand indicates it is the subject of an investigation of possible violations of the Deceptive Trade Practices Act, Sections 17.46(a) and (b) in the marketing, advertising, financing, and selling of used vehicles. We provided the Texas Office of Attorney General with all requested information in August 2008. At that time, we met with the state’s Attorney General’s Office to provide them with an overview of the Company and discuss the requested materials. In addition, the Attorney General’s Office indicated that they would review the materials we provided to them and if there were any concerns they would contact us to meet, discuss and resolve the concerns. The Texas Attorney General has requested additional information and documentation from time to time, most recently in February 2010 when it requested clarifying information limited to vehicle inspections, after sale repairs, warranty, loan servicing, and consumer concerns. We believe the request is routine in nature and we have responded accordingly. We believe we are in compliance with all applicable state laws and regulations and we intend to continue to cooperate with state officials, and we will continue to
fully cooperate with the state’s Attorney General’s Office in responding to the demand and any follow up discussions with them. We believe we do not have loss contingencies related to this matter.
On April 12, 2012, the Consumer Financial Protection Bureau (the “CFPB”) delivered a Civil Investigative Demand to DTAG requesting that DTAG produce certain documents and information and answer questions relating to certain components of the business of DTAG and its affiliates. The CFPB has not alleged a violation by DTAG of any law and DTAG is cooperating with the CFPB's requests for information. We have provided the documents and information initially requested by the CFPB. On February 21, 2013, we also received a limited request to clarify and supplement certain information previously provided to the CFPB. Such information has since been provided.
On March 4, 2013, Credit Acceptance Corporation filed a patent infringement complaint against DTAG, DTAC and GO in the U.S. District Court for the Central District of California, Western Division. In its complaint, the plaintiff alleges infringement of its U.S. Patent No. 6,950,897, entitled “System and Method for Providing Financing.” The complaint seeks injunctive relief as well as awards of damages and attorneys' fees. We have not yet answered the complaint but believe we do not have loss contingencies related to this matter.
Additionally, in the ordinary course of business, we are a defendant in various other types of legal proceedings. Although we cannot determine at this time the amount of the ultimate exposure from these lawsuits, if any, based on the advice of counsel management does not expect the final outcome to have a material adverse effect on us.
(14) Retirement Plan
The Company sponsors a qualified 401(k) retirement plan (defined contribution plan) for its employees. The plan, as amended, covers substantially all employees having no less than 60 days of service, who have attained the age of 18, and work at least 1,000 hours per year. Participants may voluntarily contribute to the plan up to the maximum limits established by Internal Revenue Service regulations. In 2012, 2011, and 2010, we provided matching contributions of cash in the amount of 40%, up to the first 6% of each employee’s deferrals. Compensation expense related to this plan totaled $0.8 million, $0.8 million, and $0.7 million for the years ended December 31, 2012, 2011, and 2010, respectively.
(15) Fair Value of Financial Instruments
Fair values of financial instruments are based on estimates using quoted market prices, discounted cash flows, or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and the estimated timing and amount of future cash flows. Therefore, the estimates of fair value may differ substantially from amounts that ultimately may be realized or paid at settlement or maturity of the financial instruments and those differences may be material. Accordingly, the aggregate fair value amounts presented do not represent our underlying institutional value.
Limitations
Fair value of financial instruments are based on relevant market information and information about the financial instrument; they are subjective in nature and involve uncertainties, matters of judgment and, therefore, cannot be determined with ultimate precision. These estimates do not reflect any premium or discount that could result from offering for sale at one time our entire holdings of a particular instrument. Changes in assumptions could significantly affect these estimates. Because the fair value is estimated as of each balance sheet date presented, the amounts that will actually be realized or paid in settlement of the instruments could be significantly different.
The following is a summary of carrying value and fair value of our financial instruments for each period presented:
(1)
Represents finance receivable principal balances, plus accrued interest, less the allowance for credit losses.
Valuation methodologies
Finance receivables
The fair value of finance receivables was estimated by discounting future cash flows expected to be collected using current rates at which similar loans would be made to borrowers with similar credit ratings and the same remaining maturities. This discounted cash flow is estimated utilizing an internal valuation model, which uses a combination of market inputs (i.e. discount rates for similar and like transactions) and our own assumptions regarding credit losses, recoveries, and prepayment rates in our portfolio. We estimate the cash flow of the portfolio and the cash flow of our retained interests in securitization and bank term transactions in measuring total cash flow. These cash flows are developed on a leveraged basis since our finance receivable portfolio is financed by these debt instruments and are not separable transactions.
Dealer Finance Receivables - GO
The fair value of dealer finance receivables was estimated by discounting future cash flows expected to be collected using current rates at which similar loans would be made to borrowers with similar credit ratings and the same remaining maturities. This discounted cash flow is estimated utilizing an internal valuation model, which uses a combination of market inputs (i.e. discount rates for similar and like transactions) and our own assumptions regarding credit losses, recoveries, and prepayment rates in our portfolio.
Securitization debt
At December 31, 2012 and 2011, the fair value of securitization debt was determined using a third-party quoted market price.
Portfolio term residual financing
This facility was amended in September 2011 which gave us the ability to pre-pay the facility at any time without penalty. Therefore, we believe the fair value of this debt approximates carrying value at December 31, 2012 and December 31, 2011.
Bank term financings
In November 2012, we executed a bank term financing with Wells Fargo. Because this financing was recently executed, we believe the fair value approximates carrying value at December 31, 2012. The fair value of bank term financings at December 31, 2011 is based on third-party discounted cash flow using market interest rates for this debt. At December 31, 2012, we had paid off the balance of the bank term financings that were previously outstanding at December 31, 2011.
Portfolio warehouse facilities
The portfolio warehouse facilities are short term in nature and the interest rates adjust in conjunction with the lender’s cost of funds or 30-day LIBOR. The Deutsche Bank Warehouse Facility was renewed in December 2012. The Royal Bank of Scotland Warehouse Facility was renewed in March 2012. The Wells Fargo Warehouse Facility was executed in December 2011. Because these warehouse facilities were recently renewed or executed and contain a floating market rate of interest, we believe the fair value of these facilities approximate carrying value at December 31, 2012 and December 31, 2011.
Senior secured notes payable
The fair value of Senior Notes payable at December 31, 2012 was determined using a third-party quoted market price.
Revolving inventory facility
At December 31, 2012, the fair value of the inventory facility was determined using a third party discounted cash flow using market interest rates for this debt. At December 31, 2011, the fair value of the inventory facility was deemed to be carrying value since this facility was executed in November 2011.
Mortgage note payable
At December 31, 2012 and 2011, the fair value of this note was determined using third-party market prices for similar commercial real estate mortgages.
Equipment note payable
At December 31, 2012, the fair value of the equipment note payable was determined to be approximately carrying value since the note is due in less than 12 months, and can be repaid without penalty. At December 31, 2011, the fair value of the equipment note payable was determined using a third party discounted cash flow using market interest rates for this type of debt.
Real estate facility
At December 31, 2012, the fair value of the real estate facility was determined using third-party market prices for similar real estate collateralized facilities.
(16) Subsequent Events
We have evaluated subsequent events for potential recognition and/or disclosure through March 28, 2013, the date the financial statements were available for issuance.
Accordingly, the following disclosures apply:
In March 2013, we renewed our portfolio warehouse facility with RBS. The facility amount is $125.0 million with interest at LIBOR plus 2.25%, and advance rate of 65% and expiration date of March 2014, with a one year term-out feature.
In March 2013, the board of directors approved $4.9 million of dividends relating to fourth quarter 2012 earnings.
(17) Recent Accounting Pronouncements
From time to time, new accounting pronouncements are issued by the Financial Accounting Standards Board (FASB) or other accounting standards setting bodies, which we may adopt as of the specified date required by each standard. Unless otherwise discussed, we believe the impact of recently issued standards that are not yet effective will not have a material impact on our consolidated financial statements upon adoption. The below information is not a comprehensive list of all new pronouncements. We have only included those pronouncements we believe the reader of the financial statements would find meaningful. We have excluded certain pronouncements that we believe do not apply to us or the industry in which we operate.
In July 2012, the FASB issued ASU 2012-02, Intangibles - Goodwill and other (Topic 350): Testing Indefinite-Lived Intangible Assets for Impairment, which allows an entity to first assess qualitative factors to determine whether it is necessary to perform a quantitative impairment test. If a qualitative assessment indicates that it is not more likely than not that an asset is impaired, a quantitative impairment test is not required. This pronouncement is effective for fiscal years beginning after September 15, 2012. The Company does not have any indefinite-lived intangible assets. Therefore, this pronouncement will not currently have an impact on us.
(18) Supplemental Consolidating Financial Information
In accordance with the indenture governing our 12.625% Senior Secured Notes due 2017 (see Note 8-Debt Obligations), certain wholly-owned subsidiaries of the Company have fully and unconditionally guaranteed the Senior Secured Notes on a joint and several basis. Pursuant to Regulation S-X, Rule 3-10(f), we are required to present condensed consolidating financial information for subsidiaries that have guaranteed the debt of a registrant issued in a public offering, where the guarantee is full and unconditional, joint and several, and where the voting interest of the subsidiary is 100% owned by the registrant.
The following tables present condensed consolidating balance sheets as of December 31, 2012 and 2011; and condensed consolidating statements of operations for the years ended December 31, 2012, 2011, and 2010; and condensed consolidated statements of cash flows for the years ended December 31, 2012, 2011, and 2010 for (i) DTAG and DTAC, the co-issuers of the Senior Notes, (ii) the separate DTAG and DTAC guarantor subsidiaries on a combined basis, (iii) the separate DTAG and DTAC non-guarantor subsidiaries on a combined basis, (iv) elimination adjustments, and (v) total consolidated amounts. Separate financial statements and other disclosures concerning the Guarantor Subsidiaries are not presented because management believes that such information is not material to the senior note holders. Consolidating adjustments include elimination of investment in subsidiaries, elimination of intercompany accounts; elimination of intercompany sales between guarantor and non-guarantor subsidiaries; and elimination of equity in earnings (losses) of subsidiaries. The condensed consolidating financial information should be read in conjunction with the consolidated financial statements herein.
Included in the column for DTAG Guarantor Subsidiaries Combined are DriveTime Sales and Finance Company, LLC and DriveTime Car Sales Company, LLC. Included in the column for DTAC Guarantor Subsidiaries Combined are DT Credit Company, LLC, and DT Jet Leasing, LLC. Included in the column for DTAG Non-Guarantor Subsidiaries Combined are all other subsidiaries that are wholly-owned by DTAG and included in the column for DTAC Non-Guarantor Subsidiaries Combined are all SPEs, which are VIEs and for which DTAC is the primary beneficiary. The column for the Issuers includes the accounts for DTAG and DTAC as issuers and as parent company for each of its respective subsidiaries.
Consolidated amounts may be immaterially different compared to the consolidated financial statements due to rounding.
DriveTime Automotive Group, Inc. and Subsidiaries
Consolidating Balance Sheets
December 31, 2012
($ in thousands)
DriveTime Automotive Group, Inc. and Subsidiaries
Consolidating Balance Sheets
December 31, 2011
($ in thousands)
DriveTime Automotive Group, Inc. and Subsidiaries
Consolidating Statements of Operations
December 31, 2012
($ in thousands)
DriveTime Automotive Group, Inc. and Subsidiaries
Consolidating Statements of Operations
December 31, 2011
($ in thousands)
DriveTime Automotive Group, Inc. and Subsidiaries
Consolidating Statements of Operations
December 31, 2010
($ in thousands)
DriveTime Automotive Group, Inc. and Subsidiaries
Consolidating Statements of Cash Flows
Year Ended December 31, 2012
($ in thousands)
DriveTime Automotive Group, Inc. and Subsidiaries
Consolidating Statements of Cash Flows
Year Ended December 31, 2011
($ in thousands)
DriveTime Automotive Group, Inc. and Subsidiaries
Consolidating Statements of Cash Flows
Year Ended December 31, 2010
($ in thousands)
(19) Selected Quarterly Financial Data-Unaudited
A summary of the quarterly data follows:
(1) Includes net loss on extinguishment of debt.
(20) Segment Information
We operate in two principal operating business segments: DriveTime and GO Financial. We organize our business based on the nature of the services and products offered. Transactions between segments are eliminated in consolidation.
Revenues, operating income (loss) and assets and liabilities of each of the operating segments is provided below as of and for the year-ended December 31, 2012. GO Financial did not have material operations prior to December 2012.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
Item 9A.
Item 9A. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
Under the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, we evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of December 31, 2012. In designing and evaluating the disclosure controls and procedures, our management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and no evaluation of controls and procedures can provide absolute assurance that all control issues and instances of fraud, if any, have been detected. Our management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective as of December 31, 2012, the end of the period covered by this annual report, to ensure that the information required to be disclosed by us in the reports that we file or submit, as if we were required to file or submit such reports under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosures. We will continue to review and document our disclosure controls and procedures on an ongoing basis, and may from time to time make changes aimed at enhancing their effectiveness and to ensure that our systems evolve with our business.
Changes in Internal Control over Financial Reporting
There has been no change in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) of the Exchange Act) during the year ended December 31, 2012, that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
Item 9B.
Item 9B. Other Information
None.
Part III
Item 10.
Item 10. Directors, Executive Officers and Corporate Governance
Executive Officers and Directors
The following table sets forth information regarding our executive officers and directors:
DriveTime Automotive Group, Inc.
Name
Age
Position(s)
Ernest C. Garcia II
Chairman/Director
Raymond C. Fidel
Director, Chief Executive Officer, and President
Mark G. Sauder
Executive Vice President, Chief Financial Officer and Treasurer
Jon D. Ehlinger
Executive Vice President, Secretary, General Counsel, and Public Relations
MaryAnn N. Keller
Director
Donald J. Sanders
Director
Gregg E. Tryhus
Director
Ernest C. Garcia II. Mr. Garcia has served as our Chairman of the Board since 1992. Mr. Garcia served as our Chief Executive Officer from 1992 to 1999, and served as our President from 1992 to 1996. Mr. Garcia has been the President of Verde Investments, Inc. since 1992. As our founder and former Chief Executive Officer, Mr. Garcia brings to his role as Chairman of the Board an extensive understanding of the automobile sales and finance industry, which enables him to serve as a resource to our management team in their assessment and management of risks and development of overall corporate strategy.
Raymond C. Fidel. Mr. Fidel has served as a Director, our Chief Executive Officer and President since 2004. Prior to that, Mr. Fidel served as our Chief Operating Officer from 2001 to 2004. Mr. Fidel graduated with a Bachelor of Science degree in finance and a Master of Business Administration degree from the University of New Mexico. Mr. Fidel’s long tenure as a senior executive of the Company, as well as his day to day leadership and intimate knowledge of business and operations, provide the Board with Company specific experience and expertise.
Mark G. Sauder. Mr. Sauder has served as our Chief Financial Officer since 2002 and as Executive Vice President since 2004. Mr. Sauder is a Certified Public Accountant and graduated with a Bachelor of Science degree in accounting from Ball State University.
Jon D. Ehlinger. Mr. Ehlinger has served as our General Counsel and Secretary since 1998, and was appointed Executive Vice President in 2009. Mr. Ehlinger graduated with a Bachelors of Arts degree in history from Drake University and received his Juris Doctorate degree from the University of Notre Dame Law School.
Maryann N. Keller. Ms. Keller currently serves as the principal of Maryann Keller and Associates, a firm providing consulting services to automotive clients. From July 1999 to November 2000, Ms. Keller served as the President of the Automotive Services unit of Priceline.com. She joined Priceline.com from Furman Selz, an investment banking firm, where she served as a managing director of the firm from 1986 to 1999. Prior to joining Furman Selz, Ms. Keller was a portfolio manager with Vilas-Fischer Associates from 1983 to 1986, and served as automotive industry analyst with Kidder Peabody & Co. Inc. and Paine Webber from 1972 to 1983. Ms. Keller also served as Chairman of the Society of Automotive Analysts from 1994 to 1999. From 2000 through 2012, she was a director of Dollar Thrifty Automotive Group, Inc. (NYSE: DTG), a publicly-traded rental car company, where she served as Chairman of the Audit Committee and was a member of the human resources and compensation committee. She has previously served as a director of Lithia Motors, Inc. (NYSE: LAD), a new and used vehicle retailer. Ms. Keller’s extensive experience as an analyst of, consultant to, and director of organizations in the automotive industry brings valuable expertise and experience to our Board.
Donald J. Sanders. Mr. Sanders has worked in the consumer finance industry for 40 years and has held management positions with Korvettes Department Stores (private label credit business), Citicorp, and Commercial Credit Corporation. In 1990, Mr. Sanders co-founded and served as Chief Executive Officer of Credit and Risk Management Associates, Inc., a risk management and marketing consulting, data warehousing, and systems integration firm that was acquired by Fair, Isaac Companies in 1996. Mr. Sanders retired from Fair, Isaac in 2001, but continues to provide private consulting services as Deer Creek Consulting, LLC. Mr. Sanders also serves as a Senior Industry Advisor to Bridgeforce, Inc., a Delaware consulting firm, and serves as an advisor to the board of directors of Collections Marketing Center, Inc., a private company. Mr. Sanders also
served on the board of directors of Metris Companies, Inc., from 2004 to 2005. Mr. Sanders’ extensive career focusing on credit scoring and risk modeling for the consumer finance industry, including as a chief executive and later as a consultant, gives him the industry knowledge to guide our Board on a variety of matters.
Gregg E. Tryhus. Mr. Tryhus is President and owner of Grayhawk Development, a company involved in land development, golf development, construction and operations, and resort development. Prior to that, Mr. Tryhus was in the land sales business and founded his own land sales company, Tryhus Company, in 1984.
As noted on our Form 8-K filed on March 7, 2013, on November 30, 2012, Alan J. Appelman, former Executive Vice President and Chief Credit Officer of DTAC, departed from his position with the Company. In connection therewith, the Company and Mr. Appelman have entered into a Settlement Agreement effective as of December 6, 2012. See "Item 11.
Item 11. Executive Compensation
Compensation Discussion and Analysis
The following discussion and analysis should be read in conjunction with the related tables that are presented immediately below.
Overview
The purpose of this compensation discussion and analysis is to provide information about each material element of compensation that we pay or award to, or that is earned by, our "named executive officers". As of December 31, 2012, other than our principal executive officer and principal financial officer, only two other officers were serving in an executive capacity with total compensation over $100,000 for the year. Therefore, for the year ended December 31, 2012, our named executive officers consist of our principal executive officer ("PEO"), principal financial officer ("PFO"), our two other most highly compensated executive officers, and a former executive officer (Alan J. Appelman) who would have been among our three most highly compensated executive officers other than the PEO and PFO but for the fact that he departed the Company prior to the end of the fiscal year. The named executive officers are as follows:
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Ernest C. Garcia II, our Chairman;
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Raymond C. Fidel, our President and Chief Executive Officer (PEO);
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Mark G. Sauder, our Executive Vice President and Chief Financial Officer (PFO);
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Jon D. Ehlinger, our Executive Vice President, Secretary, and General Counsel; and
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Alan J. Appelman, our former Executive Vice President and Chief Credit Officer.
This compensation discussion and analysis addresses and explains the compensation practices that we followed in 2012, the numerical and related information contained in the summary compensation and related tables presented below, and actions we have taken regarding executive compensation since the end of our 2012 fiscal year.
Compensation Determinations
Most, if not all, of our compensation policies and determinations applicable to our named executive officers have been the product of research by and discussion among our management team.
Objectives of Compensation Programs
We pay our named executive officers based on business performance and individual performance, and, in setting compensation levels, we take into consideration our past practices and our current and anticipated future needs, the relative skills and experience of each individual executive, and the competitive market. To date, we have not utilized the services of a compensation consultant and have not engaged in any benchmarking when making policy-level or individual compensation determinations.
Compensation philosophy. A named executive officer’s total compensation will vary based on the Company’s overall performance and with the particular named executive officer’s personal performance and contribution to overall results. This philosophy generally applies to all of our employees, with a more significant level of variability and compensation at risk depending upon an employee’s function and level of responsibility. Implementing this philosophy allows us to attract, motivate, and retain highly qualified individuals responsible for guiding us and creating value for our shareholders.
Overriding objectives. The overriding goal of our executive compensation program is the same as the Company’s goal-to create long-term sustainable shareholder value. Additional objectives of the executive compensation program are:
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to motivate our named executive officers to achieve and exceed our financial performance goals and drive the value of our business by rewarding such success;
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to ensure that executive compensation programs are effective in attracting, retaining, and motivating top quality executives who have the ability to significantly influence our long-term financial success and are responsible for effectively managing our operations in a way that maximizes the value of our business;
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to achieve a balance between compensation levels and our annual and long-term budgets, strategic plans, business objectives, and investor expectations;
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to motivate executive officers to achieve our business objectives, and to align the incentives of our officers with, on a prospective basis, long-term incentive awards;
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to provide named executive officers with appropriately leveraged total compensation opportunities that are competitive in form and in value with comparable companies taking into account the following factors: industry sector, market capitalization, revenues, profitability, and regional operational focus; and
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to have programs that are simple, well understood, which reward accountability and are closely tied to our key financial goals and strategic objectives.
Company compensation policies. A named executive officer’s total in-service compensation consists of base salary, a cash bonus, a deferred bonus, a long-term incentive program, and limited perquisites. With regard to these components, we have in the past adhered to the following compensation policies:
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Base salaries should be competitive and should encourage retention. Our compensation programs should reflect base salaries as being competitive compensation for the named executive officers to perform the essential elements of their respective roles.
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Bonuses should be structured to reward superior company performance and encourage retention. Each of our executive officers may be entitled to an annual cash bonus based on our annual financial performance. To encourage continuity of management, an additional amount equal to each annual cash bonus is awarded on a deferred basis and such amounts are paid, subject to continued employment, three years following the year in which the deferred bonus was awarded.
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Short- and long-term incentives. Our compensation programs are structured to assure that those key executives who are involved in critical decisions that impact our success have a meaningful, competitively supportable portion of their total compensation linked to their success in helping meet performance objectives.
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Compensation should be paid in cash. As a private company whose equity securities are not publicly traded, we believe that the true compensatory value to be accorded to equity-based incentives would be difficult for both us and a recipient to determine. With the exception to the Restricted Stock Grant awarded to our CEO in December 2010, we have not in the past utilized equity based incentives and have instead focused entirely on providing the opportunity for our named executive officers to earn total cash compensation at levels that enable us to achieve the motivation and retention goals described above.
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Benefits. Benefits are offered that are competitive within the defined talent market, generally on par with our employee population, and offered on the basis of business need and adequate individual protection. Our benefit plans provide participants with reasonable flexibility to meet individual means.
We believe our policies have helped us achieve our compensation objectives of motivation and retention, as evidenced by the limited turnover in our executive officer ranks over the past several years.
Compensation Programs Design and Elements of Compensation
We choose to pay each element of compensation to further the objectives of our compensation program, which, as noted, includes the need to attract, retain, and reward key leaders critical to our success by providing competitive total compensation.
Elements of in-service compensation. For our 2012 fiscal year, our executive compensation mix included base salary, discretionary cash bonuses, and other benefits generally available to all employees. We generally determine the nature and amount of each element of compensation as follows:
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Base Salary. We typically agree upon a base salary with a named executive officer at the time of initial employment. The amount of base salary agreed upon, which is not at risk, reflects our views as to the individual executive’s past experience, future potential, knowledge, scope of anticipated responsibilities, skills, expertise, and potential to add value through performance. We review executive salaries annually and may adjust them based on an evaluation of our performance for the year and the performance of the functional area(s) under an executive’s scope of responsibility. We also consider qualitative criteria, such as education and experience requirements, complexity, and scope or impact of the position compared to other executive positions internally.
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Non-Equity Incentive Plan Compensation. We provide cash bonuses to recognize and reward our named executive officers with cash payments above base salary based on our success in a given year. The cash bonuses are paid annually and the bonus program includes an additional deferred bonus in the amount of the annual bonus that is payable three years after the payment of the annual bonus, subject to the executive officer still being employed by us at the time of payment. Amounts deferred accrue interest at the prime rate. For each year, the bonuses received by Messrs. Fidel, Sauder, Ehlinger, and Appelman reflect, in part, bonuses for the fiscal year performance and, in part, the deferred portion of bonuses earned three years prior. See “-Impact of Performance on Compensation-Bonus Plan.”
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Retention Bonus Plan. We provide cash bonuses under our retention bonus plan to Messrs. Sauder, Ehlinger, and prior to his departure from the Company on November 30, 2012, Mr. Appelman. Under the terms of the plan, we were committed to make six annual contributions beginning May 1, 2006 through May 2011 to fund the plan. An executive must remain employed by us to receive annual benefits paid out under the plan beginning in May 2011 through May 2015.
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Perquisites. We seek to compensate our named executive officers at levels that eliminate the need for material perquisites and enable each individual officer to provide for his or her own needs. Accordingly, in 2012, we provided limited perquisites to our named executive officers.
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Other. We offer other employee benefits to key executives for the purpose of meeting current and future health and security needs for the executives and their families. These benefits, which we generally offer to all eligible employees, include medical, dental, vision and life insurance benefits; short-term disability pay; long-term disability insurance; flexible spending accounts for medical expense reimbursements; tuition reimbursement; and a 401(k) retirement savings plan.
Elements of post-termination or change of control compensation and benefits. None of our named executive officers is a party to an employment agreement with us, although certain of our executives are parties to special retention agreements that provide for benefits to be accelerated upon certain events involving termination of employment or a change of control. See “-Severance and Change of Control Arrangements” below.
Impact of Performance on Compensation-Bonus Plan
We have an annual cash bonus program that is based primarily on pretax earnings. When evaluating whether earnings targets have been satisfied, we typically disregard certain non-operating gains and/or losses over which management has no control, and certain performance measures may be adjusted in extraordinary circumstances. We determine target earnings at the start of each year. If the earnings threshold to achieve a bonus is met, bonuses can be paid anywhere from 50% to 150% of the respective executive’s base bonus, depending on our performance against the targets. If the earnings threshold to achieve a bonus is not met, we do not pay a bonus for the fiscal year. We determine the targets by analyzing our budget and forecasted earnings, and economic and other competitive factors. The cash bonuses are paid annually.
The bonus program also includes a deferred component. The deferred portion is equivalent to the executive’s annual bonus (as described above) and is payable three years after the payment of the annual bonus, subject to the executive officer still being with us at the time of payment. For example, the Payment Date for the deferred portion of the 2012 bonus is January 2016. The Company will pay simple interest at the prime rate on the amount of the bonus to which each executive is entitled under the Plan during the Vesting Period. For purposes of this Plan, the “Vesting Period” begins on January 1st of the year after the bonus year and ends on December 31 before the January in which the bonus is paid. For example, the vesting period for the
deferred portion of the 2012 bonus begins on January 1, 2013 and ends on December 31, 2015. The amount paid in January 2016 is equal to the amount earned under the annual bonus plan for 2014, plus the amount of the deferred bonus from 2012.
Retention Bonus Plan
In July 2005, we replaced existing retention plan agreements with the retention plan in which Mark G. Sauder and Jon D. Ehlinger currently participate, and in which Alan J. Appelman participated until his departure from the Company on November 30, 2012. Raymond C. Fidel was not included in this plan because it was determined that, as a shareholder at that time, his ownership interest in the Company encouraged Mr. Fidel to remain employed with the Company, and that he would be financially rewarded in his capacity as one of our shareholders. Subsequently, in 2008, Mr. Fidel entered into an agreement with Mr. Garcia for the purchase of Mr. Fidel’s ownership interest. See “-Executive Employment Agreements.”
Under the terms of the retention bonus plan, we were committed to make six annual contributions beginning May 1, 2006 and for each year thereafter through May 1, 2011 to fund this program. Executives must remain employed by us to receive these benefits. If the executive terminates his employment without cause or is terminated with cause, any unpaid amounts are forfeited and revert to the Company. If the executive is terminated without cause (including on account of disability), the executive terminates for good reason, or upon certain change of control events, the executive will receive all amounts that have been contributed to date. The total contributions paid under this plan were $14.0 million, funded by us over the first six years to be paid out to the executive in five installments beginning May 1, 2011. We recognize compensation expense under this plan based upon the service period required to receive payments of ten years (exclusive of acceleration and forfeiture clauses).
At December 31, 2012, the plan was fully funded and, during the years ended December 31, 2012 and 2011, the first and second of five payments were paid out of the plan, respectively.
Contributions are made into secular trusts that were set up on behalf of each participant. We funded contributions into the trusts to provide participants a level of certainty regarding payment of their retention benefits. Contributions to the secular trusts are taxable to the named executive officers and the funds are not subject to claims from creditors in the event of bankruptcy. The named executive officers also have investment discretion with respect to the contributions.
Chief Executive Officer Restricted Stock Grant
In December 2010, the Board of Directors of each of DTAG and DTAC approved a restricted stock award to Mr. Fidel, our Chief Executive Officer. On December 28, 2010, Mr. Fidel entered into a Restricted Stock Agreement with each of DTAG and DTAC, pursuant to which he was issued an award of 2.8595 shares of restricted stock in each of DTAG and DTAC, subject to certain vesting restrictions. Mr. Fidel made an election under Section 83(b) of the United States Internal Revenue Code of 1986, as amended, to be taxed on the fair market value of the entire restricted stock grant as of the award date. In connection therewith, that portion of shares the fair market value of which was sufficient to satisfy Mr. Fidel’s federal and state income tax obligations with respect to the entire award was deemed to be vested in full as of the award date. However, only those shares of a value equal to the minimum statutory federal and state withholding due from Mr. Fidel on the grant were repurchased by DTAG and DTAC, and the proceeds from such repurchases were delivered to the relevant tax authorities. The remaining unvested shares of restricted stock vest one-third each year over a period of three years based on Mr. Fidel’s continued employment with us and on the achievement of certain income before income tax targets for the consolidated results of DTAG, measured for the preceding twelve months as of June 30, 2011, 2012 and 2013. During the year ended December 31, 2012, we recognized $1.5 million in restricted stock expense due to the shares that vested during the current year.
For income tax purposes, Mr. Fidel was deemed to own 2.8595 shares at the grant date, and immediately thereafter the Company repurchased 1.0899 shares resulting in Mr. Fidel owning 1.7696 shares in each of DTAG and DTAC as of December 31, 2010, 2011, and 2012. A shortfall in the performance target measured at June 30, 2011, 2012, and 2013 (and therefore a failure of one-third of the unvested shares to vest at such date) may be made up at a subsequent date if the consolidated results of DTAG exceed the relevant income before income tax target applicable to such subsequent period. Shares of restricted stock that would otherwise vest at June 30, 2013 will only become vested shares if Mr. Fidel’s employment with us continues until December 31, 2013. In connection with the execution of the Restricted Stock Agreements, Mr. Fidel also entered into a Shareholders’ Agreement with our principal shareholder and DTAG and DTAC, which, among other things, restricts his ability to transfer his shares of restricted stock and grants him certain tag-along rights in the event of a sale by our principal shareholder and certain piggy-back registration rights in connection with a public offering of our shares or any successor entity. See “Item 13 - Certain Relationships and Related Transactions, and Director Independence-Related Party Transactions-Shareholders’ Agreements.”
Internal Revenue Code Section 409A
Section 409A of the Code requires that “nonqualified deferred compensation” be deferred and paid under plans or arrangements that satisfy the requirements of the statute with respect to the timing of deferral elections, timing of payments and
certain other matters. Failure to satisfy these requirements can expose employees and other service providers to accelerated income tax liabilities and penalty taxes and interest on their vested compensation under such plans. Accordingly, as a general matter, it is our intention to design and administer our compensation and benefits plans and arrangements for all of our employees and other service providers, including our named executive officers, so that they are either exempt from, or satisfy the requirements of, Section 409A. With respect to our compensation and benefit plans that are subject to Section 409A, in accordance with Section 409A and regulatory guidance issued by the IRS, we are currently operating such plans in compliance with Section 409A.
Conclusion
We believe that the compensation amounts paid to our named executive officers for their service in 2012 were reasonable and appropriate and in our best interests.
Executive Employment Agreements
None of our named executive officers is a party to an employment agreement with us, except for Mr. Fidel's participation in the 2010 Restricted Stock Grant (see below for further details) although certain of our executives are parties to special retention agreements and non-equity incentive plan compensation that provide for benefits to be accelerated upon certain events involving termination of employment or a change of control. See “-Severance and Change of Control Arrangements” below. On December 28, 2010, Mr. Fidel entered into a Restricted Stock Agreement with each of DTAG and DTAC, pursuant to which he was issued an award of 2.8595 shares of restricted stock in each of DTAG and DTAC, subject to certain vesting restrictions. The unvested shares of restricted stock vest one-third each year over a period of three years based on Mr. Fidel’s continued employment with us and on the achievement of certain income before income tax targets for the consolidated results of DTAG, measured for the preceding twelve months as of June 30, 2011, 2012 and 2013. As of June 30, 2012, the vesting requirements were met for the first third of the award and we recognized $1.5 million in restricted stock compensation expense. See “-Chief Executive Officer Restricted Stock Grant” for detail.
There have been no other material changes to items of compensation applicable to our named executive officers or directors for fiscal 2012, other than the departure of Mr. Appelman from the Company on November 30, 2012.
Summary Compensation Table
The following table sets forth the total compensation earned for services rendered by our named executive officers for the fiscal year ended December 31, 2012.
(1)
As discussed in “-Retention Bonus Plan” above, reflects amounts awarded to the applicable named executive officers in 2010 and 2011 respectively under the retention bonus plan. We began paying amounts awarded under this plan to participants in May 2011. Payments will be made in five installments and will be subject to forfeiture as provided above. The difference in the bonus paid to Mr. Sauder, in comparison to bonuses paid to Messrs. Ehlinger and Appelman, reflects the terms of the bonus plan and the value it places on Mr. Sauder’s performance in his position as chief financial officer of the Company, which is a critically important role in our company given the complexity of our business model and the importance of financing to our business.
(2)
As noted in our 8-k filed on March 7, 2013, on November 30, 2012, Alan J. Appelman, former Executive Vice President and Chief Credit Officer of DTAC, departed from his position with the Company. In connection therewith, the Company and Mr. Appelman entered into a Settlement Agreement effective as of December 6, 2012, which provided for severance payments to Mr. Appelman in connection with his departure.
(3)
See “-Chief Executive Officer Restricted Stock Grant.”
Non-Equity Incentive Plan Compensation includes amounts as described in “-Impact of Performance on Compensation-Bonus Plan”. Component amounts are as follows:
All other compensation consists of the following:
(1)
Relates to usage of aircraft owned by the Company and an aircraft we lease from Verde. See “Item 13 - Certain Relationships and Related Transactions, and Director Independence-Related Party Transactions-Aircraft lease and operating expenses.” The incremental cost to us of personal use of the aircraft is calculated based on the variable operating costs to us, including fuel costs, trip-related maintenance, universal weather-monitoring costs, on-board catering, landing/ramp fees, crew travel expenses, and other miscellaneous variable costs. Fixed costs that do not change based on usage, such as pilot salaries, our lease costs, and the cost of maintenance not related to trips, are excluded.
The difference in Mr. Garcia’s base salary in comparison to other named executive officers reflects his status as the founder, Chairman of the Board, and owner of a private company, which entitles him to dividends and a salary. With respect to Mr. Fidel, his salary is attributable to his contributions to the Company and the Company’s performance. In particular, his salary reflects the substantial progress the Company has made under his direction in its operations and financial performance since he became the Chief Operating Officer in 2001 and President/CEO in 2004. While our other executive officers have also made significant, meaningful contributions over this time period, we believe Mr. Fidel’s compensation appropriately reflects his additional contributions to our success. Finally, in setting Mr. Fidel’s salary, we have reviewed his base compensation in the context of overall compensation.
Severance and Change of Control Arrangements
The annual cash bonus program, in which our executive officers participate, and the deferred bonus arrangements with Mr. Fidel, Mr. Sauder, Mr. Ehlinger, and prior to his departure from the Company on November 30, 2012, Mr. Appelman, entitle them to certain severance payments and other benefits in the event of certain types of terminations and changes of control, which are summarized below. The table below reflects the amount of compensation to be paid to each of them in the event of termination of such executive’s employment. The amounts shown assume that such termination was effective as of December 31, 2012, and thus includes amounts earned through such time and are estimates of the amounts that would be paid out to the executives upon their termination. The actual amounts to be paid out can only be determined at the time of such executive’s separation from us.
Pursuant to the Restricted Stock Agreements described above under “-Chief Executive Officer Restricted Stock Grants,” Mr. Fidel would be entitled to the vesting in full of all of the then-unvested shares of restricted stock granted under such agreements if at any time during the terms of the agreements there is a Change in Control of the company or if his employment is terminated by the company without Cause or if he terminates his employment for Good Reason, as each such term is defined in the respective Restricted Stock Agreement. In addition, in the event of Mr. Fidel’s death, only those shares that have previously vested under the Restricted Stock Agreements shall remain vested shares and Mr. Fidel’s estate (or any beneficiary named by him) shall be entitled to the proceeds of an insurance policy on Mr. Fidel’s life with a death benefit in the amount of $10 million. The premium on such policy will be paid by the company, and the benefit amount will reduce in proportion to the amount that any vested shares on a vesting date bear to the unvested shares. The premium paid for the 2012 policy year was $8,760.
(1)
Amounts included are for the restricted stock grants and Retention Bonus Plan.
(2)
Amounts included are the Retention Bonus Plan and Deferred Bonus Arrangement.
(3)
Reflects actual severance compensation payable to Mr. Appelman in connection with his departure from the Company on November 30, 2012 and in accordance with the Settlement Agreement dated effective December 6, 2012.
Director Compensation
We pay our non-employee directors an annual cash retainer of $50,000 for their board service.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
The following table sets forth information regarding the beneficial ownership of our common stock as of December 31, 2012 for:
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each person, or group of affiliated persons, known to us to own beneficially 5% or more of our outstanding common stock;
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each of our directors;
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each of our named executive officers; and
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all of our directors and executive officers as a group.
The information in the following table has been presented in accordance with the rules of the SEC. Under SEC rules, beneficial ownership of a class of capital stock includes any shares of such class as to which a person, directly or indirectly, has or shares voting power or investment power and also any shares as to which a person has the right to acquire such voting or investment power within 60 days through the exercise of any stock option, warrant or other right. If two or more persons share voting power or investment power with respect to specific securities, each such person is deemed to be the beneficial owner of such securities. Except as we otherwise indicate below and under applicable community property laws, we believe that the beneficial owners of the common stock listed below, based on information they have furnished to us, have sole voting and investment power with respect to the shares shown. Unless otherwise noted below, the address for each holder listed below is 4020 East Indian School Road, Phoenix, Arizona 85018.
(1)
Consists of (i) 6.5 shares held of record by the Ernest C. Garcia III Multi-Generational Trust III, (ii) 87 shares held of record by Ernest C. Garcia II and Elizabeth Joanne Garcia, and (iii) 6.5 shares held of record by the Ernest Irrevocable 2004 Trust III. Mr. Garcia is deemed to be the beneficial owner of shares held by these trusts.
(2)
Mr. Fidel’s shares were awarded pursuant to a Restricted Stock Agreement dated as of December 28, 2010, and vest equally over a three-year period, one-third on each of June 30, 2011, June 30, 2012, and December 2013, based on the achievement of certain performance targets by the Company. See “Item 11 - Executive Compensation-Compensation Discussion and Analysis-Chief Executive Officer Restricted Stock Grant.”
Item 13.
Item 13. Certain Relationships and Related Transactions, and Director Independence
Policies and Procedures for Related Party Transactions
We have a written code of business conduct and ethics governing policies and procedures for related party transactions.
Relationship with Verde Investments, Inc.
Verde Investments, Inc., or “Verde,” is an Arizona corporation that is wholly-owned by Ernest C. Garcia II, our Chairman and principal shareholder. Verde engages in the acquisition, development, and long-term investment in real estate and other commercial assets. Mr. Garcia is the principal shareholder, president and director of Verde. Another affiliate of Mr. Garcia is the Garcia Family Limited Liability Partnership, LLP, of which Mr. Garcia and Verde own jointly. The other interests are owned by Mr. Garcia's son and one related trust. Transactions between us and Verde, as well as other related parties, are described below.
Related Party Transactions
During the year ended December 31, 2012, 2011, and 2010, we recorded related party operating expenses as follows:
Property leases
Included in property lease expense are costs of operating leases with Verde for certain dealership and reconditioning facilities which the Company operates, and certain store closing costs. For the years ended December 31, 2012, 2011, and 2010, we leased an average of 13, 14, and 15 vehicle sales facilities, respectively, three reconditioning facilities, our former loan servicing center (which is currently being subleased to third-party tenants), and our corporate office from Verde and the Garcia Family Limited Liability Partnership, LLP. Three of these facilities were closed locations as of December 31, 2012 and 2011. During the year ended December 31, 2010, we also leased one vehicle sales facility, and a reconditioning center from Steven Johnson, a director and former officer of DTAC who is also Mr. Garcia’s brother-in-law. As of December 31, 2012 and 2011 we had no remaining leases with Steven Johnson. For the years ended December 31, 2012, 2011, and 2010, we rented one vehicle sales facility from Stephen Fidel, the brother of Mr. Fidel, our President and CEO. At December 31, 2012, the maturity of these related party leases range from 2013 to 2023. Future minimum lease payments required under related party leases are disclosed in Note 13-Commitments and Contingencies to our consolidated financial statements included herein.
During the year ended December 31, 2011, we paid an aggregate of $0.4 million in a lease termination fees on two of our closed properties to terminate the leases with Steven Johnson. During the year ended December 31, 2010, we paid $0.4 million in a lease termination fee on one of our closed properties to terminate the lease with Verde.
Restricted stock compensation expense and non-cash compensation expense
Restricted stock compensation expense represents stock compensation expense under a restricted stock agreement between DTAG, DTAC and Mr. Fidel. See Note 12-Shareholders' Equity & Dividends to our consolidated financial statements included herein for further information.
Non-cash compensation expense represents compensation expense associated with an employment agreement entered into in connection with a stock purchase agreement between Mr. Garcia and Mr. Fidel, in which Mr. Garcia agreed to purchase Mr. Fidel’s 5% interest in DTAG and DTAC for $17.5 million. The terms of the purchase were such that Mr. Garcia paid Mr. Fidel $6.25 million in cash and $11.25 million in a promissory note bearing interest at 8.0% per annum. The term of the note was five years with annual principal payments required. For the years ended December 31, 2012, 2011, and 2010, Mr. Garcia made total interest payments to Mr. Fidel, of $0.1 million, $0.3 million, and $0.5 million, respectively. The note was paid off in June 2012 with the payment of the fifth and final principal installment to Mr. Fidel.
The agreement contained an employment condition, requiring Mr. Fidel to remain employed with the Company through June 30, 2010. Under the terms of the agreement, if Mr. Fidel voluntarily terminated his employment as the President and Chief Executive Officer of the Company at a time prior to June 30, 2010, one-half of the principal balance of the note would be waived and would no longer be payable by Mr. Garcia. Accordingly, under GAAP, one-half of the $11.25 million note was deemed non-cash compensation expense to be recognized over the term of the employment condition, with the final amount being recognized in 2010.
Aircraft operating and lease expenses
We are party to a lease agreement for an aircraft with Verde under which we agreed to pay monthly lease payments of $150,000 plus taxes, and are responsible for paying all operating costs and repairs and maintenance related to the aircraft. The lease expires in August 2015.
Salaries and wages, general and administrative, and other expenses
Certain general and administrative expenses and salaries and wages of Verde and Verde employees who are enrolled in our health plan are reflected in our general and administrative expenses-related party.
Reimbursement of general and administrative expenses
For each of the periods presented, we received reimbursement of certain general and administrative expenses incurred by us on Verde's behalf.
Interest Expense
During the years ended December 31, 2012, 2011, and 2010, we recorded related party interest expense as follows:
In August 2012, Verde purchased $5.0 million of the Senior Notes on the open market, at a purchase price of 111.0% to par, plus accrued interest. Subsequent to this transaction, Mr. Fidel purchased $0.5 million of the notes from Verde at an identical purchase price.
During the year ended December 31, 2011, we recorded related party interest expense associated with our June 2010 issuance of $200.0 million of the Senior Notes, an aggregate of $49.0 million of which were held by Verde and Mr. Fidel. In June 2011, Verde purchased Mr. Fidel's portion of Senior Notes, and Verde sold the Senior Notes it held on the open market. As a result, at December 31, 2011, none of the Senior Notes were held by a related party and interest expense during 2011 is related only to the period in which the related parties held the notes.
During the year ended December 31, 2010, we recorded related party interest expense associated with junior secured notes, senior unsecured notes, subordinated notes, and Senior Secured Notes as depicted above. For the terms of these debt instruments see Note 8-Debt Obligations.
Shareholders’ Agreements
On December 28, 2010, Mr. Fidel, our chief executive officer, entered into a Restricted Stock Agreement with DTAG and DTAC pursuant to which we awarded a specified number of shares of restricted stock to Mr. Fidel, which shares will become vested shares over a three-year period based on the achievement by the company of certain income before income tax targets. See “Item 11 - Executive Compensation-Compensation Discussion and Analysis-Chief Executive Officer Restricted Stock Grant.” In connection with the grant of shares of restricted stock, Mr. Fidel entered into a Shareholders’ Agreement with us and our principal shareholder. Each Shareholders’ Agreement sets forth certain restrictions on transfer of the shares of common stock of such entity owned by each shareholder, grants Mr. Fidel certain tag-along rights in a sale of shares by our principal shareholder as well as preemptive rights to participate in new issuances of common stock by such entity. Each Shareholders’ Agreement also grants Mr. Fidel certain piggy-back registration rights in connection with a public offering of common stock of such entity or a successor entity.
Director Independence
Our debt is not listed on any exchange and our equity is privately held. Our Board of Directors has determined that Ms. Keller and Mr. Sanders would each be considered independent under current New York Stock Exchange listing standards. Under current New York Stock Exchange listing standards (to which we are not currently subject), we believe that Mr. Garcia would not be considered independent due to his holding of the substantial majority of our equity capital, that Mr. Tryhus would not be considered independent because of current and previous business dealings with Mr. Garcia and his affiliated companies, and that Mr. Fidel would not be considered independent due to his employment relationship with us.
Item 14.
Item 14. Principal Accountant Fees and Services
Grant Thornton LLP, has been our independent registered public accountants since 2006. We have not had and do not have an Audit Committee, and our executive management has appointed Grant Thornton as our independent registered public accounting firm and approved the engagement of Grant Thornton to perform the audit of the financial statements and internal control over financial reporting included in our annual report for the fiscal year ending December 31, 2012. Grant Thornton’s
additional function is to review certain related filings with Securities and Exchange Commission and to conduct limited reviews of the financial statements included in our quarterly reports.
The following table sets forth the fees billed to us for the audit and other services provided by Grant Thornton LLP to us for the years ended December 31, 2012 and 2011:
(1)
Audit fees are for the audit of the Company’s consolidated financial statements and quarterly reviews of unaudited consolidated financial statements.
(2)
Audit-related fees are fees paid to our principal accountant for services rendered in connection with various registration statements, an offering memorandum, other attest services, and general technical accounting consultations.
(3)
Tax fees include fees associated with general tax consulting, research and development tax credits, and tax impacts of GO Financial, and tax implications incurred in conjunction with the rescinded sale of the Company in 2012.
Part IV
Item 15.
Item 15. Exhibits and Financial Statement Schedules
EXHIBIT INDEX
*
Filed herewith.
**
Furnished herewith.
†
Portions of this exhibit have been omitted and filed separately with the Securities and Exchange Commission in accordance with an order granting confidential treatment pursuant to the Securities Exchange Act of 1934, as amended.
††
Certain confidential information contained in this exhibit was omitted by means of redacting a portion of the text and replacing it with an asterisk. This exhibit has been filed separately with the Secretary of the SEC without the redaction pursuant to a Confidential Treatment Request under Rule 406 of the Securities Act.
+
Indicates a management contract or any compensatory plan, contract, or arrangement.
SIGNATURES
The Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Phoenix, State of Arizona, on March 28, 2013.
DRIVETIME AUTOMOTIVE GROUP, INC.
By:
/s/ RAYMOND C. FIDEL
Raymond C. Fidel
President, Chief Executive Officer and Director
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons in the capacities below on March 28, 2013.
Signature
Title
/s/ ERNEST C. GARCIA II
Chairman of the Board of Directors
Ernest C. Garcia II
/s/ RAYMOND C. FIDEL
President, Chief Executive Officer and Director
Raymond C. Fidel
(Principal Executive Officer)
/s/ MARK G. SAUDER
Chief Financial Officer and Executive Vice President
Mark G. Sauder
(Principal Financial and Principal Accounting Officer)
/s/ GREGG E. TRYHUS
Director
Gregg E. Tryhus
/s/ MARYANN N. KELLER
Director
Maryann N. Keller
/s/ DONALD J. SANDERS
Director
Donald J. Sanders
SIGNATURES
The Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Phoenix, State of Arizona, on March 28, 2013.
DT ACCEPTANCE CORPORATION
By:
/s/ RAYMOND C. FIDEL
Raymond C. Fidel
President, Chief Executive Officer and Director
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons in the capacities below on March 28, 2013.
Signature
Title
/s/ ERNEST C. GARCIA II
Chairman of the Board of Directors
Ernest C. Garcia II
/s/ RAYMOND C. FIDEL
President, Chief Executive Officer and Director
Raymond C. Fidel
(Principal Executive Officer)
/s/ MARK G. SAUDER
Chief Financial Officer and Executive Vice President
Mark G. Sauder
(Principal Financial and Principal Accounting Officer)
/s/ STEVEN P. JOHNSON
President and Director
Steven P. Johnson
/s/ GREGG E. TRYHUS
Director
Gregg E. Tryhus
/s/ MARYANN N. KELLER
Director
Maryann N. Keller
/s/ DONALD J. SANDERS
Director
Donald J. Sanders