CACC Part 1: A wonderful business buying back its shares

Credit Acceptance Corporation is a $2.7B company that finances and services subprime auto loans.  Brett A. Roberts has generated an impressive track record since becoming CEO in January 2002.  The share price, book value per share, and earnings per share (not shown) have grown at impressive rates.

CACC-stock-history-02

CACC-10yr-summary

The share count has dropped from 43.3M (diluted) at YE2002 to 24.0M at YE2013.  The company continues to repurchase shares through open market repurchases and tender offers, sometimes issuing debt to repurchase shares.

I’m very impressed by the way the CEO communicates with shareholders.  The company website contains the CEO’s letters to shareholders and answers to shareholder questions.  The shareholder letters explains the risks in the business, explains the CEO’s thinking on risk and underwriting quality, explains distortions caused by GAAP accounting, and helps investors to understand the business.  It is obvious that Brett Roberts is influenced by Warren Buffett in his writings.

What the company does

Credit Acceptance works with automobile dealers to provide subprime auto loans to consumers.  Many consumers with bad credit, little credit history, etc. are turned away by most car dealers because the dealer cannot obtain financing.  Credit Acceptance finances auto loans to these customers who would otherwise be unable to purchase a car or would be forced to purchase an unreliable car.

Because Credit Acceptance specializes in the riskiest buyers and because it demands a margin of safety on its loans, it charges extremely high interest rates.  The average interest rate for 2006 originations was 22.4% (source).  Even at these extreme interest rates, not all auto dealers find it worthwhile to offer financing to all potential buyers.

Oddly enough, some car buyers are actually grateful that Credit Acceptance exists and appreciate the chance at car ownership that has been given to them.  To these buyers, the benefits of car ownership outweigh the cost of ridiculously high interest rates.

How dealerships make money

Generally speaking, dealerships try to profit from selling products and services to consumers at high mark-ups.  One of the reasons why interest rates are high on Credit Acceptance loans is because the salesperson may try to mark up the interest rate charged to the consumer.  If the finance and insurance salesperson believes that the customer is ignorant of the financing options available to them, he/she may try to mark up the financing.  Credit Acceptance and the dealership split the proceeds.  The salesperson may also deceive the consumer into thinking that financing depends on the purchase of high-markup add-ons such as an extended warranty, GAP insurance, etc.

I suspect that Credit Acceptance has put a lot of thought into such sales tactics and how their partners (the car dealers) make money.  Credit Acceptance offers vehicle service contracts and GAP insurance on its loans.  Credit Acceptance pays dealerships a commission for selling these add-ons.

How Credit Acceptance creates value for dealers

By offering financing to subprime buyers, Credit Acceptance allows dealers to make sales that they would otherwise be unable to make.  However, the CEO’s shareholder letters do state that many dealers leave the program due to the work involved:

We have developed a much more complete program for helping dealers serve this segment of the market. Over the years, many dealers have been overwhelmed by the work required to be successful in our program. Many dealers have quit, telling us the additional profits generated from our program were not worth the effort. We have continually worked to provide solutions for the many obstacles that our dealers encounter. It is impossible to quantify the impact of these initiatives on our loan volume because of the changing external environment. However, anecdotal evidence suggests our efforts have been worthwhile. We believe that continuing to make our program easier for dealers will likely produce additional benefits in the future.
(Source: 2013 shareholder letter.)

Credit Acceptance allows dealers to share in the profit from the financing of a vehicle.

Finally, Credit Acceptance allows dealers to advertise “guaranteed credit approval”, where allowed by law.  To some degree, guaranteed credit approval is misleading.  If the downpayment is high enough, a lender could offer a loan to any potential buyer.  However, such a loan will often be unrealistic if the buyer does not have enough money for the downpayment.  Credit approval can also be obtained by charging a very high interest rate.  However, the higher interest rate may make monthly payments unaffordable and price the potential buyer out of buying a car.  Nonetheless, this sales gimmick may help dealerships attract subprime buyers that have been turned away repeatedly by other dealerships.  This is a unique selling proposition for Credit Acceptance and its partners as most lenders simply do not offer guaranteed credit approval.

How Credit Acceptance creates value

I believe that the main area in which Credit Acceptance creates value is by being very good at debt collection.  The 2013 shareholder letter states:

We understand the daily execution required to successfully service a portfolio of automobile loans to customers in our target market. There are many examples of companies in our industry that underestimated the effort involved and produced poor financial results. Approximately 50% of our team members work directly on some aspect of servicing our loan portfolio, and we are fortunate to have such a capable and engaged group.

Car buyers report that they immediately receive multiple phone calls a day when they are late on a payment by a single day (see this webpage with consumer reviews of Credit Acceptance).  The collectors have scripts that they are supposed to follow.  I believe one technique is to try to convince delinquent payers to borrow money from their friends to stay current on their loans.  The 10-K states that the company has IT systems in place to aid in collections:

Collectors rely on two systems; the Collection System (“CS”) and the Loan Servicing System (“LSS”).  The CS interfaces with a predictive dialer and records all activity on a Consumer Loan, including details of past phone conversations with the consumer, collection letters sent, promises to pay, broken promises, repossession orders and collection attorney activity.

The 10-Ks (YE2013, YE2012, YE2011) also suggests that the company outsourced some functions to Costa Rica and India, though this practice seems to have stopped in 2013.  The YE2013 10-K states:

We used a company in India to support the DSC in reviewing Consumer Loan documentation for legal compliance until February 2013.

[…]

We outsourced a portion of our collection function to a company in India until February 2013.

Historically, Credit Acceptance has demonstrated impressive returns on invested capital throughout entire economic cycles (except in the mid 90s when the company’s founder, Don Foss, was still the CEO).

Risk management and industry cycles

The shareholder letters contain extensive discussion about the cyclical nature of the subprime lending market and risk management.  When credit is tight, there is less competition and the profitability on new individual loans goes up due to lower competition.  However, lenders may not be able to obtain enough credit to grow as much as they would like.  When credit is loose, the opposite happens.

Large jumps in unemployment may negatively affect loan performance.  However, Credit Acceptance did not experience this much in 2008 and 2009.  Profits (per loan) dramatically increased during 2008-2010.

Credit Acceptance is currently in a tough competitive environment.  It has been (effectively) dropping its prices to avoid bigger losses in volume per dealer.  Management is well aware that lower pricing on its part decreases the margin of safety on its originations and increases risk.  It has tried to mitigate this risk by lowering pricing modestly and focusing on driving growth through signing up new dealers rather than price decreases.  In 2012, Credit Acceptance greatly increased its sales force to execute on this new strategy.  Because of this, Credit Acceptance was able to grow modestly from 2012 to 2013 despite a drop in volume per dealer.

Debt strategy

During 2008 and 2009, many of Credit Acceptance’s competitors left the market and/or greatly reduced the amount of loans they were willing to originate.  Because of this, Credit Acceptance was able to originate new loans at very high levels of profitability.  However, it was not able to deploy as much capital as it would have liked.  Because Credit Acceptance depended on short-term borrowings, it was not able to obtain more debt on favorable terms.

The company is currently better prepared for a 2008/2009 scenario.  (Though this may be a case of “fighting the last battle”.)  It has issued $300 million of 6.125% senior notes due 2021, seven years from now.  If credit markets were to freeze up, this $300M in capital will still be available unlike shorter-term debt that will mature and may not be renewed.  By paying slightly higher interest in the short term, Credit Acceptance will still have access to that capital if credit markets were to freeze up in the future.  (Note that this debt can still get the company into trouble if losses on loans are much higher than originally anticipated.  The conservative route is to opt for less debt.)

The second notable feature about the 6.125% senior notes is that there is an early redemption option (see this 8-K filing for a summary of the terms).  If interest rates were to drop in the future, the company could redeem the notes to replace its debt at better terms.  It has already done this by redeeming its 2017 senior notes with the issuance of its 2021 notes.  The company could also redeem its debt early if it does not see good opportunities to invest capital.

If Brett Roberts wanted to inflate GAAP earnings, he could have taken on debt without the early redemption feature as such debt would carry a lower interest rate.  He could also have used short-term debt instead of a mix of both short and long-term debt.  I am pleased to see that he is not trying to inflate earnings.

Is Credit Acceptance’s debt dangerous?

I don’t know.  I think that the level of debt is reasonable but I could be wrong.

In terms of the debt-to-equity ratio, it is possible to compare CACC to similar publicly-traded peers.

  • NICK:  0.9
  • RM:  1.86
  • CACC:  2.18
  • Rifco (CVE:RFC):  10.55
  • CPSS:  12.87

CACC seems quite reasonable if compared to CPSS or Rifco.

CACC performed exceptionally well in 2008 and 2009, growing GAAP earnings dramatically in both years.  Arguably, this makes CACC less risky as its earnings improved dramatically during a recession and tight credit markets.  However, this may not necessarily happen in a future recession.

The shareholder letters contain a lot of information on how the CEO maintains underwriting quality and thinks about risk management.  I highly recommend that you read them.

Insider trading, share repurchases

The shareholder letters state the CEO’s policy when it comes to returning capital to shareholders:

We have used excess capital to repurchase shares when prices are at or below our estimate of intrinsic value (which is the discounted value of future cash flows).

CACC often trades at a large premium to book value.  It currently trades at a price-to-book ratio of around 3.97.  If Credit Acceptance were to slowly liquidate, it seems that CACC would be trading at a large premium to the “discounted value of future cash flows” rather than a discount.  It seems that Brett Roberts is attributing significant value to Credit Acceptance’s franchise.  He sees value in the people, existing dealer relationships (it takes time for them to figure out how to make money on subprime buyers), the company’s CAPS software, business processes, skill in collections, etc.

So far, share repurchases have been extremely beneficial for shareholders given the dramatic increase in share price over the past decade.

Insider selling

Don Foss, the company’s founder and largest shareholder, has been selling a significant portion of his shares.  In April 2013, he sold 1.5M shares for proceeds of $100.275/share.  The current share price is around $121.

I would not read too much into this insider selling.  Don Foss may have personal reasons for selling, especially given his age (70).  He cannot take his money with him to his grave.

Valuation

On an unleveraged basis, Credit Acceptance generates fairly high returns on capital.  The 2013 shareholder letter contains a table showing the company’s adjusted return on capital:

CACC-adjusted-return-on-capital

Since 2004, adjusted return on capital has ranged between 11.2% to 18.7%.  This is a wonderful business.  Most (though not all) of Credit Acceptance’s earnings can be reinvested at similar rates of return.  The compounding effect of such returns being reinvested is very powerful.

On top of this, the business can be safely leveraged with non-recourse debt.  As of YE2013, Credit Acceptance used $938.9M in non-recourse secured financing (Term ABS or warehouse facilities; estimated fair value).  It used $473.7M from different forms of recourse debt ($3.8M mortgage note, $102.8M line of credit, and $367.1M in senior notes; estimated fair value).  The company had a book value of $750.1M.  The amount of “unsafe” recourse debt is rather low relative to the company’s book value.

So here’s a quick and dirty attempt at valuing CACC.  Assume:

  • Equity of $715M.  (Book value as of the latest quarter.)
  • Return on capital (after tax) over an entire economic cycle is 14%/year.
  • The cost of debt (after tax) is 5%.
  • The debt-to-equity ratio is 1:1.  Assume that the debt is completely safe and the company should not be penalized for using such a level of debt.

The company will generate $164M/year.  If the market cap is $2,730M, then the adjusted P/E ratio would be 16.6.

One could also make the argument that it would be more accurate to use the company’s P/E- 11.9.  In either scenario, it seems that this company is cheap given its extremely high growth.  Quickly growing companies such as CACC deserve much higher multiples.

*Disclosure:  No position at the moment.  I will likely buy shares in the future.

Links

Part 2: The fundamentals of subprime auto financing

Youngmoney post on why Credit Acceptance is a bad investment –  It is always good to invert and to think about why something may be a bad idea.

Consumer Affairs reviews of Credit Acceptance – Generally speaking, companies involved in debt collection receive an unusually negative response from consumers.  The people who had a positive or neutral experience with a debt collector tend not to go out of their way to write positive reviews.  I was surprised to see some consumers actually defend Credit Acceptance.

FICO forums / Anyone have experience with Credit Acceptance auto loans? – A forum thread that shows what the customers are thinking about the company.

 The Don Foss story – I’m not sure who paid for this video but Don Foss explains his history and provides some insight into Credit Acceptance.  He notes that while there are “barriers to profit”, Credit Acceptance ran into trouble because there are no barriers to entry.  He also talks about the importance of collections.

Find dealers that offer financing from Credit Acceptance –  Google’s “search by image” feature will find websites that use an image that appears on Credit Acceptance’s website.

Confessions of an auto finance manager – This article on edmunds.com provides the ‘inside scoop’ from somebody who has worked as an auto finance manager.  (The manager does not handle subprime loans.)

Buying a new car when you have bad credit – Edmunds.com article.

The CEO’s letters to shareholders

Answers to shareholder questions

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6 thoughts on “CACC Part 1: A wonderful business buying back its shares

  1. If you were to force rank this business against, say CRMT, how would they stack up?

    I am probably still a quarter behind on CRMT’s results, but my understanding is that ultra-low rates are attracting a lot of competition in the non-prime auto loan market (via securitization).

    If memory serves right, CRMT goes even further down the credit spectrum into lending to customers who’s credit is below the minimum required for securitization / warehouse facilities. Arguably a specialization in that portion of the market insulated them some of the competition for low credit auto buying / loans. But my tentative inference here is that such ‘protection’ wouldn’t apply to CACC…

    • 1- CACC uses securitizations and warehouse facilities. I don’t think that the securitizations have a minimum FICO score. Here is an interesting document regarding one of their securitizations:
      http://www.dbrs.com/research/261880/credit-acceptance-auto-loan-trust-2013-2-pre-sale-report-series-2013-2.pdf

      2- I suspect that CRMT doesn’t deal with the riskiest loans. Their website does not talk about low credit scores, bankruptcy, etc.

      3- Car-Mart might be poorly positioned in the current financing environment. They could adapt and change their business around by taking advantage of loose lending by subprime lenders like CPSS. However, they don’t seem to have the flexibility to do that.

      I think that going forward, their business model might be shaky. They have to be good at running a car dealership AND making subprime loans. Speciality lenders such as CACC are much more efficient at collecting on loans. I think that the vertical integration is not the best model.

      4- CRMT’s 10-K (I haven’t read the whole thing) talks about securitization because the securitization market dried up leading up to 08/09. People were getting burned on other securitizations backed by crappy mortgages and liar loans.

      5- CACC is the higher quality business based on unleveraged returns on capital. CRMT is still a pretty good business.

  2. Thanks for the response. It is reasonable.

    I do assure you, though, that CRMT is very far down on the credit spectrum. The company has an average loan term of 2.5 years (with most loans at that amount +/- 6 months) and yearly Charge-offs net of collateral recovered, as a percent of average Finance Receivables, in the range of 20% to 30%– year in and year out. One interpretation is that, at least for the lower end of CRMT’s business, it loses money on each loan originated, but the markup on wholesale cost of the vehicle sold is so high, that CRMT makes money on the overall bundled transaction of selling a car. (While not quite right, we can think of this as almost the inverse of the pricing model of the razors and razor blades– in part to accommodate state usury laws.) Under this interpretation, the loans cannot be securitized even theoretically unless sold at a huge discount. This may explain why CRMT states a fair value for its Finance receivables of around 80% of Carrying Value and 62 – 63% of Gross Book Value.

    There is no doubt more to it, and it has been some time since I’ve looked at CRMT in detail, but food for thought.

    The business of specializing in lending to any specific class of risky debtors can be an interesting proposition. But it makes me very nervous when that loan product becomes ‘hot’.

  3. Thank you for the analysis! I own a small position in CACC, hoping to add more below the $120 mark. The shareholder letters are fantastic to read, though they read about the same every year except for different numbers.

    Although the barriers to entry are non-existent, I believe management is the competitive advantage in this industry, similar to insurance. The capital allocation is amazing given the compound in book value, revenue, earnings and decreasing share count.

    But who knows, it’s a tough industry to be in. Only time will tell.

    Cheers,
    Henry

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