CACC Part 3: Why Credit Acceptance is brilliant

In my opinion, Credit Acceptance has excellent execution across all areas of its operations:

  1. Creating value for dealerships.
  2. Servicing loans efficiently and keeping costs low.
  3. Learning how to underwrite well across a wide range of situations.
  4. Being disciplined in underwriting.

Very few companies do all four of these things well.

Benefits for dealers

Dealers can outsource underwriting and servicing (mostly)

The design of Credit Acceptance’s program is such that the dealer can focus on selling cars rather than worrying about underwriting and servicing loans.  In practice, the dealer still has to put in a lot of work.  They have to understand Credit Acceptance’s stipulations (stips) and they have to understand how to structure profitable loans with Credit Acceptance.

One of the major changes that a dealer has to make is to ensure a suitable inventory of vehicles for subprime buyers.  The dealer has to buy cheap vehicles (in the $3000-$6000+ range) and sell them at very high markups.  The mileage on these vehicles cannot be too high.  The end goal is:

  1. High markups.
  2. A vehicle that the lender likes.
  3. Monthly payments that the buyer can afford.  The vehicles cannot be too expensive.

By structuring the deal in this manner, the dealer can generate an immediate cash profit on the sale of the vehicle due to the advance from Credit Acceptance.  On top of that, there is a future profit on the back-end as Credit Acceptance collects on the loan.  Credit Acceptance’s underwriting risk is reasonable because the dealer pays fixed fees to be on the program, the dealer has some skin in the game, and because shortfalls in collections come out of the dealer’s holdback on the loan pool.

Guaranteed credit approval

According to the website insider-car-buying-tips.com (here and here), Credit Acceptance is the easiest company to get a loan from.  They offer financing across a wide range of borrower situations and more or less offer guaranteed credit approval, a feat that other lenders simply do not match.

For BHPH dealers who use Credit Acceptance’s program, this is helpful because it allows them to take on customers that they might otherwise turn away because they don’t understand the underwriting risks for that customer.  For example, a BHPH dealer might automatically reject any buyer with more than one bankruptcy or repossession.  The second benefit to BHPH dealers is that they can advertise guaranteed credit approval (where legally permitted).

For dealers who do not finance their own customers, the guaranteed credit approval is also extremely helpful.  It allows them to make sales that they would otherwise be unable to make.  Secondly, dealers now know that they can finance any customer who walks onto the lot.  They do not have to engage in “yo-yo financing”.  Some dealers will allow spot delivery of a car before financing is in place.  The customer will drive home to tell friends and family about his/her new purchase and develop an emotional attachment to the car.  Meanwhile, the dealer is submitting loan applications to various funding sources and trying to arrange financing.  If the financing falls through, the dealer will have to call the buyer and take back the car.  This results in a failed sale and a customer that will likely never do business with the lot again.

Software

Credit Acceptance’s CAPS system helps dealer easily figure out deals that (A) the buyer can afford and (B) will generate profits for the dealership.  As an additional benefit, loan pre-approvals are nearly instantaneous (most lenders take hours to pre-approve a loan application).  The system also works during evenings and weekends when other lenders may be closed and do not process loans.

Training and support

In subprime, the buyer generally needs to pay an extremely high mark-up on the car so that the principal balance on the loan is very high.  The loan-to-value of the loan is intentionally inflated (this may be unintuitive because other lenders do not like high LTV).  To achieve this, the dealer can advertise inflated prices for its cars (this makes it slightly more difficult to sell to prime buyers).  Or, it can advertise reasonable prices and simply tell the customer that the price needs to be marked up for the car to be financed (this is probably illegal).  Or, it can have some cars without a displayed retail price.  The latter allows a dealership to target both prime and subprime buyers.  The difficulty with this tactic is that the salespeople have to actively pre-qualify customers to determine their creditworthiness.  It is not good if a subprime customer falls in love with a car only to discover that they need to pay much higher than retail or that they cannot buy the car.

At the end of the day, dealers that cater mainly to prime buyers need to spend the time to learn and develop efficient business processes to handle the deep subprime market.  Credit Acceptance tries its best to help them through their online CAPS university and marketing area managers (MAMs).  Credit Acceptance provides lists of the top 25 cars being financed with Credit Acceptance to help dealers get the right inventory.

A low-cost operator

Credit Acceptance has taken many steps to try to run more efficiently and to lower its costs:

  • Its call center uses a predictive dialer.  The dialer can call delinquent borrowers from different telephone numbers in case they try to avoid Credit Acceptance calls.  The system also (presumably) tracks good and bad times to contact a borrower.
  • Credit Acceptance’s IT systems allow collectors to store information about a borrower, to track collector performance, record collector’s calls for quality control, check if collectors are following their script, etc. etc.
  • It has experimented with offshore labour in Costa Rica and India.  I believe it has given up on this.
  • It has setup a reinsurance subsidiary.  This is an optimization of the service contracts and GAP insurance contracts that the company resells as an optional component on its loans.
  • It has automated its underwriting decisions with computer systems, allowing near-instant 24/7 pre-approval of loans.
  • A subsidiary handles the remarketing of possessed vehicles to be sold at auction.
  • It knows how to sue debtors to garnish their wages and go after their bank accounts.
  • With experience, Credit Acceptance has understood which dealers are likely to succeed and which are likely to fail on their program.  This allows them to focus their efforts on profitable, sustainable relationships.

Disadvantages of Credit Acceptance

  • The fixed fees require dealers to make a substantial commitment to Credit Acceptance, making it more difficult to attract new dealerships to sign on.
  • The fixed fees price Credit Acceptance out of dealerships that do not generate enough subprime buyers.
  • Credit Acceptance needs to hire a team of Market Area Managements to sign up new dealers and to help existing dealers succeed on the program.
  • Because Credit Acceptance insists on a high rate of return on its capital, it essentially has high prices.  Some dealers realize that they operate more profitably by using competing lenders or by extending credit themselves.
  • It does not have a compelling offering for customers who are somewhat risky but not deep subprime.

In practice, Credit Acceptance has a rather high attrition rate.  Every year, around a quarter of their dealers will stop originating new loans.

Credit Acceptance versus other lenders

Nicholas Financial (NICK)

As a stock, Nicholas Financial has performed very well.  Their impressive track record suggests that they are very good at what they do.

NICK takes hours to approve loan applications (according to its website) and rejects 85% of potential clients (according to this VIC writeup).  (Their rejection rate will likely vary over time as the company raises/lowers its standards.)  This is a very different style of underwriting than Credit Acceptance.  Whereas Credit Acceptance tries to accurately price everything to offer guaranteed credit approval, Nicholas Financial is selective.  NICK’s competitive advantage seems to be in finding talented human beings who can underwrite just as well or better than a computer model.  In my opinion, Credit Acceptance generates a lot more value for dealers than NICK.  Dealers want all to finance all of their customers and do not want to wait hours for preapproval.

NICK’s business works well when it can selectively pick off good loans.  In highly competitive environments it has seen its earnings shrink despite opening more branches.  While Nicholas has a good business model and has been well managed under Vosotas (who has now left the board and may very well be selling his shares), NICK seems to be at the mercy of the competitive environment.  It could be the case that Credit Acceptance is less affected by competition due to superior collections and the value that it adds to dealers.

NICK is a no-frills company.  It does not hire cleaning staff.  Employees have to clean their own offices.  According to comments at glassdoor.com, its computers are antiquated.  One employee commented that there is no Internet access or “modern technology”.  I am surprised that this ex-software company uses little technology to make their business run more efficiently.

Consumer Portfolio Solutions (CPSS)

They have had problems in the past with poor underwriting leading to significant losses.  Given CPS’ extremely high debt to equity ratio (currently 13, in the same ballpark as its historical range), it is likely that CPS has loose origination standards.  The issue with maintaining a very high debt-to-equity ratio is that the company will grow very quickly in favorable competitive environments.  (And if it isn’t growing quickly, then they are underwriting poorly.)  However, it is difficult to reinvest large sums of new capital while maintaining the same underwriting quality.  If the company continues to maintain high levels of leverage for extended periods of time, it is highly likely that the company is loosening its standards so that it can rapidly expand.

They seem to be sophisticated on the operations side (similar to Credit Acceptance).

Westlake Financial Services (private)

Westlake is very similar to Credit Acceptance and seems to be their most direct competitor.  Some dealerships will use both.  The dealer will first use Credit Acceptance’s CAPS software to structure a Credit Acceptance deal.  They do not use Westlake’s software because Credit Acceptance approves more borrowers than Westlake.  This suggests that Credit Acceptance has a deeper understanding of underwriting.  After figuring out a Credit Acceptance deal that is profitable for the dealership, the dealer will then shop around for the best financing (Westlake, BHPH, etc.).

Westlake does not have fixed fees and is therefore more attractive to very small dealerships.  However, Westlake has pooling/holdback agreements similar to Credit Acceptance.  I believe pooling protects Westlake somewhat against dealers stuffing them with bad loans and keeping good loans for themselves.

The company may have had underwriting issues that led it to suffer losses in 2009.  One article on the company states that the founder put in $90M of his own money into the company.  Around that time, the company started looking around for investors.  Judging from an investor presentation on the company website, it seems that the company targets a return on equity rather than return on assets.  This is perhaps not the smartest thing to do from a risk management standpoint.  Targeting return on equity encourages managers to hit the target by increasing leverage rather than operating performance.  Targeting a set return is also not a good idea in very competitive underwriting environments.  Disciplined underwriting requires a company to stop underwriting if the risk/reward is not there.

Comparing ROA to ROE, it seems that the company maintains a medium amount of leverage at around three or four times debt to equity.  This suggests to me that Credit Acceptance has superior underwriting discipline.  In any case, it is clear that Credit Acceptance is better managed than Westlake (which is probably the second best managed company in deep subprime).

Car-Mart (CRMT)

As mentioned in a previous post, Car-Mart has a very unique selling proposition in offering ultra-low downpayments of $99.  (I believe that this offer is targeted at subprime buyers above deep subprime.)  Because they finance their own deals, they can be more entrepreneurial and innovative in their underwriting.  The problem with specialty lenders is that they have to protect themselves against dealers giving them only their bad loans.  Many specialty lenders like Credit Acceptance will rate their dealers or only do business with good dealers.  They have to be extremely careful when offering new programs because it may be exploited in ways that they did not anticipate.  Because a BHPH dealer has more control over the loan origination, I think that they can be a little nimbler in spotting market opportunities.  Of course, running a BHPH operation is still extremely challenging as it is difficult to find managers who are good at running a car dealership and ensuring good underwriting.

The integration between running the dealership and financing customers can create some value.  A specialty finance company does not care about the value of a repeat customer while a BHPH dealer does.  A specialty finance company will be more likely to repossess quickly while a BHPH dealer will work on ensuring good relationships with customers.  If a BHPH dealer works with only one lender, the paperwork process is much simpler.  With Credit Acceptance, 75% of all loan applications are not funded right away due to problems with the application (according to this training website).

BHPH dealers and GPS-SID

When it comes to the use of GPS and SID devices, a BHPH dealer can extract greater value out of such devices.

Some BHPH dealers secretly install a GPS device into the customer’s car.  (The legality of this is unclear… but some BHPH dealers do it anyways.)  If the car needs to be located, it is unlikely that the buyer will remove the GPS device because they simply aren’t aware of it.

Regardless of whether or not a GPS device is disclosed, a BHPH dealer can offer free oil changes and “safety checks” to its customers.  After a loan is paid off, the BHPH can use the oil change as an excuse to remove the device.  Recycling these units allows the dealer to lower the costs of using these devices.

A SID (starter interrupt device) provides reminders to customers about unpaid amounts and will disable the car from starting if the borrower is delinquent.  A bad situation can happen if the car is disabled on a workday and the driver really needs to get to work.  The borrower will likely try to disable or remove the SID.  It can also be extremely frustrating for the borrower if the car is disabled when the borrower is far away from home.  This can lead to an angry borrower who will not become a repeat customer.  They may damage the car prior to repossession.  A SID works best when it is disclosed to the buyer and the buyer understands that they should proactively work with the lender to avoid their car from being disabled.  Knowing what was disclosed to the customer aids in collections efforts.

The cost-effectiveness of GPS-SID devices is unclear.  If the collections team is very good at skip tracing, then a GPS is not very economic given that very few delinquent borrowers turn into very difficult repossessions where the car cannot be located.  The benefit of SID is in reducing the cost of collections and hopefully reducing delinquencies (they do not really help in repossessions).  However, borrowers often try to disable or remove the SID system.

Credit Acceptance does not subsidize the cost of GPS-SID units on its loans.  It receives commissions every time a dealer purchases a GPS-SID device through Credit Acceptance (as disclosed in the 10-Ks).

The bottom line

It its niche, I think that Credit Acceptance is clearly better managed than its next closest competitor (Westlake).

Compared to other players in the subprime auto industry, Credit Acceptance has higher returns on capital and demonstrated growth during industry downturns (2007-2009 and 2011-present) while competitors saw their earnings shrink or go negative.  I think that it is the best managed company is a very competitive and cyclical industry.

*Disclosure:  Long CACC common shares.

Links

Auto Dealer People forum

800notes – This website has notes on phone numbers that originate a lot of calls.  Retail customers and an employee go back and forth about cars with GPS-SID that are being serviced by Credit Acceptance.

Car buying tips for Credit Acceptance – This excellent website (mentioned earlier) explains how to game Credit Acceptance’s CAPS system.  The website takes affiliate commissions from Funding Way, Auto Credit Express, etc.  There may be a minor bias due to the affiliate commissions.

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8 thoughts on “CACC Part 3: Why Credit Acceptance is brilliant

  1. CRMT earns similar returns with less leverage and grew right through the recession of 2008-2009 as well, no? Also repurchased shares aggressively (shrinking >20% over last 5 years).

    Why CACC over CRMT?

    Anon

    • Both CRMT and CACC have very good management. If you look at 2006-2009 or 2007-2009, CRMT’s earnings growth was roughly flat. Their earnings shrank YOY between 2013 and 2014.

      CACC scales a little better due to its technology and not having to find skilled managers to run each location. Both companies have difficulty finding good people. CACC grows a little faster. I think CACC is the higher quality business.

  2. I agree that CACC indeed is nice business, but I couldn’t shake the feeling that the business seems to be relying on peoples stupidity.

    Sure you could argue that people have the right to make bad decisions, but I’d feel a lot more comfortable knowing that the business provides lots of value for consumers.

    I have to admit though, that I couldn’t pass the opportunity if the potential returns were truly phenomenal 😉 – Everyone has a price, I guess.

    Anyways, thanks for the articles and the idea.

    • I suppose they’re a notch above investment banks, tobacco, alcohol (destroys some people’s lives), casinos, payday lenders, etc. etc.

      To some degree subprime auto loans do provide value to the consumer. The buyer gets a car that works, therefore saving a lot of time traveling. They pay a steep price for it though. The crazier the loan, the more they have to subsidize the deadbeats. And crazily enough, the lenders have gotten good enough that they can make some pretty crazy loans.

    • I think origination quality is high. The NY Times article talks about loan fraud, which is the exception rather than the rule. The lenders generally perform a high level of loan compliance and the subprime lenders have extensive stipulations (stips).

      The market will likely get more competitive and bring pricing down. At CACC, you can see volume per dealer come down. They happen to have grown volumes and earnings anyways. Going forward, it will be interesting to see if they can outrun the volume losses from the increasingly competitive environment by signing up more dealers.

      Regulations: These may not be as bad as they appear. Regulations will push BHPH dealers to outsource more and more of their loan servicing. Right now it doesn’t seem like there will much regulation coming.

  3. When I look at CACC, I see a company that:
    • had a flat stock price from 2002-09, with all of its appreciation occurring during the past 5 years
    • trades at 4x TBV
    • trades near its all-time high
    • has expanded its loan book during a period of rapidly declining auto-lending standards

    This looks like an okay business in a bad sector that’s seen its profits inflated by the auto-lending bubble, but even if it’s a wonderful business, you’re buying it at a peak valuation at the peak of the cycle. There have to be better investments out there.

    • Thanks for the comment!

      CACC expanded its loan book by signing up more dealers. Volumes per dealer has come down.

      I think that underwriting quality is fairly high in subprime auto lending. The loan compliance work performed is fairly substantial. Loan applications initially get rejected all the time. This is not like buying a house where an unemployed person could buy multiple houses based on stated income. The auto lenders will actually call the employer and the references.

      The market is past its peak though. Spreads (return on capital – cost of capital) are coming down. So far they’ve been able to outrun that via signing up more dealers, which shouldn’t have a big impact on their underwriting quality.

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