I think despite Credit Acceptance Corp’s incredible stock performance, it still looks interesting.
Credit Acceptance Corp (“CACC”) is “non-bank lender”, essentially meaning they make loans to borrowers who are deemed to be low credit quality. How low? As of the end of 2018, 96% of borrowers had FICO’s below 650.
The majority of CACC’s loans go to purchase automobiles. Without credit, these customers would not be able to buy a vehicle. Their incomes are typically strained and most likely they have damaged credit. Vehicles are necessary in most parts of the US to get to your job so there is a reason why there needs to be some sort of credit provider for these borrowers. In exchange, CACC charges high rates of interest (more on this later).
I think CACC will continue to compound earnings at a high rate – perhaps even better than recent history. Trading at 12.5x 2020 EPS and 2.6x book value is way too low. My thesis is not predicated on any catalyst, but more so on long-term capital appreciation.
- CACC has averaged ~35% ROE over the past 10 years. In 2008 & 2009, it earned 22% and 35% respectively.
- Median and average ROE since 2000 is 26% and 30% respectively
- Credit performance has been stronger than you think = buying a strong management team
- Performance has been hindered by strong credit and competition, but this is typical of a cycle. Credit is overextended and then pulls back – historically an opportunity for CACC
But you may be asking yourself, “Hey – doesn’t that mean CACC is making extremely risky loans?”
Not quite. As stated in this article from the FT,
“When economists created models of consumer behaviour late in the 20th century, they tended to assume that if a household was going to default on its debt, it would do so in a particular order: first credit cards, then car loans and, last, mortgages. That was the historical pattern, and it seemed to make sense given the cultural importance of housing. In the early years of the noughties, though, it seems that this sequence began to change. Consumers started to default on mortgages before auto loans and credit cards (seemingly because it became more acceptable to walk away from a house, but Americans still needed credit cards to live).”
So first and foremost, American’s have shown they are more likely to walk away from their home than they are to walk away from their car. It makes some sense if your car is the only way to work. If you don’t go to work, you don’t have any realy income.
Second, unlike unsecured consumer credit loans, CACC’s loans are actually backed by the automobile. This means if a borrower defaults, the car’s value helps the recovery value of the loan. CACC is listed as the lien holder on the vehicle’s title in ~70% of the loans outstanding.
Typically the way it works is that a dealer will receive a down payment on the car as well as a cash advance from CACC to finance the purchase. In exchange, CACC receives the right to service the loan. Servicing the loan means that CACC will be responsible for collections and the collections coming in will first go to pay down collection costs, pay servicing fee (~20% of collections), reduce the balance advanced, and lastly pay back the dealer once the advance has been recovered (which they call the Dealer Holdback). The “waterfall” of this is shown below:
This puts CACC near the top of the stack. After underwriting each loan, the company forecasts what its collection will be. Roughly 22% of the recovery comes from the spread (interest) and balance comes from paying down the advance. There will be defaults, but what this table essentially shows you is that (i) the company bakes in significant defaults and (ii) they’ve typically been right on target.
What is notable about this table is that the spread was at the high end of the rand in 2009 and 2010 when competition was unusually favorable to CACC (when the tide goes out, you can see who has been swimming naked).
Somewhat counter-intuitively, some of the best years CACC has are when the credit markets were very tight. Since credit has been loose, more entrants have emerged and made the field more competitive. Like I said above though, quoting Warren Buffet, the way new entrant lenders typically gain share is by offering credit at more aggressive terms than its peers. CACC has been operating since the 1980s, so I trust their track record and management team.
In my view, I think CACC’s earnings then are actually being depressed by competition and the company will be somewhat countercyclical – they should outperform in a recession. This also makes some sense given the labor market is extremely tight and we’ve started to see some wage growth and overall credit quality of borrowers has improved dramatically. These are all headwinds to CACC’s available pool of customers.
How have CACC’s returns been?
As shown, the company generates really solid returns on equity.
Let’s take a look at growth in book value assuming the average ROE since 2005 or the median ROE for the past 20 years (30%). Compounding is a beautiful thing.
However, this is a bit too simple to analyze the stock given the company trades for 3.4x the latest book value and 2.6x FY+1 book value.
Let’s say the company trades for 10x earnings by year 10. That foots to a $4,000 stock price or a 25% IRR for investors. Does 10x earnings makes sense? That foots to a 10% discount rate and assumes no growth in net income after year 10, which seems conservative. Another way to think about it is if the company decided to distribute 100% of net income to shareholders and stop growing. $400 a year foots to a 10% yield on a $4,000 stock price.
As shown above, ROEs for the company could compress by ~10 percentage points (20%) and the multiple could compress to 10x and we’d still have a pretty good return. At this point in the cycle, there is no question that competition has increased. CACC historically hasn’t always been the cheapest option, but it’ll be there through the cycle – something its competitors can’t say.
New Accounting Standards May Create Opportunity
Under a new impairment model called CECL (current expected credit loss), new standards will now require CACC to change its accounting. Essentially, it is based on expected losses, rather than incurred losses.Since CACC effectively takes the loan over from the dealer, an allowance must be recorded for the difference between the initial balance and the NPV of the future cash flows.
When CACC underwrites new loans in 2020, the timing that it recognizes income will change significantly – essentially recording provision for a loan loss up front at around 12-15% of the loan amount. So that will be a large, upfront expense that usually did not occur. The amount of loan income over the life of the loan and the actual economic value of the loans will not change, but 2020 may create confusion for investors and may cause CACC’s results to look worse than they have been in the past.
I would view this as an opportunity.