|Shares Out. (in M):||26||P/E||6.07||4.80|
|Market Cap (in M):||172||P/FCF||N/A||N/A|
|Net Debt (in M):||50||EBIT||0||0|
Overview of the Company and auto finance industry
CPSS is a specialty finance company focused on lending to consumers with limited credit histories, past credit problems or lower credit ratings. It does so by purchasing and servicing these “sub-prime” retail automobile contracts originated primarily by franchised car dealers. CPSS has purchased over $11 billion of contracts from dealers and has acquired over $800 million in contracts through four acquisitions since its inception in 1991. Currently the Company is managing $1.7 billion in its portfolio.
Currently, there are $886 billion in auto loans outstanding of which 39% are below prime according to Experian Automotive. The automobile financing industry is the second largest consumer finance market in the United States. Approximately $140 billion in new subprime auto loans were originated in 2014 according to Equifax. There are significant barriers to entry due to the specialized credit and labor intensive nature of originating, servicing and collecting subprime auto loans. These complexities make having a database of historical subprime auto loan credit statistics essential to competing successfully in this space.
The subprime auto lending industry has consolidated over the past 15 years as smaller players have been absorbed by larger better financed companies. CPSS is one of three independent players left in this space. The largest independent subprime auto lender is Exeter Finance Corp which is controlled by the private equity firm Blackstone Group which acquired the business in August 2011. Westlake Financial is the other independent player and is slightly larger than CPSS. The main industry players are the large banks and the captive auto finance companies. Among banks, the participants are Wells Fargo, Capital One, Santander and JP Morgan Chase.
After funding the origination under a warehouse line, sub-prime auto loans are typically securitized by the finance companies and sold to institutional investors. During the “Great Recession” these loan pools did not default like other securitized receivables. The rationale for this was that lenders in this space had much more stringent underwriting standards than the banks did for home mortgages and borrowers needed their cars to get to work and could not afford to lose their automobile. With an asset that is easily transported, lenders typically require job and home verification and proof of income. This careful underwriting has enabled these securitizations to typically carry AAA or AA credit ratings for the senior tranches and are often investment grade through many other tranches.
Servicers, like CPSS, make a spread on the difference between the interest cost to the consumer and the cost of funds, servicing and default rates. Loans are gathered into pools by CPSS who then sells them quarterly to institutional buyers. CPSS provides credit enhancement to each pool in the form of a 1% cash deposit at origination and accelerated payment of principal on the note to reach overcollateralization of 4%. The pools usually have a maximum life of 72 months and typically have durations under 3 years. As the pool matures and pays down to below 15% of original face, CPSS typically will pay off the pool and roll part of the remaining loans into its next securitization. This allows CPSS to realize its equity participation without waiting for final maturity. Annual default rates on subprime auto loans run in the 7% to 8% range and can vary quarter to quarter based on seasonality. To offset this high rate of default, subprime auto lenders charge rates in the high teens or low twenties. The economic model for CPSS is as follows (source Company presentation April 2015):
This model works even better inside of a medium to large bank since the institution can use its low cost deposit base to fund these loans. A bank could potentially earn an additional 200 to 250 basis points in net interest margin over CPSS’ model as it replaces warehouse lines and securitizations with its deposits.
CPSS History and Operations
Consumer Portfolio Services was founded in 1991 by Charles Bradley and Jeffrey Fritz, the current CEO and CFO, in Orange County, California. CPSS grew through organic means until its first acquisition in 2002. The Company grew steadily until the “Great Recession” when demand for its securitizations dried up. This broad economic weakness and high levels of unemployment made many of the obligors under CPSS receivables unable or unwilling to pay and thus caused higher delinquencies, charge-offs and losses. Despite this, all of CPSS securitizations performed within their contractual terms and there were no defaults on these pools. The Company was able to secure a short-term credit line in 2009 which enabled it to survive the liquidity crunch caused by these conditions.
The securitization market for subprime auto loans reopened in 2011 and the Company began growing its managed assets. Over the last five years CPSS has grown its managed loans from $756 million at December 2010 to $1.726 billion at December 2015. Note that this level is still below peak assets of $2.2 billion at December 2007. Origination volume has rebounded from the low of $9 million in 2009 to $945 million in 2014. I am looking for origination volume of $1.163 billion in 2015 and $1.285 billion in 2016. This represents less than 1% market share of new subprime auto industry originations and at this rate, CPSS can grow its portfolio to about $3.9 billion over a three year time frame ($1.3 billion times a 3 year average life).
CPSS corporate headquarters and one its branch offices in Las Vegas, Nevada but its main operating headquarters is still in Irvine, California. It has other regional offices in Virginia, Florida and Illinois. Each regional office has origination, marketing and servicing staff. The Company has 884 employees spread out through these offices and carefully tracks the number of contracts per employee to help manage operating expense.
The marketing staff is responsible for maintaining relationships with new and used car dealerships. In densely populated areas this requires face to face contact to encourage dealers to utilize CPSS for their subprime auto loans. In more remote areas CPSS uses telephone representatives to maintain contact. These representatives actively call on their dealers after a loan application is sent simultaneously to multiple lenders to make sure CPSS gets its fair share or greater of the volume. Sometimes they will negotiate terms within Company standards on an individual loan to help secure the business.
The origination staff’s responsibility is to make sure that each loan has the proper underwriting standards and paperwork and that all job and residence information has been verified and is correct. Each loan is touched at least three times as the paperwork and its information is checked. While this is laborious, it is important that any errors are caught early as CPSS has the right to reject loans from car dealers that are deficient before they are purchased and securitized. Contracts purchased per member of the marketing and originations staff tends to be about 50 per quarter. In the past, when CPSS anticipated increased future volumes it hired extra employees and brought this ratio down to about 46 per employee for a quarter or two. However, as the Company’s staffing levels have deepened, I believe that incremental new hires will have less overall financial impact.
The servicing staff interacts with obligors after the loan has been purchased. This department’s activities consist of;
1 mailing monthly billing statements
2 collecting, accounting for and posting of all payments received
3 responding to customer inquiries
4 taking all necessary action to maintain the security interest granted in the financed vehicle
5 investigating delinquencies
6 communicating with the customer to obtain timely payments
7 repossessing and liquidating the collateral when necessary
In short, their job is to help delinquent and current obligors make payments. If a loan is delinquent the servicer must act within legal guidelines to collect arrearages. If the servicer determines that payment is not forthcoming the loan is turned over to the repossession department. Delinquencies and repossessions average around 7% of total managed portfolio. Contracts in force per servicing employee have trended down to about 279 at year end 2014 from a historical high of 330 in 2012. This was caused by the opening of its Las Vegas office as a new servicing center in April 2014. The first quarter of 2015 saw an improvement to 285 contracts per servicing employee and the Company expects to move back to a 300 to 320 contract level over the next few quarters as employee utilization improves.
Upon receipt of purchaser information from the dealer the Company uses a proprietary auto-decision system that makes instant credit decisions on over 99% of incoming applications based on two credit scores from the national reporting agencies along with job and income information. The Company has a database established over 24 years that allows it to back-test credit information. This is a critical component in making profitable credit decisions and a large barrier to entry for new entrants. In some cases a dealer may ask for better terms for the contract. In those situations a credit underwriter will look at the automobile contract and make modifications that still fall within CPSS’ credit underwriting standards.
CPSS purchases contracts from a multitude of dealers with no dealer being larger than 0.40% of its total. Its contracts are only purchased from the 48 contiguous United States. The largest states in which the Company underwrites contracts are Texas (10%), California (8.7%), Ohio (5.7%), New Jersey (5.1%), Florida (5.0%) and Pennsylvania (4.8%). The Company’s contract and buyer profile is shown below: