|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|
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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:
CPSS requires automobile dealers to have a dealer agreement to be eligible to submit contracts for purchase. The contract must be secured by a first priority lien on the vehicle and meet the Company’s underwriting criteria. The contract also requires the purchaser to maintain physical damage insurance with CPSS as the named loss payee. The contracts have a maximum term of 72 months and are fully amortizing with level payments over the term.
CPSS offers seven different financing programs for these subprime car purchasers. Which program is offered depends on the Company’s proprietary scoring model and risk-adjusted pricing. The programs are shown below:
The most utilized program is “Alpha”. Approximately 42% of contracts purchased in 2013 and 2014 fell into this category. CPSS credit profile and yield on its customers has improved from the end of the last cycle. Today average FICO score and yield are 569 and 19.7% versus 533 and 18.9% in 2007. While there can be increased competition from quarter to quarter, the industry has solid standards when it comes to underwriting and pricing credit as evidenced by the performance of subprime auto loans pools during the “Great Recession”.
The Company finances the purchases of loans primarily through warehouse lines of credit and asset securitizations. CPSS has two separate $100 million warehouse lines with Fortress and Citibank which mature in April 2019 and August 2017, respectively. These lines are utilized to make interim purchases of auto loans until the Company has gathered enough loans to package them into a securitization. The Company and other industry participants typically issue these asset-backed securities quarterly through major investment banks. Historically, the Company’s pools have been rated by Moody’s and DBRS with the top three tranches receiving investment grades. The Company has replaced Moody’s with S&P and believes that it is likely that S&P will improve the top rating from AA- to AAA later this year. This is where its competitors securitizations are rated and would likely reduce funding costs by about 25 basis points on asset pools going forward. In the last deal, less than 10% of the pool was rated below investment grade.
CPSS uses subordinated renewable notes as part of its capital structure. The subordinated debt is issued through a broker dealer to individual investors on a continuous basis. These notes have no covenant structure and mature anywhere from 3 months to 10 years. They are callable at any time with no premium. The rate on these notes has been dropping over the last few years as CPSS’ balance sheet and cash flow have strengthened. I expect these notes will be paid off out of free cash flow over the next three years.
The final piece of CPSS’ capital structure is residual interest financing. This debt allows CPSS to borrow up 70% against its equity interest in the Company’s securitizations. CPSS provides equity to each securitization in the form of a 1% cash investment upfront and accelerated principal repayment until over-collateralization is 4%. Over time, this equity component of each securitization grows as the loan pool outperforms its’ costs. The cost of this residual interest facility is Libor plus 11.75% and I expect that it will be repaid in full over the next two years.
CPSS has now weathered two negative industry cycles to remain one of the few independent auto finance companies. It has achieved fourteen consecutive quarters of improving profitability and has built an infrastructure to handle growth to levels above its previous peak origination volume in 2007. Here are my major assumptions for the following projected income statements:
1. Loan origination volume to run around $1.2 billion per year for 2015 and 2016, which will increase the Company’s managed assets from $1.7 billion to about $2.5 billion over that time.
2. Rates on new securitizations will increase as the Federal Reserve raises interest rates starting in September 2015 by 25 basis points per quarter until December 2016. I assume that this rate hike negatively effects net interest margin.
3. A 25 basis point improvement in pricing as the Company receives an AAA rating on its senior tranche going forward starting in September 2015.
4. Employee staffing efficiency levels improve but remain below levels from 2011 and 2012. For the servicing staff this means running at 309 contracts per staffer versus peak levels of over 330. For Originations and marketing staff I project average contracts per staffer in the mid to upper 40’s versus a historical level of over 50 per employee.
5. Credit loss provisions will run 2% per quarter. This is in-line with current levels and conservative given the improving economy.
6. Residual interest financing and subordinated debt levels do not drop despite the generation of free cash flow that I estimate will be in excess of $8 million per quarter.
Projected Income Statement
Valuing CPSS based on traditional merger and acquisition multiples undervalues the Company as most historic deals have been done when the target company was in distress. I believe the most likely acquirer for the Company is a medium to large sized US bank. I ran a Bloomberg screen for US banks above $10 billion in assets to determine their return on assets (ROA) and equity (ROE) and their trading multiples in term of price earnings ratio (P/E) and price to book value (P/B). The table below shows CPSS as compared to the median values for the qualifying banks.
CPSS runs an asset light model to finance its purchase of subprime auto loans. A large bank would benefit from its ability to use deposits to fund its purchase of these assets. Subprime auto loans have a duration of less than three years. By funding the loans with deposits instead of securitizations and warehouse lines, a bank acquirer would be able to pick up in excess of 200 basis points of net interest margin on CPSS assets during that time. At a current asset level of $1.7 billion this would translate into an additional $35 million in pretax and $21 million in after tax income exclusive of any cost cutting synergies. By 2016 this additional earnings becomes $44 million pretax and $26 million after tax. CPSS trades at one third the P/E ratio of these banks despite having higher returns on equity and assets. CPSS is also growing its revenues at approximately 20% per year, which should be attractive to banks that are dealing with little loan growth and compressing net interest margin. I believe that one of these banks would be able to pay at least twice CPSS’ current price and still have a deal that would be very accretive on a P/E basis from the start.
I believe CPSS trades cheaply because of investors’ misconception about the riskiness of it business model. Having survived the “Great Recession” without any defaults of its securitizations CPSS has proven that subprime auto lending is viable consumer finance business. CPSS has also de-levered its own balance sheet and should benefit over the next two years from a reduction in corporate interest expense. CPSS has one competitor that trades publicly, Santander Consumer USA Holdings (SC), a public subsidiary of Santander Bank. SC trades at a 9.7 P/E ratio and 2.4 times book value. While SC and CPSS have similar models, SC benefits from having the ability to use deposits to help fund its loan purchases and therefore generates a higher ROA and ROE. This higher return level does not justify the 59% premium to P/E and 94% premium to book value multiples that SC trades at when compared to CPSS.
Valuing CPSS’ 2016 earnings per share (EPS) and using today’s SC P/E multiple yields a price target of $13.19 per share. Using the large banks’ P/E multiple of 17.15 with CPSS’ 2016 EPS yields a price target of $23.50 per share.
I believe that CPSS stock price will increase as investors recognize the strength of its business and industry. Large banks that are looking to grow their earnings should find CPSS to be an attractive asset to own. As one of the cheapest small capitalization stocks in the US markets on a P/E basis, value investors should own this stock in their portfolios.
1. Market recognized the discount that CPSS trades at relative to peers and banks.
2. Acquisition by a medium to large US Bank.
3. Continued EPS growth.
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