Description

Summary: Credit Acceptance Corporation (NASDAQ:CACC) is a deep-subprime auto lender (Average FICO of ~550). We believe Credit Acceptance (“CAC”) is a high-quality, difficult-to-replicate business run by an A+ management team. We believe the market does not appreciate the advantages of CAC’s unique loan structure, and bears anchor to the valuation of peers who have substantially different, and in our opinion inferior, business models. Despite a defensive and low-risk business model that peers have been unable to replicate, significant growth prospects, loan yields near historical trough levels, and a history of excellent capital allocation and operating results, CAC has 33% short interest and trades at 9-10x 2017 estimated earnings. We project a 5+ year runway of mid-teens net income growth. However, the path of the current competitive cycle will dictate the path of said earnings growth.

Business Overview: CAC provides indirect auto loans to deep subprime consumers. CAC has a unique loan structure which aligns the incentives of dealers with CAC – called the “Portfolio Program”, CAC provides an advance to dealers to sell cars to customers, which is enough to guarantee the dealer makes a day-one cash profit. Once CAC has recouped its advance, dealers receive 80% of the remaining cash flows. If a loan goes well, dealers will profit significantly on the back end. In addition to the portfolio program, CAC’s purchase program offers certain dealers (largely franchise dealers + independents who have proven themselves through the portfolio program) a traditional loan structure where CAC purchases a loan and retains the full economics.

Key Pillars of the Thesis:

1.       Management: A key component to investing in any financial is trust and confidence in the management team, and the ingredients for trust are there for CAC. Further, our work uniformly suggests CAC has a compliance-conscious culture, which is vital when offering a financial product to deep subprime consumers.

2.       Counter-cyclical characteristics: CAC is largely counter-cyclical, and we expect CAC to thrive in a subprime credit downturn.

3.       Growth Runway: We believe CAC has plenty of room to grow before fully penetrating its TAM.

4.       Unique Loan Structure: CAC’s portfolio program structure, which accounts for the majority of issuances, is unique from both a financial perspective (the portfolio program nearly eliminates credit risk in aggregate) and a consumer/regulatory perspective (dealers are incentivized to put consumers in cars they can afford). Further, CAC’s advantage is defensible: competitors have tried and failed to replicate the portfolio program.

5.       Negative Sentiment: 6 of 10 sell-side analysts are sell-rated & short interest is 33% of float.

6.       Attractive Valuation

#1: Management

Operational: CAC management’s operational and capital allocation track records are excellent. In terms of operations, for a financial, we want to see demonstrated excellence in (a) risk management and (b) capital allocation. We measure CAC’s risk management by its track record at forecasting expected collection rates. From 1999-2016 CAC initially forecasted an average collection rate of 71.2% and ultimately realized an average rate of 71.9%, +0.7% higher. CAC’s worst performance at forecasting came in 2007, when realized came in 2.5% below CAC’s initial projection.  In addition, CAC’s capital allocation has added significant value over time. CAC has reduced shares outstanding from mid’99-YE’16 by 55%. The VWAP of CAC’s stock over that period was $66; the average price of repurchases was $43.

Incentive Alignment: CAC’s compensation scheme for CEO Brett Roberts is arguably the best we have encountered to date, and at the very least it’s the longest measurement period we have ever seen on a performance-based award. His compensation is primarily performance-based RSUs and share awards based on cumulative growth in economic profit (defined as adjusted net income – cost of capital) that don’t start vesting until 2022. Other key executives have similar, but less drastic, comp structures. The cyclical nature of the industry magnifies the importance of this long-term incentive structure. This is exactly what we would hope to see in a financial.

Compliance-Focused Culture: Our research suggests management has created a deeply-embedded risk-averse, regulatory-progressive culture  that starts from the top and flows down to field reps. CAC appears to be doing everything within its control to insulate the business from regulatory risk. CAC has increased its compliance spending significantly. As an example, when it comes to GPS devices (a controversial topic and the subject of a recently announced FTC CID), CAC a) reportedly spoke to all state AGs before moving forward with the program, b) only pulls customer data from the provider when the loan is delinquent, and c) has relatively very clear T&Cs.

#2: Counter-cyclical characteristics

Our impression is that the sell-side and most investors believe CAC, like CPSS or Santander, is a cyclical business currently at or near the peak of a cycle. In particular, they are concerned that a decline in used car prices could have a significantly negative impact on recovery values. In contrast, we believe (a) CAC’s direct exposure to the auto cycle, especially in terms of used auto prices, is limited, and (b) CAC is the “strong hand” within a fractured deep subprime lending market, and hence, they actually benefit from a weak market as competition pulls back and CAC’s  market share expands + loan pricing improves.

Point A: The sell-side is concerned about the impact of lower used car prices on CAC and competitors, as the consensus expectation is for used car prices to fall ~10%+ over the next 1-2 years as a significant number of vehicles come off-lease. While this likely has a significant impact on competitors, CAC should be largely insulated, because a) a very small portion of its collections comes from the sale of repossessed vehicles and b) any headwinds would be shared between CAC and dealers (due to the loan structure).

Point B: The deep subprime market is heavily fractured, and most loans are issued by small regional players. In general, our research has suggested that these players are far more aggressive and less disciplined than CAC, and in the event of a downturn (likely due to a combination of higher interest rates + lower recovery rates), we expect many to be forced to pull back from the market. Given CAC’s unique loan structure, discipline, cost of capital advantage, and conservative capitalization, CAC will likely be ready to fill in the holes left by the “weaker hands”. As weak hands recede, we’d expect (a) CAC to gain significant market share and (b) earn higher spreads on loans issued. See the GFC for a case study.

#3: Growth Runway

There are two ways to think about TAM – (A) # of active dealers, and (B) Market Share. We think that both measures support CAC having significant additional TAM to penetrate.

Number of Active Dealers: As of 2016, CAC had 10,536 active dealers (dealers who generate a loan in a given period). There are roughly ~60,000 auto dealers in the U.S., and the majority of these dealers do some used subprime business.

We believe the TAM for CAC’s portfolio program is likely the ~20K or so high-quality independent dealers (half of total independents) + a small number of lower-quality independent dealers (dirt lot  / very small independent dealers, some of which may have their own buy-here-pay-here financing) + a small number of the ~20K franchise dealers. In total, we estimate the portfolio program TAM at ~25-30K dealers. The incremental TAM (non-overlapping) for CAC’s purchase program likely covers ~5-10K franchise dealers. In total, this brings CAC’s potential TAM up to ~30-40K dealers out of 60K total. We think it is unlikely CAC will ever penetrate 100% of this figure…but our research suggests there is a long runway from current levels (from cycle to cycle). Santander and Americredit both reached over 20K active dealers.

Bears sum churned dealers and conclude CAC has worked through the TAM. This analysis a) 2-4x counts dealers who come in and out of the program over time (depending on the competitive environment) and b) assumes the 60K dealer TAM is static over time.

Market Share: In addition to dealer count, we look at CAC’s dollar issuance of loans as a percentage of total subprime dollar issuances. While the data here is relatively low quality, we calculate CAC’s market share of issuance dollars to be roughly 4% of total subprime (defined as <620 FICO). It’s unclear what percentage of issuance is a realistic TAM for CAC, but we believe it is more than ~4%. One sanity check is CAC’s penetration in its most established markets where share is estimated to be 6-7%+ and still growing.

#4: Unique Loan Structure

CAC’s core portfolio program accounts for the majority of total issuances. While its % of total loans has been decreasing lately, we think that is at least partially cyclical (see GFC). We like CAC’s portfolio program because it is superior to competitor’s models from (a) a financial risk perspective, (b) a regulatory perspective, and in addition (c) it is likely a defensible competitive advantage.

Financial Risk: With a portfolio loan CAC has the benefit of dealers being in a first-loss position and also benefits from cross-collateralization across a dealer’s loan book. It is hard for CAC to lose money via the portfolio program despite lending to deep subprime customers.

Consumer/Regulatory: With a traditional loan, a lender buys a loan that a dealer originates and the dealer has nothing to do with the loan from that second onwards. This creates a bad incentive structure – dealers want to originate the highest number of loans and all they care about is the lender’s approval. As long as they convince a lender to buy-in, they make their money and are done. With CAC’s portfolio program, dealers have a continued interest in the loan. CAC advances less money upfront than traditional lenders, and it is enough for a dealer to make a day-one cash profit, but not necessarily enough to make an attractive profit. The dealer then has the right to 80% of the cash flows after CAC recoups its initial advance, called dealer holdback. There are two benefits to this. The first is financial (dealers’ incentives are aligned with CAC’s which is good for CAC from a financial risk perspective). The second, and less understood, in our view is regulatory. As a regulator, we would be most concerned about dealers and lenders putting individuals in cars they cannot afford. In the deep subprime market high default rates are inevitable, but CAC’s structure aligns dealer incentives with consumer best interests, which isn’t the case for deep subprime borrower alternatives. 

The Portfolio Program is Defensible: There is no lender of size that has been able to successfully replicate CAC’s portfolio program. The largest example we can find is GO Financial, but GO pulled out of the auto loan market in May 2016.

A key reason competitors have failed to enter despite the attractive economics of the portfolio program is a lack of trust. The portfolio program requires dealers to choose to accept less money upfront in exchange for a promise of more money several years later if things go well. Dealers are unlikely to be willing to accept this arrangement if the lender is a new, unproven entity due to scars from fly-by-night dealers observed through previous cycles. CAC can point to thousands of dealers over decades who have successfully received holdback payments when it is pitching itself to a dealer.

#5: Negative Sentiment

The sell-side universally dislikes CAC and lumps it into a bucket of subprime lenders like CPSS and Santander Consumer, businesses we believe are very different and inferior to CAC. The high short interest indicates a substantial percentage of the buyside agrees.

We believe the sell-side and/or market misunderstands several key aspects of the business…

(1)    They do not fully understand unit economics, and thus underappreciate CAC’s insulation from market pain

(2)    They underestimate CAC’s pricing abilities and discipline

a.       Our research suggests that management is hoping & planning for tighter credit markets.

b.      Raymond James: “Fitch recently noted the majority of the negative movements in 2016 delinquencies were due to small irrational lenders who stretched credit terms and are now beginning to reap the consequences. We believe CAC is one of these lenders…CAC is one of the irrational lenders most at risk from incremental deterioration.”

c.       Our research uniformly painted a picture of disciplined management and superior pricing capabilities due to scale advantages and more sophisticated systems.

d.      We’re willing to make the leap of faith that CAC’s loan book will hold up better than peers (on top of the significant insulation provided by CAC’s unique loan structure).

(3)    They fail to fully appreciate the counter-cyclical nature of the business

a.       “Almost unanimously I’m hearing from lenders that we are at a point in the cycle where you manage your book, you don’t grow your book.” – Manheim Q2’16 Industry Update

b.      Sell-side analysts interpret the above sentence as negative for CAC, whereas we interpret it as a positive.

c.       Some sell-side analysts cite recent exits by small players and the general increase in financing costs as negatives for CAC, whereas we view these same data points as a positive.

We believe market share and loan economics are inversely correlated with credit availability in sub-prime.

#6: Attractive Valuation

CAC trades 9-10x our estimated 2017 EPS, and we believe EPS will compound at a healthy clip for years to come. Almost all power variables are pressured by the competitive cycle, which is likely to be closer to a trough than mid-cycle.

The dealer count should growth from cycle to cycle. Loans/dealer should cyclically rebound as competitive intensity declines. Loans IRRs – the most important variable – should move higher from current historical low levels as competition tightens. These compounding factors should drive healthy EPS growth for years to come. That said, we are not calling a turn in the cycle…it is very possible competitive intensity – and thus CAC results – get worse before they improve.  

We and our affiliates are long Credit Acceptance Corporation (CACC) and may buy additional shares or sell some or all of our securities, at any time. We have no obligation to inform anybody of any changes in our views of CACC. This is not a recommendation to buy or sell securities. Our research should not be taken for certainty. Please conduct your own research and reach your own conclusion.

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