|Shares Out. (in M):||21||P/E||0||0|
|Market Cap (in $M):||3,918||P/FCF||0||0|
|Net Debt (in $M):||0||EBIT||0||0|
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Credit Acceptance Corp. (“CAC”) is an innovative US subprime automotive lender that targets consumers at the bottom of the credit spectrum and a very popular hedge fund short with 61% of CAC’s public float sold short at the moment. We believe the shorts are wrong for a variety of fundamental reasons explained herein. They are also placing a risky bet for technical reasons. Only 19% of CAC’s shares are held by non-insiders and the Company has purchased an average of 6% of its shares annually for the past decade. CAC’s capital structure/liquidity is stronger than ever, which will allow management to continue to buy in their float at a healthy clip while funding organic growth, which we expect to continue to accelerate as the cycle turns and weaker competitors pull back from the market. This dynamic will make CAC’s shares even scarcer and has the potential to trigger a short squeeze similar to the one experienced on November 24th, the magnitude of which short sellers may not fully appreciate.
In the traditional auto lending framework, a consumer purchases a car with a down payment and then receives financing offers from lenders that cover the balance of the retail price of the vehicle. These offers are mainly based on the consumer’s creditworthiness, and the value of the collateral. CAC targets consumers that struggle to qualify for financing in this traditional framework, but it does not do so simply by extending riskier loans. Rather than advancing an amount that covers the entire retail price of the vehicle, CAC only advances dealers an amount that allows them to cover their cost and earn a small up front profit. The dealer has the opportunity to earn additional back-ended profit through a sharing agreement with CAC, but only after CAC has received ~130% of its initial advance. A close relationship with auto dealers and deep understanding of the consumer segment is required to facilitate this lending model, which creates a meaningful barrier for entrants seeking to duplicate CAC’s approach.
Counterintuitively, this model allows CAC to make loans that have both higher returns and lower risk than its auto lending peers, despite the fact that it targets a weaker segment of the credit spectrum. This is because CAC advances a much lower amount to dealers (improving downside protection and reducing capital intensity) and recovers its principal on a first-out basis. After ~130% of its principal is recovered, CAC takes 20% of the cash flow as servicing fee in addition to being reimbursed for certain collection costs (equates to ~25%). Since 1992, the average spread between advance and collected payments is ~25% of loan value; this figure has never gotten close to zero, meaning CAC has never failed to recover its loan to the dealer. The dealer, meanwhile, benefits from increased sales volumes driven by access to a segment of the consumer population it otherwise would not be able to address. The benefits of this model can be seen in over a decade of data during which CAC has earned an average ROA of 10% and ROE of 30%, both roughly double the average of its peers. Importantly, CAC did not report a single year of losses in that period. These results have come alongside significant growth, with adjusted earnings rising at 15%+ CAGR over the last decade. We believe there continues to be a solid runway for growth, with CAC’s active dealers representing less than 15% of what we would consider the eligible US dealer base.
Ordinarily we would expect a business with CAC’s characteristics to trade at a substantial premium to the market, and yet CAC trades at only 13x LTM adjusted earnings. In our experience, it is unusual to find high-quality, high-ROE businesses with double-digit growth prospects trading at low double-digit multiples. In the current market, it is particularly surprising to find all of these characteristics in a stock. We value CAC between $318 (70% upside) and $363 (97% upside) per share. In both cases, the valuation is derived from our discounted cash flow model with a 10% discount rate and 2% terminal growth rate. Our valuation assumes 13% annual earnings growth over the next five years through the completion of the current auto credit cycle, and slowed growth of 10% CAGR for the five years thereafter. While we feel that CAC is better positioned from a liquidity standpoint today than ever before to expand through the cycle, we chose these modest growth rates to account for the law of large numbers and to provide buffer for potential macro risks. At the low end of our price target range, we assume CAC ceases to repurchase shares in the open market, despite their consistent buybacks over the last ten years (average 6% of shares outstanding each year). At the top end of the price target range, we assume that CAC uses 100% of excess cash (net of investments for growth) for share repurchases. This is roughly in line with historical capital allocation trends. We believe that our assumptions are conservative and see relatively limited downside to shares from current levels even in draconian scenarios.
We believe CAC’s cheap valuation is largely the result of (i) regulatory concerns and (ii) fears that the auto lending cycle is near its peak. Regulatory scrutiny of subprime lenders (particularly payday lenders) has recently reached a fever pitch with the Consumer Financial Protection Bureau (“CFPB”) and Department of Justice (“DOJ”) aggressively examining lending practices throughout the financing space. Within auto lending, regulatory actions so far have been mild, ranging from minor fines (less than 2% of revenue) to small changes to business practices. These changes will likely increase operating expenses, however we expect this to affect all players in the industry leading to a repricing of risk (i.e. passing on costs to consumers). Our work leads us to believe that CAC has very stringent collection guidelines against discriminatory practices targeted by the CFPB (fraudulent/ deceptive disclosures, abusive collections practices), and should not receive any outsized penalties. Separately, the CFPB has targeted lenders in other industries for broader policy changes (e.g., usury rates, product markups, lender discount rates, etc.) that has had material impact on the viability of the industry. These lenders (e.g,, student loan and payday) operate under fundamentally different business models and offer considerably less value to consumers. For this reason, we believe that broad policy changes to the subprime auto lending industry are unlikely, and any regulatory impact on CAC is likely to be immaterial to its long term operational health.
Equally we feel that the risks presented by the auto credit cycle are also misunderstood. While a turn in the cycle is unquestionably bad for many lenders, CAC’s business model has proven to be resilient. Its smaller advances and shorter payback periods mitigate the likelihood of credit losses on its existing loan portfolio. CAC’s forecasted collections have proven to be remarkably stable even during severe recessions. Furthermore, CAC’s capital-light business model allows it to gain market share from weaker competitors.
Simply put, we believe that a misunderstanding of the auto credit cycle and overstated regulatory concerns have created an opportunity to buy a 30+% ROE business with multiple years of double-digit growth prospects at only 13x LTM adjusted earnings.
CAC has a wide economic moat
Understanding CAC’s unique loan structure is key to appreciating the strength of its business model. Unlike a traditional loan where a lender advances the full principal balance up front, CAC advances just ~45% of a consumer’s loan value (principal and interest) or ~67% of the loan principal. The consumer’s down payment and the CAC advance generally covers the dealer’s cost of goods and allows them to earn a small up-front profit. As the consumer makes payments on its loan, CAC keeps all cash flows until ~130% of the loan to dealer is collected, and then it takes a stream of ~25% from the remaining cash flow as servicing fee. This dynamic is illustrated below and unit economics are included in the appendix.
At the time of the sale of vehicle:
During loan repayments / collections:
There are two important takeaways from this structure: (i) the small size of the initial advance provides an immense margin of safety, as CAC needs to collect less than half of all loan obligations in order to recover its advance and (ii) the payback period on the initial advance is very short (two to three years on average) since CAC receives all cash flows until its advance is fully repaid. The combination of these factors means CAC earns an annualized return of ~25% with significant downside protection due to their priority position in the waterfall.
If we consider a hypothetical $100 loan with a 20% down payment, a 4 year term and a 20% interest rate, the below table indicates the economics to both dealer and lender at various ultimate collection rates (expressed as a percentage of the loan balance):
In looking at the amounts collected by both the lender and the dealer, the strength of CAC’s partnership model becomes evident. CAC gives up modest upside for significant downside protection. This model improves business performance because it increases the stability of returns, and provides far greater downside protection. Downside protection has outsized benefit to upside optionality in this industry because losses could lead to liquidity constraints that further destabilize the business.
In looking at over 20 years of data, CAC has seen collection rates average 73%, significantly in excess of its average ~45% advance rate and its ~55% breakeven cost (the advance fully loaded with operating expenditures). Importantly, CAC weathered the greatest financial crisis of our generation without a single year of losses. Despite substantial deterioration in credit markets, CAC’s collection rates dipped only modestly, allowing it to not only endure the 2007-2008 correction, but to take market share and grow. Below are its collections and advance rates:
The strength of this model cannot be overstated. CAC advances less initially (capital-light), gets repaid more rapidly and has a higher margin of safety than its auto-lending peers. This explains CAC’s high and stable ROEs and lack of loss-making years.
The strengths of the business model raise two important questions: (i) what does the dealer get out of this relationship, and (ii) why are competitors unable to duplicate this model?
In answering the first question, it is important to understand that the type of consumer CAC targets would not typically qualify for a loan under a more traditional lending model (full upfront advance). CAC’s loan structure enables lending (and hence vehicle sales) to a segment of the consumer market that would otherwise be unavailable to a dealer. This is important as 70% of CAC’s dealer partners are independents that are seeking ways to compete effectively with larger, more established franchises. Sales to deep subprime customers can be a significant source of revenue, and a powerful differentiator against major franchises that do not specifically support the segment. CAC, which is known for guaranteed credit approval, is useful to these dealers. In addition, while a dealer might earn more up-front in the traditional auto lending framework (where it simply receives an origination fee and has no economic interest in the viability of the loan), it is possible for the dealer to earn a higher ultimate margin if collection rates are high. Since the consumer’s down payment and the CAC advance cover the dealer’s cost, their risk of economic loss is eliminated and all incremental margin represents upside to the dealer.
In answering the second question, it is important to understand that CAC’s business model is substantially different than traditional lenders’, and implementing this model often requires a meaningful change in the way business is done with significant upfront costs. This translates into different hurdles for competitors attempting to steal existing CAC dealers versus develop relationships with new deep subprime dealers. In order for a lender to target an existing CAC customer, they have to:
Collect many years of underwriting and collections data – CAC has been involved in the deep subprime segment of the auto lending market for decades. The Company has collected a significant amount of lending and collections data specific to this consumer segment that enhances both its underwriting and servicing efforts. In addition, CAC has also collected data on dealers that allow it to adjust its advance based on expected performance and eliminate dealers that are unprofitable from the network. The data collected increase accuracy of forecasts and improves the overall quality of loans, which represents a competitive advantage that cannot be easily duplicated by a new entrant.
Build a trusted and reliable brand – CAC began in 1972, after founder Don Foss built the largest independent dealership in Michigan and started offering financing to other dealers. Since then it has developed a reputation as the go-to lender for deep subprime loans. As a dealer has the ability to earn back-end economics, they are interested in partnering with lenders that have a stellar reputation and collections operation. While lenders can compete easily on the front end by undercutting advances, the back end requires trust that can only be built through a successful track record. This is particularly important for high volume and loan quality dealers that generate substantial cash flow through back end collections. They are CAC’s most valuable dealers and are least likely to switch to other profit sharing lenders based on short-term incentives.
Develop software and implement usage at each dealer – The key to deep subprime lending is pairing the consumer with the right vehicle. This requires the lender to be part of the origination process, helping the dealer set up the loan to be profitable based on the vehicle cost, down payment, advance and expected payments. CAC provides its dealer partners an integrated technology platform (“CAPS”) to originate new business and estimate profitability. This is unique as most competitors rely on a third party origination programs to access and purchase potential loans. CAPS is highly entrenched within CAC dealers and that many use it as their default platform for deep subprime consumers. An entrant would have to develop the software and more importantly convince dealers to implement a new system.
Develop a strong sales force and network – The profit sharing aspect of the CAC’s model requires the lender to maintain a close relationship with the dealer, with frequent touchpoints even after loan origination. In addition, most of CAC’s dealers are independents (~70%) whereas traditional lenders work more with established franchises. This means CAC customers are highly fragmented and have closer relationships with the lender. In order to appropriately service these customers, competitors need to build an extensive localized sales force and foster individual relationships.
In addition to the factors above, in order for a lender to target a potential new dealer, the lender needs to train the dealer on how to appropriately target and sell to the deep subprime customer segment. Often these dealers have not previously done meaningful amounts of business with very low credit quality consumers. In order for a new dealer to become a valuable long-term partner, the lender must aid the dealer in establishing a successful deep subprime business first. This involves:
Inventory Management – Deep subprime loans only work with certain types of cars. They need to have high markups (so that the dealer can recover cost of vehicle upon sales), be affordable for the consumers, and should last the entire length of the loan. This requires the dealer to commit to stocking a specific type of inventory, often highly targeted to this market segment. They are also incentivized to condition the vehicle prior to sales to ensure that the length of the loan does not outlast the vehicle’s lifespan.
Staff training in sales and financing – A dealer must commit to training their staff to separate customers of differing credit quality in order to optimize efficiency and improve sales success. For example, sales reps are trained to recognize deep subprime customers so they are brought into the financing office before browsing through the car lot. This allows the dealer to plug the customer into CAPS up front, narrowing down the inventory to only cars that work for CAC and the dealer, which avoids setting customer expectations for vehicles they cannot afford.
Marketing – Dealers must cater/alter their marketing strategy to ensure customers are aware of their new offering and positioning towards deep subprime borrowers.
It’s evident that a large part of the operational process of running a dealership needs to change in order to adapt to the needs of this specific customer segment and lending model. Because the time and capital commitment on behalf of the dealer is substantial, CAC is advantaged by its decades-long track record in the space, which gives dealers comfort that the investment is more likely to succeed. CAC’s role extends beyond that of a simple lender to that of a partner with a vested interest in the overall success of the dealership. This co-development helps strengthen the relationship between the dealer and lender making successful dealers unlikely to leave CAC’s platform. From a competitor’s perspective, this operational model differs significantly to that of a traditional lender, and requires a strong commitment across all areas of operation. Given the relatively small size of the market in comparison to the rest of auto lending, hurdles of this magnitude are likely sufficient to deter more established players. Small regional players typically suffer from severe capital constraints during market downturns in addition to the barriers described above, making survival through the cycles and expansion very challenging.
CAC’s strong execution compounds the benefits of its economic moat
In addition to the structural advantages established over the years, CAC has a strong, properly aligned management team that maintains a conservative underwriting philosophy and an accretive capital allocation strategy.
Conservative underwriting philosophy – CAC has demonstrated consistently disciplined underwriting since the early 2000s. As mentioned earlier, the Company has consistently maintained a spread between advances and collections of 20%+, even during market downturns. Beyond having a strong business model, achieving this record requires discipline around competitive pricing, and willingness to sacrifice short-term growth. During the last period of intensified competition from 2004 to 2008, the Company’s adjusted earnings grew at a modest 10% CAGR. However immediately when the market turned in 2009, the Company grew earnings by 28% CAGR for the next 5 years. This is because many peers during this period had severe losses from poor quality loans originated in peak-cycle years and a lack of credit access. CAC uses these opportunities to purchase higher quality loans at better prices and aggressively take share from those competitors.
Strong capital allocation – Over the last decade, the company has consistently repurchased shares, reducing diluted weighted average shares outstanding from 39 million in 2005 to 22 million in 2014. Adjusted EPS has grown in the same period at a ~25% CAGR from $1.74 to $12.21. In 2010, the Company began issuing long term senior notes for the first time to diversify and improve its capital position. The debt has been refinanced and extended in 2014 with an average interest rate of 6.125%. Given the low interest rate environment, this was likely a prudent decision and demonstrates the Company’s thoughtfulness around sources and uses of capital. CAC has also recently extended the maturities of their various credit facilities, which should allow it to capture profitable market share when competitors fail during the next downturn. From our discussions with management, we expect that they will continue to make disciplined capital allocation decisions including repurchasing additional shares when the stock is trading significantly below its intrinsic value.
Aligned management – CEO Brett Roberts received 310,000 RSUs and 190,000 restricted shares in 2012, approximately 410,000 of these shares/units vest from 2022 onwards. The options are based on economic profit growth, which measures how efficiently the Company utilizes total capital, both debt and equity, and is a function of the return on capital in excess of the cost of capital and the amount of capital invested in the business. This structure both in terms of metric and time frame is among the best (most shareholder friendly) that we have encountered and ensures that the leadership is highly aligned with shareholders.
As a result of the strong economic moat and execution, CAC has consistently generated strong returns and is positioned for double digit growth
While the power of the model described speaks for itself, we can see the strong returns CAC has generated in over a decade of data. Indeed, CAC earns ROAs and ROEs more than double the average of its auto lending peers:
The high returns generated by the business combined with the strong growth that we’ve seen over the past decade has allowed CAC to compound capital at a rapid rate. We expect this trend to continue in the next cycle.
CAC is a 50-cent dollar
CAC is a rare investment that exhibits all of these traits:
Strong economic moat
Aligned management team
Long runway for growth
CAC shares are presently trading for just 13x LTM adjusted earnings and are cheap on both an absolute and relative (to the market) basis. Our target price range is between $318 and $363, which provides 70% to 94% upside. The range uses the same economic assumptions and differs only in capital allocation (i.e. share repurchases). Our valuation is derived from a discounted cash flow analysis using a 10% discount rate. We assume conservatively that the average earnings CAGR from 2015 to 2019 is 13% (as compared to 17% over the last ten years), and a gradual decline over the next ten years before a terminal growth rate of 2% in 2027. The low end of our target assumes no share repurchases despite consistent buybacks over the last 10 years (6% each year). We feel that in this case, the growth and capital allocation assumptions are conservative given the Company’s track record and current trajectory. The goal is to provide us with sufficient downside protection in the case of any unprecedented changes to regulations, the competitive landscape or credit market conditions. It also provides downside protection in case the shares rally such that accretive share repurchases are no longer available to the Company.
Our upper-end price target is derived from the same DCF, assuming however that the Company continues to repurchase shares at a price consistent with the company’s current earnings multiple using 100% of surplus cash (net of capital for growth). This is consistent with CAC’s capital allocation strategy historically. In 2026, we expect CAC to have 12 million diluted shares outstanding, which is just 55% of the current share count. While we appreciate the unscientific nature of this valuation, we wanted to provide some parameters around the upside derived from prudent capital allocation, given management’s 10+ year track record.
What keeps us up at night
The following items are the biggest risks to the CAC investment.
Regulatory risk – Various regulatory bodies including the CFPB and the DOJ have announced that they are examining players within the auto lending space. The official process is likely to begin for CAC and has already been completed for some of its competitors. So far the investigation has been focused around discriminatory and predatory lending. Based on precedents, fines for peers such as Westlake, Ally, and DriveTime have all been minor relative to size of company, without significant long term implications on profitability or operations.
CAC’s portfolio has higher net losses, higher repossession rates and is secured by vehicles with higher markups than many competitors (with the notable exception of BHPH players such as DriveTime, which has been through the CFPB audit already and suffered minimal penalties). As a result, CAC might be singled out as an outlier based on any of these metrics. We feel however that they are simply offering a different product that other players are unable/unwilling to offer. CAC does not appear to exhibit predatory lending behaviors or promote discriminatory practices. The collections staff are monitored and regularly polled for ethics and compliance.
There is also uncertainty around the risk of broader policy changes (e.g., usury rates, dealer discount, vehicle markups, etc.) that could inhibit CAC’s operations. While there are no precedents within the auto lending space nor indicators of intended actions by the regulators, it is possible that regulators will introduce new policy that could severely limit the profitability of the industry. However we believe a policy overhaul is improbable due to the inherent disparity between auto lending and recently-regulated industries like student and payday lending. Payday lenders for example charge extremely high interest rates of 100%+ on loans and typically rely on loan rollovers for outsized profits. Auto lenders like CAC offer simple loans with <25% interest rate that do not refinance. In the case of the student loan industry, recently increased regulation was largely a result of the fact that the government directly subsidizes student loans with significant taxpayer dollars at risk. It is also important to note that any major policy change would prevent a sizeable group of consumers from accessing vehicles, and prohibiting them from leveraging this to reestablish credit (~50% of CAC’s customers pay back the loan in entirety without defaults and consequently improve their credit scores). Consequently, new policy materially affecting consumer access to credit would be highly radical and unpopular.
Loan length – Since 2009, the capital markets have gradually reopened for subprime auto asset-backed securitizations. Today, credit is once again easily accessible for both new and existing players, resulting in intensified competition amongst existing and new players. Loan quality as a result has deteriorated over time as lenders compete to maintain/grow share.
In order to grow, CAC has increased the average term of their loans from 38 months in 2009 to 50 months as reported in Q2 2015 (figure below). While they have a conservative process of piloting the extended loan length before fully extending that duration to consumers, there is a risk that the data collected is inaccurate and the lengthier loans will exhibit extraordinarily poor collections over time. The flip side of this argument is that they have historically always increased their loan term, from 20 months in 1993. So while payment recovery is inevitability slower and loan quality lower with longer term, it is possible that they have fully anticipated and accounted for these changes in their forecasting and underwriting process.
Liquidity & credit cycle – Access to capital is a critical element of growth in the industry, particularly in market downturns when competition is weak. Credit access during the downturn is determined both by the characteristics of the company as well as creditors appetite for products offered by subprime auto lenders. CAC has, since the last cycle, improved its position by diversifying its credit sources and strengthening its track record. Today, they have extended debt maturities, loosened covenants, and issued long term debt / bonds. A covenant analysis (table below) demonstrates that they have substantial headroom based on the current setup.
In the short term, the consensus view is that the credit market is reaching (if not already surpassing) 2007 levels for auto lending asset-based securities. This could have cause investors to exit the stock in anticipation of a sell-off due to market movements.
Loan performance (forecasted collections over time):
Also, though we don't really pay attention to short-term financial results, the Street's 2016 estimates are way too pessimistic.
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