CACC - Credit Acceptance Corp

[wknecht]

CACC is an indirect subprime auto lender. I started a position recently, modest thus far. At ~4.5x book, it is definitely not the cheapest stock I’ve ever purchased. My rationale:

• Track record: Their track record is very strong. The last 5y/10y, they have compounded BVPS 23.5%/14.7%, adjusted EPS 31.5%/34.2%, and unit volumes 10.8%/12.7%.
  
• Management ethos: I am very impressed by management. They (a) strike me as very rational, focused, and disciplined; operate on margin of safety/value investing principles, (b) strong capital allocation; have also bought back a lot of stock (24%/42% of the stock the last 5y/10y), and © seem to be shareholder friendly; quite clear and transparent communication
  
• At 11.9x TTM NI (management’s “adjusted” earnings), the price seems reasonable, or at least not unreasonable. For context, historically CACC has sold for 13.5x-14x earnings on average the last decade; competitors currently trade in ranges of 9x (CPSS) to 15x (SC). My thinking is you're not paying a lot, if anything, for growth which they have delivered plenty of.
  

Some thoughts on risks:

[*]The main risk that CACC faces in my view is funding. They are highly dependent on the capital markets, which no question is not ideal. While I cannot dismiss this risk entirely, the 2008 credit crisis was a very good stress test of their business model, and they passed with flying colors. They grew adjusted earnings per share 30.5%, 52.1%, and 41.4% in 2008, 2009, and 2010 respectively. This is in spite of decreasing loan volume in 2009 due to capital constraints imposed by the crisis.

[*]Competitive environment:

• The competitive environment is characterized by (1) saturation - there are many competitors (NICK, SC, CPSS, commercial banks, savings banks, credit unions, WFC moving more into subprime space etc), and (2) reduced volumes due to trailing off of pent up demand during the crisis. This combination of forces is a concern. Are we at the top of the cycle with a slow motion crash ahead (rates decrease and losses rise slowly, but dramatically)? I'm not one to predict cycles, but I actually don't think this would be so bad for CACC because they strike me as very disciplined, and over time it would weed out weaker players and tighten supply. Anecdotal commentary I’ve read though indicates that (a) on the supply side, while loose historically, it is still tighter than 2006-2007, and (b) losses in subprime credits remain at historical lows. Overall, while a very legitimate concern, I take comfort in the fact that management has navigated these cycles successfully in the past by sticking to their principles and staying disciplined on price. I also take comfort in the ‘skin in the game’ portfolio program approach CACC takes (rather than outright purchases). This significantly reduces credit risk relative to the alternative, and gives dealers an additional revenue source.
  
• While SCUSA appears quite strong, on a lot of operating metrics (e.g., efficiency ratio, ROE), CACC seems very well positioned relative to its competitors.
  

[*]Collection forecasting accuracy is critical to their success. Competition threatens the accuracy of their forecasts by way of adverse selection. They include running backtests of their performance in their reports.

[*]Specialty finance companies do not sell for premium earnings multiples. I'm not sure if this is due to some stigma, or just the fact that they're balance sheet lenders (commodity). Other than companies in trough/unusual earnings situations, only a couple companies currently trade at earnings multiples in the high teens (e.g., FCFS at 17x).

[*]Don Foss (founder and chairman, age 69) is selling all of his shares. Mr. Foss owns roughly 4.4mm shares, and per disclosures in recent tender offers, he intends to sell 100% of these. I'm not exactly sure what to make of this, but I think it's doubtful that he is opportunistically selling based on his view that the price as currently high, and also doubtful that he thinks the company’s prospects long term are poor (after going for 41 years, through multiple cycles, and recent performance etc).

[*]Regulation - Dodd-Frank established the Consumer Finance Protection Bureau (CFPB). While the CFPB is a potential wildcard, at the moment it does not seem to be cause of much concern from CACC's perspective. To date their main focus seems to be fair lending practices (i.e., not discriminating based on race, religion etc). Something to keep a close eye on.

Here's a link to FAQs answered by management, it has a lot of good information: http://www.ir.creditacceptance.com/faq.cfm?faq=shareholder.

[writser]

Nice first post. I spent some time looking at CACC a while back. The share buybacks looked compelling and their track record is very good. Their disclosure to stockholders is exemplary, I really appreciated the stockholder letters. If I remember correctly, they still have a bit of room to grow even though per dealer revenue is declining. They did very good during the recession.

 

Nevertheless, I passed on it. A minor reason is that the founder is indeed selling out but the major reason was that it wasn't _extremely_ cheap and this business is too hard for me to understand thoroughly. Or phrased differently, to be sure I have an edge in valuing this company. I have no clue about the business cycles, their 'black box' credit score card model, future prospects, sustainability of margins etc. Combined with the fact that there is no margin of safety in the balance sheet I had to throw it on the 'too hard' pile.

 

Nevertheless I'm very interested in what more capable investors think of this company so I'll follow this topic closely :) . Also, I might consider some speculative operations (re-reading Security Analysis) around tender offers once in a while.

[writser]

Somebody just released the bear case: link.

[wknecht]

A few thoughts I had on the article are below. I have more, but am short on time.

• The author seems to be thinking quite short term. I have no clue what will happen as a result of the tender offer but I don't care at all about +/-10% until mid June.
  
• It's true, as he points out, that the advance rate is the highest it has been in the decade. But, what matters is the spread. The spreads (and yields) were lower in 2006 (23.4%), 2007 (21.4%), and 2008 (25.5%). This of course assumes their collection forecasts are accurate. In the past, their forecast has been conservative. Supposing they're not being conservative this time, in order for spreads to reach 2007 levels, their forecasts would need to be inaccurate by an absolute percentage that is greater than they have been off the last decade (on the downside of the projection).
  
• Mr. Foss has been selling for a long time, somewhat consistently. I haven't gone through all the tenders, but he was tendering large quantities of shares both in October 2006 and July 2010 (two totally different points of the cycle).
  
• The author showed a graph of P/B. If one had purchased at the peak on April 18, 2007 (5.5x bvps, which is higher than the 4.5x book today), and held through today, CACC would have returned 23.5% compounded annually versus the S&P of 5.7% (including dividends). I'm not saying this will repeat, but am merely pointing out that the valuation then was higher, when the metrics looked worse (e.g., spread), and things turned out just fine. Can we count on similar growth? Probably not, but I think steady unit volumes would produce reasonably good results as the loans are still yielding 27%.
  

[ItsAValueTrap]

I'm starting to dig into this company and I'm very impressed by what I see.  This company seems to be a wonderful company at a fair price.

- Compounded book value per share at a very high rate.  17.80%/yr over the past 10 years according to gurufocus.com.

- Management is non-promotional

- Management's communication with shareholders is excellent.

- Constant tender offers to repurchase shares.

 

The company seems to be a success due to the current CEO, Brett Rogers.  He became the CEO in 2002 and the stock has taken off since then.

 

I think that the CEO really understands lending discipline and isn't showing short-term profits at the expense of a possible future bankruptcy.  The company seems like it will be one of the least likely companies to blow up.

[ItsAValueTrap]

How do you guys feel about the interest rates that they charge?  These guys seem like uh... loan sharks.

 

http://www.ir.creditacceptance.com/common/download/download.cfm?companyid=CACC&fileid=141188&filekey=4E0B72D3-D052-4EA2-ACF4-8182D23E4CC1&filename=Investor%20Question%20-%20November%202%202007.pdf

1. What are current range of interest rates that you offer in the US, ie what rate

would a person get if they had horrible or no credit and what rate if they had

perfect credit?

 

Generally, consumers that get financed under our program have either bad credit or no

credit at all. For consumers with perfect credit, dealers would likely seek financing

through a lender or finance company that focuses on providing financing to low risk

consumers because it would generally result in better economics for both themselves and

the consumer purchasing the vehicle.

 

On our program the dealer-partner sets the interest rate on the retail installment contract

(referred to as “consumer loans”) and we maintain controls within our systems to ensure

consumers are not charged an interest rate that exceeds their states maximum allowable

interest rate. In states where there isn’t a maximum limitation, we have an internal

maximum interest rate allowable of 29.0%. The average interest rate for 2006

originations was 22.4%.

 

Because we retain 20% of every dollar collected as a servicing fee and remit the

remaining 80% to our dealer-partners, the amount we actually collect is far more

important than the underlying interest rate on the contract. In fact, one could think of the

20% servicing fee as the interest rate on the consumer loan from our perspective.

[peter1234]

Not as high as some pay day lenders....

;D

 

Apparently, they are lender of last resort.

 

When no one else provides a loan, they will and the person is able to buy a car.

If this car is your ticket to a job, looks like a trade-off worth taking.

;)

[writser]

Honestly, probably a nice chunk of their returns is made by ripping off poor and/or unsuspecting consumers. If you have moral qualms about that you shouldn't invest in it.

[wachtwoord]

Loan sharking is an attractive business to be in as long as you're skilled in collecting. If their main customer base consists of the lower part of society, how worried should I be about that?

[ItsAValueTrap]

Honestly, probably a nice chunk of their returns is made by ripping off poor and/or unsuspecting consumers. If you have moral qualms about that you shouldn't invest in it.

 

Hmm looking into it a bit more, I don't think it is a rip-off.  Subprime auto lending actually isn't that profitable for the car dealer.  Many car dealers stop doing subprime because they find it isn't worth the effort (or they aren't good at it).  This isn't like other areas of finance where retail consumers are charged well above cost (e.g. title insurance, currency conversion, etc.).

 

It is definitely a bad deal for the consumer.  Basically... subprime auto lending enables people to do financially irresponsible things with their money.  Is that really so bad though?  I think that these auto loans are fairly harmless compared to gambling, alcohol, toxic mortgage backed securities, etc.

 

In terms of deception... I don't think that there is much deception involved.  I think that these consumers know what they're getting into.  I don't know if the salespeople are sleazy and omit certain facts about how these loans work.  I don't know if CACC has structured the loans in a way that charges lots and lots of hidden fees and fine print.

[jouni1]

Loan sharking is an attractive business to be in as long as you're skilled in collecting. If their main customer base consists of the lower part of society, how worried should I be about that?

you so cold, ww.  :-*

[wachtwoord]

Loan sharking is an attractive business to be in as long as you're skilled in collecting. If their main customer base consists of the lower part of society, how worried should I be about that?

you so cold, ww.  :-*

 

I never considered loan sharking unethical because it's always a choice for people. Apparently taking this loan under these conditions is better than not taking it in their judgement. Also, do you think for a second another investor won't take your place if you opt out? :)

 

Strange I don't see similar concerns in the topics of all banks (with an emphasis on the largest ones), in the topics of credit card companies, in the topic of EBAY (Paypal!!!) or in the topic of WU (which I own). I think those are the most unethical companies around.

[jouni1]

i agree it's a choice. it's just that in some way i feel like people who don't know what interest rates mean should be somehow protected from things like this :D

 

there's a place for high interest financing but "the lower part of society is easy to collect from" just made me laugh  ;D

 

legislators up here made payday loans illegal, but somehow we ended up having 5000eur limit loans with 20+% interest rates for the unemployed. guess it's more an educational than a legal/moral problem.

[wachtwoord]

i agree it's a choice. it's just that in some way i feel like people who don't know what interest rates mean should be somehow protected from things like this :D

 

there's a place for high interest financing but "the lower part of society is easy to collect from" just made me laugh  ;D

 

legislators up here made payday loans illegal, but somehow we ended up having 5000eur limit loans with 20+% interest rates for the unemployed. guess it's more an educational than a legal/moral problem.

 

Actually I was asking how easy it is to collect. I mean, it's impossible to collect of the borrower doesn't have any money left ...

[jouni1]

oh :D i think most of the value is still left in the (used) car they bought. i'm not sure how easy it is to collect in the states though, maybe someone else can shed some more light on this. interesting company and valuation but not something i'm really interested in.

[wknecht]

Loan sharking is an attractive business to be in as long as you're skilled in collecting. If their main customer base consists of the lower part of society, how worried should I be about that?

I don't think it's worth worrying too much about from an investors point of view. Their forecasts have tracked actual collection rates well, and have been slightly conservative. This forecast versus actual comparison is an important metric to track. Efficiency ratios (which servicing expenses would fall into) are worth tracking also.

 

It's critical to the business though, and I would be surprised if management doesn't devote considerable time thinking about this. From the CEOs annual letter: "We understand the daily execution required to successfully service a portfolio of automobile loans to customers in our target market. There are many examples of companies in our industry that underestimated the effort involved and produced poor financial results. Approximately 50% of our team members work directly on some aspect of servicing our loan portfolio, and we are fortunate to have such a capable and engaged group." They also have a section in the AR describing their servicing process in a little more detail.

[ItsAValueTrap]

A vehicle is a good piece of collateral from the lender's perspective.  They can repossess a car without going to court.  They can also go onto the car owner's property to repossess the car.

http://www.consumer.ftc.gov/articles/0144-vehicle-repossession

[giofranchi]

http://glennchan.wordpress.com/2014/07/14/cacc-a-wonderful-business-buying-back-its-shares/

 

Very good write-up by ItsAValueTrap.

There are 3 things, tough, that I don’t understand:

1) Why is Mr. Don Foss selling? You suggest he is old… but actually he is 70… he might still have 20 years in front of him! And human life is getting longer and longer… I just don’t see he is selling because of age…

2) Valuation: you say it deserves an higher multiple, because it has enjoyed high growth. But you also say that in 2012 and 2013 CACC was able to grow modestly, and showed a drop in volume per dealer… So, how do you judge CACC’s prospects for future growth? Are they as bright as in the past? Or are they somehow deteriorating?

3) If you think future growth will be quite similar to past growth, why did Mr. Don Foss say CACC ran into trouble because there are no barriers to entry? Are there barriers to entry? If not, how can future growth be predicted?

 

Thank you,

 

Gio

 

[giofranchi]

Btw, why do I think I am able to predict future growth for the businesses I invest in?

Nowhere does history indulge in repetitions so often or so uniformly as in Wall Street. The game does not change and neither does human nature.

Edwin Lefevre, Reminiscences of a Stock Operator

 

The businesses I invest in generate safe and steady free cash that is used by their owner/manager to buy new assets, either outright or through the stock market. It is by their ability to use free cash intelligently that I predict future growth… because neither the game nor human nature change.

Instead, I almost never count on growth coming from operating earnings… That would be too difficult for me to predict… And it is exactly the difficulty I find right now in trying to value CACC.

 

Gio

 

[ItsAValueTrap]

1) Why is Mr. Don Foss selling? You suggest he is old… but actually he is 70… he might still have 20 years in front of him! And human life is getting longer and longer… I just don’t see he is selling because of age…

I don't think that he knows when he will die. 

 

If you're 70... it makes sense to sell your stock so that you can enjoy your money.  Some people hoard their wealth (e.g. Buffett), but not everybody is a hoarder.

 

Of course... it's possible that Foss is selling for valuation reasons.  So then you would have to think about why (A) Brett Roberts is effectively borrowing money to buy back shares and (B) why he isn't trying to inflate GAAP earnings in the short run by using shorter-term debt without call features.

 

2) Valuation: you say it deserves an higher multiple, because it has enjoyed high growth. But you also say that in 2012 and 2013 CACC was able to grow modestly, and showed a drop in volume per dealer… So, how do you judge CACC’s prospects for future growth? Are they as bright as in the past? Or are they somehow deteriorating?

If you look at the quarterly results, the company continues to grow even in this difficult competitive environment.  (A credit crisis is potentially very good for CACC because its earnings can grow dramatically coming out of a credit crisis.  The current environment is the opposite of that.)

 

As of the latest quarter:

Average volume per active Dealer: -1.5%

Active Dealers: +16.1%

Consumer loan volume: +14.3%

 

3) If you think future growth will be quite similar to past growth, why did Mr. Don Foss say CACC ran into trouble because there are no barriers to entry? Are there barriers to entry?

The barriers to entry are few.  The Youtube video explains it.  Because there were few barriers to entry, there was intense competition that caused the industry to be unprofitable.

 

If not, how can future growth be predicted?

Future growth is always difficult to predict.

 

Comparing CACC's offering to its competitors, I think that CACC has a very compelling offering that should drive growth.  However, I could be wrong about CACC's future.

 

CACC's valuation is highly dependent on what it will earn in the future.  There is a very large premium to book value... you are paying for the franchise (if it exists or not).

[wknecht]

Don Foss has been selling consistently through time, at very different points in the credit cycle and at very different prices (and from memory I believe before the CFPB existed). That just smells like long term planning of some kind rather than opportunistic selling based on price or fundamental concerns. Recall, as one datapoint, that Buffett has started disposing of his BRK (he got rid of a lot more today in fact). Granted, Buffett has been clearer on his intentions.

 

Although I don't look much into it, Foss did withdraw his offer to sell shares in the latest tender. His intention though appears to sell over time.

[giofranchi]

I don't think that he knows when he will die. 

 

If you're 70... it makes sense to sell your stock so that you can enjoy your money.  Some people hoard their wealth (e.g. Buffett), but not everybody is a hoarder.

 

Of course... it's possible that Foss is selling for valuation reasons.  So then you would have to think about why (A) Brett Roberts is effectively borrowing money to buy back shares and (B) why he isn't trying to inflate GAAP earnings in the short run by using shorter-term debt without call features.

 

Yeah! Sure… We all could be dead by tomorrow morning… Anyway, we just do not plan our lives that way!

Enjoy his money?! Well, I surely don’t know his “tastes”… But I guess “normal” people (with at least some resemble of “inner score card” balance…) might come to enjoy $40 - $60 million (depending of the size and length of the yacht they want to buy…)… Certainly, you don’t “enjoy” hundreds of millions!

 

I had understood Mr. Roberts is borrowing to get ready to expand if and when another credit crunch might come our way… Instead, is he really borrowing to buy back shares??

 

Thank you, ItsAValueTrap, because CACC is a very interesting company. Now I will read Mr. Roberts’ letters to shareholders very carefully. :)

 

Gio

 

[wknecht]

Interesting article in the times:

http://dealbook.nytimes.com/2014/07/19/in-a-subprime-bubble-for-used-cars-unfit-borrowers-pay-sky-high-rates/?_php=true&_type=blogs&ref=business&_r=0

 

CACC's "skin in the game" program and discipline alleviate a lot of the dealer fraud and underwriting deterioration concerns discussed in this article.

 

It wasn't directly mentioned in this article, but it got me searching for S&P's report: US Subprime Auto Lending Market Harkens Back to 1990s. Has anyone seen a copy of this floating around on the internet? I haven't been able to locate it.

[wknecht]

I found the report actually. It's Moody's not S&P, and it's attached.

Structured_Thinking.pdf

[HJ]

Yeah, it's useful to get a perspective of the market then.  I was involved in structuring some of the earlier subprime auto ABS's.  So here's my take for what it's worth, not that dissimilar to Moodys':

 

The entire subprime market (mortgages, credit cards and auto loan) developed in conjunction with the private label securitization market, which got started on the heel of the S&L crisis.  You have these non-bank lenders who are able to directly access capital market, and compete with banks, who historically have the reputation of being very conservative, not extending any credits to subprime.  The new players aggressively expanded the lending market, in credit card space, you had Capital One, First USA, in subprime mortgages you had guys like Aames, Delta Financial (Countrywide back then played a bit safer in the Alt-A sand lot, which was a rung above the subprime), and in Autos you had players like Olympic Financial (subsequently bankrupt) and Western Financial (bought by Wachovia, which is today, the core of Wells' auto lending platform).  With accounting rules permitting "gain on sale", all these specialty finance companies are able to show healthy accounting gains, but constantly in need of plugging the capital hole for expansion.  In many ways the underlying lending market was much more competitive, where the mantra was all about showing growth, which you can then take to the equity or high yield market to get more capital.  Through the magic of gain on sale accounting, you are able to book an accounting gain the minute you do a securitization.  The subprime market was always shady, because that's the nature of the borrowers you are dealing with.  And the shadiest of characters are always the middle man, the mortgage brokers and auto dealers, whose only incentive is to push a loan through.  Late 90's / early 2000's, bond markets had notable interruptions caused by the Asian crisis and then the telecom bubble.  Most of these players either folded or got absorbed onto stronger balance sheets, Capital One went on to buy banks to stabilize funding.  We all know the story of mortgages since then.  The subprime auto ABS market have been much more "sane" since then, and the most recent crisis only cleansed the market further.  GMAC and all the captive financing companies were never really subprime.  But since the crisis, there have been more of these non deposit funded players entering, notably Santander and Exeter.  To get good valuation on IPO, they probably all pushed origination volume pretty hard.  The overall market structure today is probably the most competitive since the late 90's.  But with all these loans now consolidated, and no more gain on sale magic, I'd still argue that it is saner today than back then.  CACC was actually around back then, and if you examine their loss rates, etc. origination today is probably still of higher quality.