Description

1. SUMMARY OF THESIS:

Credit Acceptance Corporation (CACC) is a subprime auto lender that is currently trading on an adjusted net earnings yield of 12%.[1] The market appears to assume that CACC's earnings will fall off a cliff because: (1) inflation, and economic hardship more generally, will cause more subprime borrowers to default on their auto loans; and (2) the recent increase in interest rates, and tighter capital market conditions more generally, will increase CACC's cost of capital and therefore decrease its profitability.

            In contrast, I believe that (1) and (2) are, if anything, likely to benefit CACC because general economic hardship and tighter capital market conditions on net tend to favor CACC by increasing its addressable market (because more people become subprime borrowers in times of widespread economic hardship) and by reducing competition (relative to its competitors, CACC has better/cheaper access to capital, which has historically resulted in an improved competitive position in times of capital market tightening).

            In line with these expectations, CACC has already seen a 25%+ year-over-year increase in dollar and unit volume in the third and fourth quarters of 2022, and during the Great Financial Crisis (GFC) of 2007-2008 (which, while different in many ways, was similar in that it was also a large exogenous shock that increased general economic hardship and led to significant capital market tightening) CACC more than doubled its adjusted net income per share from $1.75 in 2006 to $3.95 in 2009.

            The stock is trading so cheaply that even if one assumes no growth in adjusted net earnings per share over the next 5 years; that management buys back the same number of shares as it has done over the past decade (i.e., a CAGR of -5.92%); and a return to the 10-year average in terms of CACC's price-to-adj net earnings ratio (i.e., p/e = 11.34), one can expect a CAGR of 12.33% over the next five years. In contrast to no growth, I would not be surprised if earnings per share will grow well above 15% in the next five years (CAGR over the past ten years has been 24.2%, with 0 years of no growth, and this was in a relatively unfavorable competitive environment).

2. DESCRIPTION OF BUSINESS

CACC has partnered with 11,901 car dealerships in the United States to provide auto loans to subprime borrowers (84.8% of borrowers have FICO scores below 650, or no FICO score at all). 69.8% of CACC's 2022 revenue came from its "portfolio program," in which CACC pays the dealer only a portion of the vehicle loan up front and the remainder of the loan while the loan is being repaid. This aligns incentives by providing a disincentive for the dealer to sell the customer a lemon and/or a vehicle that the customer can ultimately not afford. The remainder of CACC's 2022 revenue came from its "purchase program," in which CACC pays the entire loan amount to the dealer up front. For dealers to qualify for the purchase program, they must have made at least 50 loans under the portfolio program and their customers' loan performance under the portfolio program must be good. Dealers tend to join CACC's programs because it increases their revenue by enabling them to sell cars to clients who would not otherwise be able to get financing. Borrowers typically come to CACC because other lenders refuse to lend them money due to their low credit score/history. In exchange for the auto loan CACC reserves the right to repossess the vehicle if the borrower defaults (which happens between 25% and 33% of the time) and charges a relatively high interest rate (22% on average). In many instances, CACC's loans enable customers to build or rebuild their credit score, allowing them to eventually refinance the vehicle with a conventional auto lender at a significantly lower interest rate.

            On the surface, this appears to be a commodity-like business without a moat; after all, why could not anyone with access to capital enter the subprime auto loan industry and eat away any excess profits?  Several qualitative and quantitative pieces of evidence lead me to believe that this is quite far from the truth.

            Starting with the numbers, CACC's adjusted net income per share has increased with a CAGR of 24.3% since 2007, with 0 years of no growth. Since 2007, CACC's return on equity has averaged 33.0% (minimum: 19.2% (2020); maximum: 43.3% (2021); median: 32.0% (2022)). It has achieved these results with an average debt-to-fcf ratio of 3.4 (current debt-to-fcf = 3.7), which I consider to be relatively modest leverage in comparison to many other lending institutions and in light of the fact that all of CACC's loans are secured by collateral (see section 6 below for further discussion on CACC's debt).

            I believe that two strong, sustainable, and mutually reinforcing competitive advantages lie behind these numbers: exceptional capital allocation discipline and an exceptional ability to predict loan default rates.[2] Running a consistently profitable subprime auto loan business is very challenging because the risk of loan defaults is extremely high, default rates are difficult to predict, and the potential to charge relatively high interest rates tends to attract a fair number of periodic cowboys who chase loan volumes, but who ultimately tend to underprice contract risks and eventually go bankrupt (e.g., in the 1990s basically all national subprime auto lenders, except for CACC, went bankrupt; and as recently as 2017, 2018, and 2023 Summit Financial Corporation, National Autolenders, and American Car Center either filed for bankruptcy or simply liquidated their subprime auto loan business due to escalating losses).

            Due to the fact that CACC has been in business since 1972, it possesses an extremely large and detailed amount of data on default rates and its determinants. It combines this data with a team of several hundred well-trained engineers and data scientists who have developed a proprietary statistical model that has historically predicted default rates on CACC's portfolio of subprime auto loans with an average margin of error of only 1% (see page 15 of the March 2023 Form 8-K for a table showing forecasting errors per year going back to 2003). This data and model enables CACC to have a very accurate estimate of the risk associated with each loan it issues (based on default rates on past consumer loans with similar characteristics).

            CACC combines the ability to accurately estimate risk with extreme patience and disciplined capital allocation. Very much in the spirit of value investing, CACC only issues loans that can be priced with a substantial margin of safety in relation to the estimated risk (e.g., it regularly occurs that CACC decides to issue significantly less loans than it could have done because it cannot get a price that sufficiently compensates for the estimated risk—it does not chase volumes if the price is simply not right). This ensures that even if CACC significantly underestimates the risk inherent in its loans, the company still remains profitable (e.g., in 2015 CACC experienced its worst miss in terms of forecasting loan performance in the past 10 years—with 2.5% more loan non-performance than predicted—but it still managed to increase adjusted net income per share from $34.70 to $38.26 in 2020-2021, when the majority of these loans came due).

            While I believe that CACC's competitive advantage derives primarily from its capital allocation discipline and exceptional ability to predict loan default rates, its competitive position is further strengthened by its reputation with dealers and capital markets. Westlake—one of CACC's competitors—has now copied CACC's model in which dealers are paid only a portion of the loan upfront, to better align dealer incentives and reduce lender risk. Dealers, however, prefer to work with CACC because they have confidence that CACC will still be in business in six years, when the auto loan will hopefully be completely paid off and they will receive their final payment. CACC's cost/access to capital is meanwhile significantly lower/better than those of its competitors, as banks and the ABS/bond market rightly view CACC as more creditworthy than its competitors. This point was well illustrated during the GFC of '07-'08 when at times CACC was the only subprime auto lender that had access to the ABS market.

3. HOW THE CURRENT MACRO ENVIRONMENT IS LIKELY TO AFFECT CACC

Current economic conditions are marked by high inflation and rising interest rates. The market appears to assume that this will have a significant negative impact on CACC's future earnings, presumably because high inflation and rising interest rates may cause an increase in loan defaults and/or a rise in CACC's cost of capital.

            However, based on the above theoretical discussion of CACC's moat, it is reasonable to hypothesize that inflation and higher interest rates will have little or no long-term impact on CACC's earnings, and may even be beneficial. This is because inflation is likely to cause more people to fall into economic hardship and become subprime borrowers (increasing CACC's addressable market) and a tighter capital market may drive out competitors that are less conservatively financed and have less easy access to reasonably priced capital (the competitive environment is in the end the most significant determinant of CACC's long-term profitability).

            I believe it is ultimately an empirical question which of these two scenarios will predominate. To get some purchase on this empirical question the best we can presumably do is look at a historical episode that most closely resembles todays circumstances and see how CACC did then. I believe that the most instructive period to look at in this regard is the GFC of 2007-2008. While evidently different in many significant ways, the GFC was similar to current conditions in that it was also a major negative shock to disposable incomes of subprime customers and access to capital for subprime auto lenders.

            In line with my hypothesis that general economic hardship and tighter capital market conditions tends to favor CACC (or at least that CACC's earnings do not tend to plummet in such circumstances) CACC reported the following results from 2006 to 2010:

• Total revenue: $211M (2006); $238M (2007); $310M (2008); $379M (2009); and $441M (2010).
• Revenue per share: $6.2 (2006); $7.7 (2007); $10.0 (2008); $12.0 (2009); and $14.7 (2010).
• Adjusted net income: $61.7M (2006); $61.7M (2007); $82.8M (2008); $125.0M (2009); and $160.5M (2010).
• Adjusted net income per share: $1.75 (2006); $1.98 (2007); $2.66 (2008); $3.95 (2009); and $5.35 (2010).

In line with the idea that widespread economic hardship and tightening capital market conditions favors CACC through expansions of its addressable market and improvements in the competitive environment, both the total number of loans and the profitability per loan increased significantly during the 2006 to 2010 time period:

• Unit volume of loans: 91,344 (2006); 106,693 (2007); 121,282 (2008); 111,029 (2009); and 136,813 (2010).
• Gross profit margin: 69.5% (2006); 61.3% (2007); 63.8% (2008); 73.8% (2009); and 75.2% (2010).
• Net profit margin: 27.8% (2006); 23.1% (2007); 21.7% (2008); 38.6% (2009); and 38.6% (2010).

One could of course argue that studying CACC's performance during the GFC is not very informative because the GFC likely benefitted CACC more than the current macro environment is likely to do (e.g., because the economic hardship was arguably significantly greater during the GFC than today, and because the credit market basically entirely dried up, which presumably drove out more competitors than the rise in interest rates is doing today). This may well be true. If this is the case, however, I would expect CACC to perform roughly in line with how it has been performing in recent years, which is also substantially better than what the market is currently pricing in (see section 5 below).

            CACC's most recent results further support my prediction that CACC's earnings will increase consistently or, at the very least, will not plummet in the coming years. More specifically, CACC's unit and dollar volumes grew by 29.3% and 32.1% respectively in Q3 of 2022 (as compared to Q3 of 2021) and then grew again by 25.6% and 26.2% in Q4 2022 (as compared to Q4 of 2021). In addition, during Q3 and Q4 of 2022, both the spread and the average volume per dealer, which have historically been good indicators of an improving competitive environment, increased quarter-over-quarter.

4. MANAGEMENT

The average tenure of the seven executives in charge at CACC is 17 years (which means that the current management team has seen some though times, including the GFC and Covid-19). CACC's CEO, Kenneth S. Booth, is 55 years old and has been with the company since January 2004. All executives, with the exception of Chief Treasury Officer Douglas W. Busk (age: 62), are more than a decade away from retirement, and all executives own multiples of their annual compensation in company stock. I thus regard the management as experienced and well incentivized, and have no reason to believe that they will do anything else than what they been doing so well in the past.

5. VALUATION

In 2022, CACC's total adjusted net income was $720.1M. The total number of common shares outstanding is 12.8M as of April 18, 2023. As of April 18, 2023, the price per share is $484.04. This gives us a price-to-adjusted net earnings (p/e) ratio of 8.6.

            Given that CACC does not distribute a dividend and is unlikely to begin doing so in the coming years, one can derive a rough estimate of CACC's upcoming 5-year compound annual growth rate (CAGR) by projecting the growth in earnings and shares outstanding, and by combining this with an educated guess about CACC's p/e ratio in five years from now.

            BAD CASE: in the bad case scenario, I assume that CACC's adjusted net income will decline with an average CAGR of 5% over the next five years, that CACC's shares outstanding will remain constant over the next five years, and that CACC will trade on a p/e ratio of 9.8 in 5 years from now (which is basically the lowest it has got over any extended period of time over the past 10 years). This provides us with a CAGR of -2.51% over the next 5 years. Thus, even with fairly conservative assumptions the bad-case scenario still loses only a modest amount of money.

            BASE CASE: in the base case, I assume that CACC's earnings will grow with an average CAGR of 15% over the next 5 years (i.e., approximately 5% lower than in the past 10 years, which was generally a competitive environment for CACC), that CACC's management will continue to buy back shares at the same rate as it has done in the past 10 years (CAGR = -5.92%), and that CACC trades on a p/e ratio of 11.34 in 5 years from now (which is CACC's average p/e over the past 10 years, and which I still regard as low given CACC's business quality). This results in a 5-year CAGR of 29.2%.

            GOOD CASE: in the good case, I assume that CACC's earnings grow with 20% per year over the coming 5 years (Yahoo Finance, for what it is worth, expects CACC's EPS to grow with a 5-year CAGR of 22.08%), CACC's shares outstanding decline with a CAGR of 10% (financed with the greater earnings assumed above), and CACC trades on a p/e of 12.5 in 5 years from now (which is still below what CACC's p/e was in 2015, 2018, and 2019). This gives us a CAGR of 43.7% over the next five years. While a net adjusted income CAGR of 20% may appear unreasonably high, it is important to note that while CACC has rapidly increased its market share over the past two decades, it still holds only about 10.6% of the total subprime auto loan industry's revenue—it therefore still has a significant runway for growth if it executes well. 

            Taken together I believe that the stock can currently be bought with a significant margin of safety, and that it has a relatively muted downside combined with significant potential upside.

6. RISKS

I think there are at least four important risks that one needs to consider before investing in CACC.

            FALLING CAR PRICES: Since the height of the Covid-19 pandemic, both the prices of used and new automobiles have decreased significantly. This can have a negative impact on CACC's earnings because, in the event of loan default, CACC tends to repossess the vehicle and sell it at auction (where, due to declining car prices, CACC may receive a price lower than the outstanding loan balance). I believe the influence of this will be modest because: (1) the interest rate that CACC typically charges (i.e., 22% on average) is in many cases most probably still high enough to offset the impact of falling car prices since loan origination; (2) even in bad years two-thirds of cars do not end up being repossessed; and (3) while a reduction in car prices may negatively affect existing loans, lower car prices actually helps new loan originations by allowing more subprime customers to meet down payment requirements and qualify for loans. Having said the above, the influence of declining car prices should be closely monitored if one decides to invest in CACC.

            DEBT: CACC has a significant amount of debt, which is always a risk, but especially so in an environment of tightening credit conditions, which could make it impossible to rollover the debt at a reasonable price, or at all. As of December 31, 2022 CACC had $5.6B of total financial obligations (all of this is essentially debt and dealer holdback). $1.7B of this $5.6B will come due in the coming 12 months. Counterbalancing these financial obligations CACC had $1.5B in unused and available lines of credit, $1.2B in free cash flow, and $6.3B in net receivables as of December 31, 2022. Given that CACC has sufficient liquidity to pay its short-term financial obligations directly and that, even if it does not make any new loans, it has sufficient net receivables to pay off its long-term debt, I consider CACC to be conservatively capitalized and do not anticipate any debt-related issues in the near future. Having said that, the amount and maturity of debt must be continuously monitored when one decides to invest in CACC. A rapidly increasing debt level to the point where CACC has to rely on future capital market liquidity to refinance its debt should be viewed as a major red flag.

            RISING INTEREST RATES: The Federal Reserve has raised the Effective Federal Funds Rate from 0.08 percent in February 2022 to 4.65 percent in April 2023. This increases CACC's cost of capital, which may reduce its future profitability, and increases the cost of servicing CACC's existing debt (which is partly on floating rate). I think the influence of this is going to be relatively modest because: (1) as of December 31, 2022, CACC had only $30.9M in outstanding debt that was not covered by an interest rate cap (every 100-basis-point increase in interest rates on this debt would reduce annual after-tax earnings by approximately $0.2M). The interest rate on the remainder of CACC's outstanding debt is capped at either 5.5% (approximately one-third of outstanding debt) or 6.5% (approximately two-thirds of outstanding debt). Even at a 6.5% interest rate, CACC's cost of capital would be approximately 4.5% below its 10-year average return on invested capital; (2) the negative effect of interest rate increases is most likely at least partially offset by rising rates increasing the borrowing cost of competitors more, thereby improving CACC's competitive position (see section 3 above); and (3) CACC has, even if it directly pays off all its upcoming 12-month liabilities, approximately $1B in liquidity remaining. CACC is thus not very dependent on raising additional capital in the market. Having said the above, the influence of rising interest rates should be closely monitored if one decides to invest in CACC.

            LEGAL CASES: CACC is presently involved in a number of court cases and has been involved in a large number of court cases in the past. These court cases typically revolve around relatively minor issues that arise as a result of ambiguities in the law/jurisprudence and/or differences in state laws that lead to errors in CACC's centralized operation (e.g., interstate differences in how many times lending institutions are allowed to call delinquent customers). CACC typically settles such cases for relatively modest sums of money (relative to its total free cash flow), and legal cases almost never impose restrictions on how CACC's management is able to run the business (the last time CACC's management was forced to change something concrete to how they were running the business was in 2018). An example of a legal problem that CACC most recently faced was an allegation by the Attorney General of the Commonwealth of Massachusetts in August 2020. Massachusetts alleged that CACC had violated the maximum interest rate that subprime auto lenders are permitted to charge in Massachusetts (i.e., 21%) because it charged customers for additional services, such as a hardcopy loan statement, that some customers may request. Massachusetts decided to prosecute CACC despite the fact that Massachusetts state law did not specify that such fees should be added to the loan's interest rate in order to comply with the state's maximum interest rate. In addition, Massachusetts alleged that CACC had made high-interest loans that it knew or should have known that many of its customers would be unable to repay. In September 2021, CACC agreed to settle this case by contributing $27.2 million to a relief fund for eligible customers and by paying the Attorney General's office's investigation costs. In 2021, $27.2M represented approximately 10 days of CACC's total free cash flow. Despite the fact that, historically, CACC has been able to successfully defend itself in court and that CACC strives to adhere to all rules and regulations, the risk of legal penalties should be continuously monitored if one decides to invest in CACC.[3]

            REGULATORY RISK: While it could be argued that any industry may be subject to changes in laws and regulations that severely reduce profitability, or eliminate the industry altogether, I think it is fair to say that such regularly risk is most probably more profound for the subprime auto loan industry as compared to many other industries. Given that the actions of future regulators are arguably inherently unknowable, I believe it is essential to account for regulatory risk in portfolio construction (by holding investments that would be unaffected by draconian regulations on the subprime auto loan industry). Having said the above, I believe it is highly improbable that the subprime auto loan industry will be banned or subjected to such stringent regulations that companies will no longer have a profit incentive to issue subprime auto loans. According to data of Experian approximately one-third (90 million) of American adults have subprime credit ratings. The vast majority of these 90 million Americans would be unable to own a car, commute to work, and meaningfully participate in American social and economic life if the subprime auto loan industry were effectively put out of business. It seems improbable that any future legislator will regard it in the general interest of social welfare or in the interest of its own constituency/electorate to deny these 90 million individuals access to auto financing.

7. ETHICAL CONSIDERATIONS

CACC is sometimes accused of being a "predatory lending", with which people typically mean that CACC either: (1) deceives borrowers into believing that their offered interest rate is lower, and the general loan terms less stringent, than it actually is; or (2) that CACC charges excessively high interest rates.

            I believe that anyone contemplating investing in CACC should form his or her own opinion regarding these allegations and confirm that investing in CACC is consistent with his or her personal ethics. I personally strongly disagree with the allegation that CACC is a predatory lender and have no ethical reservations to investing in CACC.

            First, the subprime auto loan industry is heavily regulated, with extremely stringent disclosure requirements and interest rate limits. It's thus hard to sustain that CACC is guilty of (1) and (2), and if is, despite clearly adhering to all rules and regulations, one's focus should presumably be on the elected bodies that create the rules, as opposed to a company that tries to compete within the rules set by a democratically elected government.

            Second, while it is true that CACC is a highly profitable company, its margins are still lower than those of many major credit card companies (which also derive a substantial portion of their revenue from subprime borrowers), and CACC earns its profits in free and fair competition with other auto lenders (which, incidentally, are must less profitable and regularly go bankrupt). It seems somewhat misguided to me to punish/shame CACC essentially because of its operational excellence.

            More in general I think it is important to recognize what important role subprime auto lenders play in the US economy. Outside of a few major cities basically everyone in the US requires a car to meaningfully participate in American socio-economic life. Many Americans with a subprime credit rating (a population of more than 90 million people) would be unable to work and meaningfully participate in society if it was not for lenders like CACC to borrow them money. It is true that CACC, like other subprime lenders, typically charges a high interest rate, but keep in mind that anyone, regardless of credit score or credit history, can in principle get a loan from CACC if they can find a car for which they can afford the minimum down payment. CACC takes on significant risk by issuing these loans and at least provides consumers with the opportunity to acquire a vehicle, re-enter the conventional financial system, and (re)establish their credit rating. Many borrowers use this opportunity to refinance with a lower interest rate after they have (re)built their credit score, and describe CACC as the only company that gave them a (second) chance when no other lending institution would even look at their application.

Catalyst

I don't have a specific catalyst in mind that would rapidly move the stock price to my estimated intrinsic value. I believe that the stock is now basically priced for a doomsday scenario (and thus that it is unlikely to fall much further, even on bad news) and that it will be gradually re-rated if CACC's operating results turn out to be significantly better than the current p/e ratio of 8.6 justifies.

            During the GFC, the stock market also grossly underestimated CACC's earnings capacity. During this period, the share price decreased by 51.8%, from $26.60 in June 2007 to $13.78 in December 2008. The stock price recovered from December 2008 onwards, surpassing $26.60 in August 2009. Overall, it took about 18 months to reach the bottom during the GFC, and another 8 months to achieve the most recent peak. Today, CACC's has decreased by 38% from its recent apex of $687.68 in December 2021, which occurred roughly 16 months ago.