Description

Summary

Union Acceptance Corporation (“UAC”) is a domestic finance company that provides and services loans for new and used cars. This stock is trading at less than tangible book value/share ($5.62, with current share price of $5.00) or price to book of 0.90. Market values in the auto finance industry have been depressed because of concerns of:

1) Overly aggressive pricing and terms by lenders in economic downturn and
2) Gross overestimation of retained interest values in securitization trusts.

While UAC has suffered from the recession and underestimating default rates, this company has come clean on its loss assumption history and has addressed the issue with a robust risk-based pricing model. UAC’s low cost structure, pricing integrity and prime to super prime credit position should allow it to resume earnings growth. As the market sees UAC‘s modeling having an impact on return on assets and provide more accurate loss assumptions over the coming quarters and its 2001 impairments reduce earnings volatility, this undervalued stock should rise above the higher risk, less efficient players in its industry.

History

UAC was formed from the automobile finance business of Union Federal Bank of Indianapolis. The business began under Union Federal in 1985 and was one of the first to securitize auto-loan receivables, as early as 1988. It was spun off in a public offering in August 1995. Prior to 1999, UAC acquired receivables of what it described as “adequate credit quality” buyers of automobiles. Since January of 1999, UAC has focused exclusively on receivables from favorable credit profile buyers, raising its average FICO score from the 660’s to 700 today.

Shareholders

UAC has concentrated share ownership – with Richard Waterfield holding over 1/3 beneficial ownership interest. There has been no notable insider trading activity. The stock is not actively traded by funds. UAC raised $86.5mm by issuing 17,600,000 shares of Class A common stock in June 2001.

Business

UAC’s typical customers are families with good credit (current average FICO score of 700), for example, looking to finance a second car purchase with a budgeted monthly payment. UAC’s primary competitors for this business are regional banks, not the high-risk lenders like Westcorp, Americredit (with 18 –20 percent coupons, compared to 11-13 for UAC).

UAC is one of the more efficient and experienced small players in this fragmented market. Relatively high asset quality, centralized processes and well-developed modeling and collection efforts enabled UAC to improve its collection efforts and improve spreads on new receivables. The company cut 11% of its workforce last fall to reduce ongoing operating expenses which should begin to pay off this year. The company claims its low cost structure enables it to take the lower risk, lower yield receivables in the marketplace.

UAC also has automated is collections using a proprietary behavioral monitoring program and automatic dialing of delinquent accounts. Smartly, the company contracts out repossession and disposes of 90% of these repossessed automobiles through local wholesalers (and 10% through its own dealership in Indianapolis).

UAC moved to risk-based pricing in 2000, and has recently improved its proprietary pricing model to evaluate applicant credit risk contract-by-contract. This model is in its fifth iteration and, with the latest revisions (which include prepayment curves derived from their 10 years of data collection), should enable the company to achieve its goal of more accurately pricing high quality receivables and is also being used to improve expected loss modeling.

Securitization

UAC uses a two-tiered financing strategy: it utilizes its revolvers ($750 between three credit facilities) to acquire receivables, then securitizes those receivables to pay down the revolvers so it can redeploy its capital. The company retains servicing rights to the receivables in these transactions. It creates and completes a securitization trust transaction roughly once per quarter, though none since September 2001. As a result of this delay, UAC’s 12/31 balance sheet shows a high Receivables held for sale of $176m (v. 43m on 6/30/01) and a relatively low $198m of Retained interest (v. $245m on 6/30/01, before the second impairment). UAC priced a $300mm securitization sale on March 11th with average bureau scores over 700, a sign that the company is regaining investor confidence.

In the quarter ended September 30, 2001 the company took a $27.9million charge ($44million pretax) for writing down retained interest in securitized receivables (though the company estimates that 60% of this impairment was due to changes in the interest rate environment, and 40% due to loss assumptions). This followed a $23.7million pretax impairment in the quarter ending June 30, 2001. With the other than temporary impairments the company addressed most of its exposure through that quarter (as have many of its competitors e.g. Westcorp and Onyx) and will remedy this problem ongoing with contract-by-contract modeling.

Assessment

Earnings per share, which showed an 18.5% change in the prior year (1.08 EPS for year ended 6/99 to 1.280 for 6/00) fell to 0.37 for year ended 6/01. With the charge for retained interest, the company reported losses of $0.75 per share for the six-months ended December 31, 2001 ($0.15 EPS without the charge).

This is not a pretty picture and shows the impact of the charges the company took to reduce retained interest and the increased rate of delinquency (4.93% of UAC’s servicing portfolio (aggregate amount) was delinquent at December 31, 2001, compared to 3.58% on 12/31/00). However, UAC should show investors that its pricing and risk assumptions have improved; the 01B trust is the first based on its latest model. The economic recovery should stabilize or lower delinquencies and put an end to the “zero percent” manufacturer financing that cut into UAC’s spreads. The used car market hit bottom last quarter with unusually high lease terminations, rental cars dumped into the market, September 11th and low rates from manufacturer finance arms on new vehicles. IBES earnings estimates for the four largest non-captives in auto finance (ACF, WFSI, WES, CACC) project an average 34% increase in EPS over the next four quarters. This recovery should have a greater impact on UAC’s earnings, given its willingness, not matched by those companies, to forgo volume for spread and emphasis on new fees.

The other companies in the auto finance space with a price to book around 1 (ONYX, MFN, UPFC, FIFS, CPSS) are sub or non-prime lenders, purchasing low-quality/high-risk receivables. The market should begin to separate UAC from this pack as it sees that UAC did not loosen its credit quality standards or skinny its pricing terms to maintain its portfolio volume. As a result, receivables acquisitions slowed to $180mm in quarter ending December 31, 2001 from $489mm the prior year as the economic downturn shifted consumer credit risk outward. Also, UAC does not engage in certain risky practices like financing dealer inventories.

UAC should distinguish itself from competitors who rely on bureau scores alone or less developed models and databases. Most auto finance companies have taken losses from overestimating residual interests in securitization trusts (underestimating defaults and prepayments, and overestimating collateral value). UAC, according to its Static Pool Data, consistently underestimated its loss assumption on securitization pools since 1993, however, the company’s shift to its risk-based pricing model is clear from the loss assumptions on the 01A Trust to the 01B. This will be proved out over time and with it, investor confidence in UAC’s book value will be restored. I would also note that it’s rare that a securitization company provides this information (http://www.unionacceptance.com/financial/SP02282002.PDF).

After the hits that the consumer credit space has taken, and the capital and data required to enter this market effectively, the survivors in this space are unlikely to face new market entrants. The used car market has been growing steadily (over 7%) for more than a decade and with it, UAC should be able to grow as a low cost financier.

Risks

UAC is exposed to any further economic downturn. The company believes it addressed prior over-estimations of retained interest but did not build a cushion or set aside a reserve for any further economic deterioration. UAC has adjusted its risk profile for new business, but faces transitional risk when economic factors impact its existing receivables delinquency rates. An increase in defaults or appreciable decrease in collateral value could cause cash flow problems for the company.

Catalyst

The market will reward UAC’s strategy of lowering operating expenses, enhancing fee income, improved modeling and pricing integrity with higher price per book value than its sub prime peers.