As always, below represents my opinions and should not be construed as financial advice. Always do you own due diligence. I welcome your feedback of my opinions and hope to have a civil discussion.
For a far better insight into the company check out their annual letters here:
http://www.ir.creditacceptance.com/static-files/bdd032a9-9b38-4847-b56d-40193536a5cb
http://www.ir.creditacceptance.com/reports-financials-accept
· Lynch/Munger Test:
o Is the company a hot stock in a hot industry or a boring stock in a boring industry?
§ Boring
o Is the company going to be the next of something or an industry leader?
§ Industry Leader
o Is the company seeking Diworsefication or focused on their core competencies?
§ Focused
o Is the company run by a Mastermind or Idiot Proof
§ Not a mastermind, not idiot proof
If there is >1 trait on the left side of the question, discard.
· Company Description
o ELI5 the company’s business model
§ Credit Acceptance Corporation is the leading provider of sub-prime auto financing. They offer lending services to virtually anyone, even with poor credit or no credit.
· Company Soundness
o How does the company collect revenue?
§ This is fairly complicated. The TLDR is they make loans to subprime borrowers. The full answer is a little bit more complicated. CACC has two financing lines.
§ The first is the portfolio program. In this arrangement, dealers pool multiple loans. The payments from those loans are first paid to CACC to reimburse collection costs. Second, they pay a ~20% service to administer the loan. Third the payments cover the advances made to dealers and fourth to the dealer holdback.
§ The second is the Purchase Program. Under this arrangement the car buyer provides the dealer with a down payment. CACC provided the dealer with a Cash Advance and then purchases the loan from the dealership. Roughly 35% of loans are under this program.
o Does the company have a good or services that is purchased frequently or at a regular interval?
§ Yes. It is important to remember their sales come mostly from partnering with dealers directly. Therefore, it stands to reason that CACC comes into the picture anytime a dealer has a customer with sub-prime credit, which is fairly regularly.
§ The auto financing market is highly cyclical. It does seem that we are in a downturn in auto. In management’s 2021 annual report they remarked, “While we expect vehicle availability and pricing to eventually return to normal, we do not expect that to occur within the coming months. Until it does, growing our business will be a challenge. Even when it does, the challenges that were present before the pandemic are likely to exist after it ends. There are no easy answers to these challenges, but we operate in a large market. There are still many dealers to enroll who would benefit from our program and we believe that we can make our product more valuable to the dealers enrolled in our program.”
o Do they operate with significant leverage?
§ Yes, they are a subprime auto lender.
o Is their balance sheet well suited for a downturn and why?
§ This is mixed. Management indicated in their most recent 10-Q that expected cash flows are likely to be enough. CACC has $1.6, 1.3 and 1 billion of debt maturing in 23,24 and 25 respectively with trailing 12-month cash flows of $1 billion and they have been trending down of late. This means CACC must refinance their debt, should credit market seize this could make for an ugly scenario. Having said that, obtaining financing should be no issue for CACC. They have been GAAP profitable every year since 2002, grew GAAP profits every year during the financial crisis (2007 to 2010) and have GAAP margins between 25% to 55% over the past 3 years.
o Are there any large deviations in Operating Income and Operating Cash Flow and if so, why?
§ While at times OI and OCF deviate, over the last 10 years they have more or less been the same.
o Is there evidence that market power is growing and that this will lead to strong financials?
§ Yes. Cash Flow and Operating Income Margins have averaged over 65% during the past decade! FCF margins have been around the same and ROEs have maintained around 18 to 40%. The median over the past 5 years was 32.6%!
o Are there major company specific risks?
§ Yes
§ At the end of 2021 long term Chief Legal Officer and the CEO (2 different people) retired after starting with the company in the mid to early 90s.
§ In my opinion its all but certain that we are in a recession. Given the nature of their low credit worthy borrowers, they may see cash flow diminished during an economic pinch.
· Management Stake
o What stake do the executives in the company have?
§ CEO Kenneth Both has purchased $4 million of company stock and has an additional $45 million in options.
o How does the compensation plan for executive’s work?
§ Options are based on the stock Performance. Most granted when named CEO.
· Can the company be replicated?
o Is there evidence that the company has defended its market position in the past?
§ Yes, Above 50% margins for a decade, high returns on equity despite an uncreditworthy customer base.
o Is technology likely to serve or harm the company?
§ I believe that technology is likely to help the company. For example, in their 2021 letter to shareholders they indicated that they are embracing a remote work option to cut operating expenses.
§ Having said that, technology may make it easier to offer sub-prime loans over times as alternative methods to evaluate risk are developed.
o Would $10 billion of capital be enough to re-create the company?
§ It would definitely make a dent. Raising capital is typically not the issue with financial institutions, its allocating it. You would also need to convince dealers to leave them when they have established procedures and deals in motion. You would also need to get a large enough to gain the benefits of economies of scale and more predictable cash flows.
o Are there structural reasons why the supply of new competition is likely to be limited?
§ Somewhat. Generally speaking, people don’t like to enter subprime lending. It can have a bad stigma and has a reputation as a tough business. Think about repossessing a car. Its collateral that moves and can obviously anger and frustrate a person and their family.
o Are there structural reasons why customers are likely to stay with the company?
§ Yes. CACC offers mission critical financing to their customers. Dealer’s only get paid if cash comes in the door from a customer. Having said that, CACC acknowledges their high rates and expects much of their loans to be refinanced out of after their customers build their credit and obtain a lower cost loan. They are a lender of last resort for some.
o Are parts of the company not able to be recreated with capital? Which parts and why?
§ Scale. Given the vast number of loans, CACC is able to credibly predict collections. In the last 10 years the worst collection was 2.6% percentage points less than the expected collection rate. In 3 of the last 10 years they overestimated. They collected more than expected in 2020 and 2021. During the financial crisis (2007 to 2010), the collected less in only 1 year and by a margin of 2.7%. Generally, they collect 65 to 73% of loans written.
o Are there competitive threats on the horizon?
§ Car sales may move more from dealers to DTC. Given that CACC’s customers are truly the dealers should this trend take further hold, they may need to uproot their go-to-market strategy.
§ Some believe should we get sell driving vehicles, the total auto sales market will drop as more and more people opt to rent cars.
o What is the competitive advantage?
§ The advantage is that because CACC is willing to serve a mostly un-servable market. This allows them to get great terms on their loans. For example, the payments on loans written are required to reimburse them for costs first, then they share revenue with dealers in the portfolio program. Additionally, they charge a holdback to dealers when they have outstanding loans. This forces the dealers to maintain collateral in the event of non-payment.
§ CACC also operates with a scale advantage. This allows them to have best in class stability and predictable financials in a very unpredictable market.
§ Given the capital needs, banking execution needs, and cyclicality of the industry combined with a 19 year track record of average ROEs at 28.7%, this suggests the cemented nature of this business.
· Growth
o Is there a 90% chance that earnings will be up 5 years from now?
§ 90% might be generous given that we are coming off a booming auto market. Having said that net income has grown fairly reliability over time.
§ CACC is pretty well entrenched in the subprime auto market. Historically, when a recession hits, competition among sub-prime lenders reduces as less lenders want to partake. Historically this has led to outsized growth in challenging times. From 2007 through 2011 (The Global Financial Crisis), GAAP Net Income increased by 6%, 22.7%, 113.9%, 22.7% and 24.7%. Of course, these growth rates are not likely but if you are fearful a recession will crush them for lending to junky creditors, it appears that has not been the case. It should be pointed out that car sales fell from ~17 million to 9 million and then rose back to 14 million during that period. If we do get a recession, it will likely be less severe than 08-09 and therefore have a less pronounced effect. Additionally, since cars surged in price during covid, the value of the collateral may depreciate faster in a recession as prices return to normal. If this was not accounted for, losses may turn out to be wider than forecasted.
§ Part of the reason why CACC benefited in earnings growth during the GFC was due to the fact many lenders pull out of subprime markets giving them more market share and a growing customer base.
o Is there a 50% chance earnings will continue to grow in excess of 7% per year after the 5 year period?
§ Yes, right around there in aggregate, far higher on a per share basis given their commitment to buybacks.
· Watch List Decision
o Do you honestly know enough about the industry and company to make an investment decision?
§ I believe I do.
o Bottom Line: Based on your answers is the company well insulated from economic and competitive shocks while able to grow for many years to come?
§ I believe it is.
· Valuation
o Value the company
§ As of their last 10-Q they had 12.9 million shares outstanding. They pay all excess capital out as share buybacks and over the last 3,5 and 7 years have reduced shares outstanding by 12%, 8% and 6.6% respectively. Its trading at an all-time high FCF yield of 20% but faces rough financials in the coming quarters. All in all, I expect shares will decrease by -8% to -4.5% over the next 3 years as higher rates will likely mean higher FCF yields and therefore more purchases per dollar of FCF.
§ Analysts expect revenue to be $1.915 billion in 3 years, basically flat from 2022 levels as CACC comes off the covid sugar high in car sales. Given my expectations of a recession, I will model the bull case with a 15% premium to estimates and the bear case with a 30% discount to estimates for 2025.
§ FCF Margins have historically ranged between 50 to 62.5% of 56.3%. Over the past 10 years, inflation was minimal, and recessions were short (covid). To that end, going forward, I will assume a 48% to 60% FCF Margin for a new midpoint of 54%.
§ FCF Yields have hovered between 8.5% and 22% for a midpoint of 14.25%. Excluding COVID times, over the past 10 years, FCF Yields ranged between 7.5% to 13%. Given the higher rate environment and potential for more volatile collections, I feel a FCF yield of 9.5% to 15% for a midpoint of 12% is more appropriate for the period ending in 2025.
§ Putting it all together we get an estimated value on 12/31/25 between $640 to $887 for a midpoint of $763.
o Would it be a prudent investment to buy the company at current levels?
§ Currently CACC trades for $441 which at the estimated midpoint implies an 20% CAGR. Given the risks in this business, I would like to have the expectations of earning no less than 11% on an investment indicating the company is fairly valued to slightly undervalued.
Sources:
Aggregated Data: https://finbox.com/NASDAQGS:CACC
IR Page: http://www.ir.creditacceptance.com/
Author is long CACC
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