In spite of the current crisis brought on by COVID-19, Credit Acceptance Corporation (CACC) remains a solid investment due to a number of defensive mechanisms within its business model. These features give the company a degree of resilience that is unmatched by its competitors. In addition, if the current crisis were to intensify, the company should benefit in the long run from reduced competition and improved per unit profitability.
I first wrote an article on Credit Acceptance Corporation on March 16th 2020. The article went into some depth on the company’s industry, business model and financial performance. The general thesis was that despite the high risk nature of its underlying customers, it remained a low risk investment due to a number of credit protection mechanisms that act like “shock absorbers” to its business model.
At publication, the stock traded at $368 per share and just one week later dropped to $234 per share. (I profess zero ability in predicting short term price movements). It even dropped to an intraday low of $199 per share on the April 3rd during the initial dark days of the COVID-19 crisis. However, investors that used this market decline to add to Credit Acceptance (as I advocated) have since been well rewarded.
I say this not to gloat (the COVID-19 crisis is still far from over and 5 months is still too short a time horizon to evaluate a thesis). But because I suspect there may be further market weakness on the horizon, which investors can continue to use to invest in the company at attractive valuations.
In this article, I will provide a quick recap of the company’s business model and the mechanisms that help insulate the company from credit risk. I will then address two recent developments worthy of comment: 1) The impact of COVID-19 2) The impact of CECL adoption. I will round off with a discussion on risks and valuation.
Credit Acceptance, founded in 1972, is an auto finance provider in the United States.
Its business model is really very simple: it extends loans, through car dealerships, to customers in order to finance auto purchases. It does this in one of two ways:
- Portfolio Program – the company extends a cash payment to the dealer at the inception of the loan (the “advance”) as well as additional payments over time based on the performance of the loan (the “dealer holdback”). In return, Credit Acceptance is reimbursed for certain collection costs and receives a 20% servicing fee of total collections. For accounting purposes, the portfolio program is treated as a loan to the dealer rather than to the underlying customers. As of June 2020, the portfolio program represented 62.5% of its unit volume.
- Purchase Program – the company provides a one-time payment to dealerships in return for loan assignment. In this sense, the purchase program is more of a traditional auto finance product. For accounting purposes, it is treated as loans that were originated by the dealerships that were subsequently purchased by the company. As of June 2020, the purchase program represented 37.5% of its unit volume.
For both the portfolio and purchase program, it almost exclusively focuses on serving customers that have limited or impaired credit histories. Approximately 95% of its customers either have a FICO score below 650 or have no FICO score at all.
At first glance, this may sound alarming. Subprime credits are notoriously vulnerable to economic slowdowns. Imprudent lenders that originate loans based on rosy repayment schedules are too often caught having to take crippling charges in later years as repayments come in below forecast.
However, a closer look at a number of mechanisms that are built into the company’s business model helps explain why the company is well insulated from the high risk nature of its underlying credits. I will explain this by way of example, using a typical company consumer loan of $23,800:
Under the portfolio program, the company’s weighted average advance rate was 43.7%. In other words, of the $23,800 consumer loan, it only provides $10,353 upfront to the dealer. This is significantly less than its weighted average forecasted collection rate of 63.1% or $15,028. This spread provides a ~ $5000 cushion on the average loan to an incorrect forecast. This is the first layer of credit insulation.
Repayment of the consumer loan takes a waterfall approach. First the company is reimbursed for certain collection costs. Then it applies a 20% servicing fee of total collections. Given the example above, this would be $3,005 (20% * $15,028). This occurs before the loan principal is repaid. The superior ranking of the servicing fee provides another layer of protection.
The loan advance of $10,353 must be repaid to the company before the dealer is eligible to receive “Dealer Holdback.” Dealer Holdback is recorded as a liability on the company’s balance sheet. Once the advance has been paid back, it is the dealer not the company that takes 80% of the collection risk. Therefore, if collections come below forecast (after the advance has been repaid), the company would reduce its liability to dealers. This is a crucial point, particular since the overall maturity of loans has been steadily increasing. In other words, it is the dealers who take the majority of the maturity risk under the portfolio program, not the company.
Loans are aggregated into pools of 50 or more loans per dealer. Dealers are not eligible to receive dealer holdback until the pool is complete. In addition, if a dealer has more than one pool, the pools themselves are cross-collateralized. This has the effect of reducing the credit risk associated with any single loan advance and allows the ‘law of large numbers’ to kick in (a concept the insurance industry was built upon).
The “Dealer Holdback” creates an alignment of interest between the dealer and the company. Since the dealer is eligible to receive 80% of total remaining collections (after the loan advance has been repaid), they are incentivized to ensure good loan performance. This includes, for example, putting customers in cars they can afford and assisting customers during the life of the loan (e.g. offering breakdown cover). This is a subtle but important credit protection mechanism that helps mitigate “principal-agent” problems that often occur between dealers and auto-finance firms.
Taken together, these mechanisms create a situation where the company is able to earn a 20% servicing fee, while at the same time taking a comparably low amount of underlying credit risk. Ultimately, this is borne out in the numbers with earnings per share growing at a CAGR of 24.12% between 2001 and 2019:
Source: Derived from the company’s 10-K
An examination of the company’s prior experience in forecasting collection rates versus realized collection rates, indicates the company tends to be conservative in its forecast practices. The majority of variances are positive ones, including a positive variance of 7.7% in the aftermath of the financial crisis in 2009. Where negative variances do occur, for example in 2001, they are relatively small (-3.1%) and swiftly followed by changes to subsequent forecasts to ensure errors are not repeated.
Source: Derived from the company’s 10-K
It should be noted that under the “Purchase Program”, the company does not have the same level of credit protections. Without a similar “Dealer Holdback”, the risk is entirely in the one-time payment provided to dealers in exchange for loan assignment. As a result, I’m less enthusiastic about this side of the business. Nevertheless, I think the lending here is still prudent with the average spread between forecasted collections and the loan advance being a comfortable 17.5%.
Impact of COVID-19
Despite the company’s previous history in successfully navigating prior periods of financial crises (the GFC of ’07-09 is a good example), a valid concern is the impact brought about by the COVID-19 crisis. In many ways, the current crisis is worse than the financial crisis of more than a decade ago, particularly in terms of unemployment and the extent to which government support has been required to sustain many parts of the economy.
Predictably, as many dealerships were forced to close or limit their operation, the company experienced a very significant reduction in loan volume during March and April. In both months, loan volume dropped 22.3% from the previous year. However, in May and June volumes have bounced back by a similar percentage as restrictions were eased and dealerships were able to satisfy pent up demand:
Source: June 2020 10-Q
Unlike many other companies during the COVID-19 crisis, the sudden and large drop in demand for its products did not have an equivalent effect on its revenue. This is because the majority of the company’s revenue is re-occurring and is derived from prior year originations (the 2016-2019 vintages contain 75% of its gross loan balance and thus the bulk of its revenue). This gives the company flexibility as the impact of any intensification of the COVID-19 crisis would only gradually affect revenue.
With loan originations seemingly rebounded, perhaps a greater concern is a drop in the credit quality of the underlying loans. The major concern here is that unemployment, triggered by the COVID-19 crisis, could cause customers to become delinquent on their loans, impacting collection rates. However, looking at the change in the servicing status of the company’s loans between June and March shows this risk did not materialize in any meaningful way:
There has been a slight increase in loans that are more than 90 days past due in the 2019 vintage, but this is more than offset by improvements in the 11-90 days past due bucket across the 2016-2019 vintages. Overall, it is quite remarkable that delinquency status, on average, actually improved during the COVID-19 crisis.
This is most likely a result of stimulus checks and enhanced unemployment benefits that have been provided. Less obviously, it seems that the average consumer is also prioritizing auto and credit card debt above mortgage debt. According to Fitch, a number of factors, including the large payment size relative to income, low interest rates and the availability of mortgage holidays, push mortgage payments down in priority relative to auto debt. This increased propensity to service auto debt relative to other debt obligations is likely conducive to better realised collection rates for the company.
Impact of CECL
An important change in the company’s accounting has been the introduction of Current Expected Credit Losses (OTCPK:CECL) in 2020. Under this new standard, companies have to record a provision upfront for any expected credit losses during the life of the loan. To understand, how this works, it will be useful to take an example of how the company accounted for a typical loan prior and post CECL.
Using the typical loan of $23,800 from the example above, prior to CECL, the company would estimate an average collection rate to arrive at a best estimate of the collections it could reasonably expect to make. By way of example, I will use the weighted average forecasted collection rate of 63.1%, meaning on the average loan, it expects to collect $15,028. It then uses this as a basis for revenue recognition on a level-yield basis.
Under CECL, however, it must use the full loan balance ($23,800) as a basis for revenue recognition. The catch is that the company must record a provision upfront on the difference between the full loan balance and what is reasonably expected ($15,028). In other words, since the company focuses on credit impaired customers, it will record a loss on every new loan that it originates. This loss is then offset by higher revenue charges and a potential reversal of the provisions if realized collections exceed forecasted collections.
As a consequence, this setup introduces a lot of noise onto the income statement and can create situations where GAAP Net Income may be misleading. To give an example, the company could choose to stop all originations which would dramatically improve reported GAAP Net Income since no upfront provisions would need to be recorded and it would benefit from the higher finance charges on existing loans. If GAAP Net Income is used to price the company’s stock and assuming a constant multiple, this (destructive action) could have the consequence of actually increasing the company’s market value, when in fact, the opposite is happening.
Overall, in my opinion, CECL does a good job for the industry in addressing the problem of provisions being ‘too little, too late.’ The standard forces companies to move from an incurred loss approach, where companies simply look at previous loss experience, to an expected loss approach where companies need to take into account current and forecasted conditions. The goal has been to make provisions more responsive. I think this has largely been achieved.
But the price to pay for this responsiveness has been increased volatility, often resulting in unintuitive outcomes (e.g. an upfront loss with no upfront revenue). This volatility is also exacerbated in parts of the industry where credit impaired customers are involved since a larger provision is recorded upfront. This makes the standard less useful in evaluating Credit Acceptance which focuses on this segment of customers. Therefore, I will continue to use adjusted net income (which excludes the effect of fluctuating provisions) when evaluating the financial performance of the business.
In terms of risks to this thesis, the main short term risk is a further intensification of the COVID-19 crisis. If further restrictions are re-introduced or if needed stimulus is not provided, this will undoubtedly have a negative impact on collections. In addition, restrictions or a lack of government support for small businesses, could have a negative impact on the overall health of the dealership network. A wave of dealership bankruptcies would certainly have a negative impact on realized collections, although this is somewhat mitigated by the size and diversity of the current dealership network (it had 13,339 active dealers in 2019 and therefore not overly reliant on a single dealership).
At the same time, however, this risk should impact all players in the auto finance industry (e.g. Ally Financial (ALLY), Santander Consumer Holdings (SC)). Some are clearly more exposed than Credit Acceptance from a credit perspective. If this risk were to materialize, it should also result in less competition as available capital is eroded by realized losses. Less competition should allow the company to improve its spread and per unit profitability in future years.
A new risk that has been accelerated by the COVID-19 crisis, is a change in buying habits of consumers when purchasing used cars. Increasingly, consumers are demanding a frictionless and digital end to end experience that by-passes traditional car dealerships. This is exemplified by the success and popularity of Vroom (VRM), the upstart used car platform. Not only does this further threaten the health of traditional car dealerships, but it also represents an entirely new form of distribution. If the company cannot pivot successfully in order to address this change in consumer buying habits, its long term health and perhaps survival will surely be affected. This is a longer term risk and it would be useful to hear the company update on its strategy to address this trend.
Valuation and Conclusion
In terms of valuation, the company earned $36.4 per share over the past 12 months in adjusted GAAP Net Income. At the current price of $468 per share, this values the company at 12.9 times TTM adjusted GAAP Net Income. This is a reasonable price to pay for a company that has compounded earnings per share at 24.13% since 2001.
If the current crisis intensifies, investors should take comfort in the company’s built-in mechanisms that provide significant credit protection. This should help limit downside risk to investors and provide the conviction needed to purchase a greater share in the company when others are fearful.
Disclosure: I am/we are long CACC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.