Seeking Alpha
Long only, value, deep value, growth at reasonable price
Profile| Send Message|
( followers)  

Credit Acceptance Corporation (NASDAQ:CACC) is an indirect auto finance company, which provides credit services and related products and services to consumers through car dealers. The company provides two dealers financing programs including the portfolio program and the purchase program. Under the Portfolio Program, it advances money to Dealer-Partners (referred to as a Dealer Loan) in exchange for the right to service the underlying Consumer Loans. Under the Purchase Program, Credit Acceptance buys the Consumer Loans from the Dealer-Partners (referred to as a Purchased Loan) and keeps all amounts collected from the consumer.


Summary Table



Low costs of borrowing

Low interest rate environment

Higher yield with low risk

Lack of credit/funds during the financial crisis postponed the purchase of a car

Expanding base of loyal dealers over time

The table above lists a summary of reasons why CACC is a good long-term hold. The value per share I have calculated for CACC is $156.25 as compared to the market price $139.12 (as of 17th Jan 2014), making now a very good point of entry into the company's stock. The following sections will explain in detail the economics and trends listed above.

Long term sustainable high profitability






Net margins






As can be seen from the table above, CACC has been able to achieve very impressive net margins for a very long period of time. This, I believe, attributes to 3 main reasons: 1) Low costs of borrowing, 2) a margin of safety, and 3) high interest rates yields.

1) Low costs of borrowing

The most intriguing part of CACC's business model is its financing strategy. CACC packages loans together to create a new asset with less risk that pays an annuity- a collateralized debt obligation (CDO).

For the less experienced investors, here is a highly summarized explanation of how CDOs work. CDOs can be divided into different tranches and sold off to various investors. Whenever a payment is not collected, this 'loss' is first allocated to the junior tranches and subsequently to the senior tranches once the buffer offered by junior tranches are depleted. Through this structure, the senior tranches can be sold at lower interest rates due to the lower risk of loss as compared to the junior tranches. By selling senior tranches of CDOs that CACC creates, CACC is able to borrow large amounts of money at lower borrowing costs.

Moreover, the CDO tranches that CACC sells are usually fixed rate in nature. This feature not only shields CACC from interest rate volatility, it also shields CACC from increasing borrowing costs in the future; a great benefit especially when interest rates are expected to increase all across the US as the downward pressure caused Fed's quantitative easing lightens due to tapering.

2) A margin of safety

Ever since the establishment of CACC, the management has a strong insistence on including a margin of safety whenever pricing the loans; even when competitors all around are paying more and more for the loans they buy over from dealers. With a margin of safety involved, the company will see higher margins on top of a lowered risk of loss.

3) High interest rates due to the higher risk of the subprime auto loan market

People in the sub-prime market often have a higher risk of defaulting on their loans, and as a result, this group of people aren't able to get loans from more traditional sources of financing. Consequently, many financing companies moved into this market with the intention to profit by charging them higher interest rates; leveraging on the fact that sub-prime borrowers have no one who is willing to loan to them.

Risks in the business

Since we are on the topic of risks, it would be best to address the issue on why CACC's faces a low risk of loss despite dealing with the sub-prime market; reputable for the carnage it has created during the 2008/2009 financial crisis.

Similar to their competitors, CACC usually buy auto loans at a discount from dealers, with the discount used to cover servicing fees and other related costs. However, things become different beyond this point. At the time of origination of the loan, CACC only pays an advance for the loan instead of its full value after the discount and stipulates that further payments to the dealer will only happen once the advance has been fully recovered.

We can therefore break down the contract into 2 smaller parts: An asset backed security (ABS) owned by CACC with a short duration due to the smaller value and the higher interest rates; and a revenue bond owned by the dealer of which will only be started once the advance has been covered.

Based on the structure above, we can see that the full risks of the auto loan are shared between CACC and the dealer, causing CACC to accept lesser risks as compared to its competitors. As risks of owning the revenue bond are borne by the dealer, we are only interested in the risks CACC faces, primarily: 1) Default risk, 2) Interest rate risk, and 3) Prepayment risk.

1) Default risk

For sharing the risk, dealers are rewarded by having a share in the interest and principal payments. Henceforth, this incentivizes dealers to assign them higher quality auto loans. This lowers the default risk that CACC faces.

In the scenario where a default really happens, CACC can repossess the owner's car as CACC is listed as a lien holder on the vehicle title. CACC will liquidate the vehicle and cover the advance. Considering short duration of the ABS, any risk of losses is greatly mitigated.

Furthermore, CACC lowers the risk of losses from defaults by grouping auto loans into pools. Ever since a very long time ago, CACC has encouraged their dealers to bundle loans assigned to them into pools of 100. They did this by offering dealers advanced dealer holdbacks where dealers receive the remaining value of the 100 auto loans owed to them plus additional profit sharing payments in one lump sum. Moreover, CACC encourages their dealers to create more pools by allowing each pool to be cross collateralized so the performance of other pools is considered in determining the eligibility for dealer holdback. By pooling the loans, those loans with better performance can cover those with weaker performance, effectively lowering the risk losses that CACC undertakes. In addition, with multiple pools, risks are further spread out across pools, with a better performing pool covering those with weaker performance.

A final aspect that lowers the risk that CACC faces is their ability to forecast loan performance with very low variances.

(click to enlarge)

Source: CACC 2012 Annual report

Being able to forecast loan performance with a high level of accuracy allows CACC to price the auto loans accurately and hence lowers the risk of loss. This can be attributed to the long and deep experience of the management.

2) Interest rate risks

Interest rates risks are lowered due to the short duration of the ABS.

3) Prepayment risks

This risk is, in fact, higher due to the smaller size of auto loans. But, as CACC mainly serves the sub-prime customer segment, the probability of prepayment is rather low.

A little note on competitors of CACC: When the economy is doing well, more and more competitors enter the sub-prime auto financing segment. There is a tendency that risk faced by competitors increases as competition for sub-prime auto loans intensifies. Risk is usually added due to weakening loan standards, such as over-compensating the dealer for the level of risk present in the loans sold. And usually, additional leverage is taken to over pay these dealers-exposing themselves to very high levels of risk.

Stable long term business volume growth

1) Expanding base of loyal dealers

CACC established a rating system for its dealers. The longer the dealer stays with CACC or the more business they bring to CACC, the higher they will be in the rating system. Being awarded a high rating gives dealers a larger amount of advance when a loan is assigned to CACC and they are entitled to a larger share of the profit sharing payments. These payments not only will improve CACC's relation with its dealers, it will also become a switching cost as well. This process makes CACC's dealers increasingly loyal to the company the longer they stay with CACC. Therefore, as time passes, CACC will have an expanding base of dealers who are extremely loyal to the company.

(click to enlarge)











Active dealers











Source: CACC Annual reports

Although we can't really know exactly how many loyal dealers there are, we can still proxy it from the stable increase in the number of active dealers shown in the table. Without loyal dealers as a floor, CACC might witness volatile movements in the number of active dealers or even declines.

The expanding base of loyal dealers brings 2 benefits to CACC:

a) An increasing minimum floor of volume of auto loans over time as their numbers increase or as they get larger.

This point deserves a bit more emphasis. More and more competitors come in when credit is abundant. As the market becomes more and more fragmented, the supply of sub-prime auto loans will be spread thinly across all competitors causing growth in the number of auto loans financed per credit company to lower or may even lead to losses in volume. Although slower growth and lowering of volume cannot be adverted in certain periods of time, in the long run, you can expect the volume of auto loans financed by CACC to increase steadily due to the increasing base of loyal dealers.

This effect can be seen in its stable increase in loan volumes.

(click to enlarge)

b) Serves as a marketing medium to influence other dealerships to take up CACC.

Dealers will be tempted to sign up with CACC's program after seeing the success the dealers under them have in terms of earnings or CACC's reliability.

This effect can be seen from the stable increase in the number of dealer enrolments per year.

(click to enlarge)

2) Ability to finance anyone and credit rating improvement a great draw

As CACC manages risk by either increasing the interest rate or lowering the amount of funds loaned to the sub-prime borrower, financing any borrower can literally be done. The caveat being that you might not get the car you want. However, many sub-prime borrowers aren't interested in getting the car of their dreams. Instead, they are just mostly interested in obtaining personal transport. Thus, being able to receive financing from someone after being rejected by many others could be quite a draw to many sub-prime auto loan borrowers. Also, with many sub-prime auto loan borrowers wanting to improve their credit rating, having to report to 3 credit bureaus would be attractive to these borrowers as well.

Besides their main auto financing business, CACC has opened up more revenues streams by offering reinsurance and earning commissions from selling 3rd party insurance as means of offering more value added services to the dealers.

Finally, listed below are some familiar trends that would bring more business volumes to CACC:

· Low interest rate environment expected to continue: Although the Fed has recently announced the beginning of the tapering of its massive quantitative easing and might trigger a jump in interest rates, interest rates are expected to be low overall in the long term due to the slow growth rate of the US economy. This secular trend would be beneficial to any goods which require financing to purchase such as houses and cars.

· Lack of credit/funds during the financial crisis postponed the purchase of a car: There were many people who wanted to change cars during the financial crisis but couldn't due to a lack of funds or credit. Now, with funds and credit coming back into the market, many car owners are looking to switch their cars.

Source: Credit Acceptance Corp.: A Low Risk Sub-Prime Auto Financing Company With 12% Upside