CACC: Recent Events Add to the Short Thesis

Our most recent post on CACC generated many thoughtful comments and questions, and I wanted to provide an update on some recent negative events and address some of the questions. Based upon recent events and capital markets activity, I have increased my conviction in a $7.50 price target, which is 56% below yesterday's (7/30/08) close of $17.16.

Access to debt capital continues to be a massive overhang for Credit Acceptance (CACC), and the current stock price does not adequately discount the risk of deleveraging the balance sheet (or worse). Recent events at Wachovia (WB) are troubling for Credit Acceptance, and by extension, very troubling for CACC investors. By my estimate, which we detailed in our previous submission, Wachovia is currently funding 60% of CACC's required debt capacity. With its capital and credit issues under Wall Street's and the FDIC's microscope, Wachovia is currently in the processes of shrinking and deleveraging its balance sheet.

On WB's second quarter conference call on July 22, management stated "across the franchise...we look at all of our relationships, and assess whether they're a core relationship with many aspects to it or whether it is credit-only, we have the opportunity for non-renewal and by up pricing of incremental credits, that will also provide some relief on the inflow slide." I could not help but think of all of the companies that were beneficiaries of years of easy credit from Wachovia. Those easy standards for borrowers cut both ways, and CACC should suffer disproportionately as the easy credit reverses.

One "core relationship" at Wachovia was commercial mortgage lender Gramercy Capital (GKK). The company's first facility from Wachovia was a $250 million line in August 2004. After a number of increases and improved terms, by December 2007 the line was $500 million, with an interest rate of LIBOR plus 133 basis points and a 60% to 95% advance rate. GKK enjoyed a multiyear run fueled by the balance sheet of Wachovia (sound familiar to our warnings about CACC, right?).

Fast forward to July 28th, 2008, when GKK signed a new credit agreement with Wachovia, cutting the line by over $280 million, to $215 million, with very unfavorable terms (LIBOR plus 242.5 basis points and advance rates of 50 to 80%!). This is an early sign that Wachovia has finally "seen the light" and is pushing through its own increased cost of funds to their borrowers. The process has been painful for GKK's shareholders, with the stock down 72% year-to-date. This may be the template for CACC's BEST case renegotiation: less capacity, higher spreads, and lower advance rates. Under this scenario, CACC would have to shrink originations significantly and deleverage the company.

This best case scenario for CACC is the quagmire that CACC's direct competitor, United PamAm Financial (UPFC), is currently facing. UPFC, similar to CACC, is an auto finance company that purchases subprime auto loans from dealers. UPFC grew aggressively over the past few years, utilizing the securitization market to leverage the company beyond what management had previously thought was possible. (Sound familiar, again, to CACC based on the commentary from management that we highlighted in our first CACC post?) Like CACC, UPFC originates loans on its credit facility, and pays off the lines by issuing a term securitization. UPFC expected to complete a securitization in the spring/summer of 2008. Since UPFC could not complete a securitization, it currently faces a violation of its warehouse covenants and its fate rests in the hands of its warehouse lender, Deutsche Bank (DB). The equity markets do not place too much faith in UPFC's ability to navigate their deleveraging, as it currently is trading at 13% of book value and 1.0 times PE (annualized second quarter of $0.26).

I also wanted to address the bullish argument that the auto securitization structure has held up well in the current credit crisis. I completely disagree with this statement. The subordination levels, interest costs and structures have changed so dramatically that financing through the securitization market is currently a money losing proposition. The prior structure has failed and has been completely revamped. The subprime auto securitization market had been driven by insured bonds over the past few years.

I tried to find one recent insured subprime auto securitization that has not been either a) downgraded, or b) put on negative watch. I could not find one. Not one. In fact, the structures were so loose at Americredit (ACF) that FSA required Americredit to cross collateralize its insured trust before FSA would wrap additional trusts. Another data point refuting the thesis that auto securitizations aren't imploding was the recent transaction between Americredit and Deutsche Bank. Americredit had to pay Deutsche Bank a $20 million fee and give it 7.5 million warrants in return for Deutsche Bank agreeing to purchase $2 billion of triple-A rated securities in future securitizations. This is NOT indicative of a healthy securitization market. When adding the dilution from those warrants into the cost of funds, Americredit's securitizations will be the most expensive in company history.

Another company, Consumer Portfolio Services (CPSS), had 24% subordination levels and an interest rate on the mezzanine tranche of over 20% in a recent securitization. At similar subordination levels and interest costs, I do not think it will be economically feasible for Credit Acceptance to finance its receivables in the securitization market. For a long time, Wachovia was the "dumb money" that financed CACC's on the cheap. Unfortunately for CACC, Wachovia may be wising up.

I also wanted to address the only other possible bullish argument for an investment in CACC: it is a debt collector. CACC is NOT a debt collection company, at least no more so than any other consumer finance lender that originates loans. The debt collectors purchase charged-off receivables at pennies on the dollar, and over the course of two-to-five years, they try to collect 3 to 4 times their purchase price. That return profile is the only way to arrive at acceptable returns.

CACC purchases auto loans at a slight discount to face value, has much higher loss severity, can only collect up to principal value (say 1.2 times purchase price), and has a defined maturity schedule. In addition, CACC is reliant on term securitizations to fund its growth, which is in stark contrast to debt collectors. I do not fully understand why CACC uses SOP-03-3 accounting treatment instead of the accounting treatment used by its peers like Americredit. Under interest method accounting, CACC would recognize revenue as interest on their loans and accretion of the purchase discount, and set up loss reserves on delinquent accounts. The only benefit of SOP-03-3 I can think of is that is allows significant management subjectivity in setting quarterly earnings.

In my first CACC submission, I questioned why management provided very little disclosure regarding vintage, collections and delinquencies. After getting my hands on an old trust report, I have a slightly better understanding behind the evasiveness. The trust report is for CACC's 2007-1 trust, the one that was downgraded by S&P earlier in the year from AAA to A-. According to the report, at year end 2007 roughly 37% of the "outstanding contracts" in the trust were "defaulted contracts." This type of information is clearly a large red flag (the extremely high default rate). However, more concerning is that fact that management is unwilling to provide transparency on its credit trends. This information is integral to understanding the reasonableness of management's future cash collection estimates.

The smoke has thickened around CACC and its shareholders. Where there is smoke there is usually fire.

Stock position: Short CACC.

Comments

[lance_f:]

I know the authors of these articles read the comments that get posted. I would like to offer a suggestion not only to Jackson but all authors who provide disclosures along with their analysis. It would be very beneficial if the author would also specify the fraction of their porfolio for which the position is held or a range. Thus, one could specify 5.6% or between 7.5-10.0%. This would avoid the author from having to disclose the worth of their portfolio, but also give the reader some guidance regarding their degree of conviction. Without this additional bit of insight, many readers could commit an excessive proportion of their funds to a position. Clearly, this could assist both well intentioned authors and their readership.

2008 Jul 31 07:32 PM

[Jackson Ame...:]

Lance,
Your suggestion is very interesting. I think that requiring (in good faith) an author to disclose his/her position is fundamental to helping readers balance an author's natural subjectivity with the inevitable other side of the argument. Sites like Seeking Alpha are fantastic because they allow investors to share their thoughts and work with the investment community. Further, these sites provide a forum for investors to present well articulated, factually-driven, negative views on stocks and sectors. Cautious investment opinions can be very helpful in highlighting investment dangers (despite the stigma associated with short selling). Feedback and comments to the author make the process even more helpful for the entire community.

However, asking authors to disclose the size of their positions takes the "intent" behind asking an author to disclose their position, to a whole new level. I also would argue that a position size is not always consistent with conviction levels, which can lead to an outcome that could actually be misleading. For example, some positions can be sized based upon daily volumes, upon sector allocations, upon strategy (quant funds may have 1000's of positions, whereas concentrated value deep value funds, may only have 10 positions), etc. Your suggestion is very interesting and I’m sure would provoke a wide variety of opinions.

2008 Jul 31 11:25 PM

[lance_f:]

I agree that short selling can serve as the voice of reason and that even individuals with greater experience will exhibit "variability" in their "conviction", as measured by the size of the position they take relative to the value of the portfolios they manage. The problem with the existing system is that it does not differentiate between an individual hyping a position for a friend who stands to benefit and a genuine academic evaluation of an existing company's situation. Presently, an individual may write an article, buy or sell short a single share of stock, and then provide the existing disclosure. I believe that the fractional portfolio disclosure would help readers distinguish, but as you have noted there are many strategies and it would remain easy for an individual managing multiple types of funds to continue to distort such an extension to the disclosure policy. I would be impressed if such a system could be put in place with rapidity and precision. I also understand it could put the more honest authors at a disadvantage to some of their more seasoned and less ethical peers who would not want to be held to such standards.

2008 Aug 01 09:07 AM

[bro_t_pro:]

Jackson,
You have presented an interesting perspective on viewing the potential funding hurdles that a company such as CACC may indeed face. However, I feel that you may not understand the operational side of CACC's business as well as you understand the financial perspective. CACC does not merely "purchase" dealer contracts at a slight discount. The majority of CACC dealer contracts purchased, are in fact purchased "with recourse". In essence, the contracts are not really purchased, they are serviced or collected by CACC's collection department, and the dealer is paid an "advance" which represents a discount of between approximately 15-50%. The dealer advance is repaid to CACC as the payments for the auto loan are made. The advance becomes a "purchase" when enough payments are made on the loan (based on an 80/20 split) to pay back the dealer advance. In addition, the dealer receives an additional incentive after this "breakeven point" because he/she stands to receive an additional 20% if the entire contract is paid in full. This is why CACC uses SOP 03-3.
I am a firm believer that this is one of the nuances that sets CACC apart from other subprime lenders in the automobile finance industry. I believe that Wachovia understands this is as well. Further, I don't think comparing a commercial mortgage lender like Gramercy Capital makes any sense at all here. Obviously, given the turmoil in the mortgage finance sector over the last 14 months, any mortgage lender is going to be put under the microscope by his banker. If anything, with GMAC and Ford Motor Credit doing away with lease financing, more consumers will be forced to purchase used cars, and that is right up CACC's alley. I have been a recent (as well as small < 1000 shares) buyer, due to my belief that recessionary times are bullish time for CACC and their collection rates are consistently 20-30% above average dealer advance ratios. I think you should cover your position if you have one.

2008 Aug 25 04:24 PM

[wes l.:]

bro_t_pro,
I believe to you to revisit your understanding of CACC. The advance to the dealer is non-recourse. See their 10k: "offer dealers a non-recourse cash payment (referred to as an “advance”) against anticipated future collections on Consumer Loans serviced for that dealer." The dealer is "in the money" at origination and historically has received little on the back end (Collection rate - advance rate - 20% fee). Dealers prefer the "purchase product" because they get a bigger advance and are more "in the money" at the sale of the car. The purchase product has grown from 5% to around 35% in the past year.

2008 Sep 03 10:40 AM