Credit Acceptance (NASDAQ:CACC) is a subprime auto finance company headed for a steep price decline in the medium term. The company is well run and I've owned it before, but it is in a notoriously difficult cyclical business and the fundamentals have been deteriorating for a while. This deterioration is not yet fully apparent in headline numbers, but if you look below the surface, the picture isn't pretty. In this article, I describe trends in the business and capital structure, the company's recent tender offer announcement, and discuss the difficulties in valuing a company like CACC. I conclude that longs should follow the Chairman and founder and cash out while they still can, and that the temporarily inflated price from the tender offer announcement offers an attractive entry point for shorts.
The Business: Deteriorating
Credit Acceptance's basic business is purchasing subprime auto loans from car dealerships at a discount. The goal is to earn a wide enough spread on the loans to make up for the high default rate. This is not an easy thing to do, because the loans are risky to begin with and car dealers do not always have a strong incentive to maintain loan quality.
CACC seems to have found a way to mitigate the problem by sharing credit risk with car dealers. About 93% of its loans are made through its Dealer Program, in which CACC pays dealers an advance up front for a loan pool. At first, 100% of the cash flows from this loan pool go to CACC to recover its advance as well as collection fees and a servicing fee that equals 20% of collections. After the cash advance is recovered, the cash flows are assigned in the following order:
1.) Reimbursement to CACC for collection costs
2.) Servicing fee equaling 20% of collections
3.) Payment to CACC as reimbursement of cash advance for any other loan pools from the dealer
4.) Payment of the residual to the dealer (called "Dealer Holdback")
One way to think about this arrangement is in terms of an asset-backed security with three tranches. The dealer originating the loan gets the AAA-rated tranche in the form of an upfront cash advance, while CACC gets the middle tranche. The dealer also owns the equity tranche with the first loss, giving the dealer a strong incentive to ensure loan quality. So while CACC is "short" the AAA-rated tranche when it makes the initial advance, it is essentially buying bonds with decent structural protections.
This risk control strategy partially insulates the company from the occasional but huge losses experienced by many of its competitors such as Consumer Portfolio Services (NASDAQ:CPSS). Additionally, management culture and incentives reward patience and capital allocation discipline, allowing to the company to hold back when credit markets get overheated and jump back in when poorly disciplined competitors are forced to exit. The results speak for themselves:
The problem is that dealers do not like this arrangement. If I were a dealer, I'd prefer to get paid upfront to move product quickly rather than balance the need for sales with the need to make quality loans. After all, most car dealerships are in the car business, not in the loan business, and many are small operations that lack financial sophistication. This means that the demand for CACC's services is highly cyclical: when competitors are flooding the industry with easy terms for dealers, CACC's delayed and uncertain dealer holdback payments are not very attractive.
When this happens, CACC has two options: increase the upfront payment for loans (which reduces CACC's profitability and increases risk), or refuse to do deals without a sufficient margin of safety. To determine which of these makes sense at a given time, CACC has developed a good sense of the intrinsic value of its assets. This essentially boils down to two variables: the forecasted collection rate and the upfront advance rate to dealers. The forecasted collection rate measures credit quality, while the advance rate represents the upfront portion that must be paid to dealers. Going back to the asset-backed security analogy, CACC would prefer to have loan pools with small advances (thin AAA-rated tranches) and a large spread between the forecasted collection rate and the advance rate (large equity tranches to soak up any unexpected losses). Here's what the loan book looks like right now by year of origination and average spread:
Some readers may find it surprising, but the company purchased its most profitable loans in 2009 and 2010 when it could be choosy about credit quality and dealers were desperate to unload loans. Ever since then, there has been a steady decline in per-unit profitability continuing into 2014, when credit quality was in line with the historical average (71.9% forecasted collection rate) but the advance rate (47.9%) was at its highest point in a decade, giving the company a modest estimated spread of 24%.
This decline in loan profitability has just begun to filter down to headline results. One reason is that many loans take 3-5 years to amortize or default and the higher-yielding 2009-2011 vintages are finally starting to run off.
Although the least profitable loans from 2014 only constitute about 20% of CACC's book right now, within a quarter or two, loans from 2013 and 2014 will constitute the bulk of the company's assets. This means a continued decline on the company's return on assets:
Clearly, the company is in a tough spot. As capital floods the industry and underwriting discipline weakens, the bargaining power of car dealers vis-a-vis capital providers strengthens. And even if industry conditions stabilize (unlikely in my opinion), the runoff of higher-yielding loans will continue to pressure per-unit profitability.
Capital Structure: Shaky
Given the steady decline in per-unit profitability, how has CACC managed to maintain strong earnings growth (despite the recent earnings miss)? The asset side of the balance sheet only tells half of the story. On the liability side, two developments have helped to fuel strong earnings: increased leverage and a declining cost of capital.
Let's take a look at the capital structure to see how this happened. Traditionally, CACC's capital structure has had four components: a set of warehouse credit facilities secured by most of the company's finance receivable assets, non-recourse securitizations, senior unsecured debt and shareholder equity. Almost all of this equity is tied up in finance receivables, which totaled about $2.3B at the end of last quarter, compared to cash of $5.6M.
One thing about this funding mix should make investors a little nervous: the company is heavily reliant on credit markets to fund its loan purchases. So long as the company can draw on its secured credit lines or market asset-backed securities, it can grow assets faster than shareholder equity to boost earnings. If not, then the company is stuck financing additional loans with current cash flow. And in a nightmare scenario, the warehouse lenders decide that the finance receivables are not worth what the company says and they force the company to raise cash by selling receivables or equity into a weak market. This is a recipe for permanent capital destruction.
Now I don't think that nightmare scenario will happen because CACC has a solid track record of profitable underwriting. But the issue of maxing out available credit is very real. And we can see that the company running up against the upper limit:
In fact, after the completion of its pending tender offer (more on that below), I estimate that the company will have an assets-to-equity ratio of 4.1 at the end of Q2. This is the highest amount of leverage in a decade. So even if you think that management has maintained underwriting discipline and that the increased leverage will pay off, investors should not be betting on further leveraging to raise earnings. Deleveraging in the medium term is much more likely as business opportunities dry up (as was the case on 2005-2006) or the company is shut out of credit markets (as was the case in 2008-2009). Of course, if leverage even modestly declines going forward, earnings will take a serious hit.
To get a further sense of the sustainability and risk inherent in the current capital structure, let's take a look at the company's recent unsecured debt refinancing. In January, the company redeemed its $350M 9.125% issue due in 2017 for a $300M yielding 6.125% due in 2021. This was a smart move that took advantage of the relentless "search for yield" among investors and will boost quarterly EPS by about $0.12 going forward, but the issues' B1 rating (deep in junk territory) underscores the fact that the current capital structure is quite speculative. So while low interest rates, renewed interest in asset-backed bonds and high levels of leverage means that CACC has a historically low cost of capital, investors should not expect further windfalls on the liability side.
As an aside, I'd prefer to see management take advantage of favorable market conditions to lock-in more longer term and conservative financing such as preferred stock. Perhaps the credit-sensitive mortgage REITs like American Capital Mortgage (NASDAQ:MTGE) could serve as a model. Although this would increase the cost of capital in the short run, it would give the company a stronger equity cushion and reassure secured creditors during the next credit contraction. Unfortunately, the company is doing the opposite, as we will see with the recent tender offer.
Valuation: Fundamental Misunderstanding
So given the business' fundamental deterioration and increasingly speculative financing, why do market participants seem so optimistic about the company? I think the answer is valuation: the market has a difficult time valuing finance companies with boom-bust profitability cycles like CACC.
Fundamentally, CACC derives its earnings power from its balance sheet, just like banks or insurance companies. But unlike these more conservative businesses, CACC and its peers do not have regulators looking over their shoulders forcing them to maintain capital adequacy. This is probably because finance companies do not have depositors or policyholders that have to be bailed out by the government if the business goes belly up. As a result, consumer finance companies can borrow as much as the market will allow. And as we have seen in the last decade, the market will allow much more borrowing than is prudent or rational, leading to liquidity squeezes and painful deleveraging when the credit cycle turns.
However, when profits are on the upswing, investors seem to forget this reality. They forget the balance sheet altogether and focus on earnings. And at less than thirteen times trailing earnings, CACC does not seem very expensive. But at more than four times tangible book, shareholders are paying an exorbitant price for a speculatively financed company whose normalized return on equity is probably below 20%.
Once the cycle turns, investors will suddenly realize that they are essentially holding a high-risk loan portfolio purchased at a substantial premium to face value. During these times, book value becomes relevant and the nosebleed multiple collapses:
It is just a matter of time. And if the tender offer is any indication, that time is sooner rather than later.
Tender Offer: The Founder Cashes Out
Now to the tender offer. Here's the terms of the deal: last week the company announced it is offering to buy back 915,750 shares at Thursday's closing price of $125.28 per share, and the offer expires on June 16. This will further stretch the balance sheet, because the company will borrow the $115M to finance the transaction even though it only has $715M in shareholder equity. The news release states that the Chairman and founder, Donald Foss is tendering all of his 4.4 million shares, so the offer will be oversubscribed and investors with 100+ shares will receive a prorated portion, which will be at most 25% of their shares. This means there is not a "hard floor" on the stock price between now and the completion of the tender because large holders will not be able to sell their entire position, but this does provide a fair amount of downside protection through mid-June.
Not surprisingly, shareholders cheered this announcement just as with a similar tender offer of 637,420 shares for $133.35 completed on March 26. Over the course of that offer period, CACC rose to a significant premium:
The S&P 500 was only slightly positive during this period, so there is good reason to believe that CACC will outperform the market through June 16, particularly if the overall market declines. However, after the expiration of the offer and before the announcement of the new offer, CACC dramatically underperformed:
The current tender offer seems likely to have a similar euphoria-to-disappointment dynamic.
Although I can't blame Foss for wanting to diversify his wealth, I think investors should pause and ask themselves why he is cashing out so aggressively right now. What is especially curious is that the transaction seems designed to give a few large shareholders the liquidity to sell. And liquidity is what they need: 54% of the stock is owned by Foss and members of his family, while another 17% is owned or controlled by another board member, Scott Vassalluzzo. Altogether, directors or family members of the founder own or control nearly 75% of all shares, leaving only 25% with the investing public.
To their credit, insiders have historically been good stewards of shareholder capital and are giving the public an equal chance to cash out, quite possibly on terms better than themselves (the stock is trading at around $130 at writing). I think outside shareholders should get out while the going is still good, and that shorts should look to initiate positions before the end of the offer period when reality sets in.
In conclusion, I believe that Credit Acceptance has much more downside than upside, given the company's business fundamentals, stretched balance sheet and current valuation confusion. Management has sent a strong signal to investors with the tender offer, and longs should cash out while they can. And because the tender offer has temporarily inflated CACC's market price, now may be a good time to initiate a short position in the company.
Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in CACC over the next 72 hours. 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.