There has been a growing discussion developing regarding the strength of the United States auto market. While at first glance it appears that much of the strength has come on the back of strong labor market and continued growth in the United States economy, it is our belief that this is a misled argument that has led to an obfuscated view of the auto market. Contrary to the general view, the auto market has not been the recipient of the relatively stronger labor market as many have said, but rather, predatory subprime lending that will result in large losses for shareholders and businesses alike.
How We Got Here:
Since the Great Recession, the United States economy has had trouble mustering a strong comeback. GDP remains lackluster, inflation has yet to reach the Fed's 2% target, and wage growth has taken time to pick up. The recession itself was a product of massive subprime lending in the housing market that fueled nearly a decade of speculation and fraud that resulted in the losses of millions of jobs, homes, and investments. After the recession, much of the fundamental picture of the United States economy, while somewhat improved, has not yet proven that its long-term rebound has strong merit.
We believe that a large majority of the improvement in the economy is a result of the doubling of US stocks and a false sense of hope in the strength of the labor market. Much of this strength in the stock market has come from easy money provided by monetary policy and a rather dangerous lack of fiscal policy to power the economy forward. Earnings have been lackluster for the past 4 quarters. Also, sales growth has been tepid at best when compared to previous cycles indicating that growth in many businesses has been unwarranted. I have inserted a table of sales growth by year.
|Dec 31, 2015||-3.11%|
|Dec 31, 2014||4.16%|
|Dec 31, 2013||2.24%|
|Dec 31, 2012||3.76%|
|Dec 30, 2011||9.36%|
|Dec 31, 2010||5.98%|
|Dec 31, 2009||-12.86%|
|Dec 31, 2008||1.70%|
|Dec 31, 2007||7.62%|
|Dec 31, 2006||8.94%|
|Dec 31, 2005||10.93%|
|Dec 31, 2004||10.88%|
|Dec 31, 2003||5.37%|
|Dec 31, 2002||-8.45%|
|Dec 31, 2001||-1.18%|
Sales figures are much less manipulated as compared to EPS, which is wildly manipulated through easy money fueling stock buybacks that has propelled stocks forward for the remainder of the bull market.
Moreover, wage growth remains stagnant. Below is a table of wage growth since 1985 as sourced from WSJ.com.
The entire argument regarding job growth centers around the fact that it provides people the ability to service payments and contribute to the economy through consumption. However, this has not been the case as people are making less money than they did before the recession. As a result, people have had to continue to borrow vast amount of money to consume. This point brings us to the auto lending space. Much discussion about the strength of the economy. Nevertheless, this is largely a false statement as auto sales have been backed by large mountains of subprime lending. Below is a table of the changes in US household debt since 2006.
Student and auto debt outstanding has risen to above pre-crisis levels pointing to the vast growth of the auto lending space after the recession. Below is a table of US auto sales since 1967 as sourced from calculatedriskblog.com.
What does this mean for the Auto Market?
My point in discussing the economy before discussing the auto market is to heed warning to bullish sentiment regarding the auto market. Many have claimed that continued economic improvement will prove the bears wrong as consumers will earn more due to the prick-up in wages and continued improvement in the labor market. While this will likely catalyze greater debt pay downs and greater spending, this has yet to happen. In my view, this will not happen given the fact that businesses are beginning to cut costs further as sales have slumped and the global economic outlook begins to dampen. It is my view that a continued slump in the economic conditions will prove dire for many auto lenders that are already reporting heavy losses.
The Auto Picture:
Auto sales units have begun to peak at pre-crisis levels. However, these numbers have been the result of a massive increase in demand for ABS securities that consist of auto and other consumer loans, and by a greater competition in the lending space rather than a pickup in the US economy. New entrants, such as Skopos Financial, have broken into the auto lending space and have done an increasing number of ABS securitization deals that are beginning to be made up of riskier and riskier loans, often consisting of borrowers with no credit history.
An argument often made is that many borrowers suffered a downgrade in FICO scores after the recession. While true, many of the borrowers of subprime loans have less than 3 years of credit history, which means they were not even borrowing before the recession. Below is a chart showing the growing number of auto loans that have been owned and securitized.
As you can clearly see, these securitization levels have reached levels far beyond the pre-crisis environment, which was an era defined by laxative and often fraudulent lending practices. The rapid growth of the securitization packaged auto loans has been the product of subprime, often deep subprime lending. These borrowers are often greatly at risk of defaulting when compared to prime borrowers presenting downside for lenders and ABS investors. According to Fitch, investor yield appetite on ABS securities has picked up as a result of the greater make-up of subprime. While we don't believe that the ABS securities will fully default, we do believe that investor appetite will likely further demand greater yield, or dry up all together exposing many issuers to severe downside. Below, we have given a table showing auto loan originations by credit score as sourced from the Federal Reserve Bank of NY.
These loans that have been given out have increasingly been given to borrowers with FICO scores below 650, which has helped spur a run in this unsustainable, and in some cases fraudulent, auto financing space. As with any debt bubble, these often come crashing down with the greatest losses coming to investors.
It is in our belief that the auto lending space will face its reckoning in the near future, as cracks have begun to show in delinquency rates and investor yield appetites. The delinquency rates on ABS packaged securities were ~4.15% according to Fitch ratings, which have been down from the previous month's 5.16% due to tax refunds. Regardless, they remain hovering above at near 20-year highs and show no sign of slowing. Many argue that these practices are not at risk of catastrophe as nobody buys cars with the hope of the appreciation.
While true, this practice cannot continue as demand from investors diminishes and lending practices come under heavy scrutiny. Furthermore, when many borrowers default, the used car market will be awash with new cars often forcing huge write-downs for lenders and compressed margins for dealers. These write downs will likely be magnified if and when the US economy contracts.
We are bearish on the US economy and are expecting that growth will further slow potentially sending the US into a recessionary environment. Our view rests on the case that debt levels remain elevated and consumer budgets remain tight as wages have yet to pick up. Given the fact that we are in the later stage of the business cycle, companies have begun cutting jobs, CapEx, which puts a dent in a bullish job market case.
Inflation, we believe, will likely remain subdued as the global economy enters a sustained period of stagflation. We are not making forecasts for monetary policy in this article; however, negative rates could be a possibility if things continue to slow as central bank policy becomes increasingly more desperate to create artificial growth. Ultimately, a slowdown in growth in the US economy will further magnify the currently daunting situation for auto lenders and has yet to be priced into lending stocks.
What's the trade?
Now that we have given a backdrop on our views of the economy and how it might affect the auto space, we would like to give a few examples of lenders and dealers that we believe are exposed and have downside potential presenting possible short opportunities.
A few companies that we believe are vastly exposed to this dynamic are America's Car Mart (NASDAQ:CRMT) and Consumer Portfolio Services (NASDAQ:CPSS). We also believe that Credit Acceptable Corp. (NASDAQ:CACC) has downside. Regarding manufacturers, company's such as General Motors (NYSE:GM) and Ford (NYSE:F) will face headwinds. However, they are well capitalized and are much less exposed to a tightening of credit standards and loan defaults.
America's Car Mart:
America's Car Mart's entire business model rests on the selling and financing of used cars to subprime buyers. The business operates in the Southern states and has had a proven track record of success in the past. However, recently, NCOs have been growing and sales have been slumping. This company is particularly vulnerable to both swings in the United States economic environment and the used car market as they do not securitize their loans, but rather, hold the credit risk on their books.
The company's margins will be hampered when many of its borrowers are unable to repay and the used car market becomes flooded with cars sending prices down. Cracks are beginning to show in the auto space as in the United States economy. A potentially recessionary environment will render any bullish cases baseless, as borrowers will further be constrained adding to the glut of used cars and NCOs. As NCOs continue to expand and inch up in the 30%+ region, the NCOs will equal ALL. Cumulatively, these will severely hurt net margins, as CRMT will experience a period of net losses and negative FCF.
Using these growth assumptions, we arrive at a target price of $7.08. We used a WACC of 6.7% and an implied perpetuity growth rate of 4.0%. These assumptions are almost too generous; however, we felt it best to remain conservative. Even in a positive scenario where revenue grows in the mid-single digits, we expect the share price to be $20.36. In an ultimate bearish case, the shares will be worth little to nothing and a restructuring and bankruptcy will ensue. We are skeptical of this scenario; however, it is a possibility.
Consumer Portfolio Services:
CPSS is a specialty finance company that has already seen a large reduction in the share price. The company relies heavily on the ABS market, as it is responsible for originating and securitizing loans. The company frequently does 4 ABS deals per year and has been successful in doing so for many years. While the bullish thesis rests on the undervaluation of the company trading at 4.14x forward earnings, we believe this valuation is warranted and there is further downside to come.
The company's most recent earnings call was dreadful. Management couldn't seem to find an end to the continuing delinquency rates. Furthermore, the company was criticized on its inability to find buyers at current rates signaling that investors are beginning to understand the risks of the ABS loans and are demanding higher premiums. This tightening of credit standards will drastically hurt CPSS.
Provision for credit losses inched up to 32% in Q1 FY2016, and according to management, will show no signs of slowing. Furthermore, delinquency rates are continuing to march higher further reiterating the bearish case. The company will face a drastic slowdown in profitability as the ABS market further tightens and credit losses continue to rise. The company is under-capitalized and will face a liquidity crisis. Unfortunately, for CPSS, the pain does not end here. We believe the shares will be worth 0 in this environment.
Credit Acceptance Corp.:
Finally, CACC is another specialty finance company that has experienced great success in the last 7 years through its binge on laxative lending standards and an explosion of cheap debt for the consumer. CACC has attracted investors due to its above average ROE, which we believe is unsustainable. We believe that, on a peer multiple basis, CACC is overvalued given its current exposure to subprime borrowers on its loan book.
We are not forecasting for a liquidity crisis as the company shares lending risk with dealers and is well capitalized. However, ROE will shrink and P/B will come down from its current value of 4.01x to ~1.7x presenting steep downside risks to the stock. Our target price for the shares are $78.83/share. For our peer analysis, we utilized Santander Consumer, Consumer Portfolio Services, and Ally Financial (NYSE:ALLY).
The auto lending space is yet another example of the dangers of subprime lending. While many believe that losses have been accounted for and are within models, we believe that this is not the case. Many borrowers have been drawn to the easy money and cheap debt that has been made available after the recession. Further securitization has led to greater competition from lenders as they chase profit targets by issuing riskier and riskier loans. These lenders are largely dependent on the ABS market to pass on the risk to.
However, as these markets begin to tighten their standards, the business will slow and profit margins will be squeezed. We believe that it is best practice to remain cautious on this sector and if you are not short, it is best to avoid the auto sector despite recent price declines. The fundamental picture remains weak and will be weaker should the US economy slow.
Disclosure: I am/we are short CPSS, CACC, CRMT.
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.
Additional disclosure: This does not constitute as an offering of securities and all opinions expressed are those of BlackVault Investments. I am receiving compensation from BlackVault Investments and SA.
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