Santander Consumer USA Holdings Inc. (NYSE:SC), a subsidiary of Santander Holdings USA Inc. (SHUSA), is a large auto loan originator based in Dallas Texas, which specializes risky loan originations. As an independent originator, they operate as a direct provider of credit and as a "captive" provider through the Fiat Chrysler Agreement, which was formed in 2013 and is an essential part of their business. More on that later…
To give you a sense of size, last year SC originated 21.6 billion in auto loans and securitized 15.8 billion making them the largest securitizers of auto-ABS in the country. The industry is highly competitive with no single player comprising more than 6% of the total vehicle financing market. Santander ranks 8th.
A little about the industry. Since the end of the financial crisis, the auto industry, as measure by units sold per year, has grown impressively. Spectacular growth of a particular industry by no means should warrant concern, but it does warrant examination. The question that should be at the forefront of every investor's mind should be this, is the growth organic or unsustainable? In the United States, vehicle growth closely follows that of the U.S. economy in general.
The growth, if sustainable, ought to be built on the back of real economic growth. While GDP per capita has grown 19% since 2010, vehicle financing has grown 49%. We believe consumers are chewing off more credit than they can swallow, and to do this, they are financing their vehicles for a record length of time than ever before. The average number of months an original buyer of the new vehicle holds that vehicle is 71, but the average loan term for new vehicles is 68 months. These numbers showing the percentage of vehicle life through which the owner is financing are at record highs.
You don't have to be an industry expert to notice something is off about the industry. We have all seen the advertisements for zero down payments and many-month financing of vehicles.
Many dealerships offer credit for those with incredibly low or no credit scores whatsoever, it is almost laughable. The auto-loan origination industry has grown on the back of easy credit and that easy credit won't last. As depicted by the graph below, we see a strong correlation between Federal funds rate and affordability of various types of consumer debt.
Since 1985, the Fed-funds has been generally downhill with intermittent periods of credit tightening in grey (followed by market corrections of 87' 00' and 07'). Cheapening of credit has created greater demand for credit. Increased origination and particularly that of risky origination has led to the increased practice of passing off that risk, securitization. The chart below shows the growth in the auto-loan origination and securitization industries. Consider this strong growth in relation to the unprecedented drop in the Fed Funds to a current rate near zero. When the credit easing ends and the Fed "normalizes," so will consumer financing and securitizations.
Here is where the date gets really interesting. While unemployment is at 20-year lows, subprime delinquencies are at 20-year highs. This is at the least, quit odd. These numbers ought not to be inverse. Below a simple graph depicts unemployment and 90+ day delinquencies. When unemployment goes down so should delinquencies, and when unemployment up, delinquencies up. Any deviation from this flow should warrant concern.
Since late 2013, this deviation is exactly what has occurred. Only once since 2004 have these data points had an inverse relationship, in 2006. Even here the correlation was miniscule. Since 2014, these movements have been much stronger. It is a chilling indicator that something is wrong with the industry, and we believe that to be the unsustainable lending practices.
We picked Santander Consumer in large part because 1) it is particularly leveraged in relation to peers, 2) carries a very risky loan portfolio in comparison to peers and 3) is fully exposed to this risky portfolio and dependent on the securitizations of these assets.
Data taken from most recent 10-Ks
1) In comparison to Santander, we have its most similar competitor Credit Acceptance (NASDAQ:CACC), American Honda Finance Corporation (AHFC), CarMax (NYSE:KMX) and Ally Bank (NYSE:ALLY). SC maintains the second highest leveraged position behind that of ALLY. We believe companies with the highest leveraged positions will be disproportionately affected in the event of an industry downturn. With an equity multiplier of 7.8, a small write-off of assets in its balance sheet will read to extreme swings in its price to book. More on this later…
Note also SC's liquidity position with a current ratio of .91. In examination of the 10-K, we see also that SC has very low cash reserves. We also see a very significant portion of its total liabilities are classified as short term. Companies that have short-term debt as a large percentage of total liabilities are often in this situation because creditors do not trust their ability to fulfill debt obligations and thus only lend for short-term time horizons. This is most definitely the case for the industry in general, but particularly, the case for SC with a whopping 90 plus percent of total liabilities being short term.
Taken from 10-Ks
2) Santander maintains a highly risky loan portfolio, specializing in high risk customers accordingly charging them an average rate of 16.2%. SC is a very undiversified company with 77% of income coming from interest on receivables and 23% from leased vehicle income. Unlike competitors, such as Ally, it is fully exposed to its risky portfolio. ALLY, which is the largest and considered a fairly risky auto-loan originator, maintains a far less risky portfolio in comparison to SC. When analyzed side-by-side, the riskiness of SC's portfolio becomes clearer. Here is a breakdown of FICO bands for context.
Page 43 of ALLY 10-K 2016
Page 106 SC 10-K 2017
While 60% of ALLY's retained origination contracts are prime and better, less than 14% of SC's are in that same band. 15.3% (includes commercial) of SC's contracts come from customers with no FICO history whatsoever! The average FICO of SC's retained loans is 598, only just within the subprime category.
3) We say retained because SC securitizes a huge portion of their contracts. Last year SC securitized 15.8 billion, making them the largest securitizer of auto-loans in the nation. Securitization is extremely important to the industry as it allows for the monetization of assets and thus the extension of more credit more quickly. SC has grown reliant on this process, not only to pay those short-term obligations we talked about earlier but also to unload its risk.
Should the demand for these securitizations go south, Santander would experience significant problems. In fact, during the last financial downturn, there was a 24-month time period under which SC could not securitize. Its ability to stay above water would have been compromised had it not been for SHUSA's extension of a favorable $6 billion line of credit.
Let's discuss that corporate structure a bit. Santander Consumer USA is a subsidiary of Santander Holdings USA Inc. (SHUSA). SHUSA is a Boston-based consumer bank, which operates as a portion of Banco Santander S.A. (NYSE:SAN). SHUSA is one of the top 30 largest banks in the U.S. with 126 billion in assets. In 2013, they became one of the first US banks to fail a stress test, and they have continued to fail every year since.
The resulting sanctions put in place by the Federal Reserve Bank of Boston have resulted in penalties and the abolition of all dividends for SHUSA and all its subsidiaries including SC (59% owned by SHUSA). Due to SHUSA's position, it is doubtful that in the event of an industry downturn, it will be able to help SC to the extent that it has in the past.
Round 4) Bonus round!
The Fiat Chrysler Agreement is a 10-year partnership between Fiat Chrysler (NYSE:FCAU), an Original Equipment Manufacturer, whereby SC serves as a "captive" and preferred provider of credit for FC and its customers. FCA is a huge portion of SC's business. In 2016, 49% of all originations were done through the Fiat Chrysler Agreement. Since its May 2013 inception, SC has originated a spectacular 38 billion in retail installment contracts though FCA. The agreement was created with certain expectations and contractual obligations to be met by both parties. On page 46 of the K we read:
Under the terms of the Chrysler Agreement, certain standards were agreed to, including SC meeting specified escalating penetration rates for the first five years…The failure of either party to meet its respective obligations under the agreement could result in the agreement being terminated.
Not once in the history of the FCA agreement has Santander Consumer met these penetration targets.
In the above screenshot taken directly from page 46 of SC's 2017 10-K, we see targeted and actual penetration rates by year. In the most recent year, SC missed by an astounding 47%! We believe that FCA will be terminated.
We see a 10% write off of SC's assets to a realistic, and very conservative estimate for the next 12 months. Let's begin with the most recent year-end balance sheet and a hypothetical balance sheet given a 10% asset write off.
As we can see, assets drop by over 4 billion, liabilities stay flat and equity adjusts accordingly. The price to book moves from a modest .86 to 3.25. Should we multiply our new PB of 3.25 by our new equity, we calculate a market cap of 4.507 billion. This divided by our shares outstanding yields a price per share of 12.51. HOWEVER, investors are not willing to pay a stock price this high for such a reduced balance sheet.
Because SC trades on price to book, if we can calculate a "fair" or more reasonable PB using an avg. ROE/WACC analysis, we can do some simple accounting and arithmetic to determine what the market cap must change to for a proper market adjustment to take place.
Using a conservative 10% asset write off, we calculate a PB of 3.25, too expensive for investors. Below we calculate a historical and more accurate PB with the new 2017 write-off factored in. We believe 10% to be highly reasonable given both A) Poor FICOs of customers and B) the "inelasitcity" of defaults. Customers are more liable to default on their car payments before other obligations such as a home.
A computed PB of 1.99 multiplied by our new Equity of 1,385 and divided by our shares outstanding, we reveal a target price of 7.65.
The Auto industry is overstretched built on the back of consumer debt and easy credit. Santander is the 2nd most leveraged publicly traded auto loan originator and maintains a very risky loan portfolio in relation to peers. SC is heavily reliant on securitizations, should the demand for these products go south, they will experience liquidity problems.
FCA is a failed agreement comprising 50% of SC's originations; it will be terminated. SHUSA's regulatory and financial situation is poor; its ability to help out SC as it has in the past is questionable. A realistic 10% write-off in SC's balance sheet will lead to a significantly reduced equity, a new PB of 1.99, and an implied share price of 7.65.
Short Santander Consumer USA Today
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in SC 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.
Additional disclosure: This research and Publication was done in collaboration between Tim O'Brien and George Daugharty of Grove City College