CACC: Recent Events Add to the Short Thesis

by: Jackson America

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 (NASDAQ:CACC), and the current stock price does not adequately discount the risk of deleveraging the balance sheet (or worse). Recent events at Wachovia (NASDAQ: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 (OTC: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 (NYSE: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 (NASDAQ: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.