Credit Rejectance (CACC)
Bleecker Street Capital, through its partnerships, has taken short positions in the equity of subprime auto lender Credit Acceptance Corporation (CACC) based on:
Deteriorating fundamentals
Deteriorating capital position
Declining loan loss reserves into a likely recession
Heavily unorthodox portrayal of its economics to investors
High expectations relative to achievable long-term economics of the company
Introduction
Credit Acceptance is one of the largest subprime auto lenders in the U.S., with gross receivables of $9.2B; small within the context of the $550B of auto loans and leases outstanding in the U.S. With originations equal to 7% of U.S. subprime auto loans made annually, its market position could be regarded as small with lots of growth runway ahead.
Indeed, since its founding in 1972 Credit Acceptance has proven an excellent business. Credit Acceptance has a market cap of approximately $5.4B and has generated annualized returns of 14%, outperforming. This performance has quelled the many concerns of some of its subprime auto lending practices and has led to Credit Acceptance being a popular holding of some prestigious value-oriented firms.
In our experience, companies that have established themselves as “compounders” can be attractive shorts at the end of their long runs. Their reputations as a quality company and their status as a long-term moneymaker in investors' portfolios can lead to over-discounting. Embedded expectations get to a level that subsequent economics fail to live up to. This is exactly where we see Credit Acceptance.
We believe that Credit Acceptance has largely saturated its addressable market. Also, do you want to be long a subprime auto lender right now? After an unusual combination of events led to years where used car prices soared in value and the low-end U.S. consumer was in a phenomenal position to repay debts. Those factors have changed, and we think Credit Acceptance will suffer from it.
We see a company that has maxed out its market position. We will also demonstrate it is not nearly as profitable as management portrays. It is heading into a mature state (not to mention a recession likely originating at ground zero of its business) in an overvalued condition. We believe the company is worth $200 to $260 per share, or 35-50% below the current price.
A Word On Subprime Auto Lenders, And Subprime In General
Subprime lending has long been a boom-and-bust business. It feels great when things are going well. When you can make loans with 25-35% APRs, that turns into 7-15% returns on assets (ROA). Lever that 5:1 and voila: 35-75% returns on equity. Sure, you’re in a gritty business. You have to repossess cars and are you are lending to the riskiest consumer, but it’s a business at the end of the day. A firm that puts up those kinds of numbers will be attractive. When optically cheap, value investors flock to these stories like moths to a flame. But if you mis-time your exit, there is a steep price to pay.
When these businesses go bad this is what it looks like: Charge-offs increase from 10% to 20%, credit spreads widen on asset-backed funding, and these profits can get vaporized in an instant. The graveyard of such lenders is populated with many such once-hot companies: Conseco / Green Tree, The Money Store, Jayhawk Lending, New Century, and Mercury Finance are but a few names investors may remember. Other storied subprime lenders such as Americredit and Providian were smart enough to sell out to large, diversified competitors following near-death experiences.
Credit Acceptance has defied those odds and racked up an impressive track record of returns. Since 2007, the company has delivered 17% to 20% compounded annual growth rates in earnings per share, book value per share, and total shareholder return.
We’re not going to argue the morality of subprime finance or pick at any legal or regulatory element of the company. We believe Credit Acceptance has managed its business well, avoiding extreme leverage, pulling back lending when competitors become too greedy, and ramping up lending when competitors go bust.
We display several of Credit Acceptance’s economics above from 2007 to 2019. It was in 2020 that Credit Acceptance adopted the Financial Accounting Standards Board (FASB) current expected credit loss (CECL) model over the former “incurred loss” model. It would not be a stretch to say the company was not pleased with this adoption. Under CECL, the optics of the accounting are vastly different in that:
All expected credit loss provisions are taken upon inception of a loan, are expensed, immediately, and are included in the reserves.
Gross loan receivables on-balance sheet increased greatly with the inclusion of the net present value of future collections on those loans, discounted at a rate similar to (but not identical) to the APR of the loan.
Accretion on the receivable increases gross carrying value in subsequent periods, but this finance charge income is suppressed in the income statement as a contra-revenue item, which increases loan loss reserves.
If this gross income were recognized in revenue without a contra-revenue item, credit loss provisions would rise by an identical amount, which would result in no difference in net income.
Upon collection on the loan or charge-off, the carrying values of the gross loans and loan loss reserves are reduced.
To understand this accounting, we have re-framed two tables Credit Acceptance presents for its receivables walk and loan loss reserve walk.
CECL has had the effect of making the income statement lumpier than in the past, which the company has helpfully pre-interpreted for investors:
From Credit Acceptance’s perspective, we should add back credit loss provisions and deduct finance income adjustments to get to adjusted net income.
From that perspective, the company didn’t earn $23.47 per share in 2020: it earned 63% more, or $38.26 per share. So far in 2022, adjusted net income the company presents is 38% higher than GAAP. In the most recent quarter Credit Acceptance presents adjusted EPS that is 106% higher than GAAP.
Since the adoption of CECL, cumulative net income on a GAAP basis has been 14% lower than the adjusted net income figure management presents.
This approach to framing its results does not reflect the reality of this business or of almost any lender. Income statements are necessarily lumpy in lending because credit costs (one of the largest expenses and in this case, the largest) can shift significantly. These costs can’t just be assumed away.
If the company had a crystal ball and foresaw perfectly the dollar amount of losses it will experience when it originates a portfolio of loans, then under CECL the loss provision it expenses in the originating quarter will be the only credit loss expense the company will ever take on that portfolio. Think about that for a second.
Credit Acceptances framing indicates we should completely ignore the biggest expense on the income statement. Candidly, this is stupid. This framing should immediately go in the pantheon of misleading pro-forma earnings adjustments.
Prior to the company’s adoption of CECL, its portrayal of adjusted net income differed immaterially from GAAP.
From 2006 through 2019, adjusted net income differed from GAAP by 1%. Here’s what various return metrics look like since the adoption of CECL in 2020:
We will point out here the subprime auto lending environment since June 2020 has been (well, had been) one of the best in history. Real interest rates have been low to negative, demand-side fiscal policy has not been this robust since the late 1960s, and used car values skyrocketed, lowering net charge-offs for lenders, and increasing the dollar value of each loan.
CECL has totally changed the visible metrics of this company. What appeared to be a 40% ROE business for years is really a 12-20% ROE business, according to our analysis. To be clear, that’s not at all a bad business given ~25% equity capital supports the balance sheet. We believe this is a 2.5% to 5.5% ROA lender in the long run, which is still an incredibly healthy business.
That’s It, You Don’t Like Their Pro-Forma Presentation?
We believe Credit Acceptance’s presentation of financials has helped set-up a mispricing as it has helped obscure the deterioration of fundamentals we see underway. Not to sound glib, but again: Do you really want to own a subprime auto lender right now?
CECL’s impact can be simply understood as more assets coming onto the balance sheet and a more transparent presentation of the company’s credit losses (though the presentation conforming to the CECL standard is still opaque). Since then, we have seen a number of key performance indicators degrade.
The company’s capital position is the first of these.
Credit Acceptance’s absolute level of equity capital isn’t problematic. We believe it is appropriate given the business model. However, the trend is indeed down and to the right and we believe that excess buybacks won’t be available for some time.
The second and more acute problem can be seen in loan loss reserves, which have declined as a percentage of gross loans over the last two years and in five of the last seven quarters.
Reserves as a percentage of past-due loans have declined from a high point of 110% in Q1 2021 to 87% in Q3 2022. DQ’s and roll-rates into very aged buckets are very high. 19% of loans were 11-90 days past due in Q3 and another 17% were 90+ days past due.
In another sign of reserve weakening, in the last four quarters credit loss provisions plus accreted finance charges only covered 83% of net-charge offs. That has led to a decline in reserves from a high of 50 months of net charge-offs to a post-CECL low of 25 months in Q3 2022.
Finally, net charge-offs have increased from 9.6% in the year in which CECL was adopted to 15.1% (annualized) in Q3 2022.
For a subprime auto lender, all of these trends going in the same negative direction is alarming.
Remember Used Car Prices???
These increase in charge-offs will become an issue as used car prices start to erode materially. The Manheim Used Vehicle index has already declined 14% from its January 2022 high and is still 40% higher than pre-pandemic levels.
This is a problem for Credit Acceptance because used cars are the collateral for their loans. When used car values are going up all is fine; that game is over for the moment. Indeed, the situation has become somewhat dire.
We believe that declining collateral values will lead to higher charge-offs, which will necessitate increases in loan loss provisions. For FY 2023 we estimate GAAP EPS of $14.61 compared to adjusted consensus of $45.00. For FY 2024, we are at $26.61 vs adjusted consensus of $49.11.
In other words, we believe the company is trading at 27x 2023 EPS while consensus numbers would have investors believe CAC is trading at 8.7x. Our difference in analytical opinion isn’t some small academic point. These differences in earnings estimates are huge.
We haven’t modeled this as a particularly severe cycle. Our model shows provisions and charge offs normalizing withing two years. In its worst year, we see Credit Acceptance producing a 2.6% return on assets and a 13% return on equity -- still a healthy level of profits.
We believe the economic returns of this business are accurately reflected in GAAP financials. We disagree, however, that adjusted net income and GAAP net income will converge, which we understand is management’s belief. We don’t see that as possible if you ignore the largest expense item in perpetuity. We believe the adoption of CECL has provided needed clarity in the economics of CAC, which were far more opaque before the adoption. Ultimately, GAAP captures the economics of this business.
There Is A Season For Everything
As good as the returns look, whatever the accounting, the company shows signs of having reached maturity. Receivables have been stagnant to lower since Q3 2020 and Q2 2021 was the higher water mark for both pretax pre-provision earnings and net income.
Furthermore, the number of active dealers from which Credit Acceptance buys loans or to which Credit Acceptance provides loans declined in both 2020 and 2021. Attrition runs at 31% to 55% annually. Credit Acceptance more than replaced departing dealers for years, but new sign-ups have failed to cover departing dealers over the last 2+ years.
Currently, the company has a lending relationship with 11,000+ dealers, or 19% of the 60,000 dealers it targets as addressable. If each of these dealers produces a larger amount of subprime loans than the average subprime dealer, then Credit Acceptance’s market share runs from an estimated 19% of its addressable market to 30%+. While the company frames its market share as only 3-4% of total subprime loan originations in the US, we believe our framing better captures the competitive reality of this situation. There are large swaths of the subprime lending market that are far more competitive, with returns nowhere near as attractive as Credit Acceptance’s.
We don’t want to call Credit Acceptance a bottom feeder, but it serves the least credit-worthy segment of borrowers. If we’re correct, it doesn’t matter if Credit Acceptance grows in the more competitive part of the market from here. Incremental growth producing returns equaling its cost of equity would have zero NPV and is therefore irrelevant (because the growth rate equals the discount rate).
Even if Credit Acceptance is holding off on growing its loan book after a run of great industry performance (which we applaud), we see subprime lending as fairly well consolidated. We believe market share of 19-30%+ in a consolidated (but still competitive) industry is indicative of maturity with lower growth in the offing.
At the current quote, here’s where Credit Acceptance is trading on a variety of metrics:
With mid-single digit topline growth over a 5, 10, and 15 year time horizon, ROA of 2.5% to 5.0% over that time horizon, and ROE of 13% to 20%, we see the company as being worth $206 to $260, with our assessed value of $235 per share comporting with a ten year period of positive incremental returns on capital vs cost of equity. Our valuation implies the following:
We believe the current valuation demands the company grow loans and net income ~10% annually for 15 years with an end-state ROA of 6% and ROE of 17%. This would require further penetration of the addressable dealer market or growth of loans per vehicle at an unsustainably high rate. In 2021, the average loan against which Credit Accetpance provided an advance was $25,000+. The payment on that at a 25% APR for 59 months is quite a bite already for this consumer set.
Conclusion.
We aren’t short this to complain about subprime lending and we don’t underwrite this company as a poorly run entity. We also don’t have a problem with GAAP accounting, which is complex and interesting, but ultimately comprehensible. We disagree deeply with how management portrays its adjusted earnings and we’re sure more than a few large institutional shareholders get that part wrong in adopting management’s framing of earnings.
We see a legendary compounder tiring. We believe this company is nearing maturity and market implied expectations will not be realized. Near-term, we believe the Street is vastly over-estimating earnings (GAAP) and see Credit Acceptance running into a number of disappointing quarters. We are therefore short this equity in our funds with a view of fair value ranging from $206 to $260.