Consumer Portfolio Services (CPSS) Stock: Securitizations Raise Some Red Flags

Overview – The business model and the past results

Consumer Portfolio Services (NASDAQ:CPSS) is active in the subprime auto loan market, where it operates as both an originator and a servicing company. They usually buy the majority of their loans from car dealers, and more than 90% of these loans are for used cars. To assure a continuous turnover of new loans they sell the acquired loans through securitizations, which help them get fresh capital that they will use again to purchase new loans.

So, how do they earn money? By collecting the remaining interest and collection fees from these securitization deals after all the other noteholders are paid off. This is called “excess spread”, which is the residual interest of the originator (CPS) after paying off the other tranches.

In the last 5 years, fueled by low-interest rates (i.e. easily accessible borrowings), the company experienced massive growth in revenues, loans, and thus net income. This led to generous multiples and market cap, and a strong stock performance that saw the market value going from a little less than $80 million to more than $300 million at its peak. But I think that this rapid growth was at the cost of assuming excessive risk at the top of the credit cycle, both in terms of the quality of the loans and the amount of the originations that still remain on the balance sheet.

An overview of their originations and securitizations

If we take a closer look at their portfolio, which can be done through the analysis of the rating report of the securitizations, we can find very alarming data. The excess spread they earn in each transaction fell dramatically from a strong 14.7% to a mere 7.5%, nearly 50% lower. This measure is particularly important as it shows how much CPS will be remunerated if the deal is successful (i.e. borrowers pay back the loans), and right now their expected profitability is worse than ever.

Even if we go back to the 2014-2015 period, when there was a very tight credit environment for auto loans, they were able to get a much better excess spread on each securitization. Now, with the BBB tranche coupon at more than 12%, it seems almost impossible for them to get a decent deal. I think this could result in revenues being cut in half in less than 12 months, while the rising cost of funding will probably negatively affect their margins.

The cost of funding, as also directly disclosed by CPS, rose to a multi-year high recently, with the October cost rising to as much as 7.5% (computed as the weighted average yield of the securitization tranches). The other relevant point is the loan-level data of their deals. In the last 12 months, going back to 2021, they originated loans with an average Loan-to-Value (LTV) above 120%, to deeply subprime customers with a FICO score of 583.

As noted, the quality of the borrowers did not improve from 2021, despite a completely different macro and credit environment, which for me raises some red flags on the risk management approach adopted by the company. As we can see, the excess spread is under pressure not only because of rising costs, but also because APRs are not increasing proportionately with these rising interests (up only 1.5% from the 2021-D deal).

Delinquencies are also on the rise in 2022, affecting the 2021 deals, and lowering the distributions to CPS coming from their residual interests in the securitizations (equity tranche).

After the summer of 2022, we can see an acceleration of 90+ days past-due loans, which are the fastest-growing delinquent loans. Although this is an example coming from a specific deal closed in 2021, many others are very similar, also from the start of 2022.

Summing up: the impact on profitability, balance sheet, and valuation

In my opinion, CPS will go through a much worse downturn than the one experienced in 2015-2017, because:

1. They have a much heavier balance sheet ($2.5bn vs an average of $2bn in the past years).

2. The credit environment is very different and substantially “closed” and risk-averse.

3. In my opinion, they incurred excessive risk in the last 2 years in terms of borrowers’ quality, as shown in the securitizations.

Most of the negative impact will come directly from the rising costs of funding the business (cost of borrowing). On their loans and credit lines alone, which have a $240mm outstanding balance, they will experience a 4-5% increase (due to LIBOR linkage). This means $10-12 million of additional interest expense or 13% of TTM net income. Then the rising costs of securitizations will come.

As the old deals will mature, they will need to roll into the newer, much more expensive, contracts, for 1.5-2x times the interest they paid in 2019, and even 5x what they paid in 2021. I expect that the $64 million of interest expense coming from these deals will almost double by the end of 2023, to more than $100 million (back to the 2018 levels).

This is a comparison to 2021, when the aggregate interest expense was $75 million, while in 2023 in my opinion could reach $116-120 million. Computing this number into a 2023 forecasted income statement, with revenue growth in the low single digit (5%), we end up with net income down by more than 80% (expected at $15-18 million from $90 million).

Net interest margin is expected at 58%, down from 78% in 2022, and 84% in 2015. A massive downturn that could only get worse from mid-2023 on, as the higher rates environment will persist and their roll-overs will become more and more expensive.

How will this affect valuation? Well, in very simple terms, if we keep the same average multiples the market used to value the company (4.5x P/E multiple), we should expect a fair equity value of around $67-80 million, or $2.6-3.0 per share.

What are the Upside Risks? (what could go right for CPS?)

The opposite could also happen. As with any other investment thesis, I could be wrong if one of these scenarios takes place:

1. The tough credit environment will cease in 2023, and low rates will come back very fast.

2. The company is able to contain the spreads from widening, by increasing the quality of borrowers while not reducing volume (very unlikely, as simple math suggests).

3. The management is able to substantially reduce Opex, and start a very aggressive cost-cutting campaign to keep net income afloat.

All these events could of course benefit the company and its valuation, avoiding a collapse of its stock price and keeping its current (generous) valuation. Also, an introduction of a dividend policy could, in my opinion, benefit the stock in the short term, although they may not have the resources to do this now.

Conclusion

Consumer Portfolio Services is on the edge of a new period in the cycle. After years of generous lending at very risky terms, and cheap borrowing to keep this cycle ongoing, the conditions have changed. This could mean a collapse of the stock price following the expectations of much lower EPS at the end of 2023, impacted by higher cost of funds and low revenue growth. I think the fair value of this stock is much lower than the current levels and lies at around $2.8-3.0 per share (a 60%+ overvaluation).