Credit Acceptance: Concerns On Provisions And Loan Book Quality (NASDAQ:CACC)

Introduction and thesis

Credit Acceptance Corporation (NASDAQ:CACC) is a subprime auto lender. They focus on credit origination and management. The company engages with dealerships by entering into agreements under which CACC advances money to them to originate loans and later purchases the loans and services them. So a couple of important considerations from this short description: (1) the company (often) assumes widespread balance sheet risk by keeping the loans on their portfolio, and (2) it is widely exposed to changes in the interest rates.

We believe that CACC is a sell because of many structural issues and exogenous threats. First of all the company is expensive both on an absolute and relative (to peers) basis. And then the higher interest rate environment is slowing down the business and exposing it to a possible wage of higher than expected default rates. We believe, based on previous long-term data related to CACC, that the current provisions for loan losses are not sufficient to cover the potential upcoming defaults.

The past performance and the securitizations

We can analyze what CACC has been doing in the last couple of years, and also look at what exactly went into their securitizations. Indeed, by using finsight.com, we can actually see the loan-level data and statistics to better understand the target clients of this subprime lender.

This is revenue growth in the last 6 years. As we can notice, the lower interest rates extremely favored loan origination and thus revenues. The company grew revenues by more than 60% between 2017 and 2021 (the peak of generous financial conditions). If we look at the 2022 results, it looks like rising rates did not really impact the business, and to see the actual effect we need to look at the bottom line.

Indeed CACC records provisions for expected losses on their loan book, which are directly correlated with the overall economic conditions (and so rates).

This is what operating income (post allowances for loan losses), actually looks like. In 2020, it took a big hit because of covid-related losses, and then again in 2022, it declined almost 50% YoY. We think that pressure on margins is not over yet, and is set to continue in 2023 along with some headwinds on the top line too. We will discuss more of this in the next section and in the valuation section.

If we now go and look at what their clients (and collateral) look like, we think readers will better understand our view on higher-than-expected loan losses.

This is from their latest securitization in 2023, so containing loans originated between the end of 2022 and 2023. As highlighted, almost 20% of the collateral did not provide a FICO score, compared to 17% in 2021. And then all vehicles are used, which increases the risk even more. In light of this data, we think that the overall quality of underwriting has been deteriorating to avoid a reduction in top-line results. And thus this leads to our second point of the thesis: are provisions for loan losses sufficient or will the company take an earnings hit?

Assessing provisions and historical trends

Lenders (and especially subprime lenders) have to put aside provisions every time they report financials, to (1) reduce volatility in earnings, and (2) assure financial stability and solvency. It is required by the GAAP. Right now, CACC has around $2.8 billion of allowances on a $9.4 billion loan book. This means that the company is covered, i.e. it does not need to reduce current earnings, for losses up to 29% of the book.

We now go and see all the statistics on the cumulative net losses of their previous securitizations, always from the same report.

This is a very insightful chart and it shows that usually, for loans that have an average life of 30-40 months, the cumulative losses almost always surpass 30%. Considering that (1) we think the quality of new originations deteriorated, and (2) past losses have always been higher than 29%, we do not believe that current provisions are sufficient. We thus expect that CACC will need to substantially increase them and this will eventually impact earnings and profitability.

What could go right for CACC?

Let’s now briefly look at the counter thesis: what is actually right with this company and what can be done to unlock value on the upside? Well, we think that it has to do with the macro environment first, and any of the company’s decisions after. We believe that a lot of the bad decision-making took place already in the last few years, and to reverse it without taking hits on profitability it would be virtually impossible.

However, an overall improvement of consumers conditions, a reduction in rates, and the used auto market going back to all-time highs would all benefit CACC. The top line of the company is of course highly sensible to all these variables, and if the market notices a pickup in growth it may be willing to increase the valuation even more.

Valuation: CACC is expensive, but what’s the fair price?

As the last point of our analysis, we also want to introduce evidence that supports our opinion that CACC is expensive on an absolute and relative basis. From an absolute perspective, we notice a forward P/E of 16, which represents an earnings yield of just 6%. This means that this stock – a subprime lender with very high risks – is priced with only a 1% premium compared to treasuries and the target FED funds rates. We do not think that this valuation weighs the risks and the downsides of a company like this and that it overestimates the chances of going back to a 2021-like scenario in the foreseeable future.

And this is on top of the comparison to the sector’s valuations. A difference of more than 70% exists from the median P/E FWD of around 9 compared to the 16 multiple of CACC. The astonishing data point is however in relation to the comparison with the 5Y average, which sits below the current level at around 15. This means that the market is more optimistic now than in the last 5 years when rates were sitting at all-time lows.

We now propose some valuation ranges that take into account the risks faced and impacts on profitability. These are only our own estimates with the assigned probability estimated in the brackets (%).

• Worst case (30%): the company will have to set aside substantial provisions as default rates increase higher than expected, and probably issue earnings warnings. This will also be reflected in a lower origination which will also affect the top line, further depressing the operating income and margin. A re-rate to a FWD P/E of around the sector median is then deserved, to around 10. Fair price of $320 per share.

• Base case (60%): CACC will experience some pressure on margins given the higher than expected losses, but the top line and origination is able to remain stable. This will affect operating margins but the re-rate is not as significant and should stabilize to a more conservative P/E of 14. Fair price of $450 per share.

• Best case (10%): very limited losses as the economy and rates may suddenly improve, leaving CACC and it subprime loan book completely hedged and covered. The topline will remain untouched and operating margins will be set on a growing path for the following year. In this case, we expect a positive market valuation to a P/E of around 20. Fair price of $640 per share.

The weighted average fair price would be $430, representing a potential downside of around 20%. We reiterate our view and commence coverage of CACC with a SELL recommendation.