Credit Acceptance Corp: Strong Returns Driven By Improving Financial Results

Credit Acceptance Corp. (CACC) is a current selection of GuruFocus’ Undervalued Predictable Companies screen. As with other low-credit lending companies, CACC has demonstrated impressive top and bottom line growth over the past decade. Since going public 21 years ago, EPS has grown at a 20.8% CAGR, with an average annual ROE of 20.7%.

This strong growth has allowed CACC to consistently earn returns higher than their cost of capital. The company has benefited in recent years from both stronger loan performance and an ability to lower their capital costs from both increased scale and lower interest rates.

As can be expected, impressive underlying financial results have created a multi-year track record of market outperformance.

While past results are encouraging, let’s take a look at how the company has achieved this and evaluate its future prospects in comparison to the current valuation of its shares.

The Business:

CACC offers financing options to automobile dealers that enable them to sell vehicles to consumers, regardless of their credit history. The company works with a nationwide network of automobile dealers, enabling them to expand vehicle sales opportunities beyond their typical customer. Customers typically consist of individuals who have been turned away by other lenders.

Key benefits for dealers include:

1. Allows dealers to share in the profit, not only from the sale of the vehicle, but also from financing.
2. Enables dealers to attract consumers by advertising “guaranteed credit approval”.
3. Enables dealers to attract consumers who mistakenly assume they do not qualify for conventional financing.

CACC generates revenues through two programs: a Portfolio Program and a Purchase Program. Under the Portfolio Program, CACC advances money to dealers in exchange for the right to service the underlying loan. Please see the company’s 10K for a detailed explanation, but CACC essentially fronts a cash advance to the dealer and makes that money back as the loan is paid off. The dealers also keep some of the profit after the initial cash advance is paid off, net of any collection costs and servicing fees. The Purchase Program is much simpler, with CACC essentially taking ownership and responsibility for servicing 100% of the loan.

CACC is primarily exposed to the more nuanced Portfolio Program. Regardless of the method however, CACC is ultimately lending money to customers with atypical (bad) credit histories and is reliant on their selected pool of borrowers to pay back these loans.

CACC’s Loan Portfolio:

Their typical loan is ~$16,000 for a term of roughly four years. No single dealer accounted for more than 10% of total revenues during any of the last three years.

Additionally, their loan portfolio is well-diversified across the United States.

As can be expected of a company offering financing to less-than-creditworthy customers, loan recovery rates have typically been ~75%, suggesting a ~25% default rate. The company uses statistical models to estimate the expected collection rate for each loan at the time of assignment.

Competition:

Unlike the personal loan market, competition for auto loan financing is highly competitive. However, the company has developed a number of programs that heighten its attractiveness to dealers seeking additional financing options.

1. Dealers have an ever-increasing incentive to stick with CACC – The company has an established rating system for its dealers where the longer the dealer stays with CACC or the more business they bring in, the higher they will be in the rating system. Higher rated dealers benefit from receiving a larger advance when a loan is assigned to CACC and they are entitled to a larger share of the profit sharing payments. This process makes CACC's dealers increasingly loyal to the company. This program has been a main contributor to the rapid growth in active dealer relationships, increasing from 950 in 2003 to 7,247 in 2014.

2. Ancillary services enhance value-add - Besides their main auto financing business, CACC has opened up more revenues streams by offering reinsurance and earning commissions from selling third-party insurance as means of offering more value added services to the dealers.

3. Low cost of borrowing helps CACC offer attractive loan terms - CACC packages loans together to create collateralized debt obligations (CDOs). These diversify CACC’s exposure and create scale to lower their cost of capital.

Rising Regulation Still A Risk:

Late last year, the U.S. Consumer Financial Protection Bureau expressed a desire to regulate the finance units of major car companies, focusing on the 38 largest nonbank lenders in the automotive sector. The bureau already supervises banks' automotive-lending divisions. It has proposed now supervising nonbank entities that make or refinance at least 10,000 loans or leases annually. Smaller and medium-sized players such as CACC should expect increases in compliance costs. Compared to the proposed regulations on consumer personal loans however, these new regulations should have a fairly limited negative impact.

Valuation:

While the shares are up >700% since 2009, most of this appreciation has been due to strong financial results as opposed to the speculative return of multiple expansion. Since 2010, CACC has traded at ~10% FCF yield and between 10-14x EV/EBIT, fairly attractive for a consistent double-digit grower.

Even with limited debt usage, CACC has continually achieved impressive returns on equity.

As mentioned, the extreme run-up in the company’s shares was primarily due to strong financial performance. Even at today’s valuation, investors are pricing in significantly less growth for the company going forward (see Gurufocus’ Reverse DCF tool).

Growing Insider Ownership:

Over the past 10 months, insider ownership has increased 500bps to almost a third of the company’s outstanding shares.

Controlling almost 20% of the outstanding shares, founder and chairman Donald Foss still has a significant interest in the company, aligning management’s interest with shareholders.

Conclusion:

While the extreme run-up in CACC’s shares may scare off some value-oriented investors, this has primarily been driven by the underlying financials rather than multiple expansion. While future regulations are a concern, this seems like an opportunity to invest in a robust and growing company at an attractive valuation. For additional companies like this, please see GuruFocus’ Undervalued Predictable Companies screen.