Credit Acceptance Corporation (CACC) Update pt 2

In the month since I posted my rationale for trimming my position in CACC, the stock has fallen just shy of 20%, and I recently began adding back to my position at $192. At these prices, modest growth is part of the thesis, so I haven't added in a really big way yet. I'll add in phases on the way down assuming no other major changes to the situation.

Additional Valuation Thoughts

My prior posts on CACC contain more background (post 1, post 2), but I thought I would lay out some additional thinking on the current valuation below.

CACC has $2.8b of capital which currently earns 12.7% and costs 5% (weighted after tax, per their Q2 PR), which includes 2.65% for the $2b of debt after tax. If we assume they don't grow or shrink and just dividend out that 12.7% in perpetuity, that leaves $14.4 per share for the equity after tax ([12.7% *$2.8b - 2.65% * $2b] /21mm shares) which makes $200 13.9x earnings (7% yield).

This ignores changes to returns on capital, interest rates, growth (or shrinkage, e.g., from a hit to capital by regulators), or changes to their capital structure. 

• Regarding ROIC, this business is cyclical, and on average CACC has earned closer to 14% on capital over the last 10 years or so (more thoughts on this 14% are below). Using this ROIC and assuming an $150mm hit to capital from regulators (see post 2) brings the multiple to 13x. 
• How are CACC's earnings are impacted by rising rates? Given the loan rates are not really interest rate sensitive, but the liabilities are, rising rates is a negative. In 2006, when the 10y treasury yield was 4.7% (vs 2.1% now), their cost of debt after tax was 5.6%. Using the above math and assumptions ($150mm hit to capital, and 14% ROIC) with this cost of debt, results in $12.30 in earnings and a multiple of 16x. On the other side of the coin, a rise in rates could improve the competitive environment because folks can achieve more reasonable returns elsewhere without extending down the risk spectrum into subprime auto, drawing capital out of the market. I cannot quantify this impact though.
• Adding in modest growth assumptions makes the stock look quite reasonable in either of the interest rate scenarios above. For example, in the less favorable high rate environment above, 5% EPS growth and a 10% discount rate (along with the 14% ROIC, $150mm capital hit assumptions) gives $240/share value. I think this scenario is pretty conservative.

It is reasonable to be concerned that the business is becoming more commoditized, and therefore 14% ROICs are a thing of the past. I don't think this is the case. I think this is a niche product that is hard to sell well. Over the years many people have gone broke by skating on too thin of ice, and this will happen again causing capital to withdrawal. Moreover, CACC "packs a bigger punch" than many other lenders in the market. Most folks take a deal that was going to get done and sweeten it a little, whereas CACC takes a deal that wasn't going to get done and makes it happen. All this leads me to believe this is not a product where the lowest cost of capital (banks) wins, end of story. There's also the possibility that something exogenous to the auto market occurs (e.g., 2008 crisis, large interest rate increase) that causes capital to withdrawal and returns to increase.

As I mentioned in the beginning, modest growth is part of the thesis at these prices, so I haven't added in a really big way yet. I will add in phases on the way down (fingers crossed) assuming no other major changes to the situation.

Disclosure: Long CACC

Basket of Japanese Stocks

Continuing on with providing a description of my portfolio changes since last September (beginning of my hiatus from writing due to fairly limited activity) is a basket of small positions (~1-2% each) in Japanese stocks purchased in October/November of 2014. I was pleased to locate these ideas from an individual on the corner of Berkshire and Fairfax message board. Below is a brief description of the rationale for each purchase, as well as the current situation and performance to date.

• Joban Kaihatsu (Ticker: 1782): At the time I purchased it, Joban had compounded book value per share over the prior 5 years at close to 15%, and it traded at 61% of book, 0.7x EBITDA, and 1.7x the average of several years FCFE. Currently it is trading at 478 JPY, which is 80% of book, 2.4x EBITDA, and 5.2x FCFE (5Y average). The return to date has been 56% in USD, and 73% in JPY.
• Fujimak (5965): At the time I purchased it, Fujimak had compounded book value per share over the prior 6 years at 10%, and it traded at 41% of book, 1.3x EBITDA, and 7x the average of 5 years FCFE. Currently it is trading at 790 JPY, which is 41% of book, 1x EBITDA, and 7x FCFE. The return to date has been 2% in USD and 3% in JPY.
• Tokyo Radiator Mfg (7235): At the time I purchased it, Tokyo Radiator had compounded book value per share over the prior 5 years at 9.9%, and it traded at 45% of book, 0.7x EBITDA, and 9x the average of 5 years FCFE. Currently it is trading at 645 JPY, which is 50% of book, 1.2x EBITDA, and 6.7x FCFE. The return to date has been 14% in USD and JPY.
• Car Mate Mfg (7297): At the time I purchased it, Car Mate had compounded book value per share over the prior 5 years at 9.6%, and it traded at 45% of book, 4.8x the average of 5 years FCFE, and had a negative enterprise value. Currently it is trading at 645 JPY, which is 43% of book, 6.8x FCFE, and the enterprise value is still negative. Due to a spike in cost of goods sold, EBITDA turned negative over the trailing twelve months, which is concerning and warrants closer monitoring of this company's progress. The return to date has been -1% in USD and flat in JPY.
• Nansin (7399): At the time I purchased it, Nansin had compounded book value per share over the prior 5 years at 13%, and it traded at 40% of book, 2.3x EBITDA, and 2.6x the average of 5 years FCFE. Currently it is trading at 400 JPY, which is 36% of book, 2.1x EBITDA, and 2.9x FCFE. The return to date has been -11% in USD, and -1% in JPY. 

In aggregate the basket is up 10% in USD and 16% in JPY. This is versus -3% for SPY including dividends since 10/31/2014 (+5% from the bottom of the short sell off in mid October). So satisfactory results to date, although not stellar because the positive performance is really due to 2 of the 5 names. These stocks still appear quite cheap, so I do not have plans to sell yet.

I have gone back and forth, but I currently have left the JPY exposure unhedged. As shown above, this has cost me a material amount.  My main reason for remaining unhedged is that it is expensive to hedge (although it has turned out to be more expensive not to hedge to date).  Additionally, aside from very large cash on these companies' balance sheets, currency movements affect these businesses in fundamental ways that I don't think is exactly 1 for 1 with the current market cap of the company. Lastly all currencies decline, and I don't know which ones will decline faster or slower than others. I no doubt will continue to cogitate on this reasoning.

I will continue to hold each of these stocks as they remain quantitatively cheap.

Disclosure: Long 1782.JP, 5965. JP, 7235.JP, 7297.JP, 7399.JP