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