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

Credit Acceptance (CACC) Update

In the short period I have owned it, CACC's business has continued to perform remarkably, and I continue to be very impressed with management.

In the last few quarters CACC has experienced solid loan growth and performance with relatively minor spread concessions (due to modest term extensions). Importantly, they have also shown growth in loans per dealer (5.8% YoY in Q2 2015), which previously had been declining sharply. Management uses this metric to monitor industry competitiveness (increasing loans per dealer indicating declining competitiveness). A few other notes:

• Q2 2015 adjusted return on average capital: 12.7% (compared to peak of 18.7% in 2010, and last cycle trough of 11.2% in 2008)
• Q2 2015 spread on origination: 24.1% (compared to 2009 peak of 35.3%, and last cycle trough of 21.4% in 2007)
• Q1 and Q2 2015 YoY loan unit volume increase: 28.4%, 30.6% 
• Collection forecast variances continue to be positive
• After having the FTC complaint resolved without incident, no additional changes have occurred on the legal inquires (DOJ and Massachusetts AG)

In short, they are firing on all proverbial cylinders. 

The stock has risen quite a bit more rapidly than I would have expected. At $250, it currently trades at 18.4x management's adjusted earnings per share (Q2 2015 TTM).

At these levels, the market is pricing in a fair amount of growth and franchise value into the stock, which is probably reasonable. I still fear regulatory issues and the possibility that they could send the stock tumbling. As I've followed the industry more though, the fines that are coming out of the CFPB and DOJ seem manageable for CACC. I've seen fines ranging from $25mm at Honda to $100mm at Ally. If one assumes an $150mm (I assume higher than others in the industry to be conservative, not because I think CACC is "worse" than the others) hit to capital due to a regulatory fine, it trades at 19.8x (150mm fine at approximately 14% returns on capital and 21mm shares is $1 per share in earning power reduction).

All this considered, I sold a large percentage of my position at around $206 (average cost of $125). I still own a non-trivial position, but it is only in the 2-3% range. However, I have and will continue to consider adding to my position because it is rare that I find something I feel I understand reasonably well with a management team as strong as this one. Clearly to date, selling shares has been a mistake.

Disclosure: Long CACC