Credit Acceptance Corporation

Moat: 2/5

Understandability: 3/5

Balance Sheet Health: 3/5

Credit Acceptance Corporation (CACC) provides auto financing and related services, allowing franchised and select independent automobile dealers to offer financing options to customers regardless of their credit history, primarily through its Portfolio Program, also offering a Purchase Program to lenders to sell their loans.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Credit Acceptance Corporation operates in the auto financing industry, with a focus on providing financing options to consumers with varying credit histories, which is quite different from traditional lenders which have strict eligibility requirements. They also offer a program for lenders to sell their loans to them which gives them an access to capital. Their profitability and success is dependent on their ability to collect payments from their loans.

Business Overview

CACC’s revenue streams from finance charges, which are generated from loans facilitated by the company and premiums, typically from the sale of their “Dealer” and “Purchase” programs.

  • Under the Dealer Program, CACC provides credit for used-vehicle buyers, earning finance charges over the life of the loans.
  • Through the Purchase Program, CACC purchases consumer loans from other lending partners, generating premiums (and associated fees) at the time of purchase, and collecting interest and principal payments over time.

The company’s profitability is closely tied to consumer loan performance, meaning that their success relies on timely repayment and minimal loan defaults. This is because the assets of the company are primarily these loans, which also provide the main source of revenue.

The automotive financing industry is competitive, featuring a wide array of lenders, from traditional banks to credit unions and specialty finance firms. Several trends are at play, including the rise of subprime lending, increasing use of technology in lending, and evolving regulations. CACC differentiates itself by focusing exclusively on the subprime market, which is a less competitive landscape compared to the primary and super prime markets. They have been operating in this space for many years and know a lot about the type of customers they serve. However, this focus also means that their business is highly vulnerable to economic downturns and bad financial performance of the customers who have the lowest credit ratings.

A notable trend is that loan quality in this sector is worsening, and that’s why this industry has become highly susceptible to regulatory changes. Recently, they have received multiple investigations and lawsuits for their handling of consumer data, and for their business model as a whole. The investigations are still ongoing, and if not handled properly, they can result in serious impacts on the operations and the overall financial situation of the company.

CACC’s Moat

Rating: 2 / 5

Credit Acceptance Corporation’s competitive advantage, or “moat,” is relatively narrow, primarily relying on:

  • Specialization in Subprime Lending: The company’s focus on a niche area of the auto financing market can be difficult for more traditional lenders to enter and compete with CACC. This allows CACC to target customers who are typically underserved by these lenders. However, they are equally exposed to the volatility of this segment of the population as their business model is concentrated on sub-prime borrowers. This can be negative as these segments of the population are highly correlated to recessionary trends, thereby hurting CACC more than a company with a more diversified consumer loan base.
  • Proprietary Analytics and Collections: CACC relies on its proprietary models to underwrite, price, and handle the collections process of its subprime auto loans. There are concerns regarding whether their proprietary models are indeed better than competitors, or if they’re using it to extract higher than reasonable rates from its clients.
  • Established Dealer Relationships: They have developed long-term relationships with dealerships, giving them an easier avenue for selling its products to their potential customers.

However, CACC’s moat is not considered wide due to:

  • Regulatory Risk: CACC is subject to a high level of regulatory risk with increasing government oversight and challenges regarding their lending model. These changes can easily cripple their profitability.
  • Intense Competition: While it has carved out a niche, the company still faces strong competition from other specialty finance companies and lending platforms. These are growing at a rapid pace, and offer more flexible options, which reduces CACC’s defensiveness against these competitors.
  • Technological Disruption: New financial technology (fintech) companies with advanced risk models, can disrupt CACC’s traditional business model, especially if they create models that allow them to better price the loans or even outcompete CACC in their credit metrics.

The nature of subprime lending exposes CACC to higher default rates and greater regulatory scrutiny, which limits its moat in the long run. Also, their business model is easily replicable. Other competitors can always adopt their model and focus on the sub-prime sector. Therefore, their moat is not very wide or defensible in the long run, as their operations are subjected to significant risks and competition.

Risks to the Moat and Business Resilience

CACC’s major risks to its moat include:

  • Economic Downturns: Because the company’s business is tied to the sub-prime market, economic recessions and periods of high unemployment can lead to more defaults in their loans, impacting profitability and shareholder returns.
    • A recent downturn in used car prices, combined with a recessionary environment, can reduce recovery rates on defaulted loans, which can negatively impact CACC’s earnings and profitability in the long run.
  • Regulatory Pressures: Increased regulatory scrutiny of the subprime lending industry could restrict the company’s ability to make loans, impose higher compliance costs, and/or lead to operational limitations for which they are not prepared for.
  • Credit Quality Deterioration: There is the risk of rising credit risk and delinquencies in their lending portfolio, especially in the event of poor economic conditions.
  • Competition: CACC faces significant competition from both traditional and non-traditional finance companies who might adopt a similar business model.
  • Technology Disruption: New technologies can easily disrupt their business model and the methods they use to evaluate and underwrite loans.
  • Negative Perception: The company’s focus on subprime borrowers has led to negative media attention and perception which is not good in their operating jurisdiction. They can also have trouble attracting top talents because of its business model.
  • Operational Difficulties: As their business relies heavily on collecting debt, they have a difficult and demanding business to run successfully for the long run. A poor management decision can hamper the collection process, creating financial losses for them.

Despite these risks, CACC has a proven history of adapting to various economic environments, and of generating profits over time. Their business model has been consistently successful in the past, and is likely to remain resilient in a wide array of economic conditions. They have also created the ability to react quickly and decisively to new changes in regulations and other factors. Their expertise in a highly specialized industry is also a great advantage. So even if they suffer some financial losses, they are likely to recover from those losses.

Financial Analysis

CACC’s financial statements show a mix of stability and potential risk:

Income Statement:

  • CACC’s revenue has been driven by loan originations and portfolio growth. They are showing consistent growth in revenue over the past few years. However, those were some of the most optimistic years of the economy, and if they continue to maintain the levels from the past few years is yet to be seen.
  • They have a history of profitability, but their profit margins tend to decline during adverse economic conditions, as more borrowers struggle to pay off their loans. Also, increasing competition and increasing regulatory scrutiny can affect their margins going forward.
  • Net income is volatile and significantly impacted by their credit loss allowance as well as interest rate fluctuations, which is expected from a sub-prime lender.

Balance Sheet:

  • CACC relies heavily on securitization and credit facilities for funding their loan originations, which leaves them vulnerable to credit market fluctuations and increasing rates from their creditors.
  • The quality of their loan portfolio appears to be questionable, given the increased reserves for loan losses, and if they are unable to collect sufficient payments from their clients, their balance sheet will face some negative pressure.
  • Their capital position appears to be on the weaker side, as they have very little capital relative to their total asset base, making their business a highly leveraged one.

Cash Flow:

  • Cash from operations is positive but highly variable, directly affected by their loan originations and the cash receipts that they get from their customers.
  • Cash used in investing activities remains low due to their lower capital expenditure needs.
  • Financing activities are a major source of cash outflow, because the company is heavily relying on borrowings to fund their lending activities.

CACC’s net income and EPS are volatile and heavily influenced by fluctuations in credit loss provisions, interest rates, and their business environment. Their margins are somewhat inconsistent, and their reliance on debt makes their balance sheet quite vulnerable.

Understandability

Rating: 3 / 5

CACC’s business is of average complexity. It’s understandable that their business model depends on lending to subprime consumers, but the underlying economics and the way they handle their business is not always transparent. Understanding what drives their profit, how these profits are tied with the credit rating and how well those are expected to hold up in the long run, requires some financial expertise that an average investor may not possess. Their financial statements also hide a lot of the inner working of their operations.

Balance Sheet Health

Rating: 3 / 5

CACC’s balance sheet health is also average, not very bad but also not too great. They have very high reliance on debt, and with interest rates on the rise, that will surely take a toll on their long term profitability. Also, many of their assets are intangible in nature, with their long term value depending on factors which are out of their control. Their loan portfolio also includes sub-prime debt, which is highly risky and can cause significant losses during a recessionary environment. They have consistently generated profits and cash flows in the past, but their long term stability is still uncertain with those financial factors in play.

Recent Concerns and Management Commentary

The main concerns for investors include multiple lawsuits that claim they overcharged their clients, misrepresented their debt collection policies, and inappropriately use their collection process to collect debt. Their management has repeatedly declined these accusations, citing them as baseless and frivolous. They claim that their business model has helped a significant number of subprime borrowers and are essential for the segment. They are also quick to note that they haven’t done anything illegal and are complying with all the regulations. However, it’s worth keeping a close eye on these investigations and on CACC’s handling of these lawsuits in the future, as that has the biggest potential to impact the company’s financials and market perception.

The management has stated on the most recent earnings call that the company intends to remain committed to the subprime market, even with the increasing regulatory scrutiny. Their strategy includes expanding their products and services, and improving technological applications to their business operations. They are also working to reduce borrowing rates to increase profitability going forward. The company also announced that their credit losses are trending towards pre-pandemic levels. This could signify that their loan portfolios are slowly normalizing. However, they are aware of the uncertainties in the overall market, and may adjust their growth strategies according to that.

Also, they’ve seen some success with their new purchase program as it is rapidly expanding and becoming a sizeable part of their revenue stream. However, it is also important to analyze whether those premiums are sustainable and will give them consistent and long term returns.

They also mentioned that they’re exploring new ways to provide their services more effectively in today’s environment. And, by investing more in technology they are aiming for a more streamlined operation.