Notes On Credit Acceptance Corp (CACC) by John Huber, Base Hit Investing
I recently made a list of a few shareholder letters I want to read, and one that I completed a few days ago was Credit Acceptance Corp (CACC). This post is not a comprehensive review of the business, as I just started reading about the company. But I thought some readers might be interested in some initial notes.
(I am thinking about putting more of these “scratch notes” up as posts. If this is interesting to readers, please let me know. Often times, I read about a company and don’t end up coming to a solid conclusion. I have many pages of notes on companies that I don’t ever discuss, simply because the information might not be actionable currently. But if these types of notes are worth reading, then I’ll begin putting up more of them.)
Credit Acceptance Corp makes used-car loans to subprime borrowers. CACC has a different model than most used-car lenders. Instead of the typical subprime auto-lending arrangement where the dealer originates the loan and the lender buys the loan at a slight discount, CACC partners with the dealer by paying an up-front “advance” and then splitting the cash flows with the dealer after CACC recoups the advance plus some profit. The advance typically covers the dealer’s COGS and provides a slight profit, and CACC has a low risk position as it gets 100% of the loan cash flow until its advance is paid back. What’s left over gets split between CACC and the dealer. The bottom line is that the dealer gets less money up front, but has more potential upside from the loan payments if the loan performs well.
The model works like this (these are just general assumptions and round numbers to illustrate their model): Let’s say a used-car dealer prices a car at $10,000. Let’s say the dealer paid $8,000 for that car. The dealer finds a buyer willing to pay $10,000, but the buyer doesn’t have $10,000 in cash, has terrible credit, and can’t find conventional financing. CACC is willing to write this loan (CACC accepts virtually 100% of their loans). The buyer might pay $2,000 down, and CACC might send an advance to the dealer of around $7,000. So the dealer gets $9,000 up-front ($2,000 from the buyer and $7,000 from CACC). The dealer now has no risk, since it has received $9,000 for a car that cost it $8,000, and although the profit might be lower than if it got the full $10,000 retail value in cash, the dealer can make more money if the loan performs well. The $8,000 loan might carry an interest rate of 25% for a 4 year term, which is about $265 per month.
As the payments begin coming in, CACC gets 100% of the cash flow from the loan ($265 per month) until it gets its $7,000 advance paid back plus some profit (usually around 130% of the advance rate). Once this threshold is hit, if the loan is still performing, CACC continues to service the loan for around a 20% servicing fee, and the dealer keeps the other 80% of the cash flow as long as the payments keep coming in.
CACC has perfected this model and has achieved significant growth over time by steadily signing up more and more dealers. The result is a compounding machine:
But the conditions are always competitive in this business, and currently, lending terms are very loose and competition is brutal. But CACC is the largest in this space, and seems to be able to perform fairly well in periods of high competition by:
- Allowing volume per dealer to decline (fewer loans get originated at each dealer as CACC is willing to give up market share to competitors who are willing to provide loans at looser terms)
- Growing the number of dealers it does business with (developing more partnerships with new dealers helps offset the decline of business that is done at each dealership)
So overall, CACC has been able to grow volume consistently in good markets and bad markets by adding dealers to its platform. The company allows market share to decline during periods of high competition, and then when the cycle hardens (money tightens up), CACC is able to take back some of that market share.
Adding New Dealers Gets Harder
The problem is that CACC is now much bigger, and growing the number of dealers to offset the declines in volume that occur during soft markets is much more difficult. The company only had 950 dealers in 2003, which was the beginning of the last cycle. By 2007, the company had roughly 3,000 dealers. Dealers provide the company with customers. The ability to triple your potential customer footprint is extremely valuable as it allows you to lose significant market share at the dealership level and still write profitable loans at high returns on capital. Indeed, the company saw the number of loans per dealer decline by a whopping 41% during the soft (competitive) market cycle between 2003-2007. But during this time, its 3-fold increase in the number of dealers enabled overall volume to increase and earnings per share went from $0.57 to $1.76.
The market tightened up in 2007 (a good thing for companies like CACC because while economic conditions are difficult, higher cost competitors go out of business which makes life much easier for the remaining players). With a dealer count that was three times as large as it was just four years before, CACC could now focus on writing profitable loans and growing volume per dealer (i.e. taking back market share it lost at the individual dealership level).
The results are outstanding for a company that can successfully execute this approach, and CACC saw earnings rise from $1.76 in 2007 to $7.07 in 2011 thanks to a combination of growing profits and excess free cash flow that was used to buy back shares.
However, the cycle has gotten much more difficult again—starting in 2011 and continuing to the current time. CACC—to its credit—has continued to fight off competition by adding new dealerships (it has doubled its dealer count since 2011). But each year this becomes harder—CACC now has a whopping 9,000 dealers on its platform (nearly a 10-fold increase from 2003).
Competition is extremely tough currently, with dealers having the pick of the litter when it comes to offering finance options to its customers. CACC proudly states in its annual report: “We help change the lives of consumers who do not qualify for conventional automobile financing by helping them obtain quality transportation”. I think in the early years, this was true. Dealers could go to CACC for financing for its customers when no one else would lend money to that subprime borrower.
But CACC isn’t the only option currently, which means the terms CACC can demand are weaker. CACC used to write loans that were 24 months in the 1990’s. The average loan now has around a 50 month term. As competition heats up, dealers have more options as the third column in this table demonstrates:
CACC has grown mightily over the years, but since 2003 it