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Short Credit Acceptance Corp (CACC)

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"Since beginning our share repurchase program in mid-1999, we have repurchased approximately 39.4 million shares at a total cost of $4.5 billion. In 2021 we repurchased approximately 2.9 million shares, representing 16.8% of the shares outstanding at the beginning of the year, at a total cost of $1.5 billion."

- 2021 Shareholder Letter

Share buybacks kept the share price elevated for the whole of 2021. I love buybacks as much as any equity investor, but the problem with buybacks at this stage for CACC is that their revenue is falling off a cliff and the only way they are managing to post great numbers is by changing the assumptions they use to calculate loan loss reserves.

A quick recap of how their business works. They sign up dealers, who sell cars to sub-prime borrowers, with financing arranged by CACC. CACC pays the dealers an upfront amount (advance) and make ongoing payments based on the loan's performance (dealer holdback). Dealers are incentivized to price vehicles at a level where their customers will be able to afford the payments, since the dealers also stand to lose money when CACC loses money on the loan.

The accounting entries for this entire web of transactions get murky. GAAP requires the company to expense a loan loss provision on loan origination. The company amortizes the loan loss provision over the loan's lifetime, by recording revenue at a lower yield than the actual interest rate on the loan. Either way, revenue recognition has no direct link to cash flow, except through the adjustments the company will make on its statistical model.

In other words, it is not prudent for an investor to evaluate the business based on the P&L statement. Not unless the investor can do actual due diligence on the 'black box' model that management uses. So let's move to the balance sheet. As of Q1, the company had $7,038.3 million in total assets, $5,409.5 million in total liabilities, of which interest bearing debt is $4,739 million, and equity of $1,628.8 million. Recorded net income was $214.3 million, in line with Q1 2021 net income of $202.1 million.

Using these figures,

  • Debt to Equity (D/E) ratio: 3.32x

  • Return on Equity (ROE): 13.16%

  • Return on Assets (ROA): 3.05%

The company's EPS numbers look great because they engaged in massive buybacks, but those buybacks are setting them up for a huge fall when their leverage blows up on their faces. With rising interest rates, their cost of capital is going to go up. At the same time, their loan book is going to start underperforming their model as collections drop off. The company is already struggling with loan origination - the number of loans originated fell from a high of 373,329 in 2018 to 268,730 in 2021, a decline of 28%. While the pandemic stimulus checks kept collections in line with their forecast (the company even changed their model to forecast lower loan loss provisions and higher collections), that situation isn't going to last. The thin equity sliver, the drop off in volume of business, plus rising interest rates is going to hurt this stock tremendously. It's just a matter of waiting. Insiders have been consistent sellers of the stock since last year.

At the current share price of $565.26, the company has a market cap of $7.427 billion. If the company manages to de-lever, assuming its loan book is sold at 100% of its recorded value ($6,327.2 million, net of $2,870.8 million in loan loss provisions) and its liabilities are paid off, the residual value of equity works out to $123.97 per share. If the loan book is sold at a 10% profit, the residual value of equity works out to $172.12 per share (book value of equity of $1,628.8 million plus $632.72 million of profits). To arrive at a residual value of equity equivalent to the current share price, the loan book would have to be sold at a 92% profit. I think that's highly unlikely to happen. Alternatively, the company can quickly accrete value to shareholder equity by borrowing more money at lower rates, originating loans at higher rates, and ensuring full collection so it keeps the fat net interest margin. That's so unlikely to happen, even management doesn't suggest that method of growing equity.

In CACC's case, the share buybacks have elevated the share price beyond any reasonable method of valuation. This is a high conviction short for me. Timing-wise, the lack of support from buybacks, higher bond yields, bearish overall market sentiment, and consumers feeling the pinch of inflation provides the right environment for a story stock like this to unravel.

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