CACC - Credit Acceptance Is Cheaply Valued But Patience May Be Required

2023-11-15 01:28:13 ET

Summary

• Credit Acceptance stock has underperformed the S&P 500 by a wide margin in the last two years due to the surge of interest rates to a 16-year high.
• High interest rates have impacted some of the customers of CACC, but the stock is now cheaply valued, at only 10.4 times its earnings.
• The company's proven ability to forecast collection rates and its consistent performance make it an attractive investment option.

Almost nine years ago, I first recommended purchasing Credit Acceptance (CACC) for its highly profitable business model and its cheap valuation. Since that article, the stock has outperformed the S&P 500 by a wide margin, as it has rallied 148% whereas the index has rallied 118%. About two years ago, I advised investors to take their profits, as the rally of the stock had rendered it almost fully valued. The stock shed 24% in the following year and thus it became interesting again. I recommended purchasing the stock again in December but the stock has declined 15% since that article, primarily due to the impact of high interest rates on its customers.

On the one hand, no one knows when the Fed will begin reducing interest rates. On the other hand, Credit Acceptance has become remarkably cheaply valued, with a forward price-to-earnings ratio of only 10.4 . As the headwind from excessive interest rates is likely to prove temporary in nature, the stock is likely to highly reward investors off its current price. Nevertheless, the stock is suitable only for patient investors, as it is nearly impossible to predict the time of the reversal of the policy of the Fed.

Business overview

Credit Acceptance operates in a niche market and thus it passes under the radar of the vast majority of investors. It offers financing programs to automobile dealers and thus it enables them to sell vehicles to consumers who cannot borrow funds via the traditional banking channels. Due to the relatively risky profile of its customers, the company has been considered somewhat risky. However, it charges its customers with such high interest rates that its business model has proved highly profitable, with impressive consistency, throughout the 51-year history of the company.

The consistent performance record of Credit Acceptance is admirable. The company grew its earnings per share at a double-digit rate every single year between 2009 and 2020 when the pandemic struck and temporarily put an end to the growth streak of the company. Credit Acceptance has more than tripled its earnings per share, from $10.54 in 2013 to $39.32 in 2022.

The key component of the successful business model of the company is its proven ability to forecast its collection rates with great precision year after year thanks to its sophisticated algorithms.

As shown in the above table , Credit Acceptance has forecast its loan collection rates with impressive precision throughout the last decade. Notably, the actual collection rates somewhat exceeded the initial estimates during the years 2017-2020. This certainly bodes well for the business model of Credit Acceptance, as it reveals that the financial services company has a reliable business model and prefers to be somewhat conservative in its forecasts at the same time.

Unfortunately for the company, the trend has reversed in the last two years. As shown in the above table, the actual collection rates for the loans initiated in 2021 and 2022 have proved slightly lower than expected so far. This is the reason behind the underperformance of the stock over the last two years ( -40% vs. -6% of the S&P 500).

The negative business trend has resulted from the surge of inflation and the resultant aggressive interest rate hikes implemented by the Fed in an effort to put inflation under control. The surge of inflation has exerted pressure on weak consumers, as it has significantly increased their living expenses. Consequently, it is natural that more consumers are struggling to service their loans. On the bright side, thanks to its aggressive response, the Fed has managed to cool inflation from a 40-year high of 9.2% in the summer of 2022 to 3.7% now. As a result, inflation is not likely to squeeze the real discretionary income of the customers of Credit Acceptance any further.

On the other hand, the surge of interest rates to a 16-year high provides a strong headwind to the business of Credit Acceptance. High interest rates make it much harder for consumers to service their loans. This is especially true for consumers who are in a weak financial position, such as the customers of Credit Acceptance.

Indeed, the company forecast a collection rate of 67.5% for the loans it initiated in 2022 but the actual collection rate has been only 63.5% so far. The difference may seem small but it is by far the largest difference between actual results and estimates for this high-quality company in more than a decade. Due to this negative trend, analysts expect the company to post a 25% decrease in its earnings per share this year, from $52.85 in 2022 to $39.59 this year.

However, it is important to realize that Credit Acceptance is likely to finally price the increased risk in its new loans and thus it will probably improve its performance in the upcoming years. Even better, interest rates have proved highly cyclical and hence they are not likely to remain around their 16-year highs for years.

As soon as inflation reverts to the target range of 2.0%-2.5% of the Fed, the central bank is likely to begin reducing interest rates. When that happens, it will make it easier for consumers to service their loans and thus the business conditions will revert to normal for Credit Acceptance, which has proved exemplary in its business under normal interest rates. Even in the Great Recession, the worst financial crisis of the last 90 years, Credit Acceptance kept growing its earnings per share, in sharp contrast to the vast majority of financial companies.

Analysts seem to agree that Credit Acceptance will recover from the ongoing downturn in its business. They expect the company to post essentially flat earnings per share in 2024 and then grow its bottom line by 9.5% in 2025. In other words, the surge of interest rates to a 16-year high is likely to prove just a temporary hurdle in the multi-decade growth trajectory of Credit Acceptance.

Valuation

Credit Acceptance is currently trading at a forward price-to-earnings ratio of only 10.3x . It is also trading at only 9.6 times its expected earnings in 2025. These valuation levels are markedly cheap for a company that has grown its earnings per share at double-digit rates over the long run, with enviable consistency.

Investors should be aware that the stock has almost always traded at price-to-earnings ratios below 15 due to the perceived risky nature of its business, as its customers are those who cannot receive loans from banks. Nevertheless, the current valuation of Credit Acceptance is much cheaper than its historical valuation and certainly attractive from a long-term point of view.

Moreover, the cheap valuation of the stock greatly enhances the value of the aggressive share repurchases of the company. Credit Acceptance has been repurchasing its shares at full throttle for several years in a row. The company has reduced its share count by 45% over the last decade. In contrast to most companies, which tend to suspend share repurchases during downturns, Credit Acceptance has kept repurchasing its shares even during the fiercest downturns, such as the Great Recession and the coronavirus crisis. As long as its valuation remains cheap, the share repurchases of the company are likely to greatly enhance value for long-term shareholders.

Risk

Given the proven quality and resilience of the business model of Credit Acceptance, the only material risk is the adverse scenario of persistent inflation for years. In such a case, the Fed is likely to maintain interest rates at excessive levels and thus it will exert pressure on some customers of Credit Acceptance.

Fortunately, as stated above, the stock is cheaply valued relative to its current earnings capacity and hence it may have limited downside even in such an adverse scenario. Even better, such a scenario has low odds of materializing. Inflation has already decreased from 9.2% in June 2022 to 3.7% now and thus it is likely to revert to the target zone of the Fed at some point in the upcoming years. Nevertheless, no one can completely exclude the possibility of high inflation and above-average interest rates for years. In such a case, the stock of Credit Acceptance is likely to underperform the broad market.

Final thoughts

Credit Acceptance is facing a downturn in its business due to the impact of 16-year high interest rates on the ability of some of its customers to service their loans. In 2022, the company overestimated its collection rates by a wide margin for the first time in more than a decade but it is likely to adjust its proven algorithm (and the interest rates it charges on its customers) sooner or later. Given the high-quality business model of the company, its impressive consistency over the long run and its cheap valuation, Credit Acceptance is likely to highly reward patient investors off its depressed stock price.

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