by Lawrence Meyers | March 13, 2013 12:55 pm
At first, I thought Credit Acceptance Corp. (NASDAQ:CACC) was another great boring stock that could make a great portfolio addition.
Of course, not everything goes as planned.
See, CACC operates in a space I love: The company finances subprime auto purchases. The vast majority of its revenue comes from advancing money to auto-dealers in exchange for the right to service the underlying consumer loans the dealer makes.
The dealer gets a down payment from the customer, a cash advance from Credit Acceptance and — after the advance has been recovered — cash from payments made by the consumer.
Each month, as Credit Acceptance collects money, that money first goes toward reimbursing CACC for its collection costs, which are incurred when the company collects payments from car owners. Then, on the remaining revenue, a hefty 20% goes towards CACC’s service fee.
Finally, cash is allocated to reduce aggregate advance balance due from the dealer … while the rest goes back to the dealer. This process accounts for 90% of CACC’s business, with the rest mostly generated by purchasing the consumer paper outright.
If you think this should result in fantastic free cash flow … well … you’re right. In 2010, it came to around $200 million, rose to $275 million in 2011 and grew again to $300 million in 2012. The company carries various amounts of term and unsecured debt, so it’s effectively about properly arbitraging the cost of the debt against the collections … and then repeatedly cycling that free cash back into making dealer advances.
I love that business model. Unfortunately, it may be facing some headwinds. Auto sales have surged since the financial crisis, particularly in the used and subprime categories. However, loan demand is slowing, as the company reported only 7% unit growth from its dealer-partners in the last quarter. In addition, the American consumer is in the process of deleveraging, and isn’t taking on lots of new debt.
On top of that, the company’s terrific earnings growth isn’t what it seems. Analysts project 13% to 15% long-term growth so, on fiscal year 2013 earnings of $9.82 per share, a 15x multiple suggests fair value is about $150. The stock is trading at $125.
But here’s where the surprise comes in. When you examine financials, you’ll find 2012 net income only rose 10% … and the company repurchased 11% of its shares. That share repurchase skews EPS growth. A P/E ratio of 10 gives fair value closer to $100, and that arguably makes the shares overvalued.
With that in mind, I think it’s best to wait to see what happens in this segment. Keep an eye on unit growth and deleveraging trends to see how they affect revenue, but stay on the sidelines for now. If you are interested in checking out the very lucrative used car markets, I’d look at America’s Car-Mart (NASDAQ:CRMT), CarMax (NYSE:KMX), or AutoNation (NYSE:AN).
But when it comes to Credit Advance Corp., steer clear.
As of this writing, Lawrence Meyers did not own a position in any of the aforementioned securities.
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