Companies that operate in a niche markets often prove to be very lucrative investments. Because small, focused companies can outmaneuver larger competition, they are able to maintain their competitive advantage and reward shareholders accordingly. I think of large companies as sharks, which in the open ocean have insurmountable competitive advantage due their size leading to economies of scale. However, try dumping a shark into a small river that is infested with piranhas. In the same way a lean, mean and nimble company can outperform a larger brute force competitor under the right conditions.
One example of such a niche market company is Credit Acceptance Corp. (NASDAQ:CACC), which provides automobile loans to consumers who would have difficulty qualifying due to less than perfect or limited credit history. The loans are grouped into two segments: Dealer Loans and Purchased Loans. For the former, Credit Acceptance Corp. (NASDAQ:CACC) forwards funding to a dealer for a fee and the right to service the resulting loan (93.7% of 2012 revenue). Alternatively, the company will purchase loans on the open market, but this is a much smaller part of the portfolio.
Credit Acceptance Corp. (NASDAQ:CACC) must compete with larger companies that have greater financial assets. For example, Ford Motor Company (NYSE:F) and General Motors Company (NYSE:GM) each have financial services divisions that have greater market share compared to Credit Acceptance. Ford Motor Company (NYSE:F) reports that their financing share was 32% for vehicles sold during the 2012 fiscal year. In fact, Ford finance division’s liabilities contribute $82.2 billion of debt compared to total liabilities of $113.7 billion (72.2%) for the entire company. General Motors Company (NYSE:GM) also reestablished its financing division with the acquisition of AmeriCredit in 2010 for $3.5 billion in cash. The division generated $744 million in net income for 2012, or 12.0% of the total net income for the company of $6.188 billion over the same period.
The financing of automotive loans is a competitive business, yet Credit Acceptance Corp. (NASDAQ:CACC) is able to gain competitive advantage through extending loans to consumers with lower credit scores while carefully monitoring risk and charging a higher premium for its service. Over the past ten years the company has on average recouped 72.9% of loans versus a forecast of 71.7%. The company’s loan performance missed their own initial forecast in only three years of the past ten (2001, 2006 and 2007 by 3.1%, 1.5% and 2.7% respectively). The ability of Credit Acceptance to weather the credit crisis is a powerful testament to their ability to manage risk while operating in a niche market that larger car manufacturers are wary of entering.
The niche that Credit Acceptance Corp. (NASDAQ:CACC) occupies is a relatively small one that should continue to perform very well in the near-term for two reasons. First, car sales have continued to show strength (Figure 1), and it is expected that all consumers and particularly those with lower credit ratings have delayed purchasing new automobiles since the recession. As a result, there is likely additional pent-up demand particularly in the market that Credit Acceptance serves. Second, banks have been relatively reluctant to lend, particularly to lower income buyers. Very loose lending conditions often depress margins for Credit Acceptance Corp. (NASDAQ:CACC); in fact 2007 was the only year that Credit Acceptance lagged the S&P 500 by more than 6% since 2000. Therefore, the current economic conditions appear to be ideally suited for the niche that Credit Acceptance serves.
Figure 1: US Vehicle Sales Have Room to Run
Comparables were analyzed for Credit Acceptance versus the average of the consumer finance sector (Table 1). Credit Acceptance Corp. (NASDAQ:CACC) trades at a valuation that is depressed compared to the average in the sector, even though the company sports exceptional earnings and revenue growth with return on equity and gross margins in the top 10%-15% percentile of companies within that sector. Therefore, the company appears to be a diamond in the rough: an exceptional business trading at a very attractive valuation.
Figure 2 shows growth in Credit Acceptance’s net income. For the 2012 fiscal year the company reported $8.62 per share in net income on revenue of $22.85 per share. Analysts expect earnings for the 2013 fiscal year of $10.07 per share, or growth of 16%. While these expectations are high, they are 4% below average revenue growth over the past five years before taking into account the effect of share repurchases. On average the company has repurchased 6% of its float each year over the past decade, making the estimates seem very achievable when the smaller float is taken into account.
Figure 2: Recent Revenue, Profit Margin and Net Income for Credit Acceptance
In addition, Credit Acceptance has undergone a pullback recently. After hitting a high of over $125 per share the stock has pulled back to nearly $100 per share and seems to have begun a new move higher. The twelve month return is 23.5%, but in the most recent quarter and month the stock is down, thus the current entry point appears very attractive. In addition, after analyzing a number of metrics, the best fit against forward returns was the ten-year normalized earnings (PE10). While the stock does not have as low a valuation as in 2003 or 2008-2009, the current valuation is below average and very good returns are expected over the next 18 months. In addition, the figure below illustrates the steady growth of EBITDA and Revenue per share as the share count has been consistently reduced from 43M in 2003 to 23M currently.