This Subprime Auto Lender Is Up 37% in 2018 -- Here's Why

Subprime auto lender Credit Acceptance Corporation (CACC -0.02%) has been a big beneficiary of the strong U.S. economy and rising auto prices, but what about when the credit cycle turns?

In this Industry Focus: Financials clip, host Shannon Jones and Motley Fool contributor Matt Frankel discuss why the stock is one of the best performers of 2018 so far and what investors need to know about the company.

A full transcript follows the video.

This video was recorded on Sept. 10, 2018.

Shannon Jones: Let's turn our attention to the second stock we've got here, which is Credit Acceptance Corporation, ticker CACC. This company basically functions in the subprime auto lending space. Matt, this is a pretty interesting stock for a number of reasons. One, obviously, the performance. It's a top performer. But I still think there's a lot left to be desired with this stock. What can you tell us about this company?

Matt Frankel: Any kind of subprime lending is a great business, one, in a booming economy like we're in right now; and two, if they get the numbers right. It's really tough to predict how many bad loans are going to pay, how many are going to default. But if you get it right, it can be a very profitable business.

Subprime auto has really exploded over the past few years. I read a statistic before we recorded that over more than one out of every four car loans right now are considered subprime or deep subprime. There's a big and growing market for this. Not only that people are spending a lot more in their cars these days, the average dollar amount of a Credit Acceptance loan has gone up 34% since 2015, and the average term is longer by seven months, which means more interest income when customers pay on time. It also increases the risk of non-payment, now that you're stretching loans out over a longer period of time, and you're loaning more money. But, so far, the results have been good.

Credit Acceptance publishes the percentage of loans they think they'll be able to collect for each period. So far in 2018, they've exceeded the amount that they thought they would collect, which has been one of the big drivers of their stock performance. Loan volume has gone up tremendously. There's more people buying cars. 20% growth in just the number of loans. 35% growth in the dollar amount of loans just over the past year. These have been big drivers.

And while the economy's strong, unemployment's low, this could continue. But this is a stock that could get hammered if the economy goes the wrong way.

Jones: Yeah, absolutely. I think with Credit Acceptance Corporation, one of the things to keep in mind is, its business model is so much dependent upon where we're at in a credit cycle. Any time you hear subprime lending in any sense, whether it be automobiles or housing, generally, there's going to be a flag that should come up, as an investor to say, "OK, where are we at, No. 1, in the credit cycle; and No. 2, is this company prepared in the event of a downturn in the credit cycle, as we know will happen at some point?"

Credit Acceptance Corporation does have a pretty unique business model. Basically, it partners with dealers by paying some upfront cash, then splits those future cash flows with the company as the company recovers the advance plus some profit. Obviously, on the consumer side, when you think about consumer subprime lending, as is usually the case, this usually means high financing charges and fees. That, for me, is a flag.

But also, in looking at the company's overall asset quality -- this is something that I think will be a key area to watch, not just for this company, but really any company that is involved with lending. You've seen the provision for credit losses steadily increase year over year for this particular company. In 2015, it was $41.5 million. Jumped up to $90 million in 2015. Then, in 2017, it was $129 million. This is all stemming from consumer loan performance. Again, this will be a huge area to watch.

Additionally, you've got collection rates on those loans down. There's even some investigations ongoing with this company. You've got the financial risk that you'll want to pay attention to with this particular stock, but also, too, the regulatory and the legal risk that comes with being a subprime lender.

All in all, kind of surprised to see this as a top performer. But then again, not in terms of where we're at in the credit cycle.

Frankel: This is my cautionary statement: Credit Acceptance kind of feels like one of those mortgage companies before the housing crisis. The market got bigger and bigger and bigger for subprime housing, like it's getting for subprime autos right now. High fees, an uptick in charge-offs. As long as the economy keeps going up and up, and people are spending more and more on cars, then it's looking fine. But as soon as the cycle turns, look out. That's kind of what you're saying there. There are a lot of parallels between the subprime auto market right now and the subprime housing market about 12 years ago. So, buyer beware with this one.

Jones: Exactly, buyer beware.