Description

Short America’s Car-Mart, CRMT.  CRMT is a used car retailer focusing on the subprime segment of the market with a captive auto finance subsidiary facilitating virtually all sales.  Ubiquitous cheap financing has resulted in deteriorating underwriting standards, extended loan terms, and consequently credit losses are deteriorating rapidly.   Additionally, extreme levels of competition and operational shortfalls have caused store growth and same store sales to stagnate, and gross margins to decline.   Consensus estimates imply fundamentals will improve, but further deterioration is likely.

CRMT focuses on rural areas of the south central United States.  Dealerships are generally located in areas with populations of 50,000 or less and management of these locations is decentralized.  It generally sells older model, lower value vehicles, purchasing vehicles at wholesale that are 6-12 years old and have 90,000-140,000 miles on them, paying between $3,000-7,000 per vehicle.  The customer base is very low income and often has no savings.  Further, half of its customers do not even have FICO scores, and those that do score around 500.  Due to locations in small communities and the lack of financial resources of its customer base there has historically not been much competition.  The business model is primarily “buy here, pay here.”  There are 143 locations, with the highest concentrations in Arkansas (37) and the surrounding area.  CRMT finances almost all of its sales through its subsidiary, Colonial Auto Finance, which holds the loans to maturity.  Used auto sales are 85% of product sales, with wholesales adding 5%, service contracts contributing 6%, and payment protection plans adding the remaining 4%.   Interest and other income also accounts for 13% of total revenue.

In case you haven’t heard, all is not well in the realm of auto finance.   CRMT operates in a very small niche of the auto industry, so it is not directly exposed to all of the vagaries of the auto cycle and its operating performance can even run contrary to the macroeconomics, in some cases.  However, I will attempt to show that the forces that are impacting the industry from the top down have been and will continue to increasingly trickle down through the ecosystem and weigh on CRMT’s results.

Auto sales were obviously weak following the financial crisis.  New vehicle sales fell from 16-17 million per year prior to the crisis and bottomed in 2009 at 10.4 million.   Since then sales have steadily grown through 2016.  Auto sales finished 2016 with the highest growth in more than a decade with record sales of 17.6 million.  As the economy improved auto loan credit quality improved with it.  The low level of realized losses coupled with relatively better rates of returns than other asset classes represented a compelling risk reward for many banks and indirect lenders that more or less had access to free money.  As happens in sectors earning excess returns on capital, more capital quickly flowed into the space.   Given the lack of differentiation in terms of product and credit, underwriting became very aggressive, driving down returns.   The strong car sales of 2016 were driven by equally strong lending last year, so that auto loans outstanding grew 8.7% to a record $1.2 trillion.  Despite the apparent strength, auto loans were already beginning to experience trouble, with delinquencies and credit losses creeping up over the past few years.

At the start of 2017 auto sale began to weaken appreciably.  Light vehicle unit sales fell 1.6% in January and .7% in February.  This week every major car manufacturer had disappointing sales for March, which had been expected to post a rebound, so sales growth has been negative in 10 of the past 12 months.   The three month decline in SAAR is 9.6%, which is the worst drop since the height (depths?) of the financial crisis in 2009.

The National Automobile Dealers Association (NADA) now expects sales of cars and light trucks in the US to fall to 17.1 million, although the annualized pace from March is 16.6 million, so the industry is retracing back to levels from 1Q15.  Most industry estimates call for continued declines through 2019.

As one might expect as sales slow, inventories begin to pile up.   The inventory to sales ratio in the past year spiked over 20% from 2.5 to 3.16x, which is the highest level during an economic expansion since the 1980’s.

As one might further expect, increasing inventories are depressing prices.  The NADA used car price index is down eight months in a row to 110.1, which is down 8% yoy.  This index also fell 3.8% mom, which is yet again the worst decline since it fell 5.6% during the crisis in November, 2008.  Manheim expects 3.6 million vehicles to come off lease in 2017, followed by another 4.1 million in 2018 and 4.3 million in 2019, or 20-25% of current SAAR, so the inventory situation is almost certainly going to get much worse before it gets better.

Slowing demand and rising inventories have also led to aggressive incentives on new cars, making used cars relatively less attractive.  Manufacturer incentive spending increased 18% yoy on new vehicles and another 14.6% in March, according to Cox Automotive.   This equates to a ~$3,600 discount per vehicle, which is the highest level in over a decade and over 10% of MSRP.

According to Fitch, motor vehicle lending growth peaked in 3Q15 and has rolled over to 6.9% in 4Q16.  Delinquencies are on the rise industry-wide, with subprime unsurprisingly leading the way higher with 60+ day delinquencies now in excess of levels experienced 2009, as well.   

Newer vintages have also been aging progressively worse, which indicates losses will continue to get worse.

Moody’s has also opined that auto sales peaked in 2016 and that credit risk is increasing, due to the “trade-in treadmill.”  According to Jason Grohotolski, senior credit officer at Moody’s, “the combination of plateauing auto sales, growing negative equity from consumers and lenders’ willingness to offer flexible loan terms is a significant credit risk for lenders.”  Credit losses and lender profitability has been worsening for several years, despite the bull market in auto sales and the strong economy, and it is about to get worse.  Low spreads and easy access to capital have already encouraged lenders to lower underwriting standards and lower vehicle sales will further encourage lenders to loosen loan terms to compete for fewer loans.   According to Edmunds and Moody’s, an astounding (and a record) 32% of US vehicle trade-ins had outstanding loans in excess of the value of the cars, up from 26% in 2013.  Car dealers generally add the value of the negative equity to the loan on the customer’s next car purchase.   To remain competitive dealers have attempted to keep monthly payments stable, so they end up having to extend the new loan term length, hence the “trade-in treadmill.”  Longer loan lengths have enabled consumers to increase the amount financed by 23%, while only increasing monthly payments 6%, since 2007.  The whole process is dramatically increasing the potential for loss severity.

More banks are beginning to forecast increasing rates of delinquencies, as well.  Not be a curmudgeon, but Moody’s and Wall Street banks are not always the most prescient forecasters, so the situation seems dire and if I were a betting man I’d say things could become worse than current forecasts.

These metrics are the worst since the financial crisis all the while the unemployment rate just hit 4.5% after the US added over 2 million jobs in 2016, so one can imagine what might happen to these numbers if there were an economic slowdown or recession.  Also, one needs to consider what the impact of the end of quantitative easing will be on consumers and lenders.

To summarize: we have demand rolling over during an economic expansion with growing inventories and falling used car prices with intense competition fueled by accommodative financing that has led to a dramatic deterioration in underwriting standards, which inevitably led to a dramatic deterioration in credit metrics.

So what does all this mean for CRMT?

Macro aside, the bull case on CRMT is unraveling and hinges on the following:  CRMT offers great customer service and builds personal relationships with customers because they are all small town folk, so they know each other well.  This should lead to referrals, repeat sales, and better credit metrics.  There is supposedly less competition because they are located in rural, small towns.  CRMT should have a long runway of organic dealership growth.

The customer service angle would be laughable if it weren’t so sad.   These Consumer Affairs reviews show a systematic abuse of customers through misleading sales practices and predatory lending.   There is probably some degree of adverse selection on that website and, normally, I would say caveat emptor, but these consumers are among the poorest people in the country often living below the poverty line and they are being ripped off.   There are numerous accounts of cars braking down while driving off the lot, aggressive collections and repossession tactics bordering on intimidation and threat, etc, i.e. generally not a great customer experience.  Management might claim that they are helping people out because their customers have no other options for purchasing a car and CRMT is the lender of last resort, but taking advantage of someone that is already down and out is pretty low.  Management has mentioned that around 50% of sales are to repeat customers and referrals, which seems hard to believe when CRMT has historically repossessed 40-50% of the vehicles it sells; low 40s would be in a more normal environment, but currently they are repossessing about half.  A previous write up mentioned, “As management says, ‘our borrowers know that they’ll see us at the high school football game on Friday night and in church on Sunday.’”  That quote was intended to convey the trust, familiarity and local knowledge management has with customers, but it must also be very useful to know where everyone will be all the time when half of these borrowers will have their cars repossessed.   Honestly, repossessing half the cars one sells every 11 months and then reselling them does seem like it could potentially be a pretty good business model, but should also seem incredibly abhorrent even to short sellers/NY hedge fund types.   I’ll get off my soapbox now.  The CFPB did look into CRMT in 2015, but nothing came of it.  I would not expect the current administration to give the matter a second thought, but am surprised that state attorney generals would allow it.

The supposed relationship building with customers has never translated into good collections.  In the good ol days, i.e. 2006-2012, allowance for credit losses were around 22% of finance receivables.   In 2013 just as competition was starting to heat up, allowance for credit losses began steadily increasing.   As a result, in F2016 (4/16), provision for credit losses as a percentage of sales increased to 28.5% compared to 25.5% for F2015 (4/16).  The 10-K notes that the F2016 provision would have been 27.6% “excluding the effect of the increase in the allowance for credit losses made in the second quarter,” which I read as, “if we didn’t make so many bad loans, credit losses would have been lower.”  For F2016, net charge offs also spiked to 31.3% of average finance receivables, compared to 27.8% the year earlier.

“The used care industry is highly fragmented and highly competitive,” in their own words.   There are no barriers to entry.   Having a small town focus provides no competitive advantage.  The internet is everywhere, and increasing price and customer (dis)satisfaction transparency.   The business can earn a decent ROE in times of limited competition, particularly when alternate sources of financing are unavailable, but there has never been a time when more cheap financing options were available to consumers than now.

Theoretically, CRMT should have a long runway to grow store count.  However, it has had several stumbles over the years executing on store growth.   It is currently experiencing one of these periods of indigestion with store count falling from a peak of 147 last year to 143, so there has been almost no store growth since early 2015.  More importantly, the unit economics of the stores that were added in recent years has deteriorated.   In F3Q17 (1/17), CRMT sold 10,866 cars with 143 stores, which is approximately the same level of unit sales as F4Q13 (4/13) when CRMT only had 124 dealerships.  As a result, the average dealership sold 76 vehicles per month last quarter, whereas 2011-2015 it was averaging mid-80s.  

New dealerships are less profitable than mature stores because they experience higher credit losses and lower volumes.   Eventually it will be able to begin to grow the store count again, but for the foreseeable future the focus will be on improving the profitability of the existing dealerships.  Management has said they have had difficulties in finding and training local dealership managers.   Due to the decentralized nature of the dealer network, a large amount of responsibility falls on the dealership manager to make underwriting decisions and execute on collections.   The average dealership annual profit is ~$150,000 and management believes it can reach $300,000.  That would create a lot of operating leverage, but given the credit trends that CRMT is experiencing it will be a long road to get there, so do not expect much store growth in the medium term.

To understand the impact of intensifying competition and the deterioration of CRMT’s fundamentals, it is useful to examine what is happening to its originations and loan portfolio.   In F3Q17 (1/17) principal collected as a percent of average finance receivables fell to 37.9% for the first nine months of the fiscal year, down from 40.6%.  This has steadily declined from 68.5% in F2011 (4/11).  The decrease in the collections percentage is primarily the result of longer average terms of loans, higher levels of contract modifications, and higher delinquencies.  Average originating contract term increased from 30.9 months to 31.9 months in the first nine months of F2017 (4/17), while the portfolio weighted average contract term increased from 30.9 to 31.9 months.   In F2011 (4/11), these were 26.3 and 27.3 months, respectively.   Competition has also driven down average down payments, which fell to 5.3% from 6.1% yoy in the first nine months of F2017 (4/17), and was 7.2% in F2011 (4/11).  The most recent 10Q cautions that in order to remain competitive term lengths may continue to increase.

Net charge-offs as a percentage of average finance receivables actually fell in the nine months ended 1/17 to 21.8% from 22.2% due to lower frequency of losses as a result of 30+ day delinquencies falling to 4.7% for 1/17 from 5% the year earlier.  While this showed some improvement the broader trends in subprime auto lending show no signs of abating, so this could prove to be a short lived reprieve.   Also, finance receivables 3-29 days past due surged to 17.23% in the most recent quarter versus 12.82% in the same period the prior year.   While this is a very early indicator that could be remedied or modified before these loans are written off, it still could portend another bulge in the pipeline.   Another management signal that they expect the tough environment to continue was the increase in provision for credit losses to 31% of sales, up from 26.9% yoy, and $37.6 million, which led to the considerable EPS shortfall of $0.35 v $0.65 consensus.   The most recent 10Q also states that CRMT anticipates credit losses will be higher than historical ranges in the short term due to significant macroeconomic challenges for its customers and increased competitive pressures.

CRMT has grown revenues at a 9% CAGR over the last ten fiscal years.  However, that growth rate is now stalling out for various reasons.  As mentioned earlier, dealership growth is constrained until further notice and aggregate demand is anemic in general.  However, CRMT is also retrenching to some degree.  Increased competition for used vehicle financing in recent years had a negative effect on collections and charge-offs, so management’s focus on improving credit metrics and dealership profitability could also be weighing on growth.  In F3Q17 (1/17) CRMT sold 10,866 vehicles, which was about 700 less than consensus expected, and down from 11,013 the year before.   Average selling price was flattish at $10,629.  All of which led to same store sales growth of only 1.1%, which was improvement over flat same store sales the year before, but was a deceleration from earlier in the year.  Furthermore, comps have been stagnating since F2014 (4/14).  Prior to 2010 double digit comps were not uncommon, so this also suggests some saturation of its markets, in addition to the competitive pressures, and calls into question how much potential there is for dealership growth.  Overall in the quarter grew 1%, which was slightly below expectations.

Gross margin on auto sales in the most recent quarter also continued to erode, falling to 40.8%, a decline of 60bps qoq.  Margins have compressed from over 42% a couple of years ago primarily because of the difference of the purchase cost of the vehicle and the sales price of the vehicle has been narrowing due to competition.  However, gross margin remains within its normal historical range, which leads me to believe there is more downside to it as the tough competitive environment persists. Management stated that will continue to try to minimize average selling price to remain competitive, and to try to keep contract terms from lengthening further, which they hope will allow customers to maintain equity in the cars and reduce credit losses.   This might drive better unit volume, but it will continue to pressure margins.  Historically, lower wholesale auction prices have translated into better gross margins.  Management states that heightened competition and less supply of used vehicles have led to increasingly higher demand for used vehicles, driving up the prices that used car retailers have to pay to stock their inventory, while competition has depressed retail prices.  CRMT has also been purchasing even lower quality, older cars than normal as a result.  While this has allowed CRMT to maintain a semblance of competiveness on the surface, it has created other problems.   Lower quality vehicles are contributing to higher repair expenses, which are putting further pressure on gross margins.  There have been periods where CRMT has also been able to re-sell their inventory at auction and recuperate some value, which is a boon to margins.  However, if you thought higher used car prices would translate into higher recovery values, then you would be wrong, although that is typically the case for the rest of the industry.  As the vehicles CRMT have been purchasing have been getting older and older there is almost most no useful life upon default or the end of the contract.  It is pretty staggering that about half the cars they sell are repossessed after 11 months and have to be scrapped at the end of that period.  Since these vehicles are being scrapped and not auctioned, this creates more margin pressure; all the more so because scrap prices are fairly low currently.  The end result for CRMT is a recovery rate of 22% down from 33%.  Management acknowledges that eventually the increases in new car sales over the past few years and the large number of vehicles coming off lease in the next few years should alleviate the used car supply situation, but they expect these tight conditions to persist for some time.

Source: Manheim

Despite the decline in used car prices recently, data from Manheim indicate that used car price have been generally flat since 2011.  Clearly, competition is intense, but management’s explanation of gross margin deterioration due to ever increasing wholesale used car prices does not seem valid.  

Another culprit for the weak quarter that management pointed out was that last year there was a large number of tax refunds that occurred in F3Q16 (1/16), which boosted sales.  While, F3Q sometimes benefits from tax refunds, historically, F4Q has been the primary beneficiary of higher sales from tax refunds, so these dynamics should not have been surprising.

Despite rising interest rates, ABS spreads are near historical lows.  Much of the increase in competition is coming from financial institutions and indirect lenders that securitize loans, whereas CRMT holds its loans internally at wholly owned subsidiary, Colonial, which acts as a loss leader for vehicle sales.  So in addition to bearing the brunt of the macro and weaker credit metrics that higher rates bring, CRMT is not benefitting from record low spreads like the rest of the industry.   The most recent 10Q states that they expect the availability of consumer credit in the auto industry to increase over the near term compared to historical levels, so the increased competition will persist for vehicles at auction and for retail sales, all of which has a negative impact on margins, down payments, term lengths, collections, liquidity and credit losses.

CRMT estimates that if it did sell it receivables, a third party purchaser would be willing to pay dramatically less than the carrying value on its balance sheet.  An appraisal done in November, 2012 indicated a 35-40% discount to face value would be reasonable, so the actual fair value of finance receivables is estimated to be $292.3 million, compared to the carrying value of $363.5 million.   The company, however, does not expect to sell any receivables, so it should collect the full book value.

As shown earlier, NADA and Manheim price indexes are declining.  Since fewer new cars were sold following the financial crisis and more used cars were being traded in to new car dealers, management has said this lack of supply and higher competition was negatively impacting margins.  However, data from JD Power also show the most precipitous declines for older vehicles, so this contradicts management’s assessment and would suggest there should have been a tail wind to gross margins over the past year because lower used car prices particularly for older models should have lowered COGS.  The inconsistency probably relates to how much easy credit is available now, which will be the most important data point to watch for CRMT.  Management told me that alternate sources of financing are by far the most important aspect of the business; more important by a factor of ten than any other macroeconomic issue.

While banks have begun to pull back from used vehicle financing as credit metrics deteriorate, others have stepped in to fill the gap.  There has been commentary from COF, SC and others about reducing exposure to auto lending and subprime more specifically, but large banks are generally not direct competition to CRMT.   Management has indicated that indirect lenders and independent dealers are continuing to be aggressive.  Management referred to CACC specifically as picking up some of the slack.

Insiders have been persistent and consistent sellers of their stock, but the magnitude of sales has picked up in the past couple quarters.

That was a long winded way of saying things are bad and getting worse, but consensus estimates suggest a snappy rebound is in the works.  Consensus estimates are $2.45 F2017 (4/17) and $3.06 for F2018 (4/18).  The recovery contemplated in F2018 estimates generally include much better same store sales and much lower provisions for credit losses.  Given the state of the industry that I have outlined in this report, I tend to think store growth, average selling price, and same store sales will continue to stagnate.  Furthermore, I believe that credit losses will remain elevated and potentially deteriorate further.   If that scenario plays out, EPS will be below $2, rather than above $3.  Historically, CRMT has traded at a P/E of 12x and EV/EBITDA of 8x, so it is reasonable to assume the shares could trade down into the low 20s in that case.

The risks to the short are: If alternate sources of financing dry up, CRMT might be in good position to gain share by filling the gap.  Its same store sales were very impressive during the financial crisis when the ABS market was frozen, although that doesn’t necessarily equate to good stock performance if there is a credit crunch, bear market, or recession.  An increase in the supply of used vehicles due to increased lease expirations could boost margins by lowering COGS.  CRMT has bought back 3.9 million shares over the past decade.

12% of the float is short and the borrow is easy.   It trades about 75,000 shares per day.  We normally do not short stocks this small (and then go on to publicize it [so please don’t drive up the cost of borrow or squeeze us if they put up a decent quarter]).

Catalyst

competition, credit losses