Description

Atlanticus Holdings Corporation (“Atlanticus”), formerly known as Compucredit, is a US subprime lender. It lends mostly through partners, both retailers and banks, which issue store cards and general purpose credit cards to consumers with poor credit histories. Even with the stock down almost 70% from peak this remains a compelling short IMO.

You can imagine that this is not a great environment for a subprime lender. Average earnings are not keeping pace with inflation, and inflation is skewed to essential items which weigh heavier on the basket of lower income consumers: rent and debt service, food, heating and electricity, and until the last couple of months, fuel.

Unsecured loans typically take time to go bad. Unless the borrower spends all the money immediately, the loan itself should fund payment of the initial instalments. And the business model is designed to permit substantial loan losses - the interest rate on Atlanticus' portfolio varies from high teens to mid-30s. Lenders have significantly levered balance sheets, however, such that underwriting miscalculations don't have to be all that extreme before loan losses start eating into equity. Atlanticus, for instance, supports $2.05bn of gross lending assets as of September 2022 with tangible equity capital of $307m. The remainder of the funding is from wholesale financing markets. Particularly given this leverage, the model is problematic: barriers to entry are low, and returns are extraordinarily (but transiently, and misleadingly) attractive in the good times. This naturally attracts capital, restricting pricing and putting pressure on underwriting standards. Loan performance tends to be highly correlated and pro-cyclical - i.e. a trickle of defaults has a tendency to turn into a flood, and the flood defences in the form of equity capital are rarely built solidly enough to withstand the flow. Wholesale financing markets are also pro-cyclical, so funding tends to dry up and become more costly at just the wrong time. Atlanticus' share price over the last twenty five years aptly demonstrates the pro-cyclicality of the business model.

Atlanticus is arguably tougher to analyse than peers. First, management has skewed the portfolio towards higher risk borrowers over the last 5 years and shifted its accounting methodology to "fair value" from "amortized cost" from 1 Jan 2020. I’m not sure I fully understand all the detail of this change, but the key point as I understand it is that the fair value approach gives management more discretion over balance sheet provisions. It also means of course that the financials have been in transition for three years (the transition is now complete). Second, Atlanticus’ loan book has grown at a breakneck pace over the last several years. New loan cohorts take at least a few months to become delinquent, and then charge-offs are typically after 180 days of failure to pay. Thus, rapid growth flatters Atlanticus' delinquency and charge-off performance relative to underlying performance.

Even with the support of its exponentially growing loan book, however, Atlanticus has seen delinquencies and charge-offs increase rapidly over the last year. And as growth fades (management reined in loan growth a little starting in Q2), this will likely continue even without increasing pressure on consumers' pockets.

I've described a terrible economic environment for the business, and significant increases in delinquencies within Atlanticus’ loan book. So why does the company continue to report near-record earnings (LTM net income as of Q3 2022 is only down 10% from the peak in Q1 2022)? Management has a lot of discretion over what assumptions are made with respect to loan losses on the balance sheet. Put simply, the company is currently assuming that the delinquent loans will see only modest default rates. I beg to differ.

The story here pre-dates the pandemic. Atlanticus had recognised large loss provisions in late 2019 as the higher risk loans it had started testing in 2017 started to perform badly. It added further to these provisions in Q1 2020 in expectation of COVID-prompted economic distress. Of course, governments stepped up with furlough schemes and direct stimulus, limiting unemployment and making consumers flush even whilst their spending options were constrained. Personal savings rates hit record highs and loan delinquencies and default rates collapsed. Atlanticus' problem cohorts were rescued, and it ended up with a large excess provision on its balance sheet. It gradually ran this provision down over the next four or five quarters, thus boosting profits beyond what I would view as the underlying operating performance. By late-2021, I would assess that the accounting stance was balanced - i.e. the excess provision from early 2020 was gone.

However, the pattern of boosting reported profits continued even when delinquencies started to increase rapidly from Q2 2021. Loan charge-offs jumped, but the loan loss provision was lifted much more gently than the increase in delinquencies: against an increase in delinquent loans since Q2 2021 of USD 303m, or 225%, the loan provision increased by just USD 80m, or 33%. Meanwhile, insiders sold almost 8% of the company for net proceeds of well over USD 50m. Unless a remarkable turnaround happens in the consumer environment, I expect the company will be forced to announce a large exceptional write-off of its loan book within the next few quarters, perhaps in the order of $200m or so. 

I would expect more scrutiny of disclosures from the auditors in association with the annual accounts, so perhaps Q4 reporting will prompt a reckoning. It’s difficult to predict timing, but such a provision would cut equity capital by more than half and could well lead to the wholesale financing market closing to Atlanticus absent a significant equity issuance. In that scenario, at the current share price, Atlanticus would trade at over 4x book value. Such a valuation seems unlikely for this company in that context. So, although the stock is down almost 70% from its peak, I continue to see significant downside. Perhaps even another 70% in a good case.

Catalyst

Large increase in loan charge-offs or balance sheet provision wiping a large chunk of tangible equity

Further slowing or reversal of asset growth