Wednesday, November 5, 2014

Santander Consumer USA (SC) – Update on Normalized Losses and Volume

A few months ago I wrote about Santander Consumer USA ("SC", "SCUSA") in an article. My long thesis was twofold. First, losses will get worse but still be manageable, so eventually reserve releases will serve as a positive catalyst. Second, volume growth will lead to steady earnings. After the 3Q14 results yesterday, my views have shifted. I now see little upside from both credit and volume, while management credibility is getting questioned. Accordingly I exited my already small positions.

Normalized Losses

In my old write up, I estimated normalized net charge-offs to be around 7.5% or 8%. Now it looks like charge offs for 2014E will be at higher end of that, meaning normalized levels could be higher depend on competition. The core auto installment loan business is actually still running within my expectations. What I completely missed was the deterioration in SC’s unsecured loans business.

SC missed its 3Q14 earnings due to a larger than expected credit provision, and that was mostly driven by unsecured consumer loans. Of the $770mm in total provision, consumer loan provisions contributed $167mm, a big jump from $70mm and $62mm in 2Q and 1Q, respectively. This is despite net charge-offs for that business being ~$80mm for the quarter. So management is either being super conservative or they see consumer loans getting destroyed in the future, perhaps both. The earning call offered little visibility, but management did explain that they see the consumer business making money from both fees and interest, so they’re ok with high charge-offs levels.

Regarding the auto loans portfolio, I now see average net charge-offs for 2014E to come in at low 7%s – a fairly comfortable level. We’re looking at 2 year average life so the worse 2013 vintage should be worked off sometime 2015 and there’s actually some credit upside there.

However the lack of visibility in unsecured loans is a big issue and I can no longer count on credit stabilization as a positive catalyst.


The company is running below target penetration of Chrysler’s originations. Management says this is due to lack of subvention support from Chrysler so they won’t be held accountable for that: 
“And I think at this moment, the amount of subvention that we have access to is not very similar to some of the other OEM captives and therefore these penetration rates for the contract would not be something we would held to. ... the actually penetration rates for the contract are tied to us being treated like other captives and I think today it's clear that we are not.”

That may be true, but it also means we can no longer assume that volumes will grow due to the Chrysler relationship, removing some of the upside. I also see SC’s value proposition to Chrysler diminishing. During the summer SC changed their strategy to selling most of the prime Chrysler loans, so at the end SC is no longer providing the financing but is more as a servicer.

Management credibility

Management continues to lose credibility in my eyes. For example, back in June SCUSA put out a press release saying that reserves are expected to come down slightly and expenses to increase due to higher compliance cost. Now the opposite has happened - reserves are actually increasing and expenses decreasing. Another example - in the 3Q14 call Dundon said that unsecured loans were not a big part of variability, when the 10Q clearly showed that it was in fact the key driver this quarter (it was even cited as a factor in the earning slides). Reading through the transcript, it appears that sell-side is also increasingly skeptical of anything management says.

The stock still looks cheap and I may get back in at some point. But I need to see of the drivers above improving first.

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