UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

Form 10-K

 

 

For the Fiscal Year Ended December 31, 2007

 

Commission File Number 000-20202

 

CREDIT ACCEPTANCE CORPORATION

(Exact Name of Registrant as Specified in its Charter)

 

 

Registrant’s telephone number, including area code:

(248) 353-2700

 

Securities Registered Pursuant to Section 12(b) of the Act:

 

Common Stock

 

Securities Registered Pursuant to Section 12(g) of the Act:

 

None

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o     No þ

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes o     No þ

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes þ     No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o     No þ

 

The aggregate market value of 5,021,041 shares of the Registrant’s common stock held by non-affiliates on June 29, 2007 was approximately $134.7 million. For purposes of this computation all officers, directors and 10% beneficial owners of the Registrant are assumed to be affiliates. Such determination should not be deemed an admission that such officers, directors and beneficial owners are, in fact, affiliates of the Registrant.

 

At February 29, 2008, there were 30,378,102 shares of the Registrant’s common stock issued and outstanding.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the Registrant’s definitive Proxy Statement pertaining to the 2008 Annual Meeting of Shareholders (the “Proxy Statement”) filed pursuant to Regulation 14A are incorporated herein by reference into Part III.

 

 

CREDIT ACCEPTANCE CORPORATION
YEAR ENDED DECEMBER 31, 2007

 

INDEX TO FORM 10-K

 

 

 

General

 

Since 1972, Credit Acceptance (referred to as the “Company”, “Credit Acceptance”, “we”, “our” or “us”) has provided auto loans to consumers, regardless of their credit history. Our product is offered through a nationwide network of automobile dealers who benefit from sales of vehicles to consumers who otherwise could not obtain financing; from repeat and referral sales generated by these same customers; and from sales to customers responding to advertisements for our product, but who actually end up qualifying for traditional financing.

 

Without our product, consumers are often unable to purchase a vehicle or they purchase an unreliable one and are not provided the opportunity to improve their credit standing. As we report to the three national credit reporting agencies, a significant number of our consumers improve their lives by improving their credit score and move on to more traditional sources of financing.

 

Credit Acceptance was founded to collect retail installment contracts (referred to as “Consumer Loans”) originated by automobile dealerships owned by our founder, majority shareholder, and Chairman, Donald Foss. During the 1980s, we began to market this service to non-affiliated dealers and, at the same time, began to offer dealers a non-recourse cash payment (referred to as an “advance”) against anticipated future collections on Consumer Loans serviced for that dealer. We refer to dealers who participate in our program and who share our commitment to changing consumers’ lives as “dealer-partners”.

 

A consumer who does not qualify for conventional automobile financing can purchase a used vehicle from a Credit Acceptance dealer-partner and finance the purchase through us. We are an indirect lender from a legal perspective, meaning the Consumer Loan is originated by the dealer-partner and immediately assigned to us.

 

Consumers and dealer-partners benefit from our product as follows:

 

Consumers.  We help change the lives of consumers who do not qualify for conventional automobile financing by helping them obtain quality transportation and, equally important, providing an opportunity to establish or reestablish their credit through the timely repayment of their Consumer Loan.

 

Dealer-Partners.  Our program increases dealer-partners’ profits in the following ways:

 

 

Our Internet address is creditacceptance.com. We make available, free of charge on the web site, copies of reports we file with or furnish to the Securities and Exchange Commission as soon as reasonably practicable after we electronically file or furnish such reports.

 

Principal Business

 

We have two primary programs: the Portfolio Program and the Purchase Program. During the year ended December 31, 2007, 83% of loans were assigned to us under the Portfolio Program and 17% were assigned to us under the Purchase Program. Dealer-Partners have the option to assign Consumer Loans under either program and sign a separate agreement for each program type. Under the Portfolio Program, we advance money to

dealer-partners (referred to as a “Dealer Loan”) in exchange for the right to service the underlying Consumer Loan. Our servicing fee is equal to a fixed percentage (typically 20%) of each payment collected. The Dealer Loan is repaid by collections from the Consumer Loans. Each dealer-partner has an opportunity to receive additional money over time based on the performance of all Consumer Loans that they assign to us under the Portfolio Program. Under the Purchase Program, we buy the Consumer Loan from the dealer-partner (referred to as a “Purchased Loan”) and keep all amounts collected from the consumer. Dealer Loans and Purchased Loans are collectively referred to as “Loans”.

 

Portfolio Program

 

As payment for the vehicle, the dealer-partner generally receives the following:

 

 

We record the amount advanced to the dealer-partner as a Dealer Loan, which is classified within Loans receivable in our consolidated balance sheets. Cash advanced to dealer-partners is automatically assigned to the originating dealer-partner’s open pool of advances. At the dealer-partner’s option, a pool containing at least 100 Consumer Loans can be closed and subsequent advances assigned to a new pool. All advances due from a dealer-partner are secured by the future collections on the dealer-partner’s portfolio of Consumer Loans assigned to us. For dealer-partners with more than one pool, the pools are cross-collateralized so that the performance of other pools is considered in determining eligibility for dealer holdback. We perfect our security interest in the Dealer Loans by taking possession of the Consumer Loans.

 

The dealer servicing agreement provides that collections received by us during a calendar month on Consumer Loans assigned by a dealer-partner are applied on a pool-by-pool basis as follows:

 

 

Dealer-partners have an opportunity to receive a portion of the dealer holdback on an accelerated basis at the time a pool of 100 or more Consumer Loans is closed. The eligibility to receive accelerated dealer holdback and the amount paid to the dealer-partner is calculated using a formula that considers the forecasted collections and the advance balance on the closed pool. If the collections on Consumer Loans from a dealer-partner’s pool are not sufficient to repay the advance balance, the dealer-partner will not receive dealer holdback or accelerated dealer holdback.

 

Since typically the combination of the advance and the consumer’s down payment provides the dealer-partner with a cash profit at the time of sale, the dealer-partner’s risk in the Consumer Loan is limited. We cannot demand repayment from the dealer-partner of the advance except in the event the dealer-partner is in default of the dealer servicing agreement. Advances are made only after the Consumer Loan is approved, accepted by and assigned to us and all other stipulations required for funding have been satisfied.

 

For accounting purposes, the transactions described under the Portfolio Program are not considered to be loans to consumers. Instead, our accounting reflects that of a lender to the dealer-partner. The classification as a Dealer Loan for accounting purposes is primarily a result of (i) the dealer-partner’s financial interest in the Consumer Loan and (ii) certain elements of our legal relationship with the dealer-partner. The cash amount advanced to the dealer-partner is recorded as an asset on our balance sheet. The aggregate amount of all advances to an individual dealer-partner, plus accrued income, less repayments comprises the amount of the Dealer Loan recorded in Loans receivable.

Purchase Program

 

We began offering a Purchase Program on a limited basis in March of 2005. The Purchase Program differs from our traditional Portfolio Program in that the dealer-partner receives a single upfront payment from us at the time of origination instead of a cash advance and dealer holdback. Purchase Program volume increased in 2007 as the program was offered to additional dealer-partners.

 

For accounting purposes, the transactions described under the Purchase Program are considered to be originated by the dealer-partner and then purchased by us. The cash amount paid to the dealer-partner is recorded as an asset on our balance sheet. The aggregate amount of all amounts paid to purchase Consumer Loans from dealer-partners, plus accrued income, less repayments, comprises the amount of Purchased Loans recorded in Loans receivable.

 

The following table summarizes key information regarding Purchased Loans:

 

 

Revenue Sources

 

Credit Acceptance derives its revenues from the following principal sources:

 

 

The following table sets forth the percent relationship to total revenue from continuing operations of each of these sources:

 

 

Our business is seasonal with peak Consumer Loan acceptances and collections occurring during the first quarter of the year. However, this seasonality does not have a material impact on our interim results.

We have two reportable business segments: United States and Other. The United States segment consists of the United States automobile financing business. The Other segment primarily consists of the discontinued United Kingdom automobile financing business. For information regarding our reportable segments, see Note 11 to the consolidated financial statements.

 

Operations in the United States

 

Our target market is a select group of approximately 70,000 independent and franchised automobile dealers in the United States. The marketing of our program is intended to: (i) result in a network consisting of dealer-partners who share our commitment to changing lives and (ii) increase the value of our program to our dealer-partners. Dealer-partners that enroll in our program have the option to pay a one-time enrollment fee of $9,850 or to defer the fee. Dealer-partners choosing to defer payment of the enrollment fee agree to allow us to keep 50% of their first accelerated dealer holdback payment. In return for the enrollment fee, we provide the dealer-partner with training and the first month’s access to CAPS. For dealer-partners opting to pay the enrollment fee at the time of enrollment, in addition to their first month’s access to CAPS, we also provide various marketing materials such as signs and sales promotion kits.

 

Dealer-partner enrollments for each of the last five years are presented in the table below:

 

 

A new dealer-partner is required to execute a dealer servicing agreement related to the Portfolio Program and, at their option, a Purchase Program agreement, which define the legal relationship between us and the dealer-partner. The agreements assign the responsibilities for collecting the amounts due on Consumer Loans to us. Under the typical agreement, a dealer-partner represents that it will only assign Consumer Loans to us which satisfy criteria established by us, meet certain conditions with respect to their binding nature and the status of the security interest in the purchased vehicle, and comply with applicable state, federal and foreign laws and regulations. If we discover a misrepresentation by the dealer-partner relating to a Consumer Loan assigned to us, we can demand that the Consumer Loan be repurchased for the current balance of the Consumer Loan less the amount of any unearned finance charge plus the applicable termination fee, which is generally $500. Upon receipt of such amount in full, we will reassign the Consumer Loan and its security interest in the financed vehicle to the dealer-partner. The dealer-partner can also opt to repurchase their Consumer Loan portfolio assigned under the Portfolio Program, at their discretion.

 

The typical agreement may be terminated by us or by the dealer-partner upon written notice. We may terminate the agreement immediately in the case of an event of default by the dealer-partner. Events of default include, among other things:

 

 

 

 

While a dealer-partner can cease assigning Consumer Loans to us at any time without terminating the agreement, if the dealer-partner elects to terminate the agreement or in the event of a default, the dealer-partner must immediately pay us:

 

 

 

 

Upon receipt of such amounts in full, we reassign the Consumer Loans and our security interest in the financed vehicles to the dealer-partner. In the event of a termination, we may continue to service Consumer Loans assigned by dealer-partners accepted prior to termination in the normal course of business without charging a termination fee.

 

Dealer-partners receive a monthly statement from us, summarizing all activity on Consumer Loans assigned by such dealer-partner.

 

Consumer Loan Assignment.  Once a dealer-partner has enrolled in our programs, the dealer-partner may begin assigning Consumer Loans to us. A Consumer Loan originates when a consumer enters into a contract with a dealer-partner that sets forth the terms of the agreement between the consumer and the dealer-partner for the payment of the purchase price of the automobile. The amount of the Consumer Loan consists of the total principal and interest that the consumer is required to pay over the term of the Consumer Loan. Virtually all of the Consumer Loans accepted by us in the United States are processed through CAPS. CAPS allows dealer-partners to input a consumer’s credit application and view the response from us via the Internet. CAPS allows dealer-partners to: (i) receive a quick approval from us; and (ii) interact with our proprietary credit scoring system to improve the structure of each transaction prior to delivery. All responses include the amount of funding (advance for a Dealer Loan or purchase price for a Purchased Loan), as well as any stipulations required for funding. The amount of funding is determined using a formula which considers a number of factors including the timing and amount of cash flows expected on the related Consumer Loan and our target return on capital at the time the Consumer Loan is assigned. The estimated future cash flows are determined based upon our proprietary credit scoring system, which considers numerous variables, including attributes contained in the consumer’s credit bureau report, data contained in the consumer’s credit application, the structure of the proposed transaction, vehicle information and other factors, to calculate a composite credit score that corresponds to an expected collection rate. Our proprietary credit scoring system forecasts the collection rate based upon the historical performance of Consumer Loans in our portfolio that share similar characteristics. The performance of our proprietary credit scoring system is evaluated monthly by comparing projected to actual Consumer Loan performance. Adjustments are made to our proprietary credit scoring system as necessary.

 

While a dealer-partner can assign any legally compliant Consumer Loan to us, the decision whether to provide funding to the dealer-partner and the amount of any funding is made solely by us. We perform all significant functions relating to the processing of the Consumer Loan applications and bear certain costs of Consumer Loan acceptances, including the cost of assessing the adequacy of Consumer Loan documentation, compliance with underwriting guidelines and the cost of verifying employment, residence and other information provided by the dealer-partner.

 

In the majority of states, Consumer Loan contracts are written on a contract form provided by us. The Consumer Loan transaction is not accepted by the Company until we have received and approved all the related stipulations for funding. The acceptance of the Consumer Loan from the dealer-partner to us occurs after both the consumer and dealer-partner sign the contract and the original contract and supporting documentation are received and approved by us. Although the dealer-partner is named in the Consumer Loan contract, the dealer-partner generally does not have legal ownership of the Consumer Loan for more than a moment and the Company, not the dealer-partner, is listed as lien holder on the vehicle title. The consumer’s payment obligation is directly to us. Payments are generally made by the consumer directly to us. The consumer’s failure to pay amounts due under the Consumer Loan will result in collection action by us.

Our business model allows us to share the risk and reward of collecting on the Consumer Loans with the dealer-partners. Such sharing is intended to motivate the dealer-partner to assign better quality Consumer Loans, follow our underwriting guidelines, and provide appropriate service and support to the consumer after the sale. We believe this arrangement aligns the interests of the Company, the dealer-partner and the consumer. We measure various criteria for each dealer-partner against other dealer-partners in their area as well as the top performing dealer-partners. Sales representatives regularly review the performance of each dealer-partner and, together with the dealer-partner, create an action plan to improve the dealer-partner’s overall success with our program.

 

Information on our Consumer Loans is presented in the following table:

 

 

Collections.  Our collectors are organized into teams. Our first payment missed team services Consumer Loans of consumers who have failed to make one of their first three payments on time. A collection call is generally placed to these consumers within one day after the payment is due. After a consumer has made their initial three payments, the Consumer Loan is serviced by either our delinquency team or our specialized team. Within our delinquency team Consumer Loans are segmented by various phone contact profiles (such as a good residence phone number, but no employment phone number). Our specialized team has higher skilled collectors with access to additional tools. This team locates consumers by finding new contact information to use to collect amounts due or to return the Consumer Loan to the delinquency team. The specialized team services Consumer Loans with the following characteristics:

 

 

 

 

When a Consumer Loan is approved for repossession, the account is transferred to our repossession team. Repossession personnel continue to service the Consumer Loan as it is being assigned to a third party repossession contractor, who works on a contingency fee basis. Once a vehicle has been repossessed, the consumer can negotiate a redemption, whereby the vehicle is returned to the consumer in exchange for paying off the Consumer Loan balance, or where appropriate or if required by law, the vehicle is returned to the consumer and the Consumer Loan reinstated, in exchange for reducing or eliminating the past due balance. If the redemption process is not successful, the vehicle is sold at a wholesale automobile auction. Prior to sale, the vehicle is usually inspected by our remarketing representatives who authorize repair and reconditioning work in order to maximize the net sale proceeds at auction.

 

If the vehicle sale proceeds are not sufficient to satisfy the balance owing on the Consumer Loan, the Consumer Loan is serviced by either: (i) our senior collection team, in the event that the consumer is willing to make payments on the deficiency balance; or (ii) where permitted by law, our legal team, if it is believed that legal action is required to reduce the deficiency balance owing on the Consumer Loan. Our legal team generally assigns Consumer Loans to third party collection attorneys who file a claim and upon obtaining a judgment, garnish wages or other assets. Additionally, we may sell or assign Consumer Loans to a third party collection company.

 

Collectors rely on two systems; the Collection System (“CS”) and the Loan Servicing System (“LSS”). The CS and the LSS are connected through a batch interface. The present CS has been in service since June 2002. The CS interfaces with a predictive dialer and records all activity on a Consumer Loan, including details of past phone conversations with the consumer, collection letters sent, promises to pay, broken promises, repossession orders and collection attorney activity. The LSS maintains a record of all transactions relating to Consumer Loans assigned after July 1990 and is a primary source of data utilized to:

 

 

 

 

 

During the third quarter of 2005, we began an initiative to outsource a portion of our collection function to a company in India. In the second quarter of 2006, we entered into another outsourcing arrangement with a company in Costa Rica. These outsourced collectors service accounts using the CS and typically work accounts that are less than sixty days past due. Outsourcing reduces the geographic risk of having two collection centers in the United States and provides additional flexibility to scale our operation.

 

Service Contracts and Insurance Products

 

We provide dealer-partners the ability to offer vehicle service contracts to consumers. Buyers Vehicle Protection Plan, Inc. (“BVPP”), a wholly owned subsidiary of the Company, has relationships with third party administrators (“TPAs”) whereby the TPAs process claims on vehicle service contracts that are underwritten by third party insurers. BVPP receives a commission for all vehicle service contracts sold by our dealer-partners when the vehicle is financed by us, and does not bear any risk of loss for claims. The commission is included in the retail price of the vehicle service contract which is added to the Consumer Loan. We provide dealer-partners with an additional advance based on the retail price of the vehicle service contract. We recognize our commission from the vehicle service contracts as part of finance charges on a level-yield basis based upon forecasted cash flows. Our agreements with two of our TPAs allow us to receive profit sharing payments depending upon the performance of the vehicle service contract programs. Profit sharing payments are received once a year, if eligible. Profit sharing payments are currently not estimable due to a lack of historical information and therefore revenue related to these payments is recognized in the period the payments are received.

 

Agreements with two of the TPAs also require that vehicle service contract premiums be placed in trust accounts. Funds in the trust accounts are utilized by the TPA to pay claims on the vehicle service contracts. Profit sharing payments, if any, on the vehicle service contracts are distributed to us after the term of the vehicle service contracts have substantially expired provided certain loss rates are met. Under Financial Accounting Standards Board (“FASB”) Interpretation No. 46, “Consolidation of Variable Interest Entities” (“FIN 46”), we are considered the primary beneficiary of the trusts. As a result, the assets and liabilities of the trusts have been consolidated on our balance sheet. As of December 31, 2007, the trusts had $21.6 million in assets available to pay claims and a related claims reserve of $20.2 million.

 

BVPP also has a relationship with a TPA that allows dealer-partners to offer a Guaranteed Asset Protection (“GAP”) product to consumers whereby the TPA processes claims that are underwritten by a third party insurer. GAP provides the consumer protection by paying the difference between the loan balance and the amount covered by the consumer’s insurance policy in the event the vehicle is totaled or stolen. We receive a commission for all GAP contracts sold by our dealer-partners when the vehicle is financed by us, and do not bear any risk of loss for claims. The commission is included in the retail price of the GAP contract which is added to the Consumer Loan. We provide dealer-partners with an additional advance based on the retail price of the GAP contract. We recognize our commission from the GAP contracts as part of finance charges on a level-yield basis based upon forecasted cash flows. We are eligible to receive profit sharing payments depending on the performance of the GAP program. Profit sharing payments from the third party are received once a year, if eligible. Profit sharing payments are currently not estimable due to a lack of historical information and therefore revenue related to these payments is recognized in the period the payments are received.

 

Businesses in Liquidation

 

Effective June 30, 2003, we decided to stop originating Consumer Loans in the United Kingdom. We sold the remaining Consumer Loan portfolio of our United Kingdom subsidiary on December 30, 2005. The selling price was approximately $4.3 million resulting in a pre-tax gain of approximately $3.0 million.

Credit Loss Policy

 

For information regarding our accounting policy for the allowance for credit losses, see Note 2 to the consolidated financial statements.

 

Competition

 

The market for consumers who do not qualify for conventional automobile financing is large and highly competitive. The market is currently served by “buy here, pay here” dealerships, banks, captive finance affiliates of automobile manufacturers, credit unions and independent finance companies both publicly and privately owned. Many of these companies are much larger and have greater resources than us. These companies typically target higher credit tier customers within our market. We compete by offering a profitable and efficient method for dealer-partners to finance customers who would be more difficult or less profitable to finance through other methods. In addition, we compete on the basis of the level of service provided by our origination and sales personnel.

 

Customer and Geographic Concentrations

 

No single dealer-partner accounted for more than 10% of total revenues during any of the last three years. Additionally, no single dealer-partner’s Loan receivable balance accounted for more than 10% of total Loans as of December 31, 2007 or 2006. The following table provides information regarding the five states that are responsible for the largest dollar amount of Consumer Loans accepted or purchased in the United States during 2007:

 

 

 

The following table provides information regarding the five states that are responsible for the largest dollar amount of Consumer Loans accepted or purchased in the United States during 2006:

 

 

 

Geographic Financial Information

 

For the three years ended December 31, 2007, 2006 and 2005, revenues from continuing operations were derived primarily from operations in the United States. Long-lived assets were also primarily located in the United States.

 

Regulation

 

Our businesses are subject to various state, federal and foreign laws and regulations, which:

 

(i) require licensing and qualification;

 

(ii) regulate interest rates, fees and other charges;

 

(iii) require specified disclosures to consumers;

 

(iv) govern the sale and terms of ancillary products; and

 

(v) define our rights to collect Consumer Loans and repossess and sell collateral.

 

Failure to comply with, or an adverse change in, these laws or regulations could have a material adverse effect on us by, among other things, limiting the states or countries in which we may operate, restricting our ability to realize the value of the collateral securing the Consumer Loans, or resulting in potential liability related to our collection of Consumer Loans. In addition, governmental regulations depleting the supply of used vehicles, such as environmental protection regulations governing emissions or fuel consumption, could have a material adverse effect on us. We are not aware of any such legislation currently pending that could have a material adverse effect on us.

 

The sale of insurance products in connection with Consumer Loans assigned to or purchased by us from dealer-partners is also subject to state laws and regulations. However, as we do not deal directly with consumers in the sale of insurance products, we do not believe that such laws and regulations significantly affect our business. Nevertheless, there can be no assurance that insurance regulatory authorities in the jurisdictions in which such products are offered by dealer-partners will not seek to regulate us or restrict the operation of our business in such jurisdictions. Any such action could materially adversely affect the income received from such products.

 

We believe that we maintain all material licenses and permits required for our current operations and are in substantial compliance with all applicable laws and regulations. Our agreements with dealer-partners provide that the dealer-partner shall indemnify us with respect to any loss or expense we incur as a result of the dealer-partner’s failure to comply with applicable laws and regulations.

 

Team Members

 

As of December 31, 2007, we had 971 full and part-time team members. Our team members have no union affiliations and we believe our relationship with our team members is good. The table below presents team members by function:

 

 

Our inability to accurately forecast and estimate the amount and timing of future collections could have a material adverse effect on results of operations.

 

Since cash flows available to repay the Loans are generated, in most cases, from the underlying Consumer Loans, the ability to accurately forecast Consumer Loan performance is critical to our success. At the time of Consumer Loan acceptance or purchase, we forecast future expected cash flows from the Consumer Loan. Based on these forecasts, we make an advance or cash payment to the related dealer-partner at a level designed to achieve an acceptable return on capital. If Consumer Loan performance equals or exceeds original expectations, it is likely the target return on capital will be achieved. However, actual cash flows from any individual Consumer Loan are often different than cash flows estimated at Consumer Loan inception. There can be no assurance that estimates will be accurate or that Consumer Loan performance will be as expected. In the event that we underestimate the default risk or under-price products, the financial position, liquidity and results of operations could be adversely affected, possibly to a material degree.

 

Due to increased competition from traditional financing sources and non-traditional lenders, we may not be able to compete successfully.

 

The automobile finance market for consumers who do not qualify for conventional automobile financing is large and highly competitive. The market is served by a variety of companies including “buy here, pay here” dealerships. The market is also currently served by banks, captive finance affiliates of automobile manufacturers, credit unions and independent finance companies both publicly and privately owned. Many of these companies are much larger and have greater financial resources than are available to us, and many have long standing relationships with automobile dealerships. Providers of automobile financing have traditionally competed based on the interest rate charged, the quality of credit accepted, the flexibility of loan terms offered and the quality of service provided to dealers and consumers. There is potential that significant direct competition could emerge and that we may be unable to compete successfully.

 

We may be unable to continue to access funding sources and obtain capital on favorable terms needed to maintain and grow the business.

 

We currently use four primary sources of debt financing: (i) a revolving secured line of credit with a commercial bank syndicate; (ii) a revolving secured warehouse facility with institutional investors; (iii) SEC Rule 144A asset-backed secured borrowings (“Term ABS 144A”) with qualified institutional investors; and (iv) a residual credit facility with an institutional investor. There can be no assurance that new or additional financing can be obtained, or that it will be available on acceptable terms. If our various financing alternatives were to become limited or unavailable, we may have to limit business activity, and operations could be materially adversely affected.

 

We may not be able to generate sufficient cash flow to service our outstanding debt and fund operations.

 

We currently have substantial outstanding indebtedness and our credit facilities allow us to incur significant amounts of additional debt. The ability to make payment of principal or interest on indebtedness will depend in part on our future operating performance, which to a certain extent is subject to economic, financial, competitive and other factors beyond our control. If we are unable to generate sufficient cash flow in the future to service our debt, we may be required to refinance all or a portion of our existing debt or obtain additional financing. There can be no assurance that any such refinancing will be possible or that any additional financing can be obtained on sustainable terms.

 

Dependence on securitization program and financial guaranty insurance.

 

We rely upon our ability to transfer Loans to securitization trusts and sell securities in the asset-backed securities market to generate cash proceeds for repayment of credit facilities and to fund new Loans. The asset-backed securities market has been currently experiencing unprecedented disruptions. Current conditions in this market include reduced liquidity, high credit risk premiums for certain market participants and reduced investor

demand for asset-backed securities, particularly those backed by sub-prime collateral. These conditions, which may increase our cost of funding and reduce our access to the asset-backed securities market, may continue or worsen in the future. We attempt to mitigate the impact of market disruptions by obtaining adequate committed credit facilities and accessing other sources of financing from a variety of reliable sources. There can be no assurance, however, that we will be successful in selling securities in the asset-backed securities market, that our credit facilities and other sources of financing will be adequate to fund Loans until the disruptions in the securitization markets subside or that the cost of debt will allow us to operate at profitable levels. Disruptions in this market or any adverse change or delay in our ability to access the market could have a material adverse effect on our financial position, liquidity and results of operations.

 

We execute securitization transactions to fund our future liquidity needs. There can be no assurance that funding will be available to us through these sources or, if available, that it will be on terms acceptable to us. If these, and other sources of funding are not available to us on a regular basis for any reason, including the occurrence of events of default, deterioration in loss experience on the Loans, breach of financial covenants or portfolio and pool performance measures, disruption of the asset-backed market or otherwise, we could be required to revise the scale of our business, including the possible discontinuation of funding Loans, which could have a material adverse effect on our ability to achieve our business and financial objectives.

 

To date, most of our securitizations in the United States have utilized financial guaranty insurance policies provided by various monoline insurance providers to achieve AAA/Aaa ratings on the insured securities issued in the securitization transactions. These ratings reduce the costs of securitizations and enhance the marketability of these transactions to investors in asset-backed securities. The downgrading of monoline insurance providers’ credit ratings or the inability to structure alternative credit enhancements, such as senior subordinated transactions for our securitization program could result in higher interest costs for future securitizations sponsored by us and larger initial credit enhancement requirements. The absence of a financial guaranty insurance policy may also impair the marketability of our securitizations. These events could have a material adverse effect on the cost and availability of capital which in turn could have a material adverse effect on our financial position, liquidity and results of operations.

 

Requirements under credit facilities to meet financial and portfolio performance covenants.

 

Our credit facilities contain various covenants requiring certain minimum financial ratios and minimum asset quality. Failure to meet any of these covenants could result in an event of default under these agreements.

 

If we cannot comply with the requirements in our credit facilities, then the lenders may increase our borrowing costs, require us to repay immediately all of the outstanding debt, enforce their interests against collateral pledged under these agreements or restrict our ability to obtain additional borrowings under these facilities. If our debt payments were accelerated, our assets might not be sufficient to fully repay the debt. These lenders may require us to use all of our available cash to repay our debt or foreclose upon their collateral. We may not be able to obtain a waiver of these provisions or refinance our debt, if needed. In such case, our financial condition, liquidity and results of operations would suffer.

 

Interest rate fluctuations may adversely affect our borrowing costs, profitability and liquidity.

 

Our profitability may be directly affected by the level of and fluctuations in interest rates, which affects our borrowing costs. Our profitability and liquidity could be adversely affected during any period of higher interest rates, possibly to a material degree. We monitor the interest rate environment and employ hedging strategies designed to mitigate the impact of increases in interest rates. We can provide no assurance, however, that hedging strategies will mitigate the impact of increases in interest rates.

 

The substantial regulation to which we are subject could result in potential liability.

 

Our business is subject to various laws and regulations which require licensing and qualification; limit interest rates, fees and other charges associated with the Consumer Loans assigned to us; require specified disclosures by dealer-partners to consumers; govern the sale and terms of ancillary products; and define the rights to repossess and sell collateral. Failure to comply with, or an adverse change in, these laws or regulations could have a material

adverse effect on us by, among other things, limiting the jurisdictions in which we may operate, restricting the ability to realize the value of the collateral securing the Consumer Loans, making it more costly or burdensome to do business, or resulting in potential liability. In addition, governmental regulations which would deplete the supply of used vehicles, such as environmental protection regulations governing emissions or fuel consumption, could have a material adverse effect on us.

 

The sale of insurance products in connection with Consumer Loans assigned to us by dealer-partners is also subject to state laws and regulations. As the holder of the Consumer Loans that contain these products, some of these state laws and regulations may apply to our servicing and collection of the Consumer Loans. Although we do not believe that such laws and regulations significantly affect our business because we do not deal directly with consumers in the sale of insurance products, there can be no assurance that insurance regulatory authorities in the jurisdictions in which such products are offered by dealer-partners will not seek to regulate or restrict the operation of the business in such jurisdictions. Any such action could materially adversely affect the income received from such products.

 

Adverse changes in economic conditions, or in the automobile or finance industries or the non-prime consumer market, could adversely affect our financial position, liquidity and results of operations and our ability to enter into future financing transactions.

 

We are subject to general economic conditions which are beyond our control. During periods of economic slowdown or recession, delinquencies, defaults, repossessions and losses may increase. These periods may also be accompanied by decreased consumer demand for automobiles and declining values of automobiles securing outstanding Consumer Loans, which weakens collateral coverage and increases the amount of a loss in the event of default. Significant increases in the inventory of used automobiles during periods of economic recession may also depress the prices at which repossessed automobiles may be sold or delay the timing of these sales. Because our business is focused on consumers who do not qualify for conventional automobile financing, the actual rates of delinquencies, defaults, repossessions and losses on these Consumer Loans could be higher than that of those experienced in the general automobile finance industry, and could be more dramatically affected by a general economic downturn. In addition, during an economic slowdown or recession, our servicing costs may increase without a corresponding increase in service fee income. Any sustained period of increased delinquencies, defaults, repossessions or losses or increased servicing costs could also materially adversely affect our financial position, liquidity and results of operations and our ability to enter into future financing transactions.

 

Litigation we are involved in from time to time may adversely affect our financial condition, results of operations and cash flows.

 

As a result of the consumer-oriented nature of the industry in which we operate and uncertainties with respect to the application of various laws and regulations in some circumstances, we are subject to various consumer claims and litigation seeking damages and statutory penalties, based upon, among other things, usury, disclosure inaccuracies, wrongful repossession, violations of bankruptcy stay provisions, certificate of title disputes, fraud and breach of contract. Some litigation against us could take the form of class action complaints by consumers. As the assignee of Consumer Loans originated by dealer-partners, we may also be named as a co-defendant in lawsuits filed by consumers principally against dealer-partners. The damages and penalties claimed by consumers in these types of matters can be substantial. The relief requested by the plaintiffs varies but includes requests for compensatory, statutory and punitive damages. A significant judgment against us in connection with any litigation could have a material adverse effect on our financial condition and results of operations.

 

We are dependent on our senior management and the loss of any of these individuals or an inability to hire additional personnel could adversely affect our ability to operate profitably.

 

Our senior management average over 9 years of experience with the Company. Our success is dependent upon the management and the leadership skills of these managers. In addition, competition from other companies to hire our personnel possessing the necessary skills and experience required could contribute to an increase in employee turnover. The loss of any of these individuals or an inability to attract and retain additional qualified personnel could

adversely affect us. There can be no assurance that we will be able to retain our existing senior management personnel or attract additional qualified personnel.

 

Our inability to properly safeguard confidential consumer information.

 

If third parties or our employees are able to penetrate our network security or otherwise misappropriate our customers’ personal information or loan information, or if we give third parties or our employees improper access to our customers’ personal information or loan information, we could be subject to liability. This liability could include identity theft or other similar fraud-related claims. This liability could also include claims for other misuses or losses of personal information, including for unauthorized marketing purposes. Other liabilities could include claims alleging misrepresentation of our privacy and data security practices.

 

We rely on encryption and authentication technology licensed from third parties to provide the security and authentication necessary to effect secure online transmission of confidential consumer information. Advances in computer capabilities, new discoveries in the field of cryptography or other events or developments may result in a compromise or breach of the algorithms that we use to protect sensitive customer transaction data. A party who is able to circumvent our security measures could misappropriate proprietary information or cause interruptions in our operations. We may be required to expend capital and other resources to protect against such security breaches or to alleviate problems caused by such breaches. Our security measures are designed to protect against security breaches, but our failure to prevent such security breaches could subject us to liability, decrease our profitability, and damage our reputation.

 

Our operations could suffer from telecommunications or technology downtime or increased costs.

 

The temporary or permanent loss of our computer and telecommunications equipment, software systems and Internet access, through system conversions or operating malfunction, could disrupt our operations. In the normal course of our business, we must record and process significant amounts of data quickly and accurately to access, maintain and expand the databases we use for our origination and collection activities. Any failure of our information systems or software and our backup systems could interrupt our business operations and harm our business.

 

Our ability to integrate computer and telecommunications technologies into our business is essential to our competitive position and our success. Computer and telecommunications technologies are evolving rapidly and are characterized by short product life cycles. We may not be successful in anticipating, managing or adopting technological changes on a timely basis.

 

While we believe that our existing information systems are sufficient to meet our current demands and continued expansion, our future growth may require additional investment in these systems. We cannot ensure that adequate capital resources will be available to us at the appropriate time.

 

Natural disasters, acts of war, terrorist attacks and threats or the escalation of military activity in response to such attacks or otherwise may negatively affect our business, financial condition and results of operations.

 

Natural disasters, acts of war, terrorist attacks and the escalation of military activity in response to such attacks or otherwise may have negative and significant effects, such as imposition of increased security measures, changes in applicable laws, market disruptions and job losses. Such events may have an adverse effect on the economy in general. Moreover, the potential for future terrorist attacks and the national and international responses to such threats could affect the business in ways that cannot be predicted. The effect of any of these events or threats could have an adverse effect on our business, financial condition and results of operations.

 

 

None.

 

United States and Other

 

Our headquarters are located at 25505 West Twelve Mile Road, Southfield, Michigan 48034. We purchased the office building in 1993 and have a mortgage loan from a commercial bank that is secured by a first mortgage lien on the property. The office building includes approximately 117,000 square feet of useable space on five floors. We occupy approximately 101,000 square feet of the building, with most of the remainder of the building leased to various tenants.

 

We lease approximately 20,000 square feet of office space in Henderson, Nevada. The lease expires in October 2009.

 

 

In the normal course of business and as a result of the consumer-oriented nature of the industry in which we operate, industry participants are frequently subject to various consumer claims and litigation seeking damages and statutory penalties. The claims allege, among other theories of liability, violations of state, federal and foreign truth-in-lending, credit availability, credit reporting, consumer protection, warranty, debt collection, insurance and other consumer-oriented laws and regulations, including claims seeking damages for physical and mental damages relating to our repossession and sale of the consumer’s vehicle and other debt collection activities. As we accept assignments of Consumer Loans originated by dealer-partners, we may also be named as a co-defendant in lawsuits filed by consumers principally against dealer-partners. Many of these cases are filed as purported class actions and seek damages in large dollar amounts. An adverse ultimate disposition in any such action could have a material adverse impact on our financial position, liquidity and results of operations.

 

For a description of material pending litigation to which we are a party, see Note 12 to the consolidated financial statements, which is incorporated herein by reference.

 

 

No matters were submitted to a vote of the shareholders during the fourth quarter of 2007.

 

 

Stock Price

 

During the year ended December 31, 2007 our common stock was traded on The Nasdaq Global Market^® (“Nasdaq”) under the symbol CACC. From July 19, 2005 until April 25, 2006, our common stock was delisted from the Nasdaq and was traded on the Pink Sheets Electronic Quotation Service (“Pink Sheets”) under the symbol CACC until it was relisted on the Nasdaq with trading in its common shares beginning on April 26, 2006. The following table sets forth the high and low sale prices as reported by the Nasdaq and Pink Sheets for the common stock for the relevant periods during 2006 and 2007. Such bid information reflects inter-dealer prices, without retail mark-up, mark-down or commission and may not necessarily represent actual transactions.

 

 

As of February 14, 2008, the number of beneficial holders and shareholders of record of the common stock was 1,574 based upon securities position listings furnished to us.

 

Dividends

 

We have not paid any cash dividends during the periods presented. Our credit agreements contain financial covenants pertaining to our maximum ratio of funded debt to tangible net worth, which may indirectly limit the payment of dividends on common stock.

Stock Performance Graph

 

The following graph compares the percentage change in the cumulative total shareholder return on our common stock during the period beginning January 1, 2003 and ending on December 31, 2007 with the cumulative total return on the Nasdaq Market Index and a peer group index based upon approximately 100 companies included in the Dow Jones — US General Financial Index. The comparison assumes that $100 was invested on January 1, 2003 in our common stock and in the foregoing indices and assumes the reinvestment of dividends.

 

COMPARE 5-YEAR CUMULATIVE TOTAL RETURN
AMONG CREDIT ACCEPTANCE CORP.,
NASDAQ MARKET INDEX AND DJ US GENERAL FINANCE INDEX

 

 

ASSUMES $100 INVESTED ON JANUARY 1, 2003
ASSUMES DIVIDENDS REINVESTED
FISCAL YEAR ENDING DECEMBER 31, 2007

 

Stock Repurchases

 

In 1999, our board of directors approved a stock repurchase program which authorizes us to purchase common shares in the open market or in privately negotiated transactions at price levels we deem attractive. As of December 31, 2007, we have repurchased approximately 20.4 million shares under the stock repurchase program at a cost of $399.2 million. Included in the stock repurchases to date are 12.5 million shares of common stock purchased through four modified Dutch auction tender offers at a cost of $304.4 million. As of December 31, 2007, we have authorization to repurchase up to $29.1 million of our common stock.

 

The following table summarizes our stock repurchases for the three months ended December 31, 2007:

 

 

 

 

The selected income statement and balance sheet data presented below are derived from our audited consolidated financial statements and should be read in conjunction with our consolidated financial statements for the years ended December 31, 2007, 2006, and 2005, and notes thereto and “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations”, included elsewhere in this Annual Report. Certain amounts for prior periods have been reclassified to conform to the current presentation.

 

 

 

 

The following discussion and analysis should be read in conjunction with the consolidated financial statements and related notes included in Item 8 - Financial Statements and Supplementary Data in this Form 10-K.

 

Critical Success Factors

 

Critical success factors for us include access to capital and the ability to accurately forecast Consumer Loan performance.

 

Our strategy for accessing the capital required to grow is to: (i) maintain consistent financial performance, (ii) maintain modest financial leverage, and (iii) maintain multiple funding sources. Our funded debt to equity ratio is 2:1 at December 31, 2007. We currently use four primary sources of debt financing: (i) a revolving secured line of credit with a commercial bank syndicate; (ii) a revolving secured warehouse facility with institutional investors; (iii) SEC Rule 144A asset-backed secured borrowings (“Term ABS 144A”) with qualified institutional investors; and (iv) a residual credit facility with an institutional investor.

 

At the time of Consumer Loan acceptance or purchase, we forecast future expected cash flows from the Consumer Loan. Based on these forecasts, an advance or one time payment is made to the related dealer-partner at a level designed to achieve an acceptable return on capital. If Consumer Loan performance equals or exceeds our original expectation, it is likely our target return on capital will be achieved.

 

Consumer Loan Performance

 

Since the cash flows available to repay the Loans are generated, in most cases, from the underlying Consumer Loans, the performance of the Consumer Loans is critical to our financial results. The following table presents forecasted Consumer Loan collection rates, advance rates (includes amounts paid to acquire Purchased Loans), the spread (the forecasted collection rate less the advance rate), and the percentage of the forecasted collections that had been realized as of December 31, 2007. Payments of dealer holdback and accelerated payments of dealer holdback are not included in the advance percentage paid to the dealer-partner. All amounts are presented as a percentage of the initial balance of the Consumer Loan (principal + interest). The table includes both Dealer Loans and Purchased Loans.

 

 

The following table presents the same information as the table above for Purchased Loans and Dealer Loans in 2007:

 

Accurately forecasting future collection rates is critical to our success. The risk of a forecasting error declines as Consumer Loans age. For example, the risk of a material forecasting error for business written in 2003 is very small since 97.1% of the total amount forecasted has already been realized. In contrast, our forecast for recent Consumer Loans is less certain. If we produce disappointing operating results, it will likely be because we overestimated future Consumer Loan performance. Although we believe our forecasted collection rates are as accurate as possible, there can be no assurance that our estimates will be accurate or that Consumer Loan performance will be as expected.

 

The following table compares our forecast of Consumer Loan collection rates as of December 31, 2007, with the forecast as of December 31, 2006 for Dealer Loans and Purchased Loans:

 

 

 

We modified our loan pricing model during the third quarter of 2006. These pricing changes were intended to increase Consumer Loan unit volumes and Consumer Loan average loan sizes in exchange for a reduction in profitability per Consumer Loan as measured by the return on capital. Beginning in February 2007, we made pricing changes designed to increase the spread between the advance rate and the collection rate.

 

There were no other material changes in our credit policy or pricing that impacted the year ended December 31, 2007, other than routine changes designed to maintain profitability levels.

Results of Operations

 

The following is a discussion of the results of operations and income statement data for the Company on a consolidated basis:

 

Continuing Operations

 

Year Ended December 31, 2007 Compared to Year Ended December 31, 2006

 

For the year ended December 31, 2007, income from continuing operations decreased to $53.6 million from $58.8 million in 2006. Income from continuing operations per diluted share increased to $1.72 from $1.67 in 2006. The increase in income from continuing operations per diluted share reflects the impact of share repurchases. The decrease in net income primarily reflects the following:

 

 

Finance Charges.  Finance charges increased by 16.9% as Loans receivable increased 23.3%. Finance charges grew slower than Loans receivable as a result of pricing changes implemented in the third quarter of 2006. Loans receivable increased as a result of an increase in the number of new Loans and an increase in the average Loan amount.

 

The following table summarizes the changes in active dealer-partners and corresponding Consumer Loan unit volume:

 

 

 

Dealer-partners that enroll in our program have the option to pay a one-time enrollment fee of $9,850 or to defer the fee. Dealer-partners choosing to defer payment of the enrollment fee agree to allow us to keep 50% of their first accelerated dealer holdback payment. This payment, called Portfolio Profit Express, is paid to qualifying dealer-partners after a pool of 100 Consumer Loans has been closed. While we will lose enrollment fee revenue on those dealer-partners choosing this option and not reaching 100 Consumer Loans or otherwise failing to qualify for a Portfolio Profit Express payment, we estimate that we will realize higher per dealer-partner enrollment fee revenue from those dealer-partners choosing this option and qualifying for a Portfolio Profit Express payment. Based on the historical average of Portfolio Profit Express payments, we expect average enrollment fee revenue per dealer-partner for those dealer-partners electing the deferred option and qualifying for the Portfolio Profit Express payment will be approximately $12,000. Through December 31, 2007, 88 dealer-partners that have enrolled under the deferred option have earned Portfolio Profit Express payments. The amount kept by the Company (50% of the first Portfolio Profit Express payment) averaged $12,000 per dealer-partner. Approximately 81% of the dealer-partners that enrolled during the year ended December 31, 2007 took advantage of the deferred enrollment option.

 

License Fees.  License fees represent CAPS fees charged to dealer-partners on a monthly basis. The decrease was primarily due to a change in our method of collecting the monthly CAPS fee. Effective January 1, 2007, we implemented a change designed to positively impact dealer-partner attrition. We continue to charge a monthly fee of $599, but instead of collecting and recognizing the revenue from the fee in the current period, we collect it from future dealer holdback payments. As a result of this change, we now record license fees as a yield adjustment, recognizing these fees as finance charge revenue over the term of the Dealer Loan. We recognized a limited amount of license fee revenue related to certain dealer-partners that only participate in our Purchase Program. The decrease in license fees was partially offset by increases in finance charges as a result of this change. Because attrition is impacted by many variables, we cannot quantify the impact of the license fee change on attrition.

 

To allow shareholders to more precisely track our financial performance and make comparisons between periods possible, we have provided non-GAAP information below reflecting the amount of revenue that would have been recognized if the license fees had always been recorded as a yield adjustment. For the year ended December 31, 2007 and 2006, total revenue would have changed as follows:

 

 

Other Income.  The increase for the year ended December 31, 2007 was due to:

 

 

The profit sharing amounts received in the first quarter of 2007 were the first amounts we have received under this arrangement. Profit sharing payments from third parties are received once a year, if eligible. The amounts of these payments are currently not estimable due to a lack of historical information and therefore the revenue related to these payments is recognized in the period the payments are received.

 

Salaries and Wages.  The increase for the year ended December 31, 2007, as a percentage of revenue, was primarily due to an increase in headcount to support Loan growth. While the increase in headcount was proportionate to the increase in Loan volume, pricing changes and the change in the application and accounting for license fees caused revenue growth to be less than the growth in Loans receivable. The increase was also due to an increase in stock compensation expense primarily related to restricted stock and restricted stock units granted in the first quarter of 2007.

General and Administrative.  The decrease, as a percentage of revenue, for the year ended December 31, 2007, was primarily due to higher than normal legal expenses in 2006 primarily related to an $11.2 million increase in our estimated loss related to a class action lawsuit in the state of Missouri.

 

Provision for Credit Losses.  The increase in the provision for the year ended December 31, 2007 was primarily due to an increase in the provision for credit losses required to reduce the carrying value of the Dealer Loans to maintain the initial yield established at the inception of each Dealer Loan.

 

Interest.  The increase for the year ended December 31, 2007 was primarily due to an increase in the amount of average outstanding debt as a result of borrowings used to fund stock repurchases during 2006 and new Loans. The increase in interest expense was partially offset by our cost of debt which decreased to 7.9% in 2007 from 8.9% in 2006. The decrease was the result of fixed fees on our secured financings and line of credit facility having less impact on our cost of debt, primarily due to higher outstanding borrowings.

 

Year ended December 31, 2006 Compared to Year Ended December 31, 2005

 

For the year ended December 31, 2006, net income from continuing operations decreased to $58.8 million, or $1.67 per diluted share, compared to $68.2 million, or $1.74 per diluted share, for the same period in 2005. The decrease in net income from continuing operations primarily reflects the following:

 

 

Partially offsetting these decreases to income from continuing operations:

 

 

Finance Charges.  The increase for the year ended December 31, 2006 was primarily due to a 9.0% increase in average Loans receivable partially offset by a 3.6% decrease in the average yield. Loans receivable increased as a result of an increase in the number of active dealer-partners, partially offset by a decrease in the number of transactions per active dealer-partner.

The following table summarizes the changes in active dealer-partners and corresponding Consumer Loan unit volume for the years ended December 31, 2006 and 2005:

 

 

 

License Fees.  License fees increased to $13.6 million in 2006 from $9.8 million in 2005. License fees represent CAPS fees charged to dealer-partners on a monthly basis. CAPS fees are charged to both active and certain inactive dealer-partners. The increase was primarily due to a 43% increase in the number of dealer-partners being charged for CAPS during 2006 compared to the same period in the prior year.

 

Effective January 1, 2007, we implemented a change designed to positively impact dealer-partner attrition. We continue to charge a monthly fee of $599, but instead of collecting and recognizing the revenue from the fee in the current period, we collect it from future dealer holdback payments. As a result of this change, we now record license fees as a yield adjustment, recognizing these fees as finance charge revenue over the term of the Dealer Loan. We recognized a small amount of license fee revenue related to certain dealer-partners that only participate in our Purchase Program.

 

To allow shareholders to more precisely track our financial performance and make comparisons between periods possible, we have provided non-GAAP information below reflecting the amount of revenue that would have been recognized if the license fees had always been recorded as a yield adjustment. For the years ended December 31, 2006 and 2005, total revenue would have changed as follows:

 

 

Salaries and Wages.  The decrease for the year ended December 31, 2006, as a percentage of revenue, was primarily related to: (i) a decrease in stock-based compensation expense which was a result of a decline in the number of unvested stock options outstanding and our adoption of SFAS No. 123R which resulted in revised turnover assumptions for the stock options granted during 2002-2004 and (ii) a decrease in support salaries as a

percentage of revenue which is consistent with our business plan of growing corporate infrastructure at a rate slower than the growth rate of the Dealer Loan portfolio. The decrease in salaries and wages, as a percentage of revenue, was partially offset by an increase in payroll taxes primarily due to employee and director stock option exercises.

 

General and Administrative.  The increase for the year ended December 31, 2006, as a percentage of revenue, was primarily due to: (i) an $11.2 million increase in our estimated loss related to a class action lawsuit in the state of Missouri, (ii) lower than normal accounting fees during 2005 as a result of the resolution of a dispute over fees paid to a former auditor, (iii) an increase in credit report expenses primarily due to an increase in vendor costs per unit and increased volume, and (iv) an increase in legal expenses related to increased litigation during 2006.

 

Sales and Marketing.  The increase for the year ended December 31, 2006, as a percentage of revenue, was primarily due to an increase in sales commissions, as a percentage of revenue, primarily due to loan origination growth exceeding revenue growth and the impact of a commission plan change during the fourth quarter of 2006, which resulted in an increase in the average commission paid per loan origination.

 

Provision for Credit Losses.  The provision for credit losses consists primarily of a provision to reduce the carrying value of Dealer Loans to maintain the initial yield established at the inception of the Dealer Loan. Additionally, the provision for credit losses includes a provision for losses on Purchased Loans and a provision for losses on notes receivable. The increase in the provision for credit losses in 2006 was primarily due to an increase in the provision required to maintain the initial yield established at the inception of the Dealer Loan.

 

Interest.  The increase for the year ended December 31, 2006, as a percentage of revenue, was primarily due to a 39.0% increase in the amount of average outstanding debt as a result of borrowings used to fund stock repurchases and new Dealer Loan originations. Interest expense also increased as a result of a 220 basis point increase in interest rates partially offset by the decreased impact of fixed fees on our secured financings and line of credit facility due to higher average outstanding borrowings.

 

Foreign Exchange.  The foreign exchange gain of $1.8 million during 2005 was primarily the result of changes in the fair value of forward contracts entered into during the third quarter of 2003. We entered into the forward contracts to ensure that currency fluctuations would not reduce the amount of United States dollars received from the liquidation of the United Kingdom operation. There were no forward contracts outstanding during 2006. In addition, we recognized an after-tax foreign currency exchange gain of $0.8 million during the fourth quarter of 2005 following the determination that the liquidation of business in Canada was substantially complete.

 

Provision for Income Taxes.  The decrease for the year ended December 31, 2006, as a percentage of revenue, was primarily due to a decrease in income from continuing operations before provision for income taxes. Our effective tax rate decreased from 37.1% during 2005 to 35.1% during 2006 primarily due to an additional state tax liability recorded in the third quarter of 2005 that was reversed in the second quarter of 2006 as a result of a favorable settlement.

Critical Accounting Estimates

 

Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. On an ongoing basis, we review our accounting policies, assumptions, estimates and judgments to ensure that our financial statements are presented fairly and in accordance with accounting principles generally accepted in the United States.

 

Our significant accounting policies are discussed in Note 2 to the consolidated financial statement, which is incorporated herein by reference. We believe that the following accounting estimates are the most critical to aid in fully understanding and evaluating our reported financial results, and involve a high degree of subjective or complex judgment, and the use of different estimates or assumptions could produce materially different financial results.

 

Liquidity and Capital Resources

 

We need capital to fund new Loans and pay dealer holdback. Our primary sources of capital are cash flows from operating activities, collections of Consumer Loans and borrowings through four primary sources of financing: (i) a revolving secured line of credit with a commercial bank syndicate; (ii) a revolving secured warehouse facility with institutional investors; (iii) SEC Rule 144A asset-backed secured borrowings (“Term ABS 144A”) with qualified institutional investors; and (iv) a residual credit facility with an institutional investor. There are various restrictive debt covenants for each source of financing and we are in compliance with those covenants as of December 31, 2007. For information regarding these financings and the covenants included in the related documents, see Note 7 and Note 13 to the consolidated financial statements, which are incorporated herein by reference.

 

Cash and cash equivalents decreased to $0.7 million as of December 31, 2007 from $8.5 million at December 31, 2006. Our total balance sheet indebtedness increased to $532.1 million at December 31, 2007 from $392.2 million at December 31, 2006. This increase was primarily a result of borrowings used to fund new Loans in 2007.

 

Restricted cash and cash equivalents increased to $74.1 million as of December 31, 2007 from $45.6 million at December 31, 2006. The balance consists of: i) $42.5 million of cash collections related to secured financings, ii) $18.3 million of cash held in trusts for future vehicle service contract claims, and iii) $13.3 million held in escrow related to the settlement of the class action lawsuit in the state of Missouri. The claims reserve associated with the trusts and the $13.3 million related to the settlement are included in accounts payable and accrued liabilities in the consolidated balance sheets. For additional information related to the settlement of the class action lawsuit in the state of Missouri, see Note 12 to the consolidated financial statements.

 

Restricted securities available for sale decreased to $3.3 million as of December 31, 2007 from $3.6 million at December 31, 2006. Restricted securities consist of amounts held in accordance with vehicle service contract trust agreements.

 

A summary of the total future contractual obligations requiring repayments as of December 31, 2007 is as follows (in thousands):

 

 

 

Based upon anticipated cash flows, management believes that cash flows from operations and its various financing alternatives will provide sufficient financing for debt maturities and for future operations. Our ability to borrow funds may be impacted by many economic and financial market conditions. If the various financing alternatives were to become limited or unavailable to us, our operations could be materially and adversely affected.

 

Off-Balance Sheet Arrangements

 

We do not have any off-balance sheet arrangements that have or are reasonably likely to have a material current or future effect on our financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.

 

Market Risk

 

We are exposed primarily to market risks associated with movements in interest rates. Our policies and procedures prohibit the use of financial instruments for trading purposes. A discussion of our accounting policies for derivative instruments is included in Note 2 to the consolidated financial statements.

 

Interest Rate Risk.  We rely on various sources of financing, some of which are at floating rates of interest and expose us to risks associated with increases in interest rates. We manage such risk primarily by entering into interest rate cap and interest rate swap agreements.

 

As of December 31, 2007, we had $36.3 million of floating rate debt outstanding on our revolving secured line of credit, with no interest rate protection. For every 1.0% increase in rates on our revolving secured line of credit, annual after-tax earnings would decrease by approximately $0.2 million, assuming we maintain a level amount of floating rate debt.

 

As of December 31, 2007, we had $198.1 million in floating rate debt outstanding under our revolving secured warehouse facility, with an interest rate cap of 6.75% on the underlying commercial paper rate. Based on the difference between the rates on our revolving secured warehouse facility at December 31, 2007 and the interest rate cap, our maximum interest rate risk on the secured warehouse financing is 1.64%. This maximum interest rate risk would reduce annual after-tax earnings by approximately $2.1 million, assuming we maintain a level amount of floating rate debt.

 

As of December 31, 2007 we had $240.0 million in fixed rate debt, and $50.0 million in floating rate debt outstanding under Term ABS 144A asset-backed secured borrowings. We entered into an interest rate swap to convert the $50.0 million in floating rate debt into fixed rate debt bearing a rate of 6.28%. As we have not designated the interest rate swap as a hedge as defined under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities”, changes in the fair value of this swap will increase or decrease interest expense. The fair value of the interest rate swap is based on quoted market values, which are influenced by a number of factors, including interest rates, amount of debt outstanding, and number of months until maturity. Since we intend to hold the interest rate swap until maturity, any increases or decreases in interest expense resulting from changes in fair value will reverse by maturity date.

 

New Accounting Pronouncements

 

Accounting for Uncertainty in Income Taxes.  In July 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes — An Interpretation of FASB Statement No. 109” (“FIN 48”). We adopted the provisions of FIN 48 on January 1, 2007. For additional information related to FIN 48 see the “Income Tax” portion of Note 2 to the consolidated financial statements, which is incorporated herein by reference.

 

Fair Value Option for Financial Assets and Liabilities.  In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS 159”). SFAS 159 permits entities to choose to measure financial assets and liabilities (except for those that are specifically exempted from SFAS 159) at fair value. The election to measure a financial asset or liability at fair value can be made on an instrument-by-instrument basis and is irrevocable. The difference between carrying value and fair value at the election date is recorded as a transition adjustment to opening retained earnings. Subsequent changes in fair value are recognized in earnings. SFAS 159 is effective for fiscal years beginning after November 15, 2007. At this time, we do not intend to adopt SFAS 159.

Forward-Looking Statements

 

We make forward-looking statements in this report and may make such statements in future filings with the Securities and Exchange Commission (“SEC”). We may also make forward-looking statements in our press releases or other public or shareholder communications. Our forward-looking statements are subject to risks and uncertainties and include information about our expectations and possible or assumed future results of operations. When we use any of the words “may,” “will,” “should,” “believes,” “expects,” “anticipates,” “assumes,” “forecasts,” “estimates,” “intends,” “plans” or similar expressions, we are making forward-looking statements.

 

We claim the protection of the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995 for all of our forward-looking statements. These forward-looking statements represent our outlook only as of the date of this report. Actual results could differ materially since the statements are based on our current expectations, which are subject to risks and uncertainties. Factors that might cause such a difference include, but are not limited to, the factors set forth under “Item 1A. Risk Factors” elsewhere in this report and the risks and uncertainties discussed in our other reports filed or furnished from time to time with the SEC.