Description

“The recent peak in the new vehicle market in both the U.S. and U.K. and the flood of nearly-new and off-lease used vehicles into these markets are applying significant pressure to our margins….”Group 1 Automotive, Inc.CEO Earl Hesterberg March 21, 2018

“The return of a record number of off-lease vehicles will be one of the biggest challenges dealers will face.” Wes Lutz, the 2018 chairman of the National Automobile Dealers Association March 19, 2018

“We are seeing a shift in mix as growth in volume from dealers was up nearly 27%...” Copart Q2’18

“We also continue to see growth in volume from our non-insurance suppliers. These suppliers include franchise and independent dealers, finance companies who give us the repossession and off-lease vehicles, charities, municipalities, equipment dealers and brokers.” Copart Q2’18

In other words, it’s time to go long Copart

Copart

Overview

What exactly does Copart do?

Operates salvage auctions

o   Market Share by Units: KAR (40%), Copart (40%), Other (20%)

o   When a car is broken/old, you can do three things with it

§  Scrap it: Break it down for commodity content

Salvage it: Strip it of any components still in working order (and then scrap it)

Repair it

o   When do you Salvage it?

§  Residual Value = Pre Accident Value – Repair Cost; When Salvage Value > Residual Value, the car is salvaged.

§  Although called “salvage” auctions, the destination for the cars sold at salvage auctions is really: Salvage (60%), Immediate Scrap (20%), Repair (20%)

o   Sellers into salvage auctions: insurance companies, non-profit organizations, automobile dealers and vehicle leasing and rental car companies and the general public.

§  Customer mix: GP per customer is fairly different. The highest gross margin per car is from franchise / dealers and the lowest is from charity cars, with insurance (the bulk of the business) and others in between.

o   Buyers of salvage auctions: automotive body shops, rebuilders, used car dealers, automotive wholesalers, exporters, dismantlers, recyclers, brokers, and where allowed, non-licensed (public) buyers.

o   Revenues for auctioneers come from many services, which are generally directly or indirectly related to both volume and transaction value of auction sales. Volume and transaction value of the underlying salvage market is the principle driver of auctioneer revenues.

What does this mean all?

o   Copart is a salvage auction pure play, auction bidding is online only (vs both online and in person at KAR)

o   Operates a minority of sales under a “principle” model (vehicle sales), where Copart itself purchases the vehicle prior to the auction, and then is the seller during the auction (accounts for ~10% of rev). This model is more common in Europe.

o   80% US, international exposure primarily UK

o   Listed in 1994

o   Revenue growth rate  has historically been  ~10% (similar to peer KAR, although Copart accelerated in 2017 and further into 2018)

o   High GPM vs main per (~50% vs ~35% at KAR) due to online only model

o   GPM and EBITDAM benefit from operating leverage, increasing each year. KAR does not exhibit operating leverage.

o   Minimal leverage at Copart (vs ~3x at KAR)

Business Drivers

Car Demand

Driven by

• Scrap metal prices: Largest exposure is aluminum which has rallied strongly in 2017 (>20%) & into 2018

• Increasing demand for recovered parts: Recovered parts utilization (in part dollar terms) in repairs has grown from 27% in 2006 to 36% in 2016 (recovered parts are much cheaper than new)

• Strong dollar weakens international demand (~20% of purchasers), which has accelerated in 2018

• Used car price (relevant only for the minority of cars which are purchased with the buyer intending to repair and resell them)

Car Supply

Traditional Channel (80-90% of auction volumes): Received from insurers after accidents – now shifting to higher margin dealers

The most important supply volume driver is the loss ratio (% of cars decided to be salvaged vs repaired). The loss ratio is driven by the ratio of repair costs to used car prices, this has increased over the past few years as used car values have increased slower than repair costs.  Repair costs have trended up as vehicle complexity increases, as well as an increasing avg age of vehicles on the road.

Repair costs increased at 3% over a 3 year CAGR from 2013-2016 (aided by a record avg car age of 11.6 yrs), compared to only a 1% increase in used car prices over the same period. In other words, repair costs are increasing faster than used car prices so the salvage opportunity is more appealing to insurance companies.  

CPRT has taken advantage of this, volume processed by the company expanded by an average of 14.5% y/y for FYE2017 (ex-catastrophic and onetime events).

Other drivers:

Number of cars sold at salvage auctions = Miles Driven X Accident Rate X Salvage Rate

• Miles driven growing at 3-4% CAGR since 2015, after being flat 2009-15, now 5% above pre crisis high

• Accident rate is flat at 2 crashes per million miles driven, as new safety features cancel out new electronic distractions

• Salvage rate had been flat at ~14% of cars in accidents over 2003-14, but has spike up to 17% over 2014-16. This has been driven by:

• Higher average age of cars (11.5 years in 2016 vs 9.5 in 2003, >7 year old cars have a >20% salvage rate vs 1-3 year old cars only at 5%)

• Higher price of repairs (repair costs growing ~3% CAGR since 2008, never having dipped, driven by more complex vehicles and consolidation of repair shops from 45thsd in 2006 to 34thsd in 2014)

• Used car price has been increasing at a 2% CAGR since 2008, now 10% above pre-crisis levels, this is a headwind to volumes, as it makes repairs more attractive (if we indeed are at a peak, and pricing begins falling, this would be another tailwind)

Other Channels (10-20% of auction volumes): 65% of the >10mln (10 year avg) cars deregistered each year do not end up at a salvage auction, most are simply scraped, despite being able to command a higher salvage price. Auctioneers now have marketing departments to work with charities/dealers/mechanics/individuals, to push some of these volumes into salvage auctions

Results  

Last year

Copart has grew its main service revenue by 16% y/y, an acceleration from its 11% 3 year CAGR. There are several drivers for CPRT, but the most important volume driver is the loss ratio (% of cars decided to be salvaged vs repaired) as repair costs have risen faster than used car prices, repair costs increased at 3% over a 3 year CAGR from 2013-2016 (aided by a record avg car age of 11.6 yrs), compared to only a 1% increase in used car prices over the same period. Repair costs are increasing faster than used car prices so the salvage opportunity is more appealing to insurance companies.  CPRT has taken advantage of this, volume processed by the company expanded by an average of 14.5% y/y in FY2017, aided by acquisitions and growth in market share as well as the overall market, with pricing increases fairly small y/y. On a year over year basis for 2017, the mix of customers has not shifted drastically, the company’s 10 year average of international buyers is 22%, below 2017’s of 20.1%.

Recent data points

Still good…

Something however has changed in the past two quarters of 2018 (CPRT has a July FYE). Volume increases (ex-catastrophic events) are still fairly strong (9% y/y increase, volume from dealers is driving this). Beyond industry commentary we can see this in real time on Copart’s auction sites. From looking at their auction sites, not all cars sold are damaged. Copart also deals w/ cars that have ‘normal wear’ and ‘water’ damage.

Just one example: auction by a Honda dealer in Pennsylvania has cars that look new w/ only minor damages (if any) and in certain cases very few miles driven (i.e. one car listed I saw had only 8 miles driven and no noticeable damages).  

https://www.copart.com/lotSearchResults/?free=true&query=hondaacurapa&intcmp=web_lotdetail_cds_pittsburgh_honda_acura

If the auto retailers are encountering a big influx of used car volume (as Group One & others have publically said), and are using Copart to offload excess volume, this can be a positive volume driver for Copart (especially since this is the highest gross margin customer for Copart).

And even better…

Pricing (ex- catastrophic events) has drastically picked up. For the last quarter (Q2’18) pricing increased y/y by 10% (Q1 was 14% y/y), a record increase in the recent past. Reasons why pricing has increased are strong scrap / value of crushed car bodies, a 16% y/y increase in Q2’18, with a reported Q2’18 y/y increase in used car prices of ~4.6-6% (depending on source), driven by a significant increase in bidders per unit, this includes international buyers which were up 42% y/y (a weaker USD helped).

The recent jump in used car prices is the fastest in the company’s 10 year history, it would be concerning if this change was occurring faster than the increase in repair costs BUT it is not. On the Q1’18 call, the company called out a growth in the loss ratio of 7% over the last seven quarters, well above the last seven qtr used car price growth of 2.7% and above Q2’18’s 4.6-6% y/y growth and Q1’18’s 6.6% y/y growth, suggesting recent repair costs have grown faster than used car prices. A big part of the price increase has been the increase in commodity prices as well as the USD weakness, causing a jump in international buyers.

Valuation

Given the 1) strong increase in high margin supply from auto dealers from their own inventory management, 2) strong increase from international buyers due to the weakening USD and increased scrap value, and 3) consolidated market with very few players, we see Copart setting up nicely for H2’18.

Today Copart trades at a 21 EV/’LTM EBITDA, 18.5 EV/’18E EBITDA (consensus) and a 16.5 EV/’19E EBITDA consensus. The company has historically traded at a LTM multiple of in the low teens.

If we extend the dynamics from the first half of 2018, Copart trades at a 17.3 EV/’18E EBITDA, a discount just over 1x to expectations. Where Copart really works out is if the dynamic extends to 2019. If dynamics continue, Copart would trade at a 13.0 EV/’19E EBITDA valuation, a 3x discount to consensus and 1-2x discount to historic multiples, valued at 15-16x 2019E EBITDA would result in a stock price of $60-$63, compared to $51/share today. The company has a July FYE, as Copart exits 2018 and similar dynamics continue, we expect revisions to 2019 estimates.

Sources:

Service departments face renewed pressures to recondition used vehicles

http://www.autonews.com/article/20180416/RETAIL05/180419955/dealers-vehicle-detailing

NADA chair Lutz talks opportunities, challenges in used-car market

https://www.autoremarketing.com/retail/nada-chair-lutz-talks-opportunities-challenges-used-car-market

Catalyst

Earnings

Weak USD