Description

CPRT is on the Mount Rushmore for high quality stocks, which is typically not conducive to shorting. Background on the company is available on prior VIC write-ups, but to summarize, CPRT has an excellent moat (clear #1 in a duopoly), two-sided network with higher margins (and incremental margins), secular growth drivers and aligned management (heavy insider ownership).

CPRT/IAA: IAA (#2 player in salvage) has been the CPRT punching bag for a decade-plus. The industry market share split (of insurance carries) was roughly equal at 50/50. Last week, it was disclosed that USAA is pivoting completely to CPRT (used to be shared 50/50). Pro-forma for USAA, CPRT’s market share will now be in excess of 75% versus IAA below 25%.

Why is IAA losing share: IAA used to be part of KAR, where the parent woefully underinvested in the IAA/salvage biz and instead milked the IAA cash flow to subsidize KAR and some of its money losing adventures. IAA lacked leadership and focus, resulting in very poor service levels for insurance customers – good service is paramount, especially in catastrophic events, e.g. IAA underperforming during hurricanes was the last straw for GEICO (moved biz over to CPRT). IAA was purchased by RBA (deal closed in March ’23). The merits of the deal for RBA are debatable, but what is not debatable, is that IAA will be a more viable competitor, the duopoly discipline in the industry is greying and IAA will likely regain lost market share in the coming years

Post-RBA Acquisition: Insurance customers largely care about two things – service/reliability and net proceeds (from auction). CPRT contends they yield higher proceeds, but underlying data on apples-to-apples to basis (same make/model/miles) point to comparable proceeds, which intuitively makes sense as the buyer pool is the same (most buyers use both auction networks). The key has been service, which was dreadful for IAA under prior management. Service is measured by SLA performance (Service Level Agreements) – there are several, different ones for different customers, etc but there are effectively two that matter - towing/inspection and title. Inexplicably, the SLA’s under prior mgmt were managed centrally and if insurance carrier had an issue, it was always a mess (didn’t know who to call, didn’t have local contact, etc). Post-acquisition, IAA is now run at a branch level and branch incentive compensation will now incorporate SLAs (starting in Jan). It’s only 4 months in, but progress has been meaningful, plus RBA management knows how to efficiently run a two-sided network auction biz

• Towing/Inspection: Simplistically, car needs to get picked up same-day and properly inspected. Towing compliance used to be in the mid 80s and recently has broken through the high 90s (percentage) – need to sustainability be at 98-99%. The other inspection component is determining whether it is a “run and drive” car, which typically yields $1k extra/car. Under prior mgmt, employees had discretion which was fraught with error (would typically just turn car on/off before denoting). They are rolling out a step-by-step checklist that is uniform across all branches. Accuracy previously was very poor (low 60s), has breached the 70s, but more work to do here
• Title: There are 3 parts to the title process and typically insurance carrier handles the first part (receiving title from the owner). Compliance was in the 80s previously, recently broke into the 90s (first ever time in IAA history)

USAA: If the above is true, why is USAA the latest to leave? Our understanding is that it was a combination of USAA looking to cut costs (lost $ for the first time in 90 years) and RBA having to pay for the sins of prior incompetent management. On the title process above, 3+ years ago, IAA proactively asked USAA to in-source the first step of title process in an effort to save USAA costs. Unsurprisingly, they bungled the process, which pissed off USAA. Secondarily, CPRT is aggressively trying to take share. In salvage auction market, CPRT/IAA earn ~80% of their profit from buyers and ~20% from insurance carriers, i.e. any market share gains and incremental volume has high incremental margins, especially relative the pricing “investments” paid to insurance carriers. CPRT has to disclose any “upfront payments” for new contracts in filings (in “contract assets” in 10K/10Q) – USAA hasn’t been filed yet, but the amount of outlay is small (prior large GEICO win cost <$20m) relative to the incremental profitability (multiples of that).

IAA Retaliation: IAA needs to deliver 9-12 months of comparable SLA performance, but assuming that is attainable, I’d expect them to be aggressive in trying to regain share. Market share (or IAA’s lack thereof) has been a huge overhang on IAA’s multiple/stock and the incrementality for IAA will be far more profound than for CPRT, e.g., IAA’s EBITDA margins mid 20’s % versus CPRT mid 40’s (where the decrementals to lost share would be high). Two top 10 carriers have RFQ’s in 2024 (Farmers and Allstate), both of which IAA has zero business with and I’d expect them to be aggressive to take share from CPRT

CPRT Valuation: Shorting a stock on Valuation is a fool’s errand, but CPRT is trading ~35x 2024 (FYE July) which is approaching peak. I’m assuming CPRT will have a down EPS year in F25 (MSD% decline) driven by share losses (decremental EBIT margins of 40-50+%). Assign historical 30x multiple = $41 stock or 19% downside with optionality of further multiple compression (used to trade low/mid 20’s prior to meaningful share gains, plus there could be growing concerns about industry structure/discipline). If I’m dead wrong, don’t think the short will “kill you” given peakish multiple

Catalyst

IAA regaining market share