Description
Copart Inc is the dominant processor of salvage vehicles in the United States with 35-40% marketshare and a $2.1 billion marketcap. Copart generates revenues by providing services such as towing, storing, and auctioning cars. The company typically takes stolen vehicles and those deemed a “total loss” from insurance companies and then auctions them to rebuilders, dismantlers, repair licensees, and used car dealers.
The entire market consists of 2.5-3.0 million cars that are totaled across the country each year. Basically, when an insurance company deems that the cost of replacing a damaged car is exceeded by the salvage value plus the repair costs, that vehicle is considered “totaled” and sold for scraps. Enter Copart. While insurance companies (which sell approximately 90% of totaled vehicles in the United States) recognize the value proposition of the salvage vehicles, they have very little clue of how to actually process the vehicle. Insurance companies fundamentally aren’t experts in valuing, towing, storing, and auctioning cars. Even handling the title transference, certainly not rocket science, simply isn’t something with which they want to deal.
Copart, which operates 109 facilities across the United States, handles the entire process for insurance companies and other sellers. Copart helps sellers determine if the vehicle is in fact totaled, arrange towing, set-up title transference, store the vehicle in one of its lots, and eventually auction the vehicle to a buyer. The company processes vehicles under two types of agreements; the company either sells vehicles for a fixed fee ($50-200) or conducts auctions for a percentage of the sales (typically 5-15%). While Copart prefers to sell under the percentage of sales method due to the potential upside, both types are profitable and scalable once facilities are in place.
The key advantage that Copart has in this business is its size, which saves insurance companies the trouble of dealing with many processors, provides access to a larger universe of salvage vehicle buyers, and, more recently, enables the company to develop superior technology. Experienced management is also an integral component of the company’s success.
Copart’s earnings growth is driven by solid top line growth and exceptional operating leverage. While this story has unfolded over the past several years, the impact of Copart’s recent conversion from on-site / in-person auctions to on-line auctions run through its own internet platform, VB2, has been vastly underestimated. The web based platform is in the early stages of driving demand for salvage vehicles and enabling greater operating leverage through cost cutting. Copart’s ability to leverage its internet platform and existing facilities within the salvage vehicle market and potentially in the used car auction market provide for an extremely compelling investment opportunity.
Valuation
My base case estimates based on stock price of $23.01 ($ in mm except per share estimates):
2003A 2004A 2005E 2006E 2007E
Revenue 347 401 453 512 578
EBIT 91 125 156 181 213
Net Income 57 79 103 119 142
Diluted EPS 0.62 0.87 1.11 1.28 1.53
Free Cash / Share 0.77 1.07 1.33 1.54 1.78
PE Ratio -- 26.6 20.8 17.9 15.1
Free Cash Yield -- 4.6% 5.8% 6.7% 7.7%
Based on my earnings projections, Copart certainly doesn’t appear cheap. Copart trades at approximately 20.8x July 2005 earnings and 17.9x July 2006 earnings. If you strip out the $200 mm of net cash that the company has on its balance sheet and the corresponding cash earnings, Copart trades at a more reasonable 19.6x 2005 earnings and 17.0x 2006 earnings.
On a free cash flow basis (net income plus depreciation minus maintenance capex), the company is far more attractively valued. By my projections, the company will have a 5.8% free cash this July fiscal year and a 6.7% yield in the July 2006 fiscal year. Once again, stripping out the cash on the balance sheet, this yield improves to 6.2% for 2005 and 7.1% for 2006.
The major caveat with this yield is that while maintenance capex has been reasonable, the company’s total capex budget has been extremely high over the years as Copart emphasized expansion; in 2002, 2003, and 2004, Copart spent $86 mm, $71 mm, and $45 mm in capex acquiring mom and pop shops and constructing their own facilities. However, what provides comfort that the capital allocation process actually has been efficient is the yield on incremental capex. Opening new facilities from scratch generally costs Copart ~$7 mm per facility. In turn, a new facility generates approximately ~$0.5 mm in revenue in its first year and then seems to ramp up to the company average (currently ~$1 mm in annual operating income). It’s difficult to complain about capex that eventually generates 15% return on invested capital ($1/$7 mm).
That being said, capital expenditure should start to ramp down in 2005 and beyond. In a recent earnings call, the company’s president, Jay Adair, indicated that he expects capex to decline going forward. As a percent of revenue, capex has steadily declined from 27% in 2002 to 11% in 2004 (and steadied at this level in the first quarter of fiscal year 2005).
Growth
Copart truly is an example of a company for which valuation and growth are joined at the hip. Over the past five years, Copart has grown its revenues, operating income, and net income by 23%, 30%, and 29% annually. Additionally, same facility sales have been terrific, annualizing at 19.5% over the past five years. Copart’s cash flow generation and dominant market share alone warrant a superior valuation, but the company’s growth potential is where a large part of the intrinsic value lies.
Copart’s web capabilities represent a huge part of the growth potential going forward. In 2004, Copart made the decision to move from an on-site auction model to a web based auction platform, which they call VB2 (“Virtual Bidding 2”). VB2 is providing a great infrastructure / network for Copart and its customers. Previously, Copart processed vehicles from an insurance company and sold them regionally to local buyers, or alternatively those few individuals willing to travel significant distances for an auction. Now, customers can go online and get a complete list of Copart’s inventory all over the country and bid for salvage vehicles. They can view the specific vehicle through every conceivable angle and are provided a list of appraisers that are willing to give an honest assessment of the vehicle. The customer can certainly visit the Copart auction facility if they so choose, but the necessity to do so has been eliminated. Additionally, a web based auction allows for higher frequency of auctions. Logistically, on-site auctions typically can only be held weekly or bi-weekly due to the need to draw a sufficiently large pool of customers to a bidding event; VB2 provides the flexibility to hold as many auctions as Copart so desires. Auctions no longer have to be six hour ordeals starting at 9 am in which buyers are waiting and waiting; a schedule can be planned for when a vehicle will be auctioned and interested customers can appropriately “attend” the auctions online as they so desire.
VB2 translates into a vastly larger and broader customer base. Sales to customers from out of state and out of country are exploding; 26% of all units in 2004 were sold to buyers out of state and 20% were sold to buyers from out of the country. Canada and Mexico represent a piece of the 20% international sales, but demand is even coming from Russia and Eastern Europe, where American parts are constantly in high demand. The company’s CEO, Willis Johnson, said that he believes that their buyer universe has expanded by 10% due to the internet platform.
Expanding the buyer universe, which drives potential demand, obviously matters because it translates into higher prices for salvage vehicles. In 2004, a year in which salvage vehicle prices actually declined, Copart’s ratio of salvage vehicle prices as a percent of actual cash vehicle (the price for a comparable used car) increased by 17%. During the 3rd 2004 earnings call, Adair indicated that he couldn’t recall this ratio ever increasing by such a large a percent. As one can expect, selling insurance companies have been delighted with Copart’s ability to utilize the internet to uncover new pockets of demand to drive pricing.
On the cost cutting side of the equation, Copart’s margins have expanded rapidly due to VB2. In 2004, Copart’s operating margin increased from 26.1% to 31.1%. In the first quarter of fiscal year 2005, operating margins further expanded to 33.7%. The company has experienced higher SG&A costs involved with maintaining the system, but has been able to cut significant yard costs otherwise associated with live auctions.
Growth is also driven by favorable supply side dynamics in terms of total volume. Copart management points out that the supply of salvage vehicles is growing because cars are now made to crumble to protect passengers. In a recent interview, CEO Willis Johnson said, “…Most cars today are made to fold in an accident to protect the occupant. The cars are supposed to absorb the impact, so they usually are totaled. You always see these reports on a car that was wrecked after hitting something going five miles an hour. But they never say they're designed to do that to protect the person inside.” A recent Wall Street Journal entitled, “The Disposable Car” also does an excellent job explaining this trend. The article reports that 16% of vehicles currently involved in collisions are deemed a total loss versus 7% in 1995. The article adds that, not only are vehicles increasingly designed to crumble, exceedingly expensive / sophisticated designs contribute to the likelihood that repairing a car will simply be too costly. Combine this trend with the increasing number of drivers / total cars in the United States, and the opportunity for salvage vehicles supply to grow is clear.
An entirely separate engine for Copart’s future growth is Motor Auctions Group (“MAG”), Copart’s attempt to enter the used car auctions market. The company believes that they can leverage their existing facilities and VB2 technology to successfully enter the used car auctions market without a large amount of incremental capex. Copart currently has six sites set up for MAG and, while they don’t break out the results, management indicates that all six are profitable. Although the used car market is extremely competitive, it is a vast (three times the size of salvage vehicle market), fragmented industry with significant potential. My overall belief in the company’s growth certainly doesn’t hinge on expanding in this arena but it could certainly provide incremental value if they can successfully leverage their current resources. In a similar vain, Copart is also trying to license its VB2 technology to other providers.
Competition
Copart’s largest competitor is Insurance Auto Auctions (IAAI), which has 20-25% marketshare in the industry. The company struggled in recent years due to its exposure to purchase agreement methods. In this arrangement, IAAI uses its own principal to purchase salvage vehicles from insurance companies and sell them. While this can be an extremely profitable arrangement when prices are rising, the opposite is obviously true in difficult times. The company has drifted away from this method of selling salvage vehicles; its current business model more closely resembles that of Copart. However, the company still strongly believes that eliminating on-site auctions is a mistake. Management believes that buyers like to “kick the tires” and actually attend live auctions. This is a reasonable point but the fact that Copart allows buyers to attend auction sites and bid at the sites through kiosks eliminates any advantage that a live auction might provide. All it actually seems to do is preserve operating costs and hinder potential operating leverage. Copart’s significantly higher operating income per facility clearly points to this fact. That being said, IAAI likely has a tremendous amount of fat that could be cut. The company trades at 21x December 2005 earnings and has potential. However, the company’s inconsistent track record leaves me unconvinced that IAAI can effectively compete with Copart for business. The company has new management, but it is unclear how seasoned they are in this specific part of the auto business. Perhaps my biggest concern is that they will start irrationally cutting prices – that hasn’t been a huge issue thus far as far as I know. It is entirely possible that Copart will attempt to acquire IAAI (it attempted to do so in 1999 but was rebuffed).
Mom and pop shops and other regional players aren’t a threat to Copart. They have significantly less capital to invest in real estate for large facilities and often are less efficient at processing cars because of their smaller scale. In addition, as previously mentioned, because of Copart’s size, it has access to more buyers; the company enjoys a much larger pool of demand that tends to generate higher prices for sellers. In addition, insurance companies, the largest group of sellers, don’t want to deal with several players…They would rather sell all their vehicles to Copart in one transaction than deal with five different regional players.
Another competitive issue is why insurance companies don’t just do this on their own. The simple answer is that there is a lot more going on here than it might seem. Firstly, insurance companies don’t really know how to value vehicles. They can hire people, but it isn’t their business. Copart provides consulting to help insurance companies understand whether a car actually is totaled or not. Which leads to the next point, how much can they sell a car for? If you do it on your own, how do you know you’re getting a good deal? By hiring Copart in the percentage of profits program (the method which currently generates 65% of revenue), insurance companies understand that they are certain to get an auctioneer motivated to achieve the highest possible price. Another reason insurance companies are unlikely competitors involves the time it takes to process cars for salvage use. States heavily regulate the process and it legitimately takes 75-90 days to process a car, transfer the title, and conduct an auction. So…in the meantime, who is going to store the car? Insurance companies don’t have huge plots. They can’t store these vehicles and protect them from Hurricane Charlie the way Copart did/does.
EBay is another potential competitor. The real estate storage and logistical processing issues however prevent EBay from viably entering this market. EBay would certainly have access to a huge universe of buyers, but it would simply be too difficult to address the other aspects of the business. The follow-up question inevitably is why any company with access to large pools of capital doesn’t buy land for facilities and in turn use EBay to conduct highly successful auctions to compete with Copart / VB2. The fact of the matter is that getting huge plots of land to store damaged vehicles isn’t that easy. Understandably, states stringently regulate the amount of land used for salvage vehicles. Copart and Insurance Auto Auctions have gained access to large real estate plots over the years, a significant barrier to entry.
Management
Management is experienced. While their disclosure is minimal, it is clear that they have a firm grasp of how to run their business. Capital allocation has always been an issue, especially as cash has built up on the balance sheet and capex has skyrocketed. However, as previously discussed, their track record for deploying capital has been solid.
Willis Johnson is motivated by holding 12 mm shares. While he seems less involved in the day-to-day business, he clearly is actively involved in the growth strategy. His involvement on this end, coupled with his large personal stake, provides comfort that Copart won’t take huge leaps towards building a shareholder destroying empire.
Risks
The biggest concern with Copart is how they will spend the $200 million on their balance sheet. The company clearly has indicated that they are interested in making acquisitions and expanding the business. While they have been successful thus far in generating return on capital, the lack of visibility is concerning. Confidence in their ability to continue deploying capital effectively is vital. Activist Blum Capital recently filed a 13-D on Copart and, while I don’t personally have contacts within the firm, my best guess is that they are also working to ensure that management takes reasonable steps going forward.
Similarly, will Copart try to grow too rapidly? In 2003, same facility sales dropped to 7.6% because management added too many facilities over too short a period of time. While the company certainly addressed the issue and existing facility revenue growth has since rebounded, the short term concerns were certainly valid (and the stock price was hammered…).
Concerns also exist involving Motors Auction Group (MAG). Will this business succeed? It is reasonable to think that Copart can leverage their existing facilities and technology to enter this business, but it is unclear that it is their core competence. Their initial profitability is encouraging.
Lack of disclosure is another issue. The company provides no earnings guidance and provides little information regarding units sold / volume. The company’s IR department and website are subpar at best. While this is frustrating, it also probably is the primary reason that opportunity exists; overly conservative sell side analysts seem to be downplaying potential revenue growth and margin expansion.
Will Copart face anti-trust issues as the company expands its marketshare? This certainly is a possibility and I won’t pretend to be an expert on the matter…If the industry continues to grow at its current pace, however, this won’t be an issue for years.
Lastly, one might think that a concentrated list of selling insurance companies could negatively impact Copart. This does not seem to be a valid concern…State Farm is their largest customer and only represents about 12% of their total business.
Conclusion
Copart is the dominant and expanding player in an industry with excellent potential for operating leverage and revenue growth. The continued impact of transitioning to web based auctions is underestimated. While Copart isn’t cheap on a conventional earnings basis, significant potential for growth and corresponding free cash flow generation should not be overlooked.
Catalyst