Description

Preface

In March 2019, we published a buy report on KAR Auction Services (KAR) prior to its spin-off of Insurance Auto Auctions (IAA).

The link to that report can be found here:

https://www.valueinvestorsclub.com/idea/KAR_AUCTION_SERVICES_INC/5257676092

The spin-off was completed more than three months ago, and IAA's recent sell-off has created a compelling entry point into the stock.

Description

IAA, Inc. (NYSE: IAA) is a global marketplace, in North America and the United Kingdom, connecting vehicle buyers and sellers. By focusing on innovation and utilizing cutting-edge technology, IAA processes approximately 2.5 million total-loss, damaged and low-value vehicles annually. IAA serves a global buyer base and a full spectrum of sellers. IAA offers customers a comprehensive suite of services aimed at maximizing vehicle value, reducing administrative costs, shortening the selling cycle time and delivering customers higher economic returns. 

Investment Thesis

IAA is an attractive, non-cyclical, secular-growth story within the automotive transformation theme. With its recent spin-off from KAR Auction Services, IAA can better focus on margin-enhancing opportunities for significant organic earnings growth that should lead to multiple expansion. The complexification of vehicles as they evolve towards semi-autonomous driving and are built lighter (the shift from steel to aluminum) creates a secular tailwind for higher total-loss rates and a catalyst for IAA shares. Given that the stock has pulled back by more than 25% from its high of $50 during the past month, the current share price offers an attractive entry point. Moreover, the significant valuation discount that IAA receives relative to Copart (NASDAQ: CPRT) is likely to compress over the next two years. We value IAA at $67 in two years, using a 17x multiple on our 2022 EBITDA estimate of $544mm and then adding back our free-cash-flow per share estimates for 2H:19, 2020, 2021, and 2022 of $0.83, $1.91, $2.17, and $2.44, respectively. At $67, IAA would provide investors with a 35% two-year CAGR.

Exhibit 1: Capital Structure

Source: Company 10-Q, proprietary estimates 

* Excludes operating leases as part of long-term debt and avoids using EBITDAR, which would back out rent expense, for valuation purposes.

Market Overview

As Exhibit 2 illustrates, the North American vehicle market includes more than 5mm units each year that are processed through salvage auctions. We estimate that the true annualized figure is closer to 6mm, given that management has estimated IAA’s market share in North America to be approximately 40% with 2.5mm vehicles sold annually. Moreover, IAA essentially competes in a duopoly in the North American market with CPRT.

Exhibit 2: North American Addressable Market

Source: Company investor presentation

A vehicle enters a salvage auction for a variety of reasons, such as when automobile insurance companies declare a vehicle to be a total-loss or a charitable organization receives a vehicle at the end of its useful life and seeks to monetize the asset.

As Exhibit 3 illustrates, the auction process takes between 1.5 and 3 months. The first three days are for transportation from the seller to IAA, the next 40 days (depending on state laws) relate to the insurance process (title procurement, inspection, imaging, and storage), and the remaining time is for auction bidding, sale, and transportation to the buyer.

Exhibit 3: Automobile Auction Process

Source: Company investor presentation

Within the salvage auction market, IAA is differentiated by offering buyers and sellers a convenient, user-friendly transaction process. For example, omni-channel auctions provide convenience for buyers and thereby increase the number of bidders, while reducing friction in the process. The company’s advanced technology and data analytics capabilities promote customer retention and adoption. Moreover, the consignment business model reduces IAA’s working capital needs by being asset light. In addition, the extensive seller and global buyer bases create a network effort and make IAA’s platform more attractive for both parties.

Our Perspective  

The secular trends toward vehicle complexification due to higher semi-autonomous content as well as light-weighting (the shift from steel to aluminum) are leading to a rise in total loss claims, driving one leg of IAA’s growth. As Exhibit 4 illustrates, U.S. light vehicle parc (number of cars and other vehicles in a given market) has grown about 2.2% per year since 2013, while U.S. miles driven has increased about 1.5% annually over the past five years. With more vehicles on the road and more miles driven, the frequency of accidents is growing. Further, as Exhibit 5 shows, the total loss percentage of total claims has increased by 500bps over the past 6 years from 14.1% in 2013 to more 19.2% in 2019. Moreover, as new vehicles become more complex with sophisticated safety features (rear and side-view cameras, lane departure warning, etc), early-stage semi-autonomous driving capability, advanced mobile technology, as well as light-weighting, the costs to repair a vehicle after even a moderate accident is necessitating insurance companies to deem the vehicle as a total loss more frequently. Simplistically, insurance companies deem a vehicle as a total loss based on a certain percentage of repair cost to vehicle market value. As a result, with an expanding market for salvage vehicles, IAA is poised to accelerate revenue growth. On average, IAA generates revenue of approximately $525 per vehicle.  

Exhibit 4: U.S. Car Parc and Miles Driven

Source: Company investor presentation

Exhibit 5: Total Loss % of Total Claims

Source: Company investor presentation

IAA benefits from a duopoly industry structure and diverse customer base underpinned by long-term relationships, insulating IAA from competition and customer-loss risk. On the seller side, IAA has strong relationships with 80 of the top 100 major national insurers, as well as many charitable organizations, dealerships, rental car companies, and fleet lease companies. In sum, IAA had 14,000 active sellers in 2018. On the buyer side, IAA maintains a sizable, global buyer network with more than 150,000 active buyers in excess of 120 countries. The number of active buyers, mostly dismantlers, rebuilders, and scrap dealers, grew 40% from 2014 to 2018. The largest buyer accounts for about 3% of total revenue, whereas the next largest buyer accounts for less than 1.5%. IAA’s strong customer relationships with both sellers and buyers, as evidenced by its 40% market share, is partly due to the company’s presence in all 50 states.   

IAA’s 6-point growth strategy is achievable with reasonable targets that are likely to yield margin improvements and multiple expansion.

1) Enhance existing relationships and expand market share. The bulk of this initiative is to grow revenue with the largest insurance carriers and build new business with smaller insurance companies. Further, within the non-insurance seller market, IAA intends to grow volume for typically low value automobiles (i.e. repossessions and high mileage vehicles).

2) Broaden service offering to deepen strategic relationships. With a commitment to innovation, IAA is launching more services and capabilities to further build its omni-channel end-to-end solutions. The key benefit of workflow integration throughout the entire process with insurance companies on total-loss cases is an increase in customer stickiness by growing the perceived switching cost to an IAA competitor.

3) Enhance international buyer network. By expanding its buyer base, IAA can achieve better results (i.e. higher vehicle selling prices) for sellers. Approximately 30% of IAA’s U.S. volume in 2018 was exported, largely due to the 50% increase in international buyers between 2014 and 2018. The company’s buyer portal is available in six languages, while its call center supports 12 languages. This initiative is critically vital for margin expansion, since international bidders typically generate 25% higher RPU (revenue per unit) than do domestic bidders. 

4) Expand margins through cost reductions, operating efficiencies and ancillary services. New technology and more efficient operating procedures will shorten the process time (i.e. reduce the 45 to 90 day window) and lower costs to expand EBIT margins. At the branch level, management is focused on cutting costs for auctions, vehicle storage, and operational processes, as well as more containment for discretionary spending. For strategic sourcing, management seeks to lower acquisition costs in key categories, obtain volume discounts, and improve transaction terms. On the corporate-expense side, management will optimize public company costs and general overhead. The path to reducing the process cycle time (and the inherent bottlenecks) is lowering the time for vehicle check-in, title and inventory, and the actual vehicle sale, which in turn will yield higher buyer fees through reduced vehicle depreciation. Management has also identified higher margin ancillary services to offer buyers (IAA 360 View, IAA Transport, Data Services) and sellers (IAA Loan Payoff, Title Procurement, and IAA Inspection Services). IAA 360 View provides buyers with better quality video of the inside and outside of the vehicle and generates more bidding activity and higher proceeds.

5) Continue to innovate and enhance data analytics capabilities. These analytics are instrumental for long-term customer relationship management, as customers seek this data to make more informed decisions through greater data transparency. Sellers benefit from reserve price optimization, total loss decision making, and performance metrics, whereas buyers benefit from market value trends, inventory optimization, and buy recommendations.

6) Expand internationally in attractive markets. Continued international expansion, in both new and existing markets, leverages the company’s technology, infrastructure, and supply chain.  IAA is most likely to enter locations with mature used car markets, stable economies, and pro-business environments.

IAA benefits from a long-tenured and experienced CEO, who is committed to unlocking greater shareholder value and is supported by a new CFO focused on margin expansion. John Kett has been president and CEO since 2014 and previously served as CFO and SVP, Planning and Business. He has more than 17 years of experience at IAA. Earlier this year, Vance Johnson joined IAA as CFO. He has served in CFO roles previously, most recently at SP Plus Corporation for 5 years and earlier at Furniture Brands International. His earlier financial management experiences were at Royal Caribbean International, OfficeMax, and Burger King.

IAA’s margin enhancing initiatives give us confidence in management’s ability to compress the margin gap (and likely valuation variance) between IAA and CPRT. Despite similar market share (40%) in the North American market, CPRT is valued at a significantly higher valuation. This variance is in part due to differing operating strategies, which currently cause CPRT to generate higher revenues and stronger margins. For example, we estimate that if IAA were to switch to an online-only auction system, operating margin could improve by 175 to 200bps. Moreover, we model an additional 150 to 175bps margin opportunity from closing the 10 percentage point gap in international buyer mix between IAA and CPRT. Further, we think IAA could grow margins by another 175 to 275bps by increasing its fees by a mere 3% to 5%. Another area for margin improvement relates to real estate whereby IAA could unlock as much as 500bps, by our projections, simply by buying out leases and saving on rent, albeit this would be a more complicated and capital-intensive initiative. On the recent 2Q:19 earnings conference call, management mentioned that the company has shifted its real estate strategy to lease or purchase depending on which option would yield the highest return profile for shareholders. Further, management indicated it has launched a process to evaluate lease buyout opportunities. Thus, there are many opportunities for IAA to grow margins, be more profitable, and thereby command a multiple more in-line with CPRT, its duopoly rival.     

Exhibit 6: EBITDA Model

Exhibit 7: FCF Model

Exhibit 8: Comparable Valuation

 * Note that CPRT is on a fiscal year-end in July, whereas IAA is a normal calendar year-end

IAA trades at an approximate 8.5x discount to CPRT on EV/EBITDA, despite the companies having similar market shares and overall business models. As IAA improves margins, we expect this wide multiple disparity to narrow. Similarly, we view IAA, a recession-resistant, secular grower, as attractive in its own right.

Risks

Loss of key insurance accounts. GEICO represents 20% of IAA’s volumes in what historically has been an exclusive contract. However, GEICO is now testing CPRT in several states, such as Texas. While we do not expect IAA to maintain 100% of GEICO’s business, similar to what transpired with Progressive, IAA is likely to keep market share given that the duopoly is in a capacity-constrained market. Thus, any loss in volume from GEICO, or other insurance customers, is likely to be offset by gains in other volumes given up by CPRT. IAA shares have sold off by 25% on fears of losing GEICO. We believe these concerns are overdone and have created an attractive entry point, as IAA’s medium to long-term potential remains undiminished.  

Drop in total-loss claim percentage. A drop in total loss claims, while unexpected, would be a negative outcome. While a world of fully autonomous vehicles could be a threat, we do not expect this to be the case for the next 15 to 20 years. Morgan Stanley projects autonomous vehicles will not reach double-digit market share levels globally until 2035 or beyond.

Events that lead to lower miles driven, thereby extending the useful life of vehicles. During a recession or in times of rising gasoline prices, there would be a low single-digit decline in miles driven. Nonetheless, we view IAA as an overall recession-resilient company given its non-cyclical nature. In fact, IAA experienced revenue and EBITDA growth even during the Great Recession of 2008-2009. Additional secular tailwinds, such as the increase in total loss claims, can drive growth even in an economic downturn.  

Conclusion

IAA provides compelling exposure to a business with recession-resistant characteristics and multi-dimensional growth at an attractive entry point. We expect that IAA management, leading a newly spun-off company, will create value by pursuing a number of margin-enhancing initiatives, expanding to new international markets, and positioning the company to benefit from multiple secular tailwinds.

Catalyst

Margin expansion. We expect EBIT margin growth, as post-spin, management is focused on achieving higher margins and has many levers available to achieve such goals.

Better-than-expected revenue and EBITDA growth. Long-term guidance for revenue is 5 to 7% organic growth (base business) plus upside from M&A and the rollout of ancillary services, whereas for EBITDA 6 to 8% organic growth plus upside from margin expansion and M&A. In our view, management’s guidance is conservative as organic growth assumes little to no margin expansion, despite management's many levers to improve margins.

International expansion. New geographic markets would accelerate earnings growth and leverage the company’s fixed costs more optimally. We would view material progress in growing IAA's global footprint beyond North America and the UK favorably. We expect IAA to enter more markets in Europe.