Description

Insurance Auto Auctions Inc. (IAAI) is one of the two national auctioneers of total loss salvage vehicle services to the insurance industry. IAAI is headquartered in Schaumberg, Illinois and went public in 1991. It’s key assets are 62 auction sites across the US and its long standing relationships with insurance companies. Three insurers, State Farm, Allstate, and Farmers supply 40% of vehicles sold by IAAI.

Business Drivers:
Volumes: There were about 6.35 million car crashes in the US in 2000 and that figure seems to be growing at 1.5%-2% per year as cars can travel faster and as number of vehicles on the road increase. While we still do not have data to back the statement we believe that the % of cars in an accident that are declared totaled is rising slightly every year as the costs of repair rise (as cars become more sophisticated and as mechanical labor costs rise). Industry folks concur with this view. We are trying to get IAAI to data mine this for us. So it is perhaps safe to assume that the unit supply of vehicles is growing by 2% a year.

There are over 2.5 million vehicles auctioned for salvage value every year and the industry’s annual gross proceeds are in excess of $3 billion. At 25% of gross proceeds net revenue opportunity is about $750 million per annum.

How do the auctioneers make money? Well for auctioning a vehicle IAAI gets two sets of fees. It obtains a fee from buyers which is on average $100/vehicle (actually scales from $15-$225/vehicle) and a fee from suppliers, the insurance companies, that averages $100-250/vehicle. A site auctions, on average 250 cars a week (auctions are held weekly) and generates net revenues of $3 million to $4.5 million per year.

Revenue Model:
There are three revenue models-
- Purchase Agreements (PA): Here the auctioneer buys the car from the insurance company at a fraction of ACV (typically 20%) and takes principle risk as it tries to auction it for a value that is greater that what it paid for it. The return from this strategy is correlated to the values in the second hand car market and the auctioneer could incur a loss if there was a significant disconnect between ACVs and SVs. CoPart the industry leader got out of PA agreements in mid-1990s. In 2001 we estimate about 16-20% of vehicles “assigned” to IAAI were under PA and we believe at present IAAI is making a negative EBIT margin on these vehicles. Management is negotiating to exit these agreements with its key customers and has targeted to bring assignments under PA to below 8% in 2002.

- Percent of Sale Method (POS): In this case the auctioneer gets a certain negotiated % of the SV of the vehicle. These agreements bundle activities such as towing, washing etc. in determining the %. At present the standard in the industry is about 25% (buyer and seller fees included) up from about 20% 5-6 years ago as the industry has consolidated.

- Fixed Fee or Consignment Method: In this method the auctioneer gets a fixed fee from the insurer (typically between $75-100/vehicle) irrespective of the SV.

In 2000, IAAI’s revenues could be broken into: PA= 26%; POS= 24%; Fixed= 50%. POS and Fixed Fee are replacing PA in the revenue mix and this is a critical piece of the improving margin story, we believe.

Pricing has been improving as the industry consolidates. We believe a 2-3% price improvement a year would continue (as cars increase in value and hence salvage value and as % appropriated by auctioneers improves).

Hence organic revenue growth opportunity in the industry is close to 4%-5% a year.

Competitive Landscape:
CoPart is the largest player in the industry with a market share of about 33% and owns 88 auction sites. IAAI is the second largest player with over 20% market share and 60 auction sites. There are two other large regional players—Allete and Sadisco with 10% share each. The rest of the market about 25% is fragmented and served by small local players.

There have been following drivers for industry consolidation:
- Consolidation of recovery operations at insurers into regional offices. Hence, the suppliers of vehicles want to deal with at least regional players if not national players.
- Increasing investment in information technology required raising scale requirements. For instance, bidding through internet is becoming an important contributor to increasing SV. Small players/moms-and-pops are unwilling or unable to make the requisite investments and the service offering gap between the large players and small players is growing.
- Attractive acquisition values: Recent acquisitions have been made at over $6 million/site. Considering that a site can generate $3 mn pa in revenues and perhaps $0.5-0.6 mn in EBIT these acquisition multiples are high and attractive for the sellers.

There are about 290 sites across the US. CPRT (88) and IAAI (62) together own 150 (52%) sites. The number of acquisitions undertaken by CPRT and IAAI over the last few years are given below, however, we think acquisitions will continue to provide an additional growth opportunities. However, the economics of this growth will be determined by the valuations these sites are acquired by. Allete had been paying a lot per site, however, both CPRT and IAAI tell me that they value sites at 3-5x cash flows.

CPRT has been a disciplined competitor. As mentioned earlier, the share of auctioneer’s proceeds have increased on average from 20% of gross proceeds 5-6 years back to 25% presently. CPRT and IAAI have both increased rates as they have continued to consolidate the market. We believe that pricing should continue to be a positive as there is immense pressure on CPRT to maintain its margins to be able to justify its lofty valuation. In fact for longer term growth CPRT has been moving into the public auction of leased vehicles rather than competing with IAAI on price in the salvage market. Further, while paying higher share to national auctioneers insurance companies could still save on operating costs as they get better information and service.

Investment Thesis:
Attractive Business with Increasing Barriers to Entry: This is not a super business but it is not a bad business either. Consider CPRT’s business economics, of course CPRT is a super operator of assets. ROE is 15%, ROCE is 11%. However, what is interesting is that these metrics have been improving as the industry has been consolidating. We think the barriers to entry are increasing for two reasons. First, investments being made by the nationals in information technology are increasingly growing the service offering gap with the smaller entities. So we see the competitive position of the nationals improving relative to that of small operators. Second, even if someone with the requisite resources wanted to make a bid to grow, such as Allete, it is becoming pretty expensive to acquire sites. Our discussions reveal that the replacement cost of a site is between $2 mn (Greenfield)- to - $6 mn (Acquisition). The difference is primarily a function of exhaustion of most prime locations and the fact that it could take over 18 months to get land zoned for this activity. Further, if there are already sites in the vicinity then it becomes harder to get a new parcel zoned for the purpose. In fact even for the existing players we think acreage of existing sites could become a major growth constraints and hence focus on yard management and inventory turns is going to be important to drive long term growth. Also the value of an auction site is a function of the number or items (cars) and the number of buyers (liquidity determinant). Hence, it is relatively difficult to compete with exisiting sites for a new entrant and this has driven up the cost of growth through acquisitions.

In this context, at current valuations IAAI is availablr at below $4 million/site. Allete has recently acquired sites at between $6-7 million/site and in March 1999 CPRT made a $152 million bid for IAAI. The bid at about $3 million/site was rejected by IAAI. We suspect CPRT’s bid was low since CPRT had been “for sale” and suffering from weak operations as well as the fact that CPRT would have had to close numerous sites due to the overlap between the sites owned by the two companies. Hence, as assets increase in value we receive downside support as well as potentially a profitable exit opportunity in the future if a bid were made upon IAAI by a player like Allete (the most likely).


Operational Turnaround will Drive Rapid Cash Flow Growth: While the organic revenue growth opportunity in the industry is limited to 4%-5% pa we think IAAI will turn in multiple years of strong cash flow growth triggered by an operational turnaround that is in process. CPRT makes an EBIT margin of 27% compared to IAAI’s 7%. When CPRT had 62 sites it had EBIT margins of 20%.

The turnaround has the following key components

Management Reorganization- Status/Target: Done
Old management, favored growth through acquisitions, were let go in 2001. New management brought in. Tom O’Brien (CEO), Scott Pettit (CFO), and David Montgomery (COO) worked together before in auto glass replacement business. They started at Globe Glass (with 100 stores and $100 mill in revenues) then acquired Windshield America (in 1996 adding another 250 stores). The combined company was called Vistar (350 stores, 3,000 employees, and $400 mill in revenues). Subsequently Vistar was sold to Safelite Glass, a private company. The present management team has worked successfully in the past.

The management organization has been reorganized with number of regions being brought to 4 from 6 with each RGM being responsible for 15 branches and an area manager. Plus a National Sales Team was put in place to market to clients nationally. A meeting of branch managers across the nation was held in November and the incentive plans of managers were tied to branch contribution/branch EBIT/and inventory turns. Options have now been issued down to the branch manager level. The COO has visited 65% of the branches while the CEO has visited over 50% of the branches since joining. Incidentally the old management had not visited most branches. Our meetings with employees at different levels revealed that the morale is high and there is a perceived need for change.

Earlier, there was no focus on integration of acquired operations, in fact the acquired units were operated in a decentralized fashion. Hence the company ended up with 28 different databases operating across the country. Now RGM’s have been given integration responsibility and a recent acquisition was integrated within 90 days of acquisition. Integration of branches is important to be able to realize economies of scale. CPRT is known to flawlessly integrate acquired sites.

Renegotiate PA Contracts- Status/Target: Ongoing/8% in 2002
As indicated earlier due to decline in resale value of cars there has been a diversion between ACVs and SVs for cars and PA contracts that IAAI entered into a few years back are now losing money on EBIT line. The management does not explicitly provide data on this but our checks with the Western RGM, where most of these contracts are concentrated, confirms this. The senior management is actively speaking with customers to convert PA contracts to POS and Fixed Consignment basis. The management has set a target of reducing vehicles assigned under PA contracts to below 8% of total assignments in 2002. This is down from 26% in 2000 and we estimate 16%-20% in 2001. This is likely to improve operating margins for the company right away.

The negotiations with insurers on PA contracts are helped by the fact that there are no service providers that work on this basis apart from IAAI.

Implement Standard Operating Procedures, Best Practices- Status/Target: Ongoing/June 2002
Synergetics, an operational consulting firm was brought in by management in July 2001 to study different process and implement best practices with an objective to reduce costs and improve efficiencies. We met with Synergetics, who has committed to taking $6 million of costs out and thinks that the cost savings could be as high as $30/vehicle or about $15 million per annum. A “Salvage Book” (manual of standard operating procedures) has been prepared and sent to all branches. New processes have been implemented in Southern California and excess staff let go. Presently the Synergetics team (9 people) are implementing and monitoring processes at branches in the Mid-West. The goal is to roll out the standard processes at all branches by the end of June 2002. Synergetics has identified the key processes and cost drivers and is now trying to improve each branch performance on each metric. Improved processes are meant to reduce days inventory which is a key driver of costs.

Implement Organization-wide IT Systems- Status/Target: Ongoing/July-Dec 2001
SEI Software is implementing a web-based IT system for IAAI. We went through a demo of the system and the system architecture and could identify the potential cost savings/productivity gains that would follow from implementation of this system. The system is on budget and schedule and should be ready for implementation by July 2002.

Good Risk/Reward Investment Opportunity
IAAI presents a good risk reward investment opportunity. As discussed above we think the downside on the stock is low due to private market values of assets. We think if the company is not fixed the stock would perhaps trade at $17.50/share range. However, if the operational turnaround is achieved and operating margins head towards 20% then the stock could trade at $30/share. At $32/share IAAI will be trading at just the private market value for its assets.

Catalyst

Operating turnaround
trading at a deep discount to private market value with an aggressive acquirer, Allete, around.