Value Investors Club / KAR AUCTION SERVICES INC (KAR)

Description

Summary

KAR Auction Services (NYSE:KAR) is undervalued on a sum-of-the-parts basis, which will be unlocked

following a spinoff of its two auctions businesses that’s scheduled to be completed by Q1 2019. In this

write-up, we will discuss why both of its businesses are currently underappreciated by the public

markets and address the public misperceptions of the whole car auctions business. Our $83 PT implies a

40% upside.

Business Description

KAR Auction Services is the holding company for ADESA whole car auctions, IAA salvage vehicle auctions,

and a supporting floorplan financing arm called AFC.

ADESA hosts whole car auction marketplaces at 75 locations globally and transacts 3.2 million vehicles a

year. ADESA sources off-lease and repossession inventory from auto OEMs, as well as from dealers and

commercial fleet operators like Hertz and Avis. Last year, ADESA acquired TradeRev to access the 10

million units/year dealer-to-dealer market. ADESA is the #2 whole car auction at 28% market share

behind closely held Cox Automotive’s Mannheim. ADESA IS ~55% of KAR revenue and 50% of EBITDA.

IAA is the co-leader in North American salvage vehicles auctions and transacts 2.4 million vehicles a year

at 175 locations. 60% of volumes are transacted online. 80% of IAA’s inventory is sourced from auto

insurers following accidents or natural disasters while the rest is from charities, dealers, leasing cos and

rental companies. Unlike the whole car auctions business, which sells to franchised and independent

dealers, IAA’s core customers are licensed dismantlers, rebuilders, recyclers, exporters and qualified

public buyers. IAA dominates the North American market along with Copart at 40% market share apiece,

and is the largest provider of salvage auction services in Canada. IAA is 35% of revenue and EBITDA.

AFC is a captive floorplan financing business that lends to auto dealers and repackages majority of the

finance receivables without recourse at a wholly-owned bankruptcy remote special purpose entity,

which in turn sells to banks in the U.S. and securitizes for broad syndication in Canada. AFC is an atypical

financing business as it earns a significant portion of revenue from fees and warranties and its loans are

short-term dated at 65 days on average, which leads to significantly lower delinquency rates than

traditional auto financing. AFC has 12,400 active dealer customers who each have $250k line of credit on

average with no dealer representing greater than 1.6% of the portfolio. The primary competitor is Cox’s

NextGear Capital. AFC is 10% of revenue and 15% of EBITDA.

Situation Overview

On February 27, 2018, KAR announced that it would be separating IAA from the ADESA and AFC

remainco in a tax-free spinoff. The form 10 was filed in late June and the spinoff is expected to be

consummated in Q1 2019.

KAR management has guided to minimal dis-synergies from the spinoff. On the top line, KAR does very

little cross-selling as whole car auctions and salvage auctions sell to different customers. ADESA and

IAA’s technology and accounting are already on separate systems, while shared services tend to be in

back office functions like HR. Further, as little as 15% of the reported corporate costs are actually tied to

the higher multiple IAA business and KAR’s management sees cost cutting opportunities at remainco

ADESA.

Investment Thesis

The whole car auctions business, ADESA, is a widely misunderstood by the market, which

underappreciates its numerous growth opportunites and deep moats. In spinoffs, existing management

typically moves to the better business, but, in this case, KAR’s CEO and CFO have opted to stay with the

much maligned ADESA remainco as that’s the platform where they see the most opportunities to effect

change in the current competitive landscape. KAR’s CFO is choosing to commute 200 miles to ADESA’s

HQ, when he lives 14 miles from IAA’s HQ. KAR’s management has had an excellent track record of

growing ancillary EBITDA/car through self-disruption by entering new online businesses like with the

OpenLane and TradeRev acquisitions, and are better suited to lead a transforming whole car auctions

business than a “self-driving” salvage auction business (pun intended).

Off-lease volumes account for 35% of industry volume and is expected to peak in 2019 following growth

of 7% and 5% in 2016 and 2017, respectively. The market is justifiably wary of peak earnings, but is

missing the fact that ADESA’s business is constrained not by supply, but by demand, which is largely a

factor of the macro economic environment and is very healthy. There are self-help levers in 2020 and

beyond. In 2013 to 2014 when off-lease volumes were at trough, KAR was able to pivot its sourcing

priorities from OEM financing arms to dealer consignments, where it is purposefully underweight in

2018, to make up for the shortfall from trough off-lease volumes. There are cyclical offsets.

Repossessions are over 20% of ADESA’s volumes and are a countercyclical source of inventory as lessors

are less likely to maintain their leases during a downcycle. There are ancillary opportunities. KAR’s

acquisition of TradeRev is widely underappreciated. TradeRev is a mobile app that allows dealers to

record a 360 degree video of the vehicle that they intend to sell and instantly curates a photo

description and identify characteristics and blemishes for the auction profile. TradeRev will open ADESA

up to a fragmented market of 20 million dealer-to-dealer whole car transactions a year (10 million of

which is addressable) that was previously overlooked by the major whole car auction houses, transacts

at similar margins to its core auctions business and should experience a J-curve acceleration in adoption

for years to come. We believe that the whole car auctions is less cyclical than publicly perceived and that

there are a number of growth levers when off-lease volumes peak next year.

Another common reservation that investors have with ADESA is the offline-to-online transition and its

effect on ARPU and margin. The company is complicit in driving investor confusion by reporting physical

ARPU at $800 and online ARPU at $120, but fails to mention the offsets. First, $200 of the $800 in

reported physical ARPU is related to ancillary services like body and detail shops and another $200 is for

services that don’t touch auction like lease inspection and transportation, so the fair apples-to-apples

comparison is $400 physical ARPU to $120 online ARPU. Second, ADESA was the first to market with

custom white-label sites for OEMs, which accounts for vast majority of online volumes. As a result of this

head start, ADESA has 70%+ market share in white label online auctions vs 28% in overall whole car

auctions. Therefore, its win rate for online off-lease cars is 2.5x that of overall whole car auctions and

close to 3x of the cars sold physically, which mitigates any share shift from offline to online. Therefore,

for every physical car sold that moved online, ADESA earns $360 in white label revenue. Finally, online

margins are 80% compared to physical margins of 60-70%. There are clearly fixed costs associated with

physical auctions and ancillary attachments are higher for physical auctions as some OEMs prefer to use

off-site bodyshops for recertification, but the headwinds from the vehicles moving online is more

negligible than the market believes.

IAA is much better appreciated by the market with very little pushback on its growth outlook given the

outperformance of its publicly traded peer, Copart. The salvage auction end market is expected to grow

at 5-7% a year on increasing accident frequency driven by more miles driven/more distracted driving, a

growing Car Parc, rising repair costs from more complex parts, lower resale prices, and increasing

average age of cars, which all contribute to increasing totaling frequency. The salvage auction business is

noncyclical (SSS down only 0.7% in 2009 at Copart) and has high barriers to entry as there are only ~150

salvage yard in the U.S., which require proximity to metro areas and special zoning permits. We believe

Copart, trading at a premium 26.6x NTM PE multiple, makes an excellent comp. While there are

differences in business model (Copart is 100% online and owns rather than leases its land), there aren’t

any actual discernible competitive advantages to either business model based on our checks with

industry insiders. We view IAA’s hybrid physical/online model as a low hanging opportunity to grow

margins by ~1.5% if it does decide to transition to purely online as it already has the digital

infrastructure in place. As it relates to the real estate strategy, it goes without saying that leasing is the

more preferable capital allocation strategy than owning, especially for salvage auction sites for which

there is little practical alternative use and demand. Land costs account for 12% of revenue, and along

with the hybrid sales model, combine for the difference in IAA and Copart’s margins. Copart does have

more exposure internationally, which we estimate to add ~1% to its growth rate over IAA at minimal

contribution margins. One of the key motivations for the spinoff is to give clarity to IAA business, which

we believe should trade at minimal, if any, discount to Copart.

Valuation

We get to a price target of $83, or 40% upside by conservatively applying an 11x NTM EBITDA multiple

for ADESA and 17x NTM EBITDA multiple for IAA. ADESA is comped to the more economically cyclical

Sotheby’s and IAA is comped to Copart with a slight 0.5x discount to account for the smaller

international exposure.

Risks

Off-lease volumes decline faster than expected. Cars are typically leased for three years, so new car

sales, for which we have the data, is a leading indicator of off-lease volumes. In a recession, the auto

downcycle would affect the 40% of ADESA volume that’s sourced from dealer consignment, but is offset

by the 20% repossessions mix and can be hedged by shorting auto OEMs, which would get hit harder

and quicker on an economic downturn. Both businesses are highly diversified with no single customer

being more than 3% of each business’s revenue.

Competition. KAR and its primary competitors have been consolidating both the whole car and salvage

auction markets into duopolies. In ancillary services, ADESA’s bodyshop have tremendous scale

advantage over standalone repair shops and its locksmith cuts more keys than any other vendor in the

country. Since cars depreciate by 1-2% a month, it is in the seller’s best interest to turn to an integrated

provider to handle the auction and the reconditioning, which favors ADESA and IAA.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Spinoff

Earnings

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			2018	2019
Price:	59.72	EPS	0	0
Shares Out. (in M):	135	P/E	0	0
Market Cap (in $M):	8,000	P/FCF	0	0
Net Debt (in $M):	2,300	EBIT	0	0
TEV (in $M):	10,300	TEV/EBIT	0	0