Description

KAR Auction Services (KAR) is extremely compelling, with a high probability for a 15-25% return within the next month or two and a three-year return of 115% on our base case. KAR's sell-off on its 2/19 earnings day (as much as 20% the day of the report) has created an excellent short-term risk/reward set up. We believe event driven investors abandoned the stock en masse as confusing management commentary on the earnings call put in doubt the long-awaited spin-off of KAR’s salvage business, Insurance Auto Auctions (IAA). Management has since clarified that the spin is on track and could receive the necessary IRS private letter ruling (PLR) approving the tax-free spin within weeks, serving as a powerful rebound catalyst. While we love the 15-25% short term opportunity, we believe the 100%+ longer-term (24-36 months) return is equally compelling.

Business Description

KAR operates as a holding company with two of its three businesses effectively duopolies:

ADESA (RemainCo) - Whole car physical auctions (think OEMs & Fincos selling off-lease vehicles, repo, used car dealer, etc. selling to used car dealer) in which it has ~30% market share, Manheim Auctions has ~40% share, the rest of the market is fragmented with mostly regional players (KMX being a distant third place at <5% share).

Insurance Auto Auctions (IAA/SpinCo) – Salvage/wrecked auto auctions in which it has ~40% share, Copart has ~40% share and the rest of the market is fragmented local players.  Vehicles sold mostly for parts and to international buyers that are able to drive the vehicles in their countries despite not being regulation in the US.

AFC (RemainCo) - KAR offers short term financing to its dealer customers at ADESA via its AFC division.  These loans are low-loss, typically 60 days or less in nature and are paid off once a dealer sells the vehicle.

For additional detail on KAR’s businesses, please see VIC_Member2015's detailed Aug 2018 write-up here:

https://www.valueinvestorsclub.com/idea/KAR_AUCTION_SERVICES_INC/1608314032

How the IAA spin creates value

By way of background, KAR announced in February 2018 that it would split its business into its whole car auction + finco (RemainCo – ADESA+AFC) and its salvage auction business (SpinCo - IAA) to capture a large valuation discount between SpinCo and its closest comp, Copart (CPRT). Assuming an 8x multiple on RemainCo., we estimate current SpinCo. valuation to be 11x or a 7x multiple discount to Copart.

With few synergies between SpinCo and RemainCo, the split makes a lot of sense and we believe will result in a re-rating of both SpinCo and RemainCo. We discuss the longer-term RemainCo opportunity later in the report, however Spinco can re-rate to 15-16x (2-3 turns cheap to Copart) and RemainCo should re-rate to 8-9x particularly given its duopoly status, defensive nature, and high free cash flow structure.

RemainCo is a high-quality recession resilient grower that private equity previously paid 10x EBITDA for in a much higher tax environment - meaning that equates to ~12x in today’s world.  If you believe SpinCo is already trading at 15.5x, RemainCo is trading at under 4.5x!!

RemainCo should earn almost $300mm of FCF this year – at 4.5x EBITDA, that’s over a 12% yield to the enterprise and over 20% yield to the equity, a great return for a business of this caliber and an unjustifiably low multiple.  We believe RemainCo should trade around 8-9x reflective of a high-quality business that is temporarily investing in technology to maintain its leadership in whole car auctions as online volumes represent an important growth area – as these investments move to breakeven and then profitability, RemainCo likely deserves an even slightly greater multiple in our view

2019 FCF Calculation

$530 EBITDA

- $100 CapEx

- $60mm Interest (~5% rate, may prove conservative post-spin)

- $75mm Cash Tax

+/- $0 WC likely to be a source of cash, using $0 for conservatism

=$295mm FCF

Why Did Shares Sell Off?

KAR held its FY18 earnings call on 2/19 in which it reported another solid year of 9% revenue growth and almost 7% EBITDA growth while guiding for ~6% EBITDA growth in 2019 (this figure includes ~$60mm of losses from investment in its online platform TradeRev).  On the call, management messaged poorly on two issues:

First, CEO Jim Hallett spent a portion of his prepared remarks talking about the ongoing transition of physical auctions towards online auctions, leading to concerns about cannibalization. Management has since stated that they view growth in online auctions as a growth opportunity and not a zero-sum game.  

Later, Hallett followed up a sell-side question about a sense of increasing trepidation around the IAA spin by falling over his words and repeating some boiler plate cautionary legal language around the potential for the spin not to occur. Management has since emphasized that the spin is on track and likely imminent.

What Is KAR Worth Longer Term?

As EBITDA compounds at mid-single digit levels in each of these businesses and with an enhanced appreciation of RemainCo as a (likely duopoly) leader in a world where physical auctions continue to co-exist with online auctions (the most likely scenario in our view), we see a more robust multiple applied to RemainCo and significant upside to both entities. Upon becoming a stand-alone company with its own capital allocation decisions – likely debt paydown, potential lease buyouts - and market appreciation for the quality of the business, SpinCo/IAA should begin to trade closer in valuation to Copart’s ~18x fwd EBITDA.  In this case, the combined entity at our base case would be 115% above current levels within three years inclusive of free cash flow accruing to the balance sheet (which would continue to be used in a shareholder friendly manner like dividends and share buybacks).

Conclusion

We believe KAR represents an opportunity to own an undervalued business with a compelling longer-term business case and a high-probability near-term catalyst that is momentarily being overlooked by the market.  We expect a spin announcement to propel shares 15-25% higher in the near-term.

Over the longer-term, as both RemainCo and SpinCo continue to execute on strategic plans, shares should receive full credit for their stand-alone value, which is 115% above current levels.

APPENDIX (For those interested in getting slightly deeper in the weeds)

What the market has wrong with the Spin and RemainCo

The Short-Term – The Spin

KAR management is committed to executing the IAA spin and therefore the large multiple arbitrage between SpinCo and CPRT should narrow when management clarifies its position more widely in some sort of 8-k or PR upon receipt of the long-awaited IRS private letter ruling confirming the tax-free spin.  When that happens, we believe the stock will appreciate 15-25%.

This target merely reflects the market going back to levels seen in Fall 2018 when investors believed the spin was going to happen and were just awaiting news.  However, we also believe there is more upside with RemainCo, which implies a very depressed multiple despite its defensive characteristics, oligopolistic structure, and high free cash flow profile.

The Longer-Term – Misunderstood Physical/Online Auction Opportunity (RemainCo)

We believe that RemainCo’s low implied valuation reflects skepticism of ADESA’s leadership in physical auctions and the likelihood that it can capitalize on its technology investments and decades of dealer relationships plus infrastructure to be an online leader in the future.  Data has shown so far that physical and online auctions co-exist well with ADESA’s online volumes growing 40% last year while physical volumes declined by just 3% (physical auction revenue actually GREW 1.3% due to higher RPUs driven by ADESA’s myriad services) and total volumes grew 9%.  We believe that management is proving there is a large TAM of vehicles currently going un-auctioned that are theirs for the taking, which won’t result in rapid destruction of physical auctions, but will actually expand the pie of vehicles that ADESA can sell. In other words, management asserts that TradeRev and online auctions are on balance additive, not cannibalistic.

Management actually intended the prepared remarks on ADESA during the earnings call to be a positive discussion around TradeRev’s leadership in the online auction marketplace and the unique position in which KAR finds itself that it can offer not only online auctions, but the entire ecosystem from online, physical auction (if a dealer’s TradeRev unit does not sell online), financing, transport/logistics, repairs, title, key cutting and other ancillary services.  In this way, ADESA offers a suite of services and scale that no other online competitor offers – ACV, the competitor pointed to most frequently by bears, has to farm out these services to third parties or simply cannot provide them at all (in the case of physical auction alternative).

ADESA is currently investing in TradeRev to the tune of $60mm of losses in 2019 which they believe will improve in 2020, reaching breakeven by FYE 2021 as more markets reach maturity.  TradeRev is currently a free call option as it is depressing RemainCo’s EBITDA, a development that should cease by the end of 2020 at which time TradeRev should contribute to rather than depress overall results.

Catalyst

Receipt of private letter ruling

Spin-off of IAA

Continued execution at both IAA and RemainCo to help market realize higher multiples justified