KAR Auction Services (KAR) operates wholesale, 2nd hand car auctions. This business is effectively a duopoly in which KAR holds a 30% market share, and Manheim (owned by the private company Cox) holds 40%. The industry is often compared with IAA Inc (NYSE:IAA) and Copart (NASDAQ:CPRT), another duopoly that operates auctions for salvage cars. At ~6-7x EV / EBITDA, KAR trades at significant discounts to CPRT (23x) and IAA (18x). This is partly justified because salvage auctions are less cyclical and have seen higher growth.
I believe KAR is currently experiencing 2 significant tailwinds, both caused by the Corona pandemic.
- First of all, Covid has accelerated the industry’s transition to a purely online model. As reported in the Q2 earnings call, KAR can now handle higher volumes with 20-35% fewer FTEs. Needless to say, this is causing significant cost savings and much higher FCF.
- Second of all, since Covid the demand for affordable, 2nd hand cars has skyrocketed. People have clearly become reluctant to commute by public transport. This is most evident in the Manheim used car index, which shows that 2nd hand car prices are up 16% YoY, despite a brief downturn in March.
Pre-covid, the 2019 guidance was for about 200m USD in FCF. I will make a case where the FCF run rate should be anywhere between 300-400m USD. With a market cap of less than 2b USD that translates to a FCF multiple of 5-6x. That’s not bad for a company that has compounded earnings since 2008 at a 9% CAGR. As a KAR shareholder you also get the potential upside of TradeRev and Backlotcars, both currently operating at break-even levels.
The main driver of KAR’s business is the sale of 2nd hand vehicles. Each year, 42m vehicles are transacted in North America. Of those vehicles, 12m are sold consumer-to-consumer and 30m are bought at a retail car dealer. This car dealer either sells the trade-ins he receives from customers, or cars that he buys on an auction.
So the buyers on auctions are all dealers. The sellers can be divided in 4 groups:
- Dealers (45-50%), who sell the vehicles they choose not to sell themselves, for instance because they are specialized in only 1 brand or price category.
- Lease companies and captive finance companies of OEMs (25%-30%), who sell vehicles that come off-lease.
- Repo companies or banks (10-20%) who sell cars that have been repossessed.
- Fleet operators (10%) such as rental companies.
KAR earns a fixed commission by the seller and a variable commission by the buyer. In addition, it tries to sell some of its many ancillary services, such as car repairs, transportation, photo services, storage, security, title processing, inspection, marketing, key replacement, etc. About 55% of revenue comes from such services.
In addition, KAR provides floorplan financing to the dealer. These are short term (30-90 days) loans which are provided to about 12k dealers. Including fees, interest rates can be in the high teens. KAR is a lender of last resort and finances up to 100% of the wholesale value of the car. Therefore, I’d have expected credit losses to be pretty high. However, past credit losses have peaked at 6% in 2008 and have quite consistently been under 2%. KAR strongly believes that they are in a better position to underwrite such loans because they speak to dealers on a weekly basis and are quite aware of their financial situation. They also perform 80k lot check per year to make sure that the financed cars, their collateral, or actually still unsold. I’m generally a bit skeptical of such an explanation, but in this case the numbers clearly back it up.
The loans are securitized and financed at about a 70% LTV. Depending on how you allocate corporate expenses, the financing business earns an ROE in the mid 10s, which is quite decent for a financing business with low historic losses and high growth.
During the Corona pandemic, KAR furloughed 11k out of its 15k employees. At the same time, all auctions were moved to online. KAR is a bit confusing in how they refer to an auction as being physical, online, or ‘online only’. In the first 2 cases, the car is physically sent to a KAR-owned location. In an ‘online only’ sale, the car remains with the seller and KAR cannot sell many of its ancillary services, leading to lower revenue per unit.
The big shift has been from physical to online. KAR has launched its Simulcast Plus platform as a replacement of Simulcast. Effectively this means there is no longer a person acting as an auctioneer. The auctioneer is now a computer. KAR also figured out that it’s not necessary to drive around with a car at the time of auction if they put sufficient photos and videos of the car online. These seem like basic changes, but before Corona, KAR’s partners had certain expectations what an auction should look like. Covid has suddenly changed those expectations and has made such cost cuts acceptable.
What I believe is important in the thesis, is that both the move to Simulcast Plus and the cuts to SG&A were already planned. KAR spun off IAA in mid-2019 and was well aware of its bloated cost structure. In late 2019 management was talking about cutting 20% in SG&A, for starters, which in 2019 amounted to 662m USD.
Management has indicated that 3k jobs have been made redundant. Furthermore, furloughed employees will be called back in steps, with the chance that another 2k positions might also have become redundant. The earnings impact of the 3k jobs is 90m USD. If 5k jobs are scrapped, the impact would be a little below 150m USD because many of those 2k jobs are part-time.
Furthermore, management indicated that Traderev, a business that has been fully owned since 2017, had finally managed to break even in May and June. Traderev is an online-only dealer-to-dealer auction platform. Because of the fragmented nature of the customer base, Traderev’s 15-20% market share and the high growth rate of the business (50% in 2019), the business has so far been loss making because of the high number of incentives that management uses to draw dealers to its platform. In 2019, Traderev did 60m USD in negative EBITDA, despite management’s expectations to break even in that year. Stronger cost discipline and fewer incentives have resulted in virtually overnight savings of 60m USD.
You can’t simply add the 90m USD in cost cuts to the 60m USD in Traderev savings as there is probably a certain overlap between the 2. In fact, certain cost cuts must have been assumed when setting 2020 guidance. However, I think it’s reasonable to assume that the above leads to 100-150m USD in run rate cost savings.
The second effect comes from the sudden increase in demand for 2nd hand vehicles. From both comments made by KAR management, as comments made by publicly traded car dealers (KMX, CVNA), you learn that the demand for older (5-10 years) and cheaper (5-6k USD) vehicles is pretty high. There has also been a restocking effect following a defensive inventory liquidation in March and April.
Mark Jenkins, CFO Carvana (CVNA) on August 5 2020:
We believe our current inventory is meaningfully limiting sales, making growing inventory our top company priority.
Bill Nash, CEO Carmax (KMX), on September 24 2020:
For the past three months, our teams have done a phenomenal job buying and producing vehicles at record levels, increasing salable inventory by more than 50% in the quarter. […] this quarter, we saw 5 to 10-year-old vehicles increase to 27% compared with 22% last year as a percentage of our sales mix, reflecting customer demand for older and less expensive vehicles.
This best shows in the Manheim used vehicle index. After an initial decline in March, used vehicle prices are now up 16% YoY. This benefits KAR in several ways:
- KAR is selling higher volumes in its auctions. Usually, KAR has a conversion ratio of 60%, meaning that 40% of cars get remain unsold and will be auctioned again at a later time. Management has indicated that conversion rates are as high as they could possibly be (without quantifying what that means). This means more revenues on an unchanged (or lower) cost base. US volumes in June were +8% YoY.
- Buyers pay a commission based on the purchase price. However, this impact on revenue is probably small as commissions go up step-wise and the current increase in prices might not be sufficient to get to a higher commission level.
- Because sellers of vehicles want to sell cars now, before car prices inevitably correct, they do not want to take the time to pay for repairs that KAR offers. Service revenue will probably be down a little.
- AFC losses will be low as collateral values are high and dealers are in good health.
I believe the used car prices are an interesting catalyst for the next few quarters. However, I’m well aware that this is only a temporary effect. Especially a reversal in Covid related government handouts could have an impact on consumer demand for cars. The only really permanent benefits are the cost savings as mentioned above.
A few words on the recent acquisition of Backlotcars. In August, KAR announced the acquisition of Backlotcars for 425m USD. Backlotcars was a direct competitor of Traderev. Management had raised cash in May through a convertible preferred issue, which comes at the extremely high cost of 7% preferred dividend plus a call option. The fact that this gets invested in a break-even business is of course earnings dilutive. Management provided pretty much no details on the investor call, which resulted in a price correction, which ironically, amounted to as much as the acquisition price.
As an investor at today’s share price, valuing KAR purely at an earnings multiple, you effectively get Traderev and Backlotcars for free. Traderev was valued at 250m USD when KAR acquired the remaining 50% in 2017 and it has grown rapidly since. The combination of the 2 companies also gets them to a more significant market share of 30-40%. We will have to wait until management decides to provide more details on the acquisition, but I would not be surprised if there is significant value here.
The capital structure of KAR is a little complicated with an expensive convertible preferred which was issued in May. There is also 735m non-recourse debt which is backed by 1,526m USD of loan receivables.
Source: company filings
In late 2019, KAR provided guidance for 2020. This guidance has since been scrapped. However, I do think it’s an interesting starting point. The guidance was for about 200m in FCF to equity.
Source: management provided guidance, adjusted for the new capital structure.
2020 earnings will be impacted by a very weak second quarter. What matters to me is what KAR will be able to earn on a go-forward basis. I think the cost savings should have an after-tax impact of at least 100m USD, but likely more. This gets us to at least 300m USD in free cash flow, or a 15% FCF yield.
Finally, it should be noted that Q3 might still have some negative impacts from Covid. While US volumes in June were 8% higher than the year before, volumes in Canada and Europe might have taken a little longer to recover. The repo market is also not yet fully functioning. This will keep supply of cars down, but this will be compensated for in future quarters. Finally, the AFC loan book was de-risked in Q2 and it will take some time to ramp this up again, also lowering earnings.
Management has been very careful in setting expectations. This is in part because they have missed their own guidance several times, of which the last time was in Q3 2019. They have indicated that they want to show the margin potential of the business in the next quarters. Since the spinoff of IAA in mid 2019, management has purchased 2m USD worth of shares. I think the next couple of quarters will be extremely strong, and I am positioned accordingly.
Disclosure: I am/we are long KAR, CPRT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.