November 12, 2010 - 2:40pm EST by
2010 2011
Price: 12.06 EPS $1.01 $1.17
Shares Out. (in M): 135 P/E 11.9x 10.3x
Market Cap (in $M): 1,625 P/FCF 7.1x 7.5x
Net Debt (in $M): 1,640 EBIT 274 298
TEV (in $M): 3,264 TEV/EBIT 11.9x 10.9x

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KAR is a high ROIC, high barrier to entry company which generates large amounts of free cash flow that faces a short-term headwind due to a severe, one-time disruption in the auto leasing industry and technical pressures due to sponsor ownership.
KAR is a car auctioneer with a #2 market position in both whole cars (~22% share) and salvaged vehicles (~35% share)
  • Both markets are oligopolies, with no other major competitor besides KAR & its main competitor (Mainheim in whole cars, Copart (CPRT) in salvage)
  • Fee business model in which KAR does not take inventory to cars, leading to low working capital requirements and zero inventory risk
  • Auctions held both online and in person - KAR has a national footprint with ~200 auction sites serving 75 metropolitan areas - zoning requirements and expansive real estate footprint make entry into this business very difficult
  • This is a network effect business - the more participants in the auctions, the more valuable they are - represents another large barrier to entry

KAR equity now trades at its IPO price of ~$12 (December 2009) (had gotten as high as $15.73 in May) despite the fact that since the IPO, the company has generated $245mm in free cash flow (15% of the market cap).  The company trades at a very attractive valuation despite the stable, duopoly nature of its industry, high returns on capital and strong free  cash flow generation.

  • 2009 Adjusted ROIC (ex. goodwill): 30.6%, 2010E ROIC: 32.9%
  • Company has generated $550mm of FCF and paid down $750mm of debt (pro-forma for coming $150mm pay-down) since the LBO by Kelso & Goldman Sachs in 2007
  • Currently trading at 6.9x EV/EBITDA, 8x EV/EBITDA-CAPEX, 14% Levered FCF Yield (18% ex-cash) and 10% Unlevered FCF Yield
  • I believe the correct way to value this company is on a free cash flow or EV/EBITDA-CAPEX basis because D&A vastly overstates the amount of necessarymaintenance CAPEX, meaning free cash flow generation per share is significantly higher than EPS
  • If company traded at a 9% Levered FCF Yield or 10X EV/EBITDA-CAPEX, stock would be worth $18 or 50% upside
  • I expect the company to generate ~$500mm of FCF over the next 2.5 years, or ~30% of the current market cap

There are two primary concerns regarding this company, which I view as short-term in nature:

  • Off-lease volumes, which represent 16% of KAR's whole car volumes, expected to markedly decline in 2011-2012 (3 year lag from large drop in lease activity)
    • Even a 30% decline in each year (at the high end of expectations) would only represent a 5% volume headwind for the entire segment, which KAR will look to offset with increased market share with the dealer consignment business
    • This is a temporary disruption in the normally extremely stable whole car auction market (between 9.1mm and 9.6mm cars for the past decade), and eventually the markewill look through this headwind
  • 55% of the float is held by private equity and is no longer locked-up - fear of the sponsors selling is contributing to pressure on the stock
    • Kelso, Goldman and ValueAct own a combined 74.7mm shares or 55.4% of the shares outstanding
    • Our understanding is that the sponsors have not been interested at selling at these valuations
    • This is another short-term, technical factor that does not alter the long-term earnings power of the company

Business description/segments:

  • ADESA / Whole Car Segment (56% of EBITDA)
    •   Adesa links used whole car sellers to buyers through an auction consignment model - declining off-lease sales is the primary risk
      • Estimated seller breakdown: Dealer Consignment (30%), Off-Lease (25%), Rental (20%), Fleet (15%), Repossession (10%),
      • Declines in off-lease volumes due to the collapse in lease activity in 2008-2009 will be a headwind for the industry in 2011-2012 (2-3 year lag)
      • Whole car auction volumes have historically been very steady in the 9-10mm range for the past decade - but Adesa is predicting that number may fall below 9mm over the next two years
      • Adesa is attempting to offset some of the volume pressure by increasing their efforts to gain share in the dealer busines
        • YTD, Adesa's whole car volumes are down 7% vs. an industry decline of over 8%
        • Adesa's dealer business grew to 35% of sales vs. 32% YoY in Q310
        • Dealer sales are correlated with SAAR (R2 = .58) - will rebound from here
      • In addition to the dealer business, volume declines in off-lease will be offset by rental and fleet businesses which have bottomed
    • While whole car volumes is clearly the main headwind facing the company, I believe this story is well-understood, priced in and volume declines should be manageable
      • The bear case here is that sell-side numbers need to come down for 2011 - and while that may be true, the long-term earnings power of the company is not impaired and eventually negative sentiment will subside and the market will look through this one-time depression in the auction market
      • In addition, tight markets for used cars lead to higher pricing, which KAR captures through % of final value fees (rev/vehicle was up 6% YoY in Q310 despite 7% volume declines) - this has also benefitted both IAAI (salvage auction values) and AFC (loan transaction sizes)
      • KAR is actively managing ahead of these volume pressures by focusing on increasing share in the dealer market where volumes are rebounding
  • IAAI / Salvage Segment (32% of EBITDA)
    • Facilitates the sale of salvage vehicles (primarily from insurance companies) to dismantlers and recyclers through the same auction sites that Adesa uses
      • Business has been extremely strong (Q310 EBITDA up 37% YoY) due to higher rev/vehicle sold (+9% YoY) offset by soft volumes (-4%)
      • Pricing gains have been lead by higher used car prices and higher scrap steel - gains are expected to mitigate on a sequential basis from here, but this segment should remain strong as the used car market remains tight and the economy recovers
      • Long-term drivers of this business are miles driven and complexity of vehicles (leading to higher % of total loss after accidents). Miles driven should rebound with the economy - and cars are getting increasing complex
      • This business represents a stable source of cash flow and a natural hedge to whole car volumes
  • AFC / Finance Segment (12% of EBITDA)
    •   AFC provides short-term (60-90 day) financing to used car dealers (known as floorplan financing)
      • 2/3rds of revenues generated by fees, 1/3rd interest income
      • Facilitates sales at whole car auctions
      • This segment has gone from being perceived as a threat to the viability of the company during the credit crisis to a profit driver - EBITDA has improved from $1.2mm at its lows in Q408 to $23.3mm in the most recent quarter, driven by lower losses and higher transaction sizes (another natural hedge to whole car volumes as used car prices go higher)
      • In early 2009, KAR installed a new management team, updated credit processes and tightened lending practices at AFC

 Other risks:

  • Shift in rental car companies away from auction selling directly to consumers
    • Merits watching, but rental cars only ~10% of whole car volumes and are beginning to refresh fleets
  • SAAR reverses course and trends lower, reducing dealer volumes
    • Seems unlikely given current level (~12mm) vs. scrappage rate (~13mm)
  • Sharp deterioration in credit quality at AFC leads to higher loan losses
    • Even in its worst quarter (Q408) this business was EBITDA break-even
    • New management and credit practices in early 2009 have lead to improved portfolio and results

Sell side "conventional wisdom":

  • 8 buys, 4 holds, 1 sell - average target price of $17.78
  • Stock is cheap on valuation - but why buy ahead of earnings deceleration in 2011?
  • This is not a big organic growth story, de-leveraging not very interesting to equity investors
  • One-off business, can't leverage research, don't spend much time on it


Company will generate $500mm in FCF over the next 2.5 years, which represents 30% of the market cap

Multiple expansion as short-term fears pass and the company de-levers

Return to lease volume growth by the end of 2012
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