Description

Adesa Inc.(KAR)

 

Summary

Adesa Inc. (KAR) is a key auction provider for the used and salvage vehicle industry (“vehicle remarketing”) as well as a provider of floor plan financing for independent used car dealers.  The company was spun off from the utility Allete in June 2004.  Both the used and salvage markets are oligopolies; KAR is #2 in used and #3 in salvage.

 

Current pessimism regarding the state of supply and demand in the used car auction market and a disappointing Q2 is creating the opportunity to buy the stock with 30%-60% appreciation potential aided by several catalysts:

 

¾    Earnings growth of around 10% for the next several years

¾    EBITDA margin expansion potential of 200-300 basis points due to previously-spent capex on process improvements

¾    Secular increases in the volume of used vehicles presented at auction to be sold (which would also improve operating leverage and expand operating margin further).

¾    Potential stock buybacks from prodigious excess free cash flow 

 

Today, the business trades at 10.5 of LTM EV/EBITDA-Capex (9X using maintenance capex).  By 2008, I expect EBITDA to reach $330MM with maintenance capex in the $40MM range while producing over $100mm of free cash flow per year in the intervening time.  Using EBITDA-Capex multiples ranging from 9X to 11X and expected zero net debt versus slightly over $200MM today, creates a price target range of $29 to $35 per share versus a price of around $22 today.

 

Description of Business

Adesa auctions over 1.9MM vehicles a year, 90% of which are used as opposed to salvage, via 54 used vehicle auction sites and 31 salvage sites (both use the internet for incremental sales as well).  In total the company receives about $425-$450 per transaction on a blended basis which is comprised of approximately $275 of fees (a closely guarded number) and the rest in services.  Pricing power has been fairly robust over the last 5 years with fees growing by approximately 5% per annum.  This business has 25%+ EBITDA margins and decent operating leverage as additional auctions or incremental sales do not add heavily to operating expense.  The company does not take inventory risk, the sales are considered wholesale consignments.  The auction side of the business should do close to $925MM in sales in ‘06 (88% of revenue and 75% of consolidated EBITDA).

 

The floor plan finance business (“AFC”) operates out of 85 branches (52 of which are on the site of auctions).  The business should do $125MM in finance revenues this year and ~$88MM in EBITDA (~13% of total revenue ~28% of EBITDA).  These loans are short term in nature (30-45 days) and made mostly to independent car dealers.  The loans are Prime Rate based plus a spread and generate fees as well ($75-$110 per loan).  Over 13,000 dealers have available credit of which 8,500 have outstanding balances.  The average line of credit is $122k with the average value per vehicle of $7,300.  This business is financed via a structured finance conduit.  At June 30, 2006, AFC managed total finance receivables of $772.7 million.  Given the nature of the dealership industry (66,000 independent and franchise dealers), providing credit is an essential and profitable ingredient in getting dealers to both buy vehicles at auction and consign vehicles they need to sell.  This creates a “virtuous cycle”.  As dealers become enmeshed in the process of buying, selling and financing cars via Adesa, profitability per customer increases. 

 

Industry

Given only 11% of the company’s auction volume is salvage, I will focus on the used auction market.  The North American vehicle population stands at 258MM—known as Vehicles in Operation (VIO).  Apart from VIO growing roughly with inflation, 19MM new vehicles join VOI per year and 12MM are scrapped each year causing a yearly net increase.  Approximately 1 in 5 used cars change hands a year.  This creates about 46MM of used vehicle transactions per year.  Auctions account for 10MM, 14MM are consumer to consumer, wholesalers account for 7MM and dealer trades account for 15MM units.  Management believes there is opportunity to steal share from the other used sales categories beyond competing auctions. 

 

Vehicles come to auction via Institutional sellers (lessors selling off-lease cars, fleet providers and rental car providers turning over their fleet) and Wholesalers (dealers and traders who buy cars and sell to retailers who in turn sell to a consumer).  At auction, the supply is split evenly between the two parties.  In the case of KAR, they are more overweight Institutional (60/40 percent).

 

Manheim Auctions is the 800 pound gorilla in the used space with 51% market share and is owned by Cox Communications.  Adesa is #2 with 18% market share.  Independents make up the remaining 31% with the next largest in the mid-single digits.  The auction business is one of scale because liquidity is paramount so the industry is consolidating more with each year.  The total industry revenue is estimated to be $4B+ (the average ticket is over $400/vehicle).

 

The salvage auction market is smaller by volume versus the used auction business—about 1/3 the size.  The auctions keep about 25% of the total gross due to the related services and additional value added.  The total revenue is estimated at $750MM.  Copart has 35-40% market share, IAAI has 25% followed up by Adesa at 8%+ (a recent acquisition has increased their share slightly).  Similar to the used auction, around 30% of the market is independent.

Capital Structure

Fully Diluted Shares Outstanding:          90.1 MM

Recent Price:                                        $22.79

Market Cap:                                         $2,053 MM

Net Debt:                                             $207

EV:                                                      $2,260 MM

 

Why Adesa is Currently Cheap

1. Conversion rates (the percentages of cars sold that are put up for auction) was 58.2% last quarter as supply increased but prices held firm (a 220 bps decline year over year).  Analysts immediately blamed retail demand which was soft (down 4.65% at the retail level). 

 

From a macro perspective, as VIO grows and scrapage rates decline (creating net growth in VIO of 7MM vehicles per year), vehicles have to clear the market eventually at some price.  Because this is an auction, price (at which the vehicle sells, not the auction fees) has to adjust when supply grows.  Many industry analysts with longer term perspectives believe that conversion rates will increase when prices decline which will increase auction sales.  As one industry player said, “demand is always there if the price is right and it eventually has to happen.”  This point is important to the thesis:  vehicles continue to depreciate and wholesalers are wasting money every day a vehicle is not sold (additionally, these vehicles are usually financed), so there is an incentive to sell ultimately at some eventual price.  Adesa will get its share of auction sales as pent up supply clears the market.

 

2. Q2 earnings disappointment of $0.40 eps versus a consensus of $0.43.  The lower conversion rate plus increased operating expense due to taking in an incremental 52k vehicles (a good thing) were the main culprit.

 

3. Several management changes at the company spooked the market.  Adesa lost the head of its Canadian operation and the head of its salvage operations.  In addition, the CFO moved into an operating role and there is a current search under way for his replacement.  While the loss of staff and CFO changes don’t always inspire a great deal of confidence, this is as a result of a new President/COO who is making organizational changes in order to improve internal operations.

 

4. Waiting for the institutional market to improve.  While it is widely believed that vehicles from the lease and fleet market coming to auction will improve in 2007 as they come to the secondary market, vehicles coming to auction were down 3% in 2004 and .8% in 2005.  Analysts expect a small increase of .3% in 2006 and a 2% increase in 2007.

 

Thesis

Secular shifts in the “institutional” vehicle auction supply due to increases from rebounding lease and fleet vehicle programs will lift wholesale auctions, and Adesa in particular, in the coming quarters.  In addition, company initiatives to expand key markets, improve processes with technology and create a more cross selling opportunities between the auction, salvage and finance units should provide additional organic growth and margin improvement in the next few years.  The combination of all of the above factors should lead to both multiple expansion and increasing earnings of at least 10% over the next couple of years.

 

Growth

The opportunity for growth comes from several avenues:

1. The expansion of current sites in major metropolitan areas allowing for larger throughput at current auctions.  Management is currently undertaking an expansion in Kansas City with Phoenix and Dallas next.  In the case of Kansas City, they are repositioning a current site and selling some excess land (a condition that exists at many of their sites) for a net investment of $5-6MM and increasing the number of lanes from 7 to 10 meaning they can show more cars at a given auction.  Management estimates that that investment will increase sales by approximately 30,000 vehicles per year.  Using an estimate of $250 of EBITDA per vehicle means that $5-6MM investment will ultimately provide a $7.5MM of incremental EBITDA—not a bad return! 

 

A brief look at the 10k shows 26 sites with 9 lanes or less in the US, 17 of which have 7 lanes or less.  I don’t believe that it would be prudent to expand all sites, but it shows there is organic expansion capability.

 

2. Anticipated increased auction supply from rebounding lease and fleet activity.  Leasing was a much more popular vehicle financing mechanism 5 years ago in a higher interest rate environment.  In 2000, 30.5% of new car sales were purchased via a lease.  That number plummeted as interest rates declined bottoming out at 19.3% in 2004 as consumers used low interest and zero down loans sold by captive finance providers or their home equity lines in place of leases.  That number has since rebounded to 23%+.  It takes roughly 3 years for those cars to go off-lease which means that its impact will be felt in 2007.

 

Fleet and Rental Car usage, a major source of used auction supply declined heavily after 9/11 and has since rebounded.  Fleet and Rental sales bottomed out in 2003-2004 at 2.54MM vehicles and have since rebounded to over 3MM vehicles in 2005.  These cars generally go to auction 18 months later which will aid in the expected increase in vehicles coming to auction in 2007 and beyond.

 

3. Anticipated softening in used vehicle pricing thereby increasing auction sales of pent up demand.  Used vehicle pricing, as tracked by the Federal Reserve, ranges in value between 50% and 67% of the value of a new car.  Currently that figure stands over 60% and is expected to decline.  Similarly, competitor Manheim Auctions maintains an index from the results of its own auctions.  They use a composite index based on their own transactions.  With 100 as the baseline, they peg the current used auction price at 112 and declining.  In speaking with people in the industry, it is believed that pricing, which is currently “firm”, meaning sellers are not dropping their price, is increasing the amount of supply going to auction and not selling.  As supply and demand ultimately even out, analysts believe that sales will increase at auction as they did in 2003. 

 

4. Increased auction activity from dealer consignments increasing Adesa auction supply.  Industry wide statistics show that dealer consignments represent 50% of auction supply sale.  Adesa has about 40% dealer consignments increasing their dependence on the lease and fleet market.  Management has made a concerted effort to increase dealer consignment with the goal of getting to 50/50.  This should also help organic growth as it increases supply.

 

5. Improved margin opportunity of combining salvage and auctions sites.  Currently only 8 salvage sites share facilities with used sites.  Management plans to combine several more sites in the coming years which should have a positive impact on operating margin.

 

6. Improved operating leverage resulting from higher unit sales and operational improvements undertaken in the last five years.  Adesa at its heart is a roll up—the company only had 19 wholesale and 19 AFC loan sites when it was acquired by Allete in 1996.  Management has spent in excess of $100MM in discretionary capex in the last 5 years on IT and process improvements.  In my conversations with management, there is a belief that this will pay off in the coming years into a 200 to 300 basis point improvement in EBITDA margins.

 

7. Acquisitions—approximately 1/3 of both the used auction and salvage auction markets are run by independents.  The company has made acquisitions on both side of the auction business in the past and continue to be on the hunt.

 

Valuation

A combination of increased supply from improved off-lease and fleet supply, Adesa’s push to increase supply from dealer consignments and the moderation of used car wholesale prices will create normalized conversion rates of around 62% or better and mid-single digit revenue growth.  This should conservatively create EBITDA of at least $330MM with maintenance capex of around $40MM or EBITDA-CAPEX of $290MM by 2008.  Given its stable industry, high free cash flow and profitability would at least garner a 10X EBITDA-capex multiple.  Assuming $200MM of incremental free cash flow by 2008 would create no net debt and a price target of $32 per share.

 

Buyout firm Kelso and Company’s acquisition of salvage auction IAAI in 2005 for 10.1X LTM EBITDA which translates to a share price of $29 using 2006 Expected EBITDA of $280MM ($37 per share using ’08 estimates).  Similarly, Allete originally paid 9.5X EBITDA in 1996 for a much smaller Adesa (475k vehicles sold at their auctions in 1996 versus 1.9MM in 2005).

 

Risks

1. Weak near-term conversion rates while we wait for auction sellers to get “religion” on accepting lower selling prices to clear out their inventory
2. Capital deployment—Management has stated organic growth and strategic acquisitions have priority over stock repurchases and debt reduction of the $100+MM the company produces each year.  Any poor decisions could destroy value.
3. Disintermediation threat from the Internet.  Though the company is making active use of the Internet as part of the auction process, there is always the threat that the traditional auction is circumvented altogether.
4. More massive dealer incentives.  Last year’s domestic manufacturer incentives swayed demand from the used market to the new vehicle market.  While domestic production levels have been cut drastically implying that reduced costs are more the preferred tactic for U.S. auto manufactures rather than “making up in volume”, this remains a risk.
5. Interest rates decline to 2003 levels again thus hurting the rebound in lease volumes.

Catalyst

1. Stock buy backs with free cash flow
2. Higher used vehicle volumes presented at auction for sale
3. Improved conversion rates at auction
4. Market expansion either via organic means or acquisitions