Description

Executive Summary

KAR Auction Services was last written up on VIC last June 2020 and this post marks the 5th write-up on the company in recent years. Since the last KAR post, several material changes have transpired at the company, including the acquisition of BacklotCars (November 2020) and the replacement of long-time CEO Jim Hallett (March 2021), both of which we view as positive developments that position KAR well for the future. KAR currently trades at 7.4x 2019 EBITDA and 6.4x our estimate of “run-rate” EBITDA, or what the company can earn under its new cost structure once volumes return.

We have studied KAR closely for many years and believe the company is incredibly misunderstood. This is due partly due to the company’s highly nuanced business model, compounded by the poor job the company has done articulating these nuances to investors. The complexity of KAR’s business – its various customer bases each having different growth rates, competitive moats and unique auction platforms - coupled with its small size causes investors to shun the company and/or make sweeping, overly simplified generalizations future challenges it faces. We believe fears regarding disintermediation are overblown and demonstrate a lack of understating about the intricacies of the company’s business.

While KAR’s is certainly under attack by very formidable, digital only incumbents (particularly ACV Auctions), we believe KAR’s omni-channel model will remain highly relevant – and will emerge as the preferred model – well into the future. (Interestingly, ACV continues to attempt to replicate many of KAR’s key features such as land access/ownership and its finance business). Further, COVID afforded KAR the opportunity to dramatically accelerate its digital transformation (its auction are now 100% online) and permanently remove significant costs from the business (>$150m or >1/3rd of pre-COVID EBITDA), which in a normal environment would have taken years to achieve. We believe KAR’s EBITDA can well exceed 2019 levels even at lower volumes levels as the leverages its new, leaner cost structure and online-only model.

In terms of the current operating environment, while used car dealers (and owners) have benefitted greatly from COVID via extremely elevated prices, used car auctions have not. In fact, 2020 was a worst operating environment for KAR and others than the 2008/2009 financial crisis. Due to a variety of COVID-induced factors, the auction industry experienced a “perfect drought” in 2020, with its effects likely lingering through much of 2021. Unlike in prior recessions, where counter-cyclical volumes such as repo softened overall volume declines, in 2020, volumes from all consignor types fell simultaneously. What this means is that cars available at auction have decreased precipitously despite a strong used and new car market. With fewer cars to sell, KAR’s revenue and EBITDA naturally suffered. The factors causing this vehicle shortage are multi-faceted and include: limited new car due to COVID production shutdowns/chip shortages, a surge in demand for personal/safe transportation (i.e. used cars) leading dealers to retain more trade-in’s, moratoriums on repossessions for social and regulatory reasons, elevated purchases by grounding dealers (or retention by consumers) of off-lease vehicles due to their “in the money” nature and slower turnover of rental car fleets due lack of availability of new supply with which to replenish. Further, the dramatic rise in used car values (peaking +45% vs pre-COVID) has limited the need for consignors to perform ancillary services. Importantly, we do not believe the current environment is 1) permanent or 2) indicative of share loss/and or decreased relevancy of KAR. Instead, as used prices inevitability normalize (which is now starting to happen) and repossessions resume, the wholecar auction industry should begin to thaw as well.

Overall, we view KAR as a well-positioned, growing, omni-channel (i.e., physical and online) provider of remarketing solutions that is economically indifferent towards the format in which cars are sold as opposed to a declining “brick and mortar” business being significantly disrupted by low-cost, app-based auction upstarts. As KAR is able to demonstrate the continued relevancy of its business via sustained positive top-line and bottom-line growth as well as powerful operating leverage post substantial cost reductions, we believe the company will begin to be valued more like the niche, digital marketplace that it is.

As detailed below, we estimate fair value for KAR to be between $27-$30, offering a high-teens to low 20’s % IRR over the next three years (2024 exit).

Business Overview

KAR Auction Services is a leader in the “auto remarketing” industry. The company hosts online used car auctions on a business-to-business (“B2B”) basis and provides other ancillary and related services (transportation, body work, etc.) via its "ADESA" segment. The company also has a floorplan financing business which extends credit to used car dealers on a short-term basis via its "AFC" segment. In 2020, the company facilitated the sale of ~3m vehicles with an aggregate value of over $40bn and had $2bn of loans outstanding. KAR had 2020 revenue and EBITDA of ~$2.2bn and ~$375m (17% margin), respectively.

KAR operates in two reportable segments: (i) ADESA, the auction business and (ii) AFC, the floorplan financing business. Within ADESA, there are a number of “banners” or platforms customers can utilize to sell or bid on inventory. These channels are delineated by vehicle type sold (distinct options exist for certain types of vehicles, such as off-lease) and auction format (instantaneous, weekly, etc.) Below we provide a summary breakdown of the revenue and EBITDA contribution of each of these businesses along with a brief description of each business.

ADESA (88% of 2020 Revenue/65% of 2020 EBITDA):

·         ADESA: ADESA hosts online (“Simulcast”) auctions, which are attended by used car dealers. Vehicles sold through this channel are broadcast online on a real-time basis (i.e., “simulcast”) for virtual bidding. Auctions are typically held once per week. ADESA generates revenue by earning buy and sell fees for each vehicle successfully sold and also offers various ancillary services (reconditioning or detail work) aimed at enhancing the value of the underlying vehicle. These services are performed at one of ADESA’s 74 yards (spanning ~75 acres each). Approximately 50% of ADESA’s revenue is service oriented, of which approximately half is “off-premise” or serving cards not sold at auction. In 2020, ADESA sold ~1.8m vehicles (approximately 60% commercial, 40% dealer).

·         Dealer-to-Dealer: BacklotCars (formerly TradeRev, more below) is an app-based, mobile “dealer-to-dealer” auction platform. Backlot allows dealers to photograph and record images and engine sounds of their vehicles and upload them for a 1 day, bid-ask auction. Like ADESA, Backlot charges success-based fees. App-based auctions offer a more convenient alternative and are currently available only to “franchise” dealers (or those selling new and used cars) to sell lower value vehicles they receive via trade-in. (Note, many of the volumes being sold via app-based auctions are units that previously were not sold at auction at all, which introducing an entirely new TAM to the market).  In 2020, Backlot sold over 200k units. Backlot is a business KAR is currently scaling up and is still in the money losing phase.

·         Openlane: Openlane is a digital only platform offered primarily to auto leasing companies (either captive finance companies at auto OEMs or financial institutions extending credit for leased vehicles). Openlane software creates and provides the back-end engine for websites that act as live auction portals for lessors to monetize their off-lease cars. Auctions are conducted in a curated format and are offered to underlying franchises as well as other dealers with cascading fees depending on the auction format and ultimate buyer. In 2020, Openlane sold ~1m vehicles. Openlane has ~50%+ EBITDA margins.

AFC (12% of 2020 Revenue/35% of 2020 EBITDA): AFC provides floorplan financing to independent used car dealers. Floorplan financing is short-term secured credit used by auto dealers to fund inventory. AFC operates this business through ADESA auctions as well as at other standalone sites. Revenues for AFC consists primarily of interest and origination fees (50/50 split) but also include other smaller ancillary revenues. In 2020, AFC extended 1.5m loans with an ending receivable balance of ~$2bn.

Key Thesis Points

Attractive Business Model

KAR’s ADESA business inherently possesses many favorable characteristics. The company operates a consignment model, hosting auctions on behalf of customers while earning buy and sell fees for successful sales (based largely on selling prices). The company takes no inventory risk and has limited exposure to fluctuations in used car prices due to the wide bands upon which fees are determined. As a marketplace business, KAR benefits from powerful network effects (connecting buyers and sellers while providing a liquid venue in which to transact) which inhibit new entrants. KAR also has limited CapEx needs (maintenance CapEx is just 25% of D&A), as the facilities which it operates do not require the same level of upkeep as other brick & mortar, customer facing businesses.

AFC is a niche lending business that earns consistent ~15%-20% ROEs due to prudent risk management processes and limited competition due to hyper-local underwriting. AFC leverages its long-term customer relationships and local presence to generate attractive lending spreads of 500-600bps, while limiting losses to 1-2% per year.  Like ADESA, AFC’s primary competitor is Manheim via its NextGear subsidiary. The customers to which AFC lends are typically smaller, independent (or used car only) auto dealers with minimal access to alternative funding, as commercial banks that typically provide floorplan financing are less comfortable and less equipped to manage a business with “elevated” loss rates of 2% exhibited by independent dealers versus 25bps-50bps for franchise dealers (or those selling new and used cars). In fact, under bank ownership, we believe loss rates would likely be higher without KAR’s local knowledge and underwriting. Additionally, given the relationship with its parent, KAR, AFC has a natural outlet for monetizing any inventory it may receive back due to defaults via the ADESA auction business. Traditional banks lack this channel (and indeed rely on ADESA for selling off cars they may repossess in their other lines of business).

Consolidated Industry Structure

The used car auction industry is a duopoly between KAR (30% share) and Manheim (40% share; owned by the Cox family). The balance of the industry is made up of small, mom and pop operators with the next largest competitor being a fraction of the size of KAR (examples include America’s Auto Auction, owned by Hunt Partners, XLerate, owned by Huron Capital and hundreds of mom & pop operators). Historically, the industry has been protected by several barriers to entry, including network effects and the need for scale and physical space for storage and to perform ancillary services at a competitive rate. This industry structure has persisted for decades and remains highly rational. Over time, we believe the scope exists for further consolidation as smaller players are not as well equipped to adapt to the needs of an increasingly online market post-COVID.

More recently, new online-only start-ups such as ACV Auctions have begun to make inroads in this market; these new entrants are discussed more below.

New CEO

Investors by and large have historically held a negative view of the management team at KAR. Now Former CEO Jim Hallett (15 years at the helm) come across as aloof and uninspiring while CFO Eric Loughmiller tends to be a bit promotional. KAR was also slow to fully appreciate the potential of app-based auctions (it acquired its initial interest in TradeRev - its predecessor dealer-to-dealer product - in 2014, before competitor ACV was even founded) and coupled with some operational and strategic missteps, the company allowed ACV to gain leading market share. Our assessment is somewhat less harsh but still skeptical. Jim and Eric have led KAR for the past 15-20 years, including through the Great Financial Crisis in 2009 when the company was owned via an LBO structure.  In our view, their experience, perspective and relationships should be viewed as an asset and we applaud their willingness to adapt and “disrupt themselves” via technology investments which many legacy business have failed to do.

Recently, Peter Kelly, was named as KAR’s new CEO (Jim Hallett with remain as Non-Executive Chairman). Peter joined KAR after co-founding and selling Openlane (to KAR) in 2011 and most recently was President of the company; prior to that, he was Head of Digital. We view Peter’s promotion as a positive development as he is an entrepreneurial, digitally oriented, strategic and analytical thinker who has helped accelerate KAR’s digital transformation during an extremely difficult period. While some have been critical of Peter given KAR’s generally slow adoption of a more online-centric business and the poor job it did rolling out TradeRev, our research suggests significant organizational dysfunction at KAR (and some product specific issues) bears more of the blame for these issues. For instance, KAR’s former General Counsel, Becca Polak, previously ran TradeRev (a decision we still cannot fathom) and we believe she reported directly to Jim Hallett. Until last year, TradeRev was sold by a distinct sales force, which prevented it from realizing the benefit of being part of the KAR organization. Further, KAR has a well-earned reputation for bureaucracy and glacial decision making, which Peter had to grapple with and should be able to accelerate.

Given the substantial investment into the company made by Apax (and the associated board seats), we are optimistic over time that the company will continue take greater steps to enhance how it communicates with investors and potential investors. As an example, at a recent conference appearance, KAR’s CFO Eric Loughmiller noted that he felt it was “important to redefine the company” and “change the narrative” by ceasing to discuss “physical auctions” but rather focus on its various marketplaces (Openlane, Simulcast, TradeRev). We believe this is a sensible re-positioning that will remove the undue focus on legacy in-person auctions and highlight the omni-channel nature of the company. The company is also considering an investor day to be hosted in 2021 to showcase its evolution and attractive collection of digital marketplaces.

Improved Post-COVID Positioning

We believe the COVID-19 pandemic has given KAR a unique opportunity to fundamentally revamp how the company does business as well as its cost structure.

In 2019, ~60% of units sold by ADESA were purchased by online buyers with the remaining 40% of sales going to live (in person) bidders. In order to accommodate live bidders, KAR maintains 74 yards comprising 75 acres each, of which 50% are owned and 50% are leased. Hosting physical auctions and accommodating physical bidders requires significant labor to stage vehicles prior to the auction, display and physically drive cars through the lane at auction and process completed sales. While many bidders may have still prefer or felt more comfortable with the in-person experience (for social or other reasons), COVID forced all activity online with 100% of vehicles transacted digitally in 2020.

This abrupt shift caused buyers to change their behavior, with even those who previously resisted transacting digitally having no choice but to go bid online. KAR was able to quickly pivot by rolling out its “Simulcast+” technology much earlier than originally planned to accommodate this demand. Simulcast+ is a fully automated and digital auction platform which simulates the physical auction experience. Vehicles are showcased from an ADESA yard or in some instances, from a customer’s facility, completely online with no live bidders and minimal ADESA staff. Simulcast+ can even host auctions from multiple sites at once, expanding the selection beyond what would be possible with a typical auction. Conversion rates on Simulcast+ are similar to that of the physical auction (~60%) with 20% more bids per vehicle and lower overall operating costs.

Going forward, while KAR will continue to allow physical bidding in the near-term (when permitted) it has announced its intention to NOT host physical auctions again in the future. We believe this shift is the right long-term decision for the business as it essentially an acceleration of where it was already heading. Further, this pivot should both help counter the view that KAR is an antiquated, brick & mortar business losing share to new upstarts and reposition the company as a digitally enabled, omni-channel marketplace worthy of a premium multiple.

This business model transformation has also enabled KAR to remove significant expenses from its cost structure. COVID afforded KAR the opportunity to look at its organization on a “clean sheet basis” and ultimately eliminated 1/3rd or 5,000 employees, reducing expenses by over $150m on a permanent basis (or >1/3rd of 2019 EBITDA). The level of significant cost adjustment would have been difficult, if not impossible, to execute absent the “cover” provided by COVID.  We believe there are cost savings opportunities above and beyond what has already been announced, including centralization of certain business processing tasks (title transfer, payments) and moving to an automated auctioneer and ringman system (as is being done at former KAR subsidiary/salvage auction provider IAA), which have the potential to equal tens of millions of dollars of incremental savings. As the business recovers, we estimate new run-rate margins for the consolidated business will be 400bps higher or low 20%’s % versus high teens % in 2019.

Misunderstood Asset

We believe the threat from new entrants to the auction market such as ACV Auctions is manageable as it is most acute in a subset of KAR’s business (dealers, which contribute a fraction of overall profits). While strong execution will be critical to managing this risk, we believe KAR will ultimately emerge in a stronger position given its already entrenched position and collection of leading assets.

Our divergent view is based on disaggregating KAR’s various sources of auction P&L – namely, dealer cars versus commercial cars - and assessing the risk to each of these businesses individually. This analysis is not straight forward as the company only provides a single revenue statistic for the entire ADESA business and makes determining sources of volume (dealer, commercial, online) somewhat cumbersome in their supplemental disclosures. As a result, investors tend to paint the entire auction business with the same brush. By unscrambling their supplemental disclosures and developing an understanding of the economics of each vehicle type, we have determined that approximately 75% of ADESA’s gross profits stem from commercial vehicles while just 25% is from dealers. Commercial vehicles are primarily those that are supplied by captive finance arms of the OEMs (when consumers return their 3-year leased vehicles), banks as they seek to monetize repossessed vehicles, and rental car and other fleet management businesses as they replenish their fleet.

This profit contribution divergence is critical as higher-value commercial customers not only generate higher RPU but they are also stickier customers with limited alternatives. Commercial sellers are far more reliant on auctions, and thus less likely to utilize app-based solutions to acquire/dispose of inventory relative to dealer customers, for a variety of reasons:

·         KAR’s commercial customers - primarily financial lenders (leasing companies), repo companies/owners, fleet managers (60% of physical volume and 70% of total volumes) - are not in the business of retailing and for the most part, are not equipped to sell vehicles directly to an end customer. Thus, sending vehicles to auction and utilizing KAR’s expertise to expeditiously monetize inventory and achieve the highest yield (price) is a core part of the process for how these customers manage inventory. While some of the rental car companies do host their own captive auctions and have some direct selling capabilities, this has been the case for years, representing just a portion of their underlying volumes and these customers represent less than ~5% of KAR’s volumes.

·         With the exception of rental companies, commercial customers also lack the vast amounts of physical land required to store vehicles until disposition (leasing companies have access to “grounding” dealer lots for only up to 30 days), and they do not own any captive body shops for the reconditioning work necessary to realize the greatest possible selling price. This speaks to the significant moat provided by KAR’s vast physical land footprint.

·         KAR’s continuum of options for commercial customers – often beginning online with custom-built web portals (via Openlane) but frequently ending with a “Simulcast” sale broadcast from a KAR auction lot – provide optionality and convenience for commercial sellers. Rather than dealing with web-only companies for a portion of a sale and later involving KAR for the physical aspects, commercial customers have a single touch point to sell their vehicles across a number of online and offline avenues.

·         Repossessions are effectively ineligible to be sold via apps due to legal issues. Sellers of repo vehicles (primarily banks and captive finance companies) must ensure they attain fair market value for any repossessed units in order to mitigate claims that property was sold hastily for less than its worth. The shallower bidding pools found in the apps today have thus far prevented them from being used for this purpose. There is also a “cure” period for certain repo volumes which necessitate land to hold the cars for periods of time. Repo cars represent approximately 15%-20% of industry volumes through the economic cycle, though KAR is overweight this market segment, with nearly 40% share.

·         Since the vehicle seller determines the venue of choice, sell fees are a key consideration for where a vehicle is sold. Large, commercial customers have fixed price agreements in place that are heavily discounted, while Openlane’s fees are low on an absolute basis ($110 on average). As a result, commercial customers have less incentive to switch to new platforms as their cost of doing business is already far more competitive relative to individual dealer customers that must pay higher, market rates.

·         Finally, commercial customers tend to deal in very large volumes of vehicles (hundreds or thousands per month), which creates massive “flow” issues and makes listing cars individually on a 3rd party app impractical. Dealer customers tend to send far fewer cars to auction at any given time (10s per month).

The relationship commercial customers have with the auctions is in almost direct contrast to how independent dealers interact with and value the auction system:

·         Dealers, by definition, are in the business of retailing cars, situated on large plots of land (i.e., lots) on which cars can be stored and showcased. For more rural dealers, this land is often plentiful, which affords them less urgency to remove cars from their lot (and send them to auction). For dealers in more urban areas where land is scarcer, leveraging the real estate footprint of the auction yards is more valuable. (In some geographies such as Boston, Chicago and parts of NJ (close to NYC), ADESA is actually adding acreage).

·         Additionally, most dealer customers own captive repair shops, which allow them to do any necessary work (pre or post auction) in-house.

·         Additionally, commercial customers tend to inherently receive greater service levels (e.g., favorable lane placement) while dealer customers may not always receive the same level of priority or treatment, which could cause them to consider alternatives.

These fundamental differences in the relationship between the auctions and dealer versus commercial customers explain why app-based solutions have been more readily adopted by dealer customers, which comprise essentially all of their volume to-date. Dealers see auction fees as something they could ideally avoid and treat the auctions as a last resort or a means of getting rid of “aged inventory” that they were not able to otherwise sell while commercial customers view them as a necessary cost of business and reasonable relative to the value they provide.

In terms of relative economics, the lower value cars being sold on Backlot and other apps naturally have lower fees that are currently in the range $250-$270 RPU, on average. In the face of these “low” Backlot fees, KAR reports “physical RPU” of >$800, which gives the appearance of potential massive reductions in fees should more of the business migrate to the apps. However, we estimate dealer cars – which are the prime target customers for the app-based auctions – generate fees of just ~$400-$450. Additionally, these vehicles tend to be higher value, which acts to inflate the fees collected.  Therefore, superficial comparisons suggesting app-based economics are inferior are not entirely apples-to-apples.

We believe there is a reasonable probability that a significant app-based migration would be a net positive for KAR. Beyond the existing ~10m-11m pool of vehicles that transact each year at auctions, the used car market also includes anywhere from 2m-5m units that change hands in the so-called “wholesale” or “dealer to dealer” market. As mentioned above, in the dealer to dealer market, used car retailers may call on local “wholesalers” to offload unwanted inventory. These wholesalers act almost as market makers, helping place inventory with nearby dealerships with whom they may have a relationship. In exchange, they may earn several hundred dollars in fees or arbitrage profit. This process is highly inefficient, typically conducted in cash and unlikely to yield the greatest price realization given the finite market in which wholesalers transact. Over time, these dealer to dealer units are prime candidates for online transactions via apps (convenient, lower cost, more of a robust competitive process). To-date, KAR and ACV management believes the majority of cars transacting via apps are share gains coming from this market. As such, we believe the introduction of app-based auctions may actually increase the total addressable market for used car auctions by 20%-50%, which would likely more than offset any lost KAR volumes and in effect be a net positive for the company. Assuming the dealer-to-dealer market is 2m-5m vehicles, every 10% share capture by Backlot is equivalent to ~5% increase in 2019 ADESA segment EBITDA (assuming just a 25% incremental margin and zero service revenue).

Potential Private Equity Target

Given these challenges to realizing fair value, we believe the company could make for a compelling private equity acquisition in the future. A sponsor could help KAR pivot towards being a primarily online business, accelerate investments in Backlot and later re-emerge in the public markets as a digital marketplace opportunity. The current timing is interesting in that KAR spun out a division (IAA, which auctions salvage/damaged vehicles) in June 2019. IRS guidelines governing the tax-free nature of spinoffs often preclude companies from entertaining a sale of the “RemainCo” for a period of 2 years (i.e., June 2021).

KAR was privately held from 2007-2009 (by a consortium led by Kelso) and was rumored to have attracted PE interest since re-listing in 2012. As mentioned, Apax Partners made a $550m preferred investment in the company, equivalent to a ~20% stake and has been involved in numerous other automotive business. Finally, BCA Marketplace, a similar but inferior business to KAR (BCA takes some inventory risk) based in the UK was acquired for 12x EBITDA by PE firm TDR in the fall of 2019. Applying that same multiple to KAR’s 2019 EBITDA would equate to over a $30 stock price or nearly a 100% premium to current trading levels (before any adjustment for the value of Backlot). We believe this recurring interest in the used car auction industry by private equity is driven by its asset-light nature, deeply entrenched positions and the potential to reinvent the business to be more digitally oriented.

Growth, Valuation & Returns

The overall used car auction industry is mature and we expect KAR to exhibit modest, low-single-digit % revenue growth on a blended basis. This growth will be supported the dealer-to-dealer volumes increasingly being conducted online, albeit off a low base, offset by minimal if any growth in the “legacy” (non dealer-to-dealer) business. Coupled with strong operating leverage, KAR should be able to grow EBITDA at least a mid-single-digit % rate on a normalized basis over time.

Given current headwinds in the business that we view as mostly transitory, we value KAR on a “run-rate” of earnings basis which reflects our view of what the company should be able to achieve over the coming 3-4 years (2024e) once volumes are stabilized. Our assumptions by segment include:

1.       ADESA segment:

a.       Units: We believe ADESA will process 3.7m units by 2024 or 98% of 2019 levels, though the composition of these volumes will be much different. We assume commercial volumes return to ~85% of pre-COVID levels (we conservatively assume certain repo and rental volumes never return and some off-lease volumes are lost to competition), dealer volumes grow to 130% of 2019 levels, driven entirely by dealer-to-dealer gains (note: total dealer volumes could exceed 2019 levels this year given Backlot acquisition contribution) and 5% annual growth for the underpenetrated European business.

b.       Revenue: Based on the new unit mix, we estimate RPU of $540 per unit or about 4% below 2019 levels with total revenue approximately 7% below pre-COVID levels.

c.        Margins/profitability: We estimate high 40’s gross margins on the company’s new cost structure (consistent with CFO commentary) versus low 40’s % margin pre-COVID, equating to ~$970m in gross profit. Deducting ~$560m of SG&A (7% below pre-COVID levels due to cost reductions), we arrive at total ADESA EBITDA of $420m or 20% above pre-COVID levels.

2.       AFC segment:

a.       We estimate AFC should be able to generate EBITDA of ~$165m by 2024, as declines in core “legacy” volumes are offset by new dealer-to-dealer volumes. We assume a 75% attach rate on financing for dealer-to-dealer volumes and a constant spread margin.

In total, we estimate consolidated revenue of $2.65bn and EBITDA of $585m in 2024 (22% margin), which compares to 2019 revenue and EBITDA of $2.8bn and $510m (18% margin), respectively.

We utilized several peer sets to arrive at what we believe to be a fair multiple for ADESA: used car dealers, niche auto services and auction companies and other auction platforms.

ADESA

         I.            Traditional used and franchise car dealers currently trade at 8.3x 2021 EBITDA (net of floorplan debt) and while they share some of the cyclical elements that KAR possess, we believe they are inferior businesses given a more fragmented marketplace, a less differentiated product, lower margins, more limited online presence and are likely overearning.

       II.            Niche auto service companies such as LKQ (auto spare parts dealer) and Monro (auto repair shop operator) are attractive businesses with high returns, reasonably high barriers to entry and pricing power. On average, these peers trade at ~12x 2021 EBITDA.

      III.            Auction platforms such as eBay (general merchandise) and Ritchie Brothers (industrial equipment) trade at 12x and 18x 2021e EBITDA, respectively. Each of these businesses, like KAR, have network effect driven moats. KAR’s growth profile is more similar to that of eBay but its favorable industry structure is more akin to Ritchie Brothers.

     IV.            Salvage auction companies Copart and IAA (which was spun out of KAR in June 2019) currently trade at 22x EBITDA. Like the wholecar industry, the salvage auction industry is a duopoly with formidable barriers to entry due to sticky relationships with insurance companies in need of land for storage and liquidity for asset disposal. The salvage auction industry is far less cyclical than the used car industry as car accidents – which drive volumes – take place in good and bad economic times. This more muted cyclicality garners a much warranted premium multiple relative to the wholecar auction industry but provides a helpful reference point.

AFC

         I.            Auto-focus lenders Ally and Santander Consumer currently trade at 7x and 6x 2021 EPS and 1.2x and 1.75x tangible book value. (EPS multiples are artificially low currently due to outsized gains related to used car pricing). We believe AFC is a superior asset should trade at a premium to these peers given higher ROEs despite lower leverage, lower charge-offs and less rate sensitivity due to a high mix of non-interest related origination fees. Note, Santander Consumer’s trading multiples are currently elevated by about 10% due to a proposal by Santander to acquire the 20% of the business is does not already own.

Sum-of-the-Parts Value: Base Case

Based on the peers above, we arrive at a blended multiple of 9x EBITDA for KAR, a slight premium to auto dealers and well below other auto-centric service and auction companies.

Sum-of-the-Parts Value: Upside Case

In our upside case, we explicitly value KAR’s dealer-to-dealer business, BacklotCars, rather than embedding it within our ADESA value. We estimate Backlot will generate ~$80m in 2024 EBITDA, based on 800k units sold at a $400 RPU and 25% EBITDA margins. Note, KAR management guided to $100m of EBITDA based on 1m units sold within four years of acquisition. In our low case we assume 15x EBITDA for the business, which we view reasonable relative to >20% growth profile. Another way to frame it is to apply ACV’s current valuation EV/unit sold of $7m (to account for size differences), which would imply $2bn of value for BacklotCars today. While we are not suggesting ACV currently trades at a reasonable valuation, the disconnect between ACV’s value and KAR’s is stark: applying ACV’s valuation to KAR’s dealer-to-dealer business implies core KAR is trading at just 3.5x 2021e EBITDA and 3x “run-rate” EBITDA despite, which we view as far too pessimistic.

Risks

·         Decreasing Reliance on Auctions by Independent Dealers

·         Long-Term Health of Car Dealers (i.e., KAR’s customers) 

Catalyst

·         Operational execution under new CEO

·         Investor Day

·         Acquisition of company