Description

KAR Auction Services is still down -32% since the market’s Feb 19 highs (and 43% from its own 52 wk high) and has only begun to recover off recent lows despite vastly improved liquidity and sales volumes that are +175% from trough levels seen in late March as the country shut down.  In short, survival is no longer an issue, but shares are priced only a few dollars above levels at which liquidity was a significant concern.  While I would have loved to get this posted late last week at better prices, at $15.80, with a large convertible preferred investment just made by Apax/Periphas, the risk/reward on KAR is still skewed significantly to the upside as valuation largely discounts the operational concerns of 2018/19 and the business should see a recovery to normalized volumes in the next 12-18 months as states re-open and car buyers return to normal life…in fact, with many consumer wallets tight, used cars could see a strong comeback, a benefit to KAR.

At 7x diluted (incl. convert) normalized EBITDA, unless you believe the US stays in a state of lockdown for 9+ months more, KAR now has minimal/no risk of distress.  My DOWNSIDE case assumes we see EBITDA at the midpoint of prior 2020 guidance by FYE2021 and KAR trades at 8x EBITDA, below historical levels and by no means a stretch valuation, which represents almost 20% upside from here.  In my BASE case, KAR exits COVID hangover having achieved some margin improvement from permanently removing some overhead that is currently furloughed.  This would allow them to achieve 2021 EBITDA above the midpoint of 2020 guidance.  At 8.5x EBITDA, shares are almost 40% higher.  I view even my UPSIDE case as achievable if pent up auto demand and the large fleet of vehicles that has been piling up on yards the last two months flows through faster than expected, but conservatively I think there’s an easy 40% upside as investors look towards 2021 earnings

*Because the convert will be used for WC, which will come back to KAR as cash as business ramps back up, I treat the $550mm investment as an offset to gross debt

Brief Business Description:

I’m not going to spend much time here as prior writeups addressed this in detail and the most important change in the story now is that shares are still cheap while the concerns around leverage and liquidity have been solved…

KAR is an auctioneer of used vehicles that operates in the US, Canada and more recently, Europe.  They operate physical auctions, online only auctions and simulcast auctions that run both physical and online.  They also offer services to customers like minor repairs and paint, key cutting, title, transportation and financing through their AFC division.  The business is now split about 45% of revenues earned on auction fees, 55% earned on ancillary services.  Their buyers are national and independent used car dealers and the sellers range widely from OEM FinCos, rental agencies, repossession cars and charity donation vehicles.  The vast majority of their business is a fee-only business in which they do not take physical ownership of the vehicles, but earn a marketplace fee. 

COVID Impact and Recovery

KAR went from a pre-COVID business with 74 locations selling almost 3.8mm vehicles annually with 60/40 split of online/physical auctions to shutting all physical auction presence in late March and moving entirely online, selling at a run-rate of only 1mm vehicles annually.  At the height of COVID in late March, the company had $350mm of available cash, but was burning $25-$30m per week while having to post $100mm of collateral for their AFC securitization facility…things were looking grim.  By the Q1 call, cash was down $100mm, though mgmt. had furloughed over 70% of the workforce and begun to achieve cash flow breakeven at only 20k cars/wk, ½ the volume levels pre-COVID. 

By mid-May, as volumes picked up to 45-50k cars/wk, KAR was even generating positive weekly cash flow and continues to do so despite generating RPU at ½ normal levels (~$450/car) due to most ancillary services (body shop, key cutting, etc.) being unavailable; however, shares were still languishing as cars were piling up, locations were not yet open and the market was concerned about the significant cash needed for working capital to get back to full operational levels - welcome Apax/Periphas strategic investment. 

Apax/Periphas Investment

On May 26th, KAR announced a strategic investment of $550m from Apax Partners and Periphas Capital to be used for working capital and continued investments in KAR’s technology platforms. Pertinent terms are below:

This facility is too large for KAR’s near-term needs, according to the company, but puts significant liquidity in place that supports operations (and hence the stock price), which gave us confidence to buy more aggressively at levels below the current price and provides security to increase ownership should shares dip for any reason in the near-term.  Apax will get a board seat as well as a non-voting board observer while Periphas will get a non-voting board observer.  It should be noted that Brian Clingen, former CEO of KAR when it was owned by Kelso/GS Capital, is an advisor to Periphas, while Periphas Capital founder Sanjeev Mehra was on the board during the same period of PE ownership.

This was not a cheap solution for KAR, but given the cash and leverage position in which the company finds itself as the world begins the COVID thaw, bringing in a strategic investment was a wiser decision than issuing stock publicly as it shows that sophisticated investors who know the name well are willing to support the company at a conversion price that was 40% higher than the day before the paper was issued

Leverage, Covenants

KAR’s current 3.8x leverage is greater than I would like to see and higher than management’s target level of 3.0x.  Obviously we are in extraordinary times and this level will go up again this quarter given 1Q20 operations were only impacted for a couple weeks and 2Q will see the brunt of the impact.  KAR amended its existing credit agreement covenants on May 1st to provide a full covenant holiday until 3Q2021, which should allow them to easily get operations back in order and clear their 3.5x Sr. Secured Leverage covenant.  As a reminder, KAR does not have any debt maturities until 2024 and has not drawn on its revolver.       

Management and Insider Transactions

As anyone who has seen my prior comments on KAR will know, I don’t love the management team of Hallett/Loughmiller.  I view them as the opposite version of that old Buffett quote on good management/bad business, these guys are a bad management team that has tackled a good business, or said another way, they have succeeded in spite of themselves.  With Apax and Periphas in place as sizeable owners that want to see significant upside to their $17.75 buy-in, I think we as passive equity owners are finally in a position that either this business grows, improves margins and garners an appropriate multiple (9-11x EBITDA IMO) or these investors take action against mgmt. 

To Hallett and Loughmiller’s credit, they too believe the stock is cheap and made large open market purchases of KAR stock in early March at levels 7% and 16% above current price, respectively.  These were their first purchases since KAR emerged as a public company.  You could say cynically that just speaks to their intelligence given COVID was very much on the horizon at the times they purchased, but I would say after hearing the 1Q call, it reflected their belief that the share price was not reflective of results that were outperforming their expectations in Q1 prior to COVID hitting.

Final Thoughts

Anyone who has followed this name for the last couple years knows this has been a popular “value” and special situation name that has frequently disappointed around earnings as well as not reaching its full potential on margins or free cash flow for various reasons that seemed like an excuse whack-a-mole. In the mid-$20/share range and 8.5x or greater EBITDA multiple, investors needed to see delivery on promises of margin expansion, TradeRev volume growth and returns on tech investments, all of which underwhelmed.  However, at $15.80 with liquidity no longer a concern, no near term debt maturities and a path towards re-opening in most states, all you need to see is volumes go back to the neighborhood of 2019 run rate and there is major upside.  If we get surprised and mgmt. has in fact reduced the structural cost of running KAR and convinced existing buyers that online is the wave of the future, I believe we could see more auctions running, better targeted buying and selling and significantly lower operational costs that will drive better margins, more cash flow and a higher multiple.  

Catalyst

States re-opening, physical auctions back up and running

2Q disaster results behind us, market looks towards 2021 recovery