Should You Invest in This eBay for Cars?

Mark is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

KAR Auction Services (NYSE: KAR) is one of the largest domestic providers of vehicle auction services. It derived 54%, 36% and 10% of its fiscal 2012 revenues from whole car auctions, salvage car auctions and vehicle floor plan financing, respectively.

Of its three segments, the whole car auctions segment is the most cyclical, depending on used vehicle sales which in turn are driven by new vehicle sales. Despite this, KAR’s whole car auctions segment provides a large existing client base and strategic locations for cross-selling to customers in its salvage car auctions and vehicle floor plan financing segments.

KAR’s salvage car auctions segment, operated under Insurance Auto Auctions (IAA), combines the best of both worlds. It has competitive advantages that keep competitors at bay and positive demand drivers supporting near-term growth.

Competitive edge of KAR in the salvage car auctions space

Unlike auctions of paintings or antique vases, vehicles cannot be placed in any storeroom. Salvage car auction operators require a sufficient quantity of lots located across the country to facilitate the efficient hauling and holding of salvage cars. New entrants face an uphill challenge finding new areas to build holding lots.

Another advantage is that insurance companies are the key suppliers of KAR's salvage car business. Most of these large national players prefer to do business with car auction companies of similar scale and reach across the country, like KAR.

Furthermore, IAA is the only salvage auction company in the country which offers buyers both physical and live online purchasing opportunities. IAA’s i-Bid LIVE platform, providing live auction internet bidding for salvage vehicles, allows potential buyer to see vehicle images and listen in to the auction event "live."

Short-term growth driver: salvage car auctions

First of all, insurers are no longer the sole source supply of salvage cars. KAR is getting a bigger share of its salvage car auction business from car dealers, charities and consumers themselves. According to KAR’s 10-K, only 30% of vehicles de-registered annually are sold through salvage auctions, with insurers accounting for the majority of sales.

Secondly, the average ownership period of a car is now at an all-time high of 10.8 years as  of 2012, according to the results of a study by Experian Automotive. 

Last but not least, recycled parts from salvage vehicles are gaining an increased acceptance within the collision repair industry. Alternative parts utilization levels have risen from about 25% to above 30% in the past decade, according to KAR’s most recent investor presentation.

Long-term growth driver: vehicle floor plan financing

KAR runs its vehicle floor plan financing segment under Automotive Finance Corporation (AFC) and works with independent used vehicle dealers. While AFC accounted only for 10% of KAR’s total revenues, it generated more than a fifth of KAR’s adjusted earnings before interest, taxes, depreciation or amortization (EBITDA). AFC delivers superior margins exceeding 60%, compared with margins in the 20%-30% range for KAR’s other two segments.

Although KAR grew its loan transaction by a four-year compound annual growth rate of 11% from 799,000 units in 2009 to 1.2 million units in 2012, loan transaction volume is small compared with about 14 million independent dealer used car sales in 2012. With a network of 11,000 dealers and more than 100 physical locations, KAR has the ability to grow AFC’s contribution through further market penetration.

KAR guided for full year fiscal 2013 earnings per share to increase by 24% year-on-year to $0.82 per share based on the lower end of its estimates.

Peer comparison

KAR’s peers include Copart (NASDAQ: CPRT) and LKQ (NASDAQ: LKQ)

Unlike KAR, Copart is primarily focused on the salvage vehicle auction market. Also, while KAR is still very much a North American play with all of its revenues coming from the U.S. and Canada, Copart ventured into the U.K. in 2007 and has recently expanded into Brazil, Germany and U.A.E. While other investors might favor the international growth angle for Copart, I still prefer KAR over Copart.

KAR, as a pure domestic North American play, should benefit from the historical high car ownership period driving new vehicle sales and salvage car auctions. Another key factor in choosing KAR over Copart is that KAR sports an attractive 3.4% forward dividend yield, while Copart does not pay any dividend. Copart does not provide any forward-looking guidance, but the company grew its revenue and earnings per share by 12% and 4%, respectively, for the nine months ended Apr. 30.

LKQ is a distributor of alternative repair products, including salvage vehicle parts, to professional repair shops. Similar to KAR, relationships with insurance companies and physical locations are key drivers for LKQ’s business. LKQ increased its share of insurers’ repair programs from 40% of its fiscal 2008 revenues to more than 50% of its fiscal 2012 revenues through the provision of free quotation services and total loss vehicles disposal services.

With over 300 facilities located across the U.S. and Canada, LKQ has an edge over smaller players as its customers prefer to deal with the company because of its national footprint. LKQ raised its organic revenue growth guidance for the full year of 2013 from 5.5%-7.5% to 6.5%-8.5%. This came on the back of a record quarterly revenue of $1.2 billion for the first quarter of 2013. Like Copart, LKQ does not pay a dividend.

Conclusion

I like KAR for its market leadership, operating the top two players for whole car auctions and salvage car auctions in North America. It is also valued at a slight discount to its peers with a forward price-to-earnings ratio of 16.6. Despite this relative undervaluation and a 3.3% forward dividend yield, KAR is still overvalued on an absolute basis with a price/earnings to growth ratio of 1.35. I will recommend investors to put KAR on their watchlist and consider taking a position if it moves below 1.0 times price/earnings to growth.

While used car auctions are an interesting play on the auto market, it's important not to neglect the emerging market opportunity facing the auto manufactures. China is already the world's largest auto market – and it's set to grow even bigger in coming years. A recent Motley Fool report, "2 Automakers to Buy for a Surging Chinese Market", names two global giants poised to reap big gains that could drive big rewards for investors. You can read this report right now for free – just click here for instant access.


Mark Lin has no position in any stocks mentioned. The Motley Fool recommends Copart and LKQ. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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