Deep dive into the automobile industry, part 2
Comparing salvage car auction yard companies, $IAA and $CPRT
In the last part, we sifted through the auto industry and identified the used car value chain as being more attractive than the new car value chain. Let’s start by taking a closer look at auction yards first. Recall that this is a highly consolidated industry with Copart ($CPRT) at ~50% market share and IAA ($IAA) at ~40% market share. At a national level, this is a duopoly and at a local level, this is a monopoly.
Auction yards – how do they make money?
Auction yards charge a fee per vehicle that they process on behalf of both buyers and sellers. The sellers are mainly auto insurers that are deemed too expensive to fix; the buyers are individual hobbyists, scrap dealers, foreign buyers that sell the cars abroad where safety standards are lower, and dealers that dismantle the cars the sell their parts. Most of the revenues are generated from buyers that are fragmented (~150k) and the remainder of revenues are generated from a consolidated base of insurers (for eg., the top 15 auto insurers in the US account for 80% of the market).
$CPRT has a longer history of being an independent public company than $IAA, which was spun-off from Kar Auctions in 2019; hence, it is easier to examine $CPRT’s financial record. $CPRT has grown revenues by 16% over the last 5yrs and by 11% over the last 10yrs. According to their investor deck, the main drivers of revenues include: 1) miles traveled, which has grown at ~2%/yr over the last 30 yrs; 2) accidents/mile, which declined in 2000s but started to increase again in 2010s due to distracted driving from things like smartphone usage while driving; and 3) salvage rate which is positively correlated with age of the vehicle (has been steadily increasing over time) and with complexity of the cars.
Demand is increasingly moving from physical auction yards to online and both $CPRT and $IAA have developed technological expertise to help with this transition. Economically, online has higher fees than at physical auctions and there is more automation involved online than at physical auctions so margins are generally higher for online transactions.
From Junk to Gold
$CPRT’s founder, Willis Johnson, wrote in the book titled ‘from junk to gold’ about how he went from owning a salvage yard to owning and operating an auction yard and then owning many others as he built up his company. In the book, you learn about why auction yards are an attractive business model – these are marketplaces that facilitate transactions so it is an asset light model. Moreover, there are network effects at the local level as buyers and sellers are attracted to locations that have the highest volumes effectively leading to a winner takes all type situation.
$CPRT initiated consolidation of the auction yard industry, which was followed by others like $IAA. There are a few reasons why $CPRT’s margins look better than those of $IAA including: 1) $CPRT largely owns the land their auction yards are located on whereas $IAA leases the land; 2) $IAA has slightly lower scale than $CPRT as it is ~20% smaller in terms of mkt share; and 3) $IAA has been under-managed vs $CPRT but management is focused on improving margins towards those of $CPRT.
$IAA plans to increase margins by ~10 pnts to 38% over the next 3 yrs implying margins that are ~90% equivalent to those of $CPRT with a focus on making several operational improvements that seem reasonable:
It helps as well that management has developed a track record (albeit short at this point) of executing well on their margin improvement plans as shown below.
Existential risks and others?
As cars get safer due to many technological improvements that may ultimately lead to autonomous driving, the accident rate should decrease over time leading to fewer vehicles processed for auction yards. So far, accident rates have increased due to distracted driving due to higher smartphone usage while driving; however, more safety features may start to reverse the accident rate. Longer-term trends like shared mobility may reduce the overall demand for vehicles by increasing their utilization rate.
The more immediate risks are operational in nature. Since auto insurers are relatively concentrated, losing one of these customers would mean losing ~10% of revs. With $IAA, there is the risk that management fails to follow-through on their plans for margin expansion.
How does valuation compare for $CPRT and $IAA?
$IAA looks considerably cheaper than $CPRT across several valuation metrics, but it has also grown revenues and earnings at a slightly slower rate than $CPRT. Going forward however, $IAA has more potential to increase margins through operational improvements which may add ~12%/yr to shareholder returns over the next 3yrs. This is on top of a 3% FCF yield and 5-10% revenue growth. While $CPRT has executed better historically, $IAA seems like the better valued here with a very similar quality profile.