07/16/2018

AFG Quarterly Focus List Idea: KAR Auction Services Inc. (NYSE: KAR)

Overview: KAR Auction Services is the 2nd largest provider of used car auction and salvage auction services in North America and the U.K., based on volume. The company provides a marketplace through 250 North American physical auction locations and multiple proprietary Internet auction venues. In 2017, KAR facilitated the sale of 5.5 million used and salvage vehicles. KAR’s segments are composed of ADESA (Auto Dealers Exchange Services of America), whose customers include sellers such as manufacturers who’ve repurchased off-lease vehicles, as well as car dealers who are turning their used car inventory. ADESA’s buyer customers are licensed franchise and independent used car dealers. The IAA (Insurance Auto Auctions) segment consists of auction services for salvage vehicles, whereby sellers include insurance companies, dealerships, rental car and fleet lease companies. Buyers in IAA auctions include global purchasers who need salvage vehicles to fulfill their scrap demand, replacement part inventory or vehicle rebuild requirements. The AFC (Automotive Finance Corporation) segment provides floorplan financing, loan origination and other services to independent used car dealers in North America. Typical loan terms are for 30 – 90 days at auctions held by ADESA and other auctions. KAR’s sales for ADESA, IAA and AFC represent 56%, 35%, and 9% of total sales in 2017, respectively. We like KAR for the following reasons:

IAA Spin-Off: In late February, KAR announced that it intends to spin-off its IAA salvage auction business in order for both businesses to focus on their separate priorities and boost shareholder value. The tax-free spin-off is expected to occur in Q1 2019. In 2017, IAA reported sales of $1.2 billion, up 11% from the prior year, and 27.4% EBITDA margin, an improvement of 137 bps from 2016. Sales in 2017 were aided in part by hurricane-related total loss vehicle inventory, which helped sales by 3%. The new company will compete directly with Copart (CPRT), which operates mainly in online salvage vehicle auction platforms.

Interest Rates Rise: On March 21, 2018, the Federal Reserve raised the Federal Funds Rate by 0.25% to a range of 1.5% – 1.75%. Interest rates are expected to be raised two more times in 2018 and three times in 2019, making borrowing more expensive compared to 2017. Rising rates may incentivize some consumers to finance used cars, instead of new ones. Jonathan Smoke, chief economist at Cox Automotive says, “borrowers who qualified for a new loan or lease a few years ago are now more likely to buy used.” This is more likely to affect borrowers with subprime credit scores, since interest rates come at a significantly higher cost than borrowers with prime and superprime scores, according to Automotive News. Nevertheless, with borrowing costs rising, the expectation is demand will be stronger for used vehicles and KAR will see increased demand from its dealership customers.

Possibility for Higher Steel, Aluminum price: On March 8, 2018, President Trump announced tariffs on steel and aluminum, though exemptions have been given to most countries since, so negotiations can continue. Should prices on steel and aluminum rise in a substantial and sustainable way, automobile manufacturers’ costs could increase, which may make new vehicles more expensive to purchase. As a result, used cars might become even more popular, which could help car auction companies such as KAR on both volume and pricing.

Catalyst: The main catalyst for KAR is the expected increase in vehicles returned after lease expiration. According to Automotive News, U.S. used car sales will rise in 2018 on additional off-lease returns, while new car volume will decline modestly. KAR expects to provide auction services for its share of 300,000 – 400,000 of additional off-lease vehicles in 2018, a number over the approximately 3.6 million off-lease vehicles hitting the market in 2017. In addition, Automotive News states that dealerships generate higher margins selling used cars than new cars, so dealers will be well-positioned to benefit from an improving off-lease market environment. Moreover, the vehicles coming off-lease have a higher mix of crossovers and SUVs, which sell at a price that is usually higher than sedans. KAR management expects average auction sale price at its facilities to be $18,000 in 2018, up from $17,000 in 2017. The higher volume of cars going through auction at a higher average selling price should bode well for KAR reported sales in 2018.


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