KAR Auction Services: A “new” KAR offered at a bargain price
After completing the sale of its physical auction business, KAR Auction Services, Inc. (NYSE: K.A.R.) held a positive update for investors on the outlook for the “new” KAR. This covered its digital auction operations between dealers and its car financing plan funding, as well as long-term P&L projections through 2025. While a potential macroeconomic slowdown poses a near-term headwind, the secular growth trend remains intact, particularly in the digital space. Additionally, KAR continues to hold a strong competitive position as the second-largest provider of full-car auction services, driving strong pricing, margins and free cash flow throughout the cycle. With KAR stock heavily discounting negatives at a cheap price of around 9x EV/EBITDA, despite the potential for a near doubling of EBITDA through 2025, I like the risk/reward ratio at these levels.
The Digital Dealer-to-Dealer is the main driver of growth
Success Sale of ADESA means that KAR is now focusing more on the more agile and lightweight digital model. According to management’s updated estimates, the market opportunity is huge with approximately 10 million addressable annual transactions for digital resellers. This number includes 40 million and 20 million retail and wholesale used vehicle transactions, respectively, with over 100,000 market players on both the buy and sell side (e.g. dealers, salespeople and buyers).
KAR estimates its remaining potential annual unit market opportunity at 2-4 million non-lease vehicles and 2 million repossessions. I wouldn’t be surprised to see that number grow even more in the years to come, as the industry accelerates its move online every year. From ~4% digital in Q4 2019, digital contribution reached ~13% in Q1 2022 amid post-COVID tailwinds as well as improved transparency/trust offered by the online channel.
Reflecting management’s optimism for digital between dealerships, revenue growth by segment is now guided to reach an impressive CAGR of 30% (excluding revenue from purchased vehicles) through 2025 – an acceleration of growth compared to recent trends. There is also a margin opportunity here – the consolidation of CARWAVE and BacklotCars in the US, which is expected to be completed later this year, is set to also drive expense reductions. Additionally, consolidation efforts are underway for the TradeRev and ADESA Canada digital marketplaces – the vision is to have a single online site providing access to the entire Canadian buyer base, which, if is completed by 2023, is also expected to deliver margin benefits.
That said, dealer-to-dealer operations will likely remain under pressure in the near term due to low dealer inventories due to challenges in new vehicle production. Still, organic unit growth of around 6% in the first quarter of 2022 indicates the resilience of demand, and as supply chains recover over time, structural tailwinds should support the revenue target. medium term.
Auto finance remains strong in the face of a cycle of rising rates
Even with rising rates, KAR’s Automotive Finance (AFC) results remained strong thanks to higher digital channel penetration and resilient dealer profitability, both of which kept charges at very manageable levels. That said, the continued pressure on wholesale volumes is concerning, particularly in the second half of this year and possibly well into 2023 as interest rates reach record highs. Yet KAR has guided a revenue CAGR of around 11% through 2025 within the segment, alongside an EBITDA CAGR of around 5% – a potentially achievable target if the contribution of revenue-based fee > 55% (in accordance with the implementation of the new Link Pay program) is achieved. The ramp-up of royalty- and product-based revenues will be key – these revenue streams are less cyclical and should insulate the segment should a moderate used-vehicle price scenario materialize.
An update of the positive net P&L
KAR has also introduced several new mid-term targets to 2025, starting with a revenue CAGR of approximately 13%, which will be complemented by cost reduction initiatives to generate an EBITDA CAGR of approximately 20% (excluding investment gains) or ~$500 million at mid-term. EBITDA term. In total, KAR is also targeting an accumulation of more than $700 million in cash from operations over the 2022-2025 period. Beyond growth in the core auction business, a cyclical upturn in non-lease vehicles and market share gains in high-growth digital dealer-to-dealer wholesale auctions present an advantage for these objectives. Somewhat surprisingly, management is sticking to its forecast of $265 million in EBITDA this year – a major positive given that this implies a ramp from Q1 2022 levels despite volume issues. (expected due to ongoing rate hikes).
On the margin side, KAR has targeted significant support by reducing expenses, building on the reduction of approximately $30 million in general and administrative expenses by the end of 2022. This implies a slowdown in the G&A and depreciation growth at a cumulative rate of approximately 8% through 2025, as well as base expense growth of approximately 15%. Judging by the optimistic comments about cost cutting and long-term growth rates, there could also be room for further cost reductions, if the cost inflation backdrop persists. That said, I would be on the lookout for negative reviews in the coming months on further new vehicle production shortages caused by supply chain disruptions. Investors willing to wait a few quarters, however, could see a recovery, thanks to broader wholesale market improvement and operating leverage.
“New” KAR on sale at a great price
With the sale of KAR’s US physical auction business to Carvana now complete and dusted off, the company now has a more streamlined operating structure and a cleaner balance sheet, enabling debt repayments longer term and a growth in mergers and acquisitions in the digital auction space (commercial and dealer-to-dealer). Mid-term P&L targets also look good, helped by KAR removing more costs from the model (in addition to ~$30m this year), resulting in strong earnings growth over the next few years.
With a cyclical recovery in trade volume also on the horizon and digital reseller-to-reseller business positioned to capitalize on secular growth trends in many adjacencies (e.g. retail refurbishment), I suspect the ability to KAR’s gain will surprise many in the years to come. While KAR will face headwinds in the industry as the macro gets tougher in the coming months, the stock has likely discounted most of the negatives at around 9x EBITDA, in my view. With EBITDA still on track to nearly double through 2025, KAR offers a compelling entry point for patient investors looking to weather short-term headwinds.