Being and investment successfully launched its Public Active Value fund the third of July this year. We have now invested ~30% of our clients’ commitments in five investments. All investments are predicated on finding companies that are undervalued, and where intrinsic value can be enhanced through operational and strategic change, through active ownership. In the dislocation caused by Covid 19, we have been able to find several cases where the short term Covid impact masks an otherwise strong business with several operational and strategic upside potentials, and whose end market is relatively stable from a cyclical point of view. KAR Auction Services is one example.
KAR Auction Services is up 41% since our investment on July third:
KAR Auction Services (KAR) is an auction-based marketplace for used cars, focusing only on business to business (B2B), i.e., used cars sold and bought between companies (not individual consumers). Typically, the sellers are large institutions, e.g., financing arms of car manufacturers, car leasing companies, car rental companies and larger car dealers (customer concentration is low). Buyers are used car dealers and wholesalers. KAR is the largest marketplace in Canada, and the second largest in the US, and has taken market share every year since at least 2008 (from 21% to 32%). Marketplaces are attractive from a busines point of view in that they have natural oligopolistic forces supporting them: the larger the market, the more relevant the market for market participants, creating a virtuous cycle that crowds out smaller marketplaces. Furthermore, in KAR’s case, the infrastructure behind the marketplace, which is also owned by KAR, requires scale, further improving KAR’s competitive position: parking spaces (real estate to perform repair, cleaning and inspection), logistical capabilities/marshalling, repair/cleaning/inspection and transaction financing (which is based on proprietary data on used car price-points and risk). KAR is purely a middle-hand, and does not take ownership of any cars, which also makes the business a low capex, high FCF business.
The business has a large and important counter-cyclical element. When times are tough, car fleets in operation (e.g., car rental companies) usually must reduce the size of the fleets, increasing volumes in the marketplace. Also, the volume of cars sold is in part largely driven by cars coming off leases. Leasing contracts are usually three to four years, meaning that volumes on the marketplace are driven by leasing contracts signed three to four years ago. Usually, at the peak of a cycle, there is a record number of cars leased. 2019 was no exception, meaning the off-lease cars volumes coming to the marketplace will increase the next two to three years. In contrast, when supply of used cars eventually falls, three to two years after a recession, demand for cars is picking up. This creates a demand-supply imbalance, which increases prices for the cars sold on the marketplace, making it possible for KAR to increase their transaction fees, mitigating part of the fall in volumes traded. Net net, the company is fairly stable over the cycle, with ~10% delta in revenues peak to trough (low point was reached in 2011, i.e., about three years after the great financial crisis).
There are several value creating initiatives. The company has been at the forefront of technological development in the industry, partly by buying tech companies, and offering them to their existing customers. Auctions are still mostly physical and the business will to a large part always remain physical: cars need to be marshalled, buyers still need to collect the cars, and the logistics and pre-transaction services are made more efficient with centralized physical real-estate capabilities. Yet in 2010, the company bought a pure online auction service for cars that are easier to sell, expanding the market to include higher priced used cars from the captive finance arms of OEMs (car manufacturers). Also, the company has made an effort to digitilize part of the transaction busines, something that has been accelerated by Covid (see below). Recently, it acquired TradeRev, a mobile-first solution that caters to the used car dealers (typically the buyers in KAR’s marketplace) allowing these to sell their cars to other used car dealers. Today this market is very limited geographically and to a large extent made through bartering. This could potentially almost double the addressable market for KAR. We believe KAR has a potential to take at least its fair share of this market, given the synergies between the two marketplaces (pricing- and profit-data allowing KAR to suggest dealer on how to buy and sell cars, pre-transaction services, and financing). Another long-term driver of growth is Europe, which they entered a few years ago. They have been very prudent in this regard, but we see an opportunity to build out the same competencies in Europe as in the US in the mid to long term (many of the key clients are the same). KAR is also a recent "reverse carve out": they recently sold off the insurance salvage business. The separation will focus management on the remaining business. The management has set out an ambitious EBITDA margin target of 25% (up from 20%) and have several other profit enhancing levers in place (they recently launched an assurance service for example).
Covid created a temporary shutdown of operations, but volumes of transacted cars have rebounded strongly, thanks to an accelerated digitization of the transaction side of the businesses. As Covid spread, all physical meetings where banned, which created a fall of ~70% of volumes in April. But volumes where not lost. Rather, inventory of cars to be sold was built up. In May, volumes improved, down 35% YoY, but the company was already cash flow positive. In June, volumes of transacted cars were up(!) +8% YoY (while attached service revenues lagged due to lockdowns). This was enabled by an accelerated full digitalization of the auction process. This, together with management’s recent cost cuts, in a business with a very flexible cost structure, will potentially allow the company to reach its 25% EBITDA margin target earlier than anticipated.
The active owner in KAR is the Private Equity firm Apax, one of the more successful large cap Private Equity firms globally. Apax invested USD ~550m to strengthen the balance sheet. It now looks like the company's balance sheet is more than stable, given the swift action from management and the rebound of transacted volumes.
Note: Historic returns are no guarantee for future returns. The value of any investment may fall as well as rise.
