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KAR Auction Services (NYSE:KAR)

Credit Suisse 15th Annual Global Services Conference

March 11, 2013 6:30 pm ET

Executives

Eric M. Loughmiller - Chief Financial Officer, Principal Accounting Officer and Executive Vice President

Jonathan Peisner - Vice President of Investor Relations & Planning and Treasurer

Unknown Analyst

Hello, everyone. Our next presentation is from KAR Auction Services. Presenting with us are Eric Loughmiller, Executive Vice President and CFO; followed by Jonathan Peisner, VP and Treasurer.

With that, I'll turn it over to Eric to head things off. Just a note, there will be a breakout session in the Pine room following the presentation. Thank you.

Eric M. Loughmiller

Good afternoon. As you can see on this slide, we have a number of what we think are key investment highlights, and I'll cover these throughout my presentation. But to introduce the company, the main thing that we're really focused on right now is we're poised to take advantage of a cyclical recovery in used car supply that will impact our largest business unit, ADESA, but let me cover these as we go through.

KAR Auction Services has 3 major business segments. First is ADESA. This is a used car wholesale auction business. It operates in the U.S., Canada and Mexico. We have 67 auction locations, and we operate this business throughout those countries for virtually all the customers. We are #2 in market share. Our largest competitor is Manheim, which is owned by Cox Media. And they have about 50% market share, and we are just under 25% market share. Then there's Insurance Auto Auctions, a salvage auction business. Predominantly, this is the auction of total loss vehicles sold by the insurance companies after they take title following an accident. And, again, this is a real solid business, operates in the U.S. and Canada in 163 locations. And we also operate in a duopoly situation where our key competitor is Copart, which, again, 35% to 40% market share for both us and Copart. The reason we're less specific on market share is there's no industry reporting data, so we kind of have to estimate based upon the number of cars sold as we can find out that information. Then Automotive Finance Corporation, or AFC, is our floorplan finance business. This business is complementary to the other 2. And the finance business operates through 104 loan origination offices, predominately located inside of auction facilities, 4 of which are now at Insurance Auto Auctions locations and the remainder are affiliated with used car auction locations. In this business, we also have a key competitor who's a little bit bigger than us. It's the combination of Manheim's captive floorplan business, as well as an independent known as DSC, or Dealer Services Corporation. They have just rebranded themselves as NextGear Capital. And, again, they are part of the Cox family of companies as well.

In terms of our marketplace, this is really an important slide, and it's traveled around the world. People have used it in actually other presentations, not by our company. There's 272 million vehicles on the road in the U.S. and Canada. We call it North America, but it's really the U.S. and Canada. And with that, at this point, 15 million to 16 million units are being added to the car park through new car sales and about 13 million units per year are actually in the car park through accidents which result in a total loss, cars that are not reregistered for various reasons. It could be an individual that quits driving the car. Due to a death, they may not reregister the vehicle. And of those 13 million units, 3 million to 4 million or about 3.5 million to 4 million end up being sold through our salvage auctions. In addition, we have 43 million used cars that change hands annually. And how do those break down? 12 million, and you see that on the lower left in a salmon color, are C2C. In other words, a consumer sells to another consumer not involving a dealer. Then you have 31 million that are changing hands, involving some type of dealer transaction. And of those 31 million, 8 million to 10 million, the dealer acquires through a wholesale auction, and 20 million to 22 million are dealer trades, taking a trade-in, trading with other dealers, avoiding the wholesale marketplace but doing it amongst the dealer network itself. So it's a very robust population of vehicles with -- again, it's been a fairly consistent number. That number in the car park has been growing over an extended period of time as more drivers are on the road. And through 2008 and 2009, with the reduced SAAR, we saw it somewhat level, but again, it's a slow-growing number now but sufficiently large that we see plenty of cars that are in our marketplace and an opportunity for us to make money selling.

So how do we make money? Well, we make money by charging for any aspect of the transaction we're involved in. On the left here, you see the sellers and on the right, you see the buyers. We draw a fee from each of them in the transaction. In addition, to the buy and the sell fee, we have a number of value-added services that we can provide before auction, predominantly paid by the seller, and that would involve reconditioning, transportation, mechanics, body shop, all of the services we can provide for a car from our own locations with our own employees. And then after the sale, we can do post-sale inspections and a number of other services, transportation, and we can actually recondition the car for a used car dealer that maybe doesn't have those facilities on his lot. So we charge a fee for everything. And then AFC is involved. If they floorplan a vehicle, they charge a fee for providing access to those resources and providing a floorplan receivable to the independent used car dealers.

Who do we do this for? We do this for virtually every consignor. The consignors are many companies you have heard of, and these consignors are utilizing our national and -- our national U.S. and Canada network and a little bit in Mexico, of course. And you can see the insurance companies are the predominant consignors within the salvage business, and they're all listed. I think the important thing to understand is it's not just the sellers having the cars, they're selling the cars where we also have the buyers. We have over 150,000 registered buyers throughout these businesses. And to register, it's not just signing up online. You have to provide credit information, dealer licenses. You have to be eligible to operate in the wholesale marketplace, and we have information on all of these suppliers. We give them a credit limit so that they aren't buying cars they can't afford based on their record and their bank accounts and their credit history. And there's over 110 countries represented by our buyers in 2012. So it's very robust. And so one of the things we say, "Okay. What's more important, the buyer or the seller?" They're equally important. The sellers want to sell where the buyers are, and the buyers want to sell where the sellers are and having them both -- and this is actually a very significant barrier to others getting into the business because you couldn't just move these cars to a field and say, "I'm going to start an auction there," and the buyers show up. So there's really a lot of stickiness to these relationships.

I mentioned early on one of the key factors in our investment highlights is the fact that we're poised to take advantage of a cyclical recovery of the supply of used cars in the marketplace. And really, there's nothing more evident than this chart. We have gone through a very difficult time in terms of the inflows of vehicles into the car park. Following 2008, we saw significant declines in the SAAR. We saw significant retention of vehicles. There was just less flow of vehicles, and that is going to begin to unwind. And, in fact, the reason we know this is off-lease vehicles are a key driver to this recovery. And the key driver here is the fact that 3 years ago, we started to see the SAAR increase and lease penetration increase. And in seeing that happen, we were able to anticipate that 3 years later, there will be more off-lease vehicles. Another factor to focus on is repossessions. The more cars we sell, the more credit that is used. Looser credit standards result in more repossessions. And then we also have a more consistent turn of the rental car fleets of the at-risk vehicles, and some of those will end up in our marketplace.

In the meantime, as we saw those declines, they were, in part, offset by increased dealer consignment cars. And when I say "dealer consignment," that will be a car taken in trade where the dealer decides I am not going to retail that vehicle, or maybe a car taken in trade that he wanted to retail but for whatever reason it's been on his lot an extended period of time and he's saying, "I need to turn this to cash and get another piece of inventory that will sell to my market." So the dealer trades have been a big part, and you see that on this slide. And it's the green, I think. I can't see it from here. And then the blue is your fleet/lease; the red, manufacturers; and you go up, you've got the online and the North American SAAR. But as you can see, that green started elevating to fill that pipeline. And as you look at this, it's important to understand that these balance themselves out. When there's less commercial cars, there will be more dealer consignment cars. As the dealer consignment cars come back, that could or could not put pressure, but we feel we can keep in the industry the level of dealer consignment volumes we've been having because they -- again, we're going to migrate back to a more normal supply situation.

In late 2011, through the ADESA part of our organization, used car, we acquired OPENLANE, which is an online provider of auction services. About 90% of their business is related to off-lease vehicles. And as you can see from this chart, OPENLANE and ADESA combined had over 90% of the OEMs and their captive finance companies as customers. In fact, in Canada, we have 100% of the OEMs. And in the U.S., we have all but 3, 2 of which use their own private label site that they manage themselves, and one of which uses our major competitor. There has been one opportunity to bid on a new platform for GM Financial, and we're proud to report that OPENLANE was the winner of that RFP process. And so we've picked up the General Motors business. As you may be aware, General Motors previously used SmartAuction, which is owned by Allied Bank, previously GMAC, and it was a captive auction site that was run internally. So we're starting to see volume. It's in the early stages because they had a 5-year deal. The Allied Bank's last GMAC portfolios are being sold on SmartAuction, but what GM has been doing through GM Financial will gradually come into the OPENLANE platform.

What's important to understand about this is this is off-lease activity. What happens is, when the car is returned from lease by the consumer and they choose not to buy the car at the residual amount, the grounding dealer gets an opportunity to buy that car at residual. If the grounding dealer turns that down, it then goes to OPENLANE and gets listed. And for a couple of days, 2 to 3 at most, it is offered to the franchise dealers of that brand of vehicle. If it does not sell in those 2 to 3 days -- remember now, it's at the grounding dealer side, it's sitting on a dealer's lot who has chosen not to own the car -- it will then go for a couple of days in what we call an open sale, on OPENLANE, offered to any dealer registered to buy cars on OPENLANE. Any brand, any dealer or an independent used car dealer could buy that car. After 2 days, usually 5 days in total, if that car has not sold, the car is transported to an auction location and now runs through the physical auction network, which was on that chart we showed you. In this case, the fact that we have the upstream private label business or all of -- this runs on a site that if you're a Volkswagen Audi dealer, when you log on, it doesn't say OPENLANE, it says Volkswagen Audi. So it is their site powered by OPENLANE technology. And we run the site, we handle the transaction, we take care of the exchange of money and the transfer of the title. But it appears to be a captive site for the OEM. If the car doesn't sell on that, it does get controlled by the captive finance company or manufacturer and not all of these cars end up at ADESA. In fact, we have about 25% market share and our competitor has 50%. So part of that decision-making is location.

We've now integrated the OPENLANE and ADESA businesses. And beginning the end of this year, there is now 1 site. It's being branded adesa.com. And by the end of the first quarter, you will log in and you will have access to all of the cars offered by ADESA online, which include cars being run through the physical auction lanes and offered online. More importantly, the OPENLANE network will have access to the entire ADESA buyer base, which is significantly larger than the OPENLANE buyer base prior to this integration. So we really think this will be a great opportunity to demonstrate value to our customers. And over time, we're hoping that we can get a greater attachment rate to go to the ADESA auction over our competitors.

Now let me turn to the fundamentals of the salvage business. And in this business, we're talking about total loss vehicles, aged vehicles, vehicles that don't run. And we've seen increased acceptance of alternative recycled parts. As a result of that, and that's in the bottom right, there's been higher demand for these parts without a significant growth in the supply, which has led to very good pricing at the auction. And in looking at this business, we have a number of things. We also have -- about 30% of the vehicles acquired end up being delivered overseas or to a foreign country. I shouldn't say overseas because the largest is Mexico, not much water between the U.S. and Mexico. But beyond that, it's West Africa, some South American countries, Eastern Europe, Middle East. A lot of places these cars go. So there's a lot of support for the pricing that goes well beyond used car values or even commodity prices in this marketplace. And the aging carpark, recently, they've announced that the average car on the road is 11 years old. As a result of that, there's really excellent demand for the aftermarket recycled parts because it's going to be hard to get that 9-year old car parts that are being manufactured currently. You'll probably have to get them in a recycled form. So we've considered this business steady and growing, growing at a little bit lower pace than the cyclical recovery at ADESA but steady growth, and it's had outstanding performance consistently over the last 7 or 8 years.

The IAA platform lives off its consistent margins, and we believe it's a technology leader now. If I go back 5 to 7 years, it was actually considered behind Copart, their primary competitor. We have leapfrogged that gap, especially on the back end. We have matched them on the front end and see ourselves as a technology leader in this business. And we're really proud of our performance there, and it's shown in the number of RFPs we've won and the number of -- and the organic growth we've shown in this business, especially over the last 3 years. And we've also done some acquisitions to fill out the map, and that you see on the right. So we've demonstrated the ability to tuck in these acquisitions, increase their performance and have them be accretive to our performance within usually a year of its acquisition.

One of the things we had to talk about in the fourth quarter is Superstorm Sandy on the East Coast. It was a unique event. It was the most catastrophic event we've experienced in the salvage business. And what made it unique was a concentration of population and the infrastructure in the New York area, New York and New Jersey. As a result, we saw incremental increases in cost for towing. We had to take over 400 acres of temporary land to park the vehicles until we could sell them, and we had to bring in labor from throughout the country. We had over 200 employees that were relocated temporarily. We had to get housing, meals. And as the CEO of that business, and occasionally, we may have had to buy them a beer when they were working 14 consecutive days and they needed to unwind. But all of that increased our cost. And as a result, we incurred a loss of $9.1 million in our fourth quarter, and we will expect to incur an additional loss of $10 million in 2013 as we sell those cars. What creates this loss is the revenue we're able to drive off of the auction transaction is not sufficient to offset the incremental costs we're incurring to marshal those cars, store them, tow them previously. The good news is a lot of this cash was an outflow in the fourth quarter. So it will not be a drain on our cash in 2013, but we will report a loss in our GAAP financial statements.

Our floorplan business of AFC has been just a really great performer. Post-2008 and early 2009, it's been a growing portfolio, had very strong credit statistics. And, again, we operate in a different model that we have 104 loan origination offices where our competitors have tended to close the offices and are using a centralized processing center. So what we think, that's allowed us to gain market share as we've been growing the volumes floored in a period in which the volumes available to floor had been declining. And the number of transaction units, we're very proud of this growth, and we have the capacity to continue lending. I am currently in discussions with the lenders. We have a facility that matures in June 30, 2014. We plan to expand the facility because of our expectations for growth and extend the term beyond 2014. Those talks are going well. We'll have more to talk about, hopefully, at the end of our first quarter and our earnings call.

And this is a huge competitive advantage because these businesses are integrated with ADESA and Insurance Auto Auctions. And as you look at it, the revenue per loan transaction is just another way for us to drive revenues. Of that $156 in 2012, 2/3 is fees and only 1/3 is interest rate spread. So we're actually interest income. In this case, it's a fee-based business. It's just another way for us to add value to the independent used car dealer and draw transaction fee as he's looking to put that car on his lot.

We have a number of opportunities to grow the business. In the near term, it's continue to do what we've been doing. It's more of the same. In the long term, though, we have the opportunity to expand into adjacent markets. This is RVs, power sports, motorcycles, things that are very similar. Heavy equipment. I mean, Ritchie Bros. is at this conference. We're not competing directly with Ritchie Bros. There's a number of things that don't efficiently go through their large-scale marketplace, and we get the opportunity to use our land, use our resources, our Internet capabilities and sell that. We can expand our market to consumers. That is not replacing the dealers. Remember, I told you, 12 million consumer-to-consumer transactions. It's very difficult for consumers to identify each other and then transact. What do we do in the B2B space? We guarantee a check to the seller if the car sells, and we guarantee a title to the buyer. And we do a number of value-added things. Well, we could do those in a consumer-to-consumer transaction, and we're about to pilot that sometime this year in one of our locations because we think there's a demand for the consumer to find a way not to have somebody come to their home and when they get there, have someone say this car is in sound mechanical condition or here's the things we find wrong with it.

And lastly, international opportunities. We have a number of opportunities to take in an asset-like fashion using our technology to enter into those markets, especially in other markets where leasing is more prevalent than it is even in the United States. I don't know if you're aware of this, but in Europe, over 50% of cars bought are leased transactions. In Canada, prior to the depression that we're all going through, or the recession, over 50% of their cars were leased transactions. That's an ideal opportunity for us to introduce the OPENLANE. And, in fact, Jon wants me to say this, so I'm going to give it to him. We have an opportunity with an existing customer who uses us in the U.S. and Canada. They've asked us to propose how we could service them in another jurisdiction, and we're currently in the process of designing that solution. So hopefully, at some point in the future, we'll be able to enter the international markets without having to have an asset-heavy investment.

So those are some opportunities for growth. We have 4 minutes and 40 seconds. That's better than Jim Hallett leaves for me. So I will turn it over to Jon to cover the financials.

Jonathan Peisner

Thank you, Eric, for those 4 minutes and 40 seconds. I'd like to provide you with a very quick financial overview, then we'll take questions. And then following this session, we do have a breakout session.

So Eric took you through our accomplishments by business unit and explained why we feel so confident about the future. And this slide really shows you those accomplishments from a car perspective. You can see, over the last 5 years, that we've grown revenue by 10%, despite a decline in the whole car industry of over 1 million units. We achieved a 400-basis-point expansion in our gross profit margin to 44.6%. And, perhaps most importantly of all, we grew adjusted EBITDA by nearly 30% and expanded these margins by over 300 bps.

For 2012, despite continued softness in the whole car industry volumes, due to our complementary business model, car posted modest increases in revenue, adjusted EBITDA and gross profit. Though net income in 2012 grew modestly, adjusted EPS was down -- EPS per share, excuse me, was down modestly, as in 2011, we benefited from an abnormally low tax rate.

This slide shows you our capital structure as of year-end, and you can see that since the LBO, we've continued to delever. We've gone from about 6.7x at the time of the LBO to 4.6x at the time of the IPO and just under 3.6x as of year-end. Our goal of achieving net debt to -- excuse me, adjusted EBITDA to net debt of 3x remains unchanged. And we did put out a press release recently regarding a repricing and resizing of our Term B facility. And I don't have any updates to that other than just to stay tuned.

And so finally, from a summary perspective, I'd like to recap for you what we have to offer you as an investment. And specifically, with its 3 unique yet interrelated business segments, we have a diverse business model that served us very well, even with the whole car industry declining significantly over the last 2 years. And, in fact, in the 8 years that I've been with the company, I've never seen industry volumes this low in my time here. Obviously, with the cyclical industry rebound that Eric discussed, we feel that ADESA, and probably more importantly, KAR, is very well-positioned to benefit from this upturn.

And lastly, as we've said many times in the past, cash has always been king at KAR. We are laser-focused on generating free cash flow. And we'll use that free cash flow to pay dividends to our stockholders, to delever, and, when appropriate, do bolt-on acquisitions and take advantage of strategic opportunities.

And with that, Eric and I would be very happy to take any questions you may have.

Eric M. Loughmiller

Before we get to questions, one thing, on our free cash flow, 2012 was adversely impacted by higher CapEx as a result of Hurricane Sandy, about $7 million. Our normal CapEx, as I look forward, should be in that $90 million to $100 million range. And, again, that was the abnormal year. 2008, we built a Kansas City facility, intended to be a sale leaseback in the markets at the end of '08. We made a sale leaseback kind of really not economically feasible. So that number was $130 million, but if I take those 2 things out, we operate in that $90 million to $100 million. That's where I expect to be as we go forward.

Question-and-Answer Session

Unknown Analyst

Thank you. There was a question there?

Unknown Analyst

Yes, I was just wondering, what's the incremental margin on that? You were showing 4% projected growth in volumes. So what do the incremental margins look like as you start to pick up that growth across your base?

Eric M. Loughmiller

Well, at ADESA, as we look at it, I don't like to answer the incremental margin because it's more complex, but we have leverage of our SG&A. So on an adjusted EBITDA basis, our expectation is we get volumes back to where they were in the industry in 2009, get our share, but we think we can grow the adjusted EBITDA margins much closer to 30%. In fact, in '09, we were just under 27%. We had a number of cost-saving initiatives that were in process that year. We did not get the full year benefit, and we would have been at about 28% if we'd had the full year benefit of actual savings derived that year. So again, you're looking at -- I wouldn't do it incrementally. We're looking at something in the mid-40s on every incremental dollar of revenue with very little, if any, SG&A increase. So the incremental improvement you see in your question would be because we don't need to add any SG&A to sell another 0.5 million cars.

Unknown Analyst

Other questions? Sure.

Unknown Analyst

As you're paying down debt here, what does that pay-down schedule look like in your minds? And what does that do from an EPS growth rate standpoint?

Jonathan Peisner

What is the what schedule?

Eric M. Loughmiller

Well, we have to pay 1% per year mandatory payments. We have an excess cash flow sweep of about $40 million from last year that gets paid in April. But we've been paying -- voluntarily paying down debt early. I mean, our delever strategy is to get to 3x or less, and then we'll look at it. But until we're at 3x, we felt, as a public company, that was important, and then we'll consider perhaps some investment options that have more strategic value. But the reduction of debt has been our priority, and we're doing it on a voluntary basis. The good news is the amortization is only 1% per year. So when I get to make those choices, I'm not stuck with so much allocated. But the dividend strategy is very important because we think that's a way to demonstrate to investors our strong belief in our cash flows and provide a return and differentiate us as you're looking at companies to invest in. And we're allocating 40% of our current free cash flow for the dividend. We're very comfortable at that level. And as our adjusted EBITDA grows, it turns into cash. We believe we have the ability, if it's prudent, to increase that dividend, but we're not making a commitment to do so.

Unknown Analyst

Other questions? I see we're out of time, so thank you very much.

Eric M. Loughmiller

We will go to the breakout room, if anybody wants to ask more questions.

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