Reminiscences of My First Car: Insights on Copart's 1Q'07 Earnings

| About: Copart, Inc. (CPRT)

My first car? A 1972 Oldsmobile Cutlass. Ok, technically, it wasn’t mine. It was my parents’ vehicle. And between my two brothers and I, we would fight it out for who got the distinct privilege of driving the “blue bomber.” Or so we nicknamed this vintage ~20 year old vehicle by the time I turned legal to drive it (well I may or may not have snuck it around the block a few times before reaching the big one six). It’s amazing how we can get excited about things that many others would consider junk. I still remember my buddy being embarrassed one day when he offered a girl a ride home (courtesy of me), only for me to drive up in a cloud of smoke (it needed a new exhaust).

72 oldsmobile cutlass
1972 Oldsmobile Cutlass in all its glory

And yes, it always seemed to be leaking something or needing water or oil, and with all of the rust on the vehicle, you had to worry that one day the right door might have just fallen off. I even seem to recall us putting together by piecemeal some sort of aftermarket radio in the car so we could pick up the FM radio stations (this is long before MP3 and satellite radio kids).

But how could you not love a V8, 350 horsepower “tank” that could barrel through just about anything at what seemed to be almost any speed? And this treasure, the blue bomber, was not only loved by me. My brother told me that after I went to college, the dude that we sold the car to called him up nearly in tears when he got into an accident (totaling the vehicle).

Eventually, like most things, we grow bored with our old toys, and want new ones (I won’t go into the little motorcycle I ended up getting that turned me into a human catapult). So while I had come to consider this (once prized possession) junk, it is truly a case of the blue bomber becoming another man’s treasure. Even after the car was “totaled” (which is the point when the insurance company determines it would cost more to repair the vehicle than what it is/was worth and cuts the owner a check for the value of the vehicle), the parts (remains) of the vehicle then became another persons’ treasure. While I think it deserved an appropriate burial, the blue bomber (even in death), was destined for a greater purpose. In this case, its parts were to be used on other people’s treasures, so they could buy the spare parts from the blue bomber at a junkyard, and fix up (run) their own “bombers.”

In the process of making its way to the junkyard, I suspect the insurance company cut a check to the dude that bought the bomber from us, and then the insurance company had the vehicle hauled to an auction like Copart (NASDAQ:CPRT). There an auction facility, like Copart, probably sold the mangled blue bomber to a “salvage” yard (a nice term for auto parts junkyard) where the vehicle would be chopped into pieces, and its parts sold off to (mostly) collision and repair shops that might need the various parts (like the bumper or maybe even that intense engine).

Although back then, sophisticated yards (that categorize and are beginning to appropriately manage inventories) like LKQ Corp. (LKQX) didn’t even exist, and while Copart has been around since 1982, I doubt Copart was nearly as sophisticated (like have its virtual bidding VB2 technology) and probably had no where near the 123 facilities they have today (and plan to open another 6 – 10 facilities this year), And, most importantly, the insurance companies were by no means as significant of a player back then as they are today. Back then (early 1990s), the insurance company did not play a significant role in where the vehicle was sent for the repairs (Direct Repair Programs I understand were something like 5% of all accidents), whereas today I understand more than 50% of all vehicles that get into accidents are sent to DRP (Direct Repair Program) repair shops.

For those of you playing along at home, you might remember my pieces about DRPs where I explained DRPs are simply programs (requirements) insurance companies put on service repair shops. The repair shop needs to meet certain requirements (like customer satisfaction scores and usage of alternative generic/recycled parts) and in return receive “referral” business as one of the shops in the insurance companies list of DRPs. It is the changed customer base (control from group purchasers like All State, State Farm, and Progressive), that has left me so encouraged with the opportunity for newly emerged national players like Keystone (in the generic parts side of the market) and LKQ (in the salvage and generic parts side of the market) to provide a real network for these customers that would desperately like to see more alternative (generic and salvage/junk) parts be used on the repair of the vehicle. In my most recent quarterly rankings, both LKQ and Keystone made the “elite 5” and have really saved my “performance butt” as my top pick (Lithia) got hosed by Chrysler with too much inventory this summer.

Now some of you may remember that when I was in Las Vegas during SEMA, APEX and NACE (all big impressive acronyms for the various automotive aftermarket association’s industry conferences) in November, I discussed Copart management’s presentation at the Gabelli Automotive Aftermaket Symposium for investors and my subsequent conversations with management on the show floor at the NACE (national association of collision experts).

Specifically, I pointed out Copart’s slide that showed the company controlling some 33% to 37% of the overall salvage auction market already, And if you take into account competitors like Adesa (NYSE:KAR) and Insurance Auto Auctions, “independents” only officially account for somewhere between 38% to 44% (according to Copart’s slide). And if you add in Manheim’s Total Resource Auction Group (which falls into the independents group,) you end up with “hardly any independents left” as Jayson Adair (President of Copart) said on the conference call today. Although Copart management did indicate on the call their belief that they can get to a 50% share of the market at some point.

The bottom line, or so I have articulated with Copart is that the low hanging fruit seems to be gone, and their business is clearly “mature” in nature, and the question simply becomes what next? You almost get the sense that management recognizes this dilemma and is methodically trying to work through it. They also seem focused on only sharing with the investment community what they can and have delivered on, not on speculating about future growth projects (although if you listen closely you get some hints as I discuss toward the end of this note). Copart ended the first fiscal quarter (October 31, 2006) with $313.7 million in cash, cash “equivalents,” and short term investments. On Wall Street, analysts politely say this is a “quality problem” to have (too much money and not quite sure where to deploy it).

BUT, this “quality problem” is more serious than it seems. As I discussed in yesterday’s piece about AutoZone’s (NYSE:AZO) earnings, management teams tend to have a propensity to want to grow for the sake of growth, squandering valuable shareholder capital. The alternative, often is to conserve capital (eaking out every last ounce of cash), but pushing the company toward a very slow (and boring) death cycle. I always tell management teams and investors to focus on the mission of the company instead.

Copart has clearly emerged as a key (if not the) leader in the space. As I discussed when I toured the NACE show floor and talked with players in the collision industry, Copart seemed regarded (in the salvage auction market) as the high end provider, offering great technology, systems and services. Insurance Auto Auctions (privately held), on the other hand came across as being very affordable (the value player in the market), leaving Adesa and Manheim’s salvage auction groups kind of meandering in the middle.

So I have to give Copart’s management a lot of credit. When you reach the “top of the heap” (pun intended), in a rather consolidated market, it just becomes difficult to deploy your capital efficiently. And collecting cash until you figure out what to do with it is far better than squandering it (although I wouldn’t mind some being returned in the form of more share repurchases and/or dividends).

On the “experimental growth” side, you have seen Copart dabble in new areas like MAG, (motor auctions group) where they were trying to have public used vehicle auction sites. It did not work. They shut it down, and incidentally, while management indicated on the 1Q conference call today that same-store sales were up ~8% (year over year), if you were to factor out the MAG revenues from last year, same- store (facility) sales were up something closer to 9% or 10% (courtesy of a question by a really good analyst known as Gary Prestopino from Barrington Research).

Another area where I have been a big fan, has been the company’s investment in lanelogic. But here again, management indicated they have now completely written down their investment in lanelogic (I think I heard a $5 million figure). And absent a new equity infusion by Copart, which sounded unlikely, Copart is unlikely to use (or generate) cash in the future on the lanelogic “experiment.”

Now I talked about lanelogic just Monday (buried somewhere in my thoughts about going to the 30 Seconds to Mars concert), after having a conference call last week with lanelogics’ CEO and President, Bruce Thompson, and Jim O’Brien. During the Copart conference call, it almost sounded like lanelogic (as an experiment) was not working. I contacted Mr. O’Brien via email today about this concern, and this is by no means the case. Lanelogic, at least from the perspective of Jim O’Brien, continues to make traction with dealers. And I should point out that later on the Copart call, Copart’s management team said lanelogic is a viable business, but it clearly is going to require additional working capital.

Copart management simply said they are in the process of securing additional equity infusion (for lanelogic), but that management can not comment on the process. I have said for some time now (in these newsletters) that I do not see the synergy between Copart and lanelogic. Copart deals with old (basically salvage) vehicles, while lanelogic is targeting late model (so 3 – 6 year old) used vehicles. Their key markets, and even technology competencies are different (lanelogic uses American Auto Exchange while Copart uses its proprietary VB2 technology). Copart, is quite simply a source of cash, for what really is a 5 year “hail marry” potentially revolutionize the late model used vehicle industry. I have therefore often said that it seems like a private equity group or potential technology or late model used vehicle auction company would serve as a much better strategic fit for a group like lanelogic (to benefit from both synergies and capital).

While I am on the topic of lanelogic, I should comment about an email I received on them. As you may recall, I challenged all of you (industry participants and shareholders of major industry participants) to find the flaw in the lanelogic concept. I did get an email from a dealer suggesting that the cultural barrier of getting any dealership to relinquish control of their used vehicle department would be almost impossible. And while I tend to agree with the dealer on profitable used departments not wanting to follow the lanelogic system, what about unprofitable dealerships? As he replied back to me, right now the approach in the industry when used departments struggle is to just keep hiring and firing used vehicle managers until you get the right person.

But at some point, I suspect it might be more efficient (easier) for dealership groups (mid to large mega groups) to turn the used function a bit more over to lanelogic for the unprofitable departments, easing the burden on the GM to only have the responsibility of improving the other three parts of the business (new, finance and insurance, parts and service). Of course, here the big problem could become GM’s saying they lost out on the sale of the new vehicle, because they know they can put “silly money” on the used because the car will get so much more than what the Kelly blue book or black book figures are calling for (as one GM recently told me). So even here, lanelogic does have a challenge in breaking down the cultural environment of the dealership (to be able to call the shots on every facet of the business,) but if I see it gaining traction anywhere (first), it is likely in underperforming used vehicle departments of mid to large dealer groups.

In any case, I once again have taken a simple earnings release and turned it into a mini dissertation about the auto retail industry (I kinda enjoy being a student of the industry). I did want to conclude with a couple areas where Copart does seem to be gaining considerable traction and developing growth opportunities (that I think moves them out of this “mature” segment of the market conundrum). First, Mr. Adair mentioned that there are opportunities abroad (to build and acquire similar auction facilities to what they have here in the United States), but he did not want to go into any expansion thoughts for competitive reasons.

In addition, international exports ( a real opportunity in my mind) represented some 27% of the vehicles they auctioned off this quarter. And “intrastate” (meaning within the same state) auction vehicles fell to an all time low of 37%, “demonstrating the efficiency of VB2” as Mr. Adair said on the call. Not to provide too much of an advertisement, but what intrigues me as an investment analyst is the 60 countries (and thousands of buyers) posting a vehicle on Copart’s VB2 facility offers, making the reach truly global. A few months ago I mentioned a comment that a leading economist in the field said about the engineering life of the vehicle exceeding the economic life. The bottom line is that the vehicles we are “scrapping” today can still run. Unlike my blue bomber where the door was practically falling off, today vehicles are often scrapped because the “sum of the parts” are worth more than the whole.

While Copart management said they did not see a correlation with fluctuations in currency, I just think the declining trend in the value of the U.S. dollar (something that is likely to continue as we print more dollars) leaves these older vehicles even that much more attractive to consumers outside of the United States. Remember, something like 9 out of 10 people in the world do not own a vehicle, so the global market remains highly untapped (unlike the U.S. where we average some 1.2 vehicles per licensed driver).

And Copart seems to be establishing itself for people here in the United States to dump their “blue bombers” even if they haven’t been totaled at a Copart Auction and allow international consumers to bid on these 10 – 15 year old vehicles. Everyone from buy here pay here dealers, banks, and rent a car companies (non insurance companies) just seem like “prime pickings” for Copart to expand their services to (while possibly bringing greater liquidity to something like the buy here pay here market). And ultimately helping international customers get behind of the wheel of their own vehicle (versus taking the bus or bicycling to work).

So I’ll end with this thought. Toward the end of the conference call, a caller asked how much of Copart’s business was represented by non-insurance customers (so buy here pay here dealers, banks, etc.) Mr. Adair said it was around 15%. So 85% of Copart’s units going through their auctions are with insurance companies right now. Then the caller said, presumably, it is this non-insurance business that is growing at a faster clip than the 85%, how big (and fast) do you think the non-insurance piece can grow? Mr. Adair said that is the question “we all would like to know the answer to.” Indeed, I think unwrapping the answer to this question tells us if it is more risk or opportunity for the company’s “cash conundrum.”

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