Going Private: Adesa To Merge With Unlisted Insurance Auto Auctions

| About: KAR Auction (KAR)

As you probably saw in the headlines Friday, Adesa (NYSE:KAR) which runs used vehicle (late model and salvage) auto auctions and finances used vehicle inventory in the U.S. and Canada, is merging with Insurance Auto Auctions (which only does salvage auctions).

I’m not going to regurgitate the details of the transaction provided in the press release. Only to say that at first blush, the price seems reasonable for shareholders. My gut reaction was that they were announcing this right before the holidays, hoping investors wouldn’t notice the modest 10% premium to its previous share price. But at the $27.85 tender price, it represents ~$2.5 billion in market cap (remember you calculate a market cap by taking the number of shares times the stock price). And including the assumption of debt, you’re looking at a $3.7 billion transaction.

Now over the last twelve months, Adesa has earned nearly $250 million in earnings before interest taxes depreciation and amortization (we use a big acronym known as EBITDA). This basically is a simplified way for us to calculate cash flow, getting rid of expenses like depreciation and interest, which are not always reflective of future expenditures. Think about the ownership in your house. Maybe the value of your home will “depreciate,” or go down. But it also may go up. It really just depends what Adesa is depreciating in these figures.

At the same time, EBITDA, still uses the reported operating profits, instead of trying to look at the reported cash flow statements (which like I said can be distorted in some periods due to radical swings in working capital). I’m not saying EBITDA is perfect, but if we are going to try to discuss “cash flows” instead of earnings (and you’ll see why we need to this in a minute) it is probably better than the cash flow statement.

What I really want to measure is my return on investment (remembering our lessons from earlier this year about separating the purchase price from the financing decision). As a result, I want to exclude interest expense, and simply look at the total price I paid for this business (and the return I should then receive). Well, if I paid $2.5 billion for the stock, I paid ~10x the EBITDA Adesa has generated over the last twelve months (trailing twlve months EBITDA). Another way to think about this. If I bring nothing to the table, and EBITDA stays the same (for infinity and beyond) I should expect (the inverse of the stock price multiple) roughly a 10% return from this investment.

However, that is assuming I just bought the stock. As I said above, the investors also assumed some debt. At $3.7 billion total purchase price (debt and stock price), it represents a ~15x multiple of the last twelve months EBITDA, or a 6.7% return. Naturally, you hope the merger creates some synergies and that earnings (revenues) grow.

Now I checked with Gary Prestopino from Barrington Research, who I think knows the salvage space better than anyone. He indicated that when Insurance Auto Auctions went private, it was done at a 10.1x the trailing twelve month EBITDA multiple. So whether we are looking at the purchase price (with or without debt) based on that historical precedent, I don’t think we can come to the conclusion that these investors are getting the stock “for a steal.” Like I said, it was just my first gut impression given it was announced the Friday before Christmas.

Beyond, the purchase price. I can only throw out a few questions about what this might mean for the industry. First of all, Adesa has been better known for its late model (3 or 4 year old) used vehicle auctions. As I said after touring the NACE (National Association of Collision Experts), the impression I got from the body shops and players in the salvage industry, was that Copart was the “high end” auction company in the salvage auction space, offering a tremendous amount of service and technology. Insurance Auto Auctions, was on the other side of the pendulum, basically being the “low cost” or value player in the space. This left Adesa and a rather struggling Manheim (on the salvage side) of the market stuck in the middle with less definition.

The merger of Insurance Auto Auctions and Adesa will likely bring more focus to Adesa’s salvage sites (as I suspect the approach, management and processes become more similar to Insurance Auto Auctions). But, what does this mean for the rest of the industry? At first blush, I think it continues to bifurcate the market, as some players gravitate toward the value offering, and others move to the full service. So does Manheim even stay in the salvage side of the market with the boundaries becoming more clearly defined? It is something only time will tell, but I can tell you this, I think it will put the pressure on Manheim to decide what (value or high end) if any direction they will take with salvage auctions.

On the flipside, given Insurance Auto Auctions expertise on the salvage side of the market, does it mean they bring some of their practices/processes over to the late model used vehicle auctions, or do they fumble on the late model vehicle side of the business losing share to a rather strong Manheim? Or does Adesa/Insurance Auto decide to exit late model used vehicle auctions entirely? In addition, Adesa has operations in Canada. Insurance Auto Auctions (from the best I can tell) does not have operations in Canada. So does this bring an international expansion opportunity (for Insurance Auto Auctions to now enter Canada) using Adesa’s late model sites and or expertise into the Canadian salvage market? Finally, Adesa has a finance arm. Something they could probably expand significantly given all of Insurance Auto Auctions relations with independent used dealers.

The bottom line. The above comments are likely just a few ways the (salvage and possibly even late model used vehicle) auction industry environment could change as a result of this merger. Whenever major powerhouses like this combine it tells me two things: 1) the industry is pretty darn mature, and 2) it will likely have a meaningful impact in some way or another on their competitors and customers. So let’s all keep an eye out.

KAR 1-yr chart:

KAR 1-yr chart