Copart: A Great Illustration of Used Vehicle Disposition Outsourcing

| About: Copart, Inc. (CPRT)
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I don't look at the business as a quarter to quarter event. So where we sit today. We think we're doing well. We think that market share is up. We think that we're going to have good quarters going forward.

Source: Jayson Adair, President, Copart FY3Q conference call June 6, 2007

Copart FY3Q07 Earnings
On Wednesday morning Copart (NASDAQ:CPRT) hosted its fiscal third quarter conference call. The results were reported the night before. Below is a snapshot of the results presented on a "per facility" basis and excludes out extraordinary/non-recurring items such as the company's experimental MAG public used vehicle stores (FY3Q06) and the impact from the hurricane vehicles (revenues and costs).

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The "theme" for the month of June is Outsourcing. We're going to start digging into some principles (ideology) and stuff next week.

But I think Copart is a great illustration of outsourcing (and a potentially emerging one at that) in the area of used vehicle disposition.

What is the need? Vehicle disposition
So let me begin as I often try to do when discussing a company by discussing the need Copart fills in the market. In December I shared a more entertaining story about my "Blue Bomber" (1972 Olds Cutlas) in an effort to explain what Copart does.

Today, I will be more succinct because we have a lot to discuss. The need Copart fills is vehicle disposition. What do you do with the vehicle when no one wants it (well at least to drive around the United States?) This is when Copart steps in.

Vehicles get damaged beyond repair ("totaled") in accidents. Or sometimes they simply get so old that the parts of the vehicle end up being worth more than the vehicle itself. In either case, Copart matches up the people who want these "junk" vehicles with the people that are trying to get rid of it (most of the time insurance companies that had to pay off a claim).
Filling the need

So when a vehicle is "totaled" insurance companies pay the claim to the customer and end up with the salvage (reclaimed) vehicles. When I attended the National Association of Collision Experts [NACE] Convention "OE" forum, the dude from Toyota cited an ADP study that said roughly 16% to 18% of vehicles that get into accidents are declared "total losses." Other studies (like CCC) that use different calculation methods I understand estimate around 13% of all vehicles that get into accidents are declared total losses.

In order to dispose (get rid of) the vehicles, insurance companies turn to auction houses like Copart, Insurance Auto Auctions (recently merged with Adesa), or Manheim.

The auction companies then allow recyclers like LKQ (LKQX) or a smaller entrepreneur (that might own a recycle/junk yard) to buy (at the auction) the totaled or scrapped vehicles, tear the vehicle apart (dismantle it) and then resell parts that can be used in the repair of "salvageable" vehicles that have gotten into accidents.

So Copart fulfills the need of the recyclers/dismantlers (who want the cars for the "scrap parts") and rebuilders (I'll explain rebuilders in a minute) to buy these vehicles at the company's 124 facilities in the United States and Canada or over the Internet through its Virtual Bidding Second Generation ("VB2") Internet auction-style sales technology. Copart also offers services like transportation (towing the vehicle), title processing, special preparation, and storage.

When I sat in Copart's presentation to investors last November (Gabelli Automotive Aftermarket Symposium), management showed a slide that suggested they control somewhere between 33% to 37% of the overall salvage auction market. And Copart's slide showed that Adesa controls 6% - 7%, and Insurance Auto Auctions controls 17% - 18% (and those two companies just merged). This leaves only 38% to 44% of the market being controlled by "independents," which I believe includes the Manheim Group's Total Resource Auctions [TRA].

The problem with doing a good job. . . at some point, your market matures
And this creates somewhat of a problem (well for investors looking for growth). Because Copart clearly already has a dominant position and you can't really call the U.S. vehicle accident market a "growth industry." Having said that, I think recyclers like LKQ still have considerable market share gain (and market "creation") opportunities. But I'd refer you to my notes on LKQ and Keystone to understand the alternative parts opportunity better.

Now when I was at the NACE show I went over and talked with Jayson Adair, the President of Copart and William Franklin, the CFO and I raised this concern specifically. "How do you grow from here?" I said point blank to Mr. Franklin. And he pointed out that the market is growing somewhere between 2% to 4%. Ok, so growth equivalent possibly to the U.S. economy [GDP].

And maybe they continue to gain some share. But market share gains are becoming more difficult and what is happening is new facility growth is cannibalizing existing facility business. Take for example a couple quotes from Copart's CFO William Franklin and President Jayson Adair Wednesday:

Same-store sales were down 4%. Driven by the absence in the current quarter of the hurricane and MAG revenues($7.5 million total) that existed in Q3 of last year. And also by the fact that currently most new stores are opened to relieve capacity constraints of existing stores and accordingly cannibalize sales from those existing stores. Making the same store sales metric less meaningful going forward.

Source: William Franklin, CFO, Copart FY3Q conference call June 6, 2007

The facilities that we will be opening, almost all of them I think, yeah, all of them will be in situations where they will be cannibalizing. And that makes sense. We handle the whole U.S. market, so pretty much anytime we open up a new store it's going to cannibalize one of the stores. I can't think of a scenario where it wouldn't.

Source: Jayson Adair, President, Copart FY3Q conference call June 6, 2007

The bottom line is that Copart already has a sizeable chunk of the disposition services market (in salvage), accounting for some one out every three savage vehicles being auctioned off. And so it becomes difficult to gain share like they used to, because they are the company everyone else is trying to take share from.

So what do you do?

And of course. . . Acquire people with similar skill sets doing it in different markets (like the United Kingdom)
Also, Copart recently acquired Universal Salvage Plc, which has seven facilities in the United Kingdom. Universal, pretty similar to Copart, manages the collection and disposal of accident-damaged cars, commercial vehicles, motor cycles, and low-value vehicles sold on a fee basis, end-of-life vehicles, and abandoned and tax default vehicles.

Universal sells these vehicles at their facilities or online and recycles the remaining vehicles through its authorized recycling facilities.

Management said they could not comment much on the acquisition until the deal receives court approval and is completed (hopefully June 15, 2007). But one thing that did come up on the conference call was management was asked about the ability to sell vehicles in the U.K. outside the U.K., like what Copart does here (remember more than one out of two vehicles go to international customers).

The reason the question came up was because in the U.K. the vehicles have the steering wheel on the right hand side, whereas most other markets (countries) have it on the left. Here was management's response:

Clearly there is a lot of buyers today, you know, Eastern European buyers that are buyers of both Universal and Copart. So I would anticipate that those types of buyers are aware of both of us and they will become more aware of us. Will U.S. buyers be buying UK product? I have no idea. These are things we'll find out over time.

What we believe is that there is an opportunity to leverage the buyer base because I am sure there is buyers that are Eastern European buyers that are buying in the UK that maybe are not aware of Copart. So we think we'll leverage that buyer base, clearly.

Whether or not the US will be in that market? We don't know.

Source: Jayson Adair, President, Copart FY3Q conference call June 6, 2007

The last publicly available financial results for Universal are for the 26 week (interim) period ended October 26, 2006. And the last annual data available was for the 52 weeks ended April 29, 2006. Based on the Chairman's Letter, it sounds like Universal has been undergoing a turnaround. And I suspect Copart management sees a number of opportunities to bring better operational efficiencies.

One area where I think there should already be a cost advantage, however, with Universal is in lower rent. I know UnitedAuto Group's Sytner Group has a lower cap rate (with the sale leasebacks) with their U.K. stores than here in the United States. And so if this is not the case with Universal, I think Copart's management should try to position its Universal facilities over time into more attractive leases.

In any case, I could not tell how many facilities Universal operated during the 26 and 52 week periods mentioned (but it looks like more than the 7 that were acquired).

So below, while I prefer a "per facility" analysis, I have simply displayed the operational metrics (on a percentage basis as currency fluctuations might not make the figures very helpful to today's acquisition).

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Finally, some of you may remember my piece on March 7, 2007 about the differences between the U.K. and the U.S. vehicle market (as Group 1 acquired stores over there.)

The chart below reminds you of a few of the differences and I added one:

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I should also mention that about half of all new cars are bought as company fleet, representing about 17% of the vehicles on the road in the U.K. (according to AEA Technology). From the best I can tell, fleet volumes only represent around 25% to 30% of U.S. new vehicle sales.

Have a great weekend.