RBA - KAR Auction Services: Cheap Enough To Be Worth The Risk

Summary

• KAR Auction Services has posted some promising financial data as of late, with sales, profits, and cash flows all improving year-over-year.
• There have been some signs of pain recently, and that trend will likely worsen from here.
• But given how cheap shares are, it likely does offer some upside from here.

The automotive space can be a very dangerous market to invest in right now. Because of supply chain issues resulting from the COVID-19 pandemic, the companies operating in this space benefited from product shortages and were able to raise prices significantly for a period of time with the end result being a significant amount of positive cash flow coming their way. But given how high prices have risen and the impact that rising interest rates have had on the demand for vehicles, the pendulum is starting to swing in the other direction. Naturally, investors should be a bit cautious moving forward. But one company that operates in this space that is worth consideration is KAR Auction Services ( KAR ).

Unlike many automotive retailers, KAR Auction Services specializes in conducting used vehicle auctions and related vehicle remarketing services. For the most part, the picture for the company has been quite appealing from a fundamental perspective. But we are starting to see some signs of weakness that could have a negative impact on results moving forward. All their investors would be very wise to keep a close eye on these areas as they develop, shares are also cheap enough, I believe, to warrant upside from where they are today.

Kicking the tires… again

Back in early October of 2022, I wrote an article discussing whether or not it made sense to consider KAR Auction Services from an investment perspective. At that time, I talked about some of the significant changes the business had gone through, the largest of which was a sizable asset divestiture. Following these changes, the company looked de-risked and seemed to offer some nice upside potential for investors. This was based in part on my belief that shares of the company were trading at cheap levels. Ultimately, I ended up rating the company a ’buy’ do you reflect my view that shares should outperform the broader market for the foreseeable future. And so far, the firm is doing just that. While the S&P 500 has seen upside of 5.5% since the publication of the aforementioned article, shares of KAR Auction Services have generated upside of 8.3%.

Even though there are some weaknesses in the automotive space, the fundamental data reported by KAR Auction Services through even the most recent quarter, the third quarter of its 2022 fiscal year, looked bullish. Revenue, for instance, came in at $393 million. That's 13.2% higher than the $347.1 million reported the same time one year earlier. The lion's share of that growth came from the service revenue the company generates. Sales here jumped from $128.2 million to $159.2 million in just one year. This increase, management said, amounting to 24% in all, which was primarily the result of an increase in transportation revenue, and repossession fees and platform fees provided by third parties. The company also benefited from a 31.1% increase in sales associated with its finance operations. This number jumped from $75.6 million to $99.1 million. A 16% increase in revenue per loan transaction and a 13% increase in the number of loan transactions were responsible for this.

Bottom line results for the company also improved for the most part. The firm went from generating a net loss of $26.9 million in the third quarter of 2021 to generating a profit of $0.5 million the same time of its 2022 fiscal year. It is true that operating cash flow worsened, falling from $24.4 million to negative $115 million. But if we adjust for changes in working capital, that number would have gone from $33.5 million to $42.9 million. And finally, EBITDA for the company also improved, inching up from $66.6 million to $69.5 million. As you can see in the chart above, results experienced for the first nine months of 2022 as a whole looked very similar relative to the year prior than results for the third quarter did. Sales were up, rising from $1.09 billion to $1.15 billion. The firm's bottom line improved marginally while most of its cash flow metrics also improved.

This is not to say that everything for the company was great. There were some signs of weakness. For instance, for the first nine months of 2022, the number of vehicles sold on its marketplace came in at only 1.01 million. That's down from the 1.26 million reported one year earlier. Dealer consignment vehicles sold actually increased during this time. The real pain was from a plunge in commercial vehicles sold from 786,000 to 510,000. For the third quarter alone, the number of vehicles sold came in only with 314,000 compared to the 357 thousand reported the same time one year earlier. Even dealer consignment vehicles sold dropped in the third quarter, indicating mounting weakness across the retail vehicle space.

Even though KAR Auction Services is showing some signs of pain, shares of the business do look quite cheap. If we annualized results experienced so far for 2022, we would get adjusted operating cash flow of $353.5 million and EBITDA of $368.4 million. Even if we strip out the preferred distributions that the company owes to its preferred stockholders, distributions that management has been paying in kind as opposed to using cash, shares would still be cheap with a forward price to adjusted operating cash flow multiple of 6.3 and an EV to EBITDA multiple of 7.8. By comparison, using the data from 2021, these multiples would be 7.2 and 6.6, respectively. I also compared the company to three similar firms. On a price to operating cash flow basis, these businesses ranged from a low of 24 to a high of 126.2. And using the EV to EBITDA approach, the range was from 12.1 to 25.5 for the two companies that had positive results. In both cases, KAR Auction Services was the cheapest of the group.

Takeaway

Truth be told, I am not a massive fan of KAR Auction Services. The company is not the healthiest firm on the planet and it's unlikely to generate tremendous upside potential. But it is an interesting firm that's trading on the cheap. This picture could worsen to some degree if market conditions for the company deteriorate further. And investors would be wise to assume that will happen. But because of how cheap shares still are, combined with the fact that the company has managed to pay down a tremendous amount of debt so far this year totaling $600 million in all while also buying back $100 million of stock since the end of the second quarter, I believe that a soft ‘buy’ rating is appropriate at this time.

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