Copart: The Car Undertaker - [Business Breakdowns, EP.121]

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0:45This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. This is Matt Russell and today we are breaking down the vehicle auction giant co -part. You may be unfamiliar with co -part, but at the time this recording, the company has a $40 billion market cap. They operate in over 200 locations across the globe and they sell north of 3 million cars per year on behalf of their unique customer base. Co -part is a unique story in a very concentrated industry where they likely have 50 % market share. It's a story defined by evolution. Its founder, Willis Johnson, didn't merely adopt a junkyard mentality.

1:26He was born into it molded by it. To break down co -part, I'm joined by Adam Mead head of Mead Capital Management. We cover all the angles of this unique industry giant. Please enjoy this breakdown of co -part. All right, Adam. Copart is not a household name. So we're gonna start this breakdown a little bit differently than some others. We had Lulu Lemon out today. I think pretty much every one of our listeners is familiar with Lulu Lemon. Copart, not so much the case. It's something as I was doing my research. I read claims such as the monopoly you've never heard of. It's the deepest moat I've ever come across.

2:06Maybe just start out with the actual business of co -part and what they do. Sure. I have to give my friend Andrew Wadney a credit for this term. He calls it the undertaker of the car industry, which I think just encapsulates co -part very well. They facilitate the end of life of a vehicle. So vehicles that are completely total, they need dismantling to maybe used cars that are at their end of life that get resold in the United States or perhaps a lot of their cars end up overseas where repair laws are less strict. So it's this two -sided network between sellers who are typically insurance companies and literally hundreds of thousands of buyers located around the world.

2:56So they sit in the middle of this and facilitate this auction network of vehicles at the end of their life. It's a win -win -win really because they're maximizing the economic value of the vehicle. So whether it's hole or part, that vehicle can be dismantled or sold in hole and it provides tremendous value for both buyers and sellers. So they've been able to extract some nice economic rinse and build a nice little for themselves. And how big is that market that they operate in? So it's hard to pinpoint exactly. Coupart does about three and a half billion annually in dollar sales. They don't like to pinpoint it, which again is a little e to the companies that are always trying to tell you how big of a market share they have, the ones that maybe aren't that strong.

3:46They go out of their way to avoid it. between co -parts major competitor and co -parts, they control about 80 % of the market. Co -parts probably around 50%. So it might be about a seven to 10 billion dollar industry annually. You mentioned it's this marketplace. So maybe we start on the supply side. If I get into a car accident, let's say it's totaled, how is my car getting into co -parts system? What's the process there? You get into an accident, it renders your car undrivable, not necessarily total but undrivable. Insurance company needs to inspect that vehicle to determine the damage, whether it's worth repairing or not.

4:30So that's where co -part steps in. They have relationships sometimes exclusively with certain insurers or certain regions. Let's just say just use round numbers. If your vehicles worth $10 ,000. If it costs them $5 ,000 to repair, they'll pay that $5 ,000. They're out five. But if co -part could sell that vehicle for $6 ,000, now they'll deem it a totaled loss, compensate you for it, and if they could get $6 ,000, now they're only out net $4 ,000. So in some ways it's counterintuitive. Co -part has created this network. The more that they can get for these cars the more liquidity that they create, the more they can create this two -sided network.

5:13It actually increases total rates for the insurance companies because it makes economic sense for them. It costs a lot of money for the insurance companies to come out and inspect the car, do estimates. Co -part is now marketing themselves to the insurance companies saying, hey, we can come in here. we could do this all electronically. We can use in some cases AI, essentially, when an incident tell you whether or not it's worth totaling this car or not. So there's a level of trust there between co -part and the insurance companies. We'll go into a little bit more on the supplier side of things, but quickly when they are assessing that value that they can get, who's on the other side of the marketplace in terms of buying the parts or perhaps buying the entire vehicle, what's the demand side of the marketplace look like?

6:02Literally hundreds of thousands of people access their worldwide network could be a company like LKQ, which is a dismantler. They're buying these totaled cars. They're saying, okay, you know, this thing is worth this much. Copart provides an incredible amount of information for buyers. They do 360 degree photographs of the inside, the outside. So they could assess, okay, if it's front end or rear end collision, okay, I know the engines probably final, and they can quickly estimate how much they can get dismantling the vehicle and selling it for pieces, sell the rest for scrap. There might be buyers overseas.

6:38About two -thirds of vehicles are purchased outside of the state that they're they originate in and that includes about 36 percent international buyers. And so you have this dynamic of the US, just use the US specifically, is a very developed market, a very high vehicles to population ratio. A lot of vehicles make their way to a low vehicles to population ratio countries that are developing. They need vehicles. They might not have the same repair laws that the United States has. And so they're economically valuable, even if they're 20 years old, and they have a couple hundred thousand miles on them.

7:22A lot of Toyota is out there. Yeah, probably. In the outer countries. So I understand it is copart actually doing any of the dismantling themselves or are they largely selling those cars into dismantlers? The business started out the very early days Willis Johnson started out as a dismantler today They're just providing that auction Mechanism in some cases they will they found in particular with the insurance companies companies have now incentivized themselves. They've aligned their incentives with the insurance companies to take for a fixed percentage or a fixed fee. Co -part will take on the responsibility of towing and listing the vehicle.

8:06They're insented, in some cases, they will actually conduct minor repairs to the vehicles to increase that selling price, which then helps them and helps the insurance company. So other than some of that work that they do, they don't really get into that nitty gritty, they're really trying to provide that turnover, getting those vehicles through the system. I highly recommend the book, Junk to Gold by founder Willis Johnson. I mean, he talks about you can see him hit these bottlenecks in the business, vesting in computers. He spent, I think, $40 ,000 creating a system for the California DMV because he was doing 300 cars a day out of this one location back in the day.

8:49And every single car remember has a title. That title has to be tracked and paperwork. And so to his benefit to create the system that also helped the rest of California. And of course now we see this everywhere. Would they integrate with the DMV to make it nice and easy? I've probably waited too long to ask about Willis Johnson. He seems like a large and unlife character, non -traditional backstory. Can you walk through his career when he started the business? How involved he's been? Some of those key decisions he's made over time? His story is the story of the industry in many ways. So it's fascinating.

9:25He did start in the 70s. He actually grew up his father had a call that a dismantling yard, what's a junkyard, where they break down the cars for parts and they would sell the carcasses basically for scrap. eventually he went off, again, the book is just fascinating, but he went off into all different things. He went off to Vietnam, came back, wanted to start his own business. He actually lived in a trailer on one of the properties, his first venture. I mean, really just bootstrap. But he had these ideas, and one of the reasons why he broke away from his father was he had all these ideas were improving the business.

10:04And as when he went away and then came back, one of the places he worked was a grocery store and retail and he could see that a nice, and this is part of his military background too, a nice orderly system, a nice orderly store would increase sales. And so even being a junkyard, he would paint the floors white every single year and organize the rows very cleanly and organize the parts and clean them for people. In the olden days, it was just ripping apart the cars. They were greasy looking for parts. That was part of it. He did specialize. One of his areas was specializing in Chrysler parts. He borrowed this model from someone in LA and elsewhere.

10:53This guy in LA was doing Chevrolet and he said, well, if I can specialize in Chrysler, I can essentially, they were the low value brand, but by specializing it allowed him to create a larger market. And so he supplied a couple of taxi companies with their parts. We saw that Chrysler was shutting down a certain manufacturing plant. We called up Leia Cocca and bought a bunch of parts in bulk. I mean, the early days he would get on the phone and tell everybody in the industry, okay, I have these parts or these parts just came in. And eventually they were faxing something like 8 ,000 pages a day, did various locations, just driving volume.

11:36He was very entrepreneurial. And he was not afraid to take risks. People thought he was crazy when he invested over $100 ,000 in a computer system. Here's a junkyard investing over $100 ,000. You know, probably multiples of what a house would cost back in those days to track his inventory. and you just take that model and just repeat it. They were the first, this online auction bidding, they've had various iterations of these. Today we're up to VB3 virtual bidding three. When the pandemic hit, they were 100 % ready. They did not miss a beat because they had already had it set up. You can see the evolution of the business from just mantling to parts, to totaled cars.

12:24And now today they're moving into more of light accidents or even whole cars, which is one of the reasons why the stock price has really taken off. People have realized the value of their network. It strikes me that the salvage business and selling parts, dismantling for parts, would be pretty capital intensive. If you were calling up a Chevy plant and trying to take some of that inventory off of them, you need the capital to buy those cars upfront. How was the business this finance early on. It sounds like he made a lot of big investments. Did they go public early on? Did they have a lot of financial backers?

13:00I'm curious because it seems like similar to a grocery store. The working capital management, inventory management is super important here. How did they do it in those early days? I don't have the early financials, but he realized that volume was key. And that's why he would pick up the phone and call all of these places, letting them know he had the parts. But But when he specialized, it went from something like $3 ,500 a month, again, show you, this was 40, 50 years ago, $3 ,500 a month to $3 ,500 a day in volume. So he could see that the more throughput you had through the system, the more turnover you had, the better the economics, one of the benefits of specializing in the Chrysler again, it was this third tier brand.

13:48And all the other junkyards were, okay fine, we'll happy to sell you these vehicles that aren't moving on our lots, but combine them and now he's the go -to guy for Chrysler and is able to supply everyone who needs it. So he was very tuned to the turnover aspects of the business. Yeah, it's super important. It makes sense with the grocery analogy, I think, in terms of connecting the two businesses and how important that is. As time has gone on, it seems like the model has shifted. You mentioned they're different than their competitor in the sense that they had the digital auction ready to go. What else different seats them today?

14:31I assume they're not specialized anymore. Maybe they're just specialized across the board. But what else differentiates them from the competition? Their main competitor is a company called IAA Insurance Auto auctions. That business was actually just bought, company called Richie up in Canada. But what's really cool about Copart is the business is the industry in many ways. So studying it can see how it's evolved. Very broad characterization. Copart is the entrepreneurial take risks but slow where they need to be not worried about of pleasing Wall Street. And then you have IAA, which was, okay, we have to do things the Wall Street way, show returns.

15:17It's, I think, most visible in their real estate strategy. So, copart owns a ton of land. The business is called vehicle remarketing. It's a junkyard. That's a nice quaint term vehicle remarketing. No one wants a junkyard in their backyard. So you have this Nimbi effect, not my backyard, where the industry lends itself to a natural duopoly. No one cares, one of a fourth food company goes in next to McDonald's and Wendy's and Burger King, but you're not gonna have five different junkyards in your town. But Copart went about the business buying their land. They saw the value in the business. They're literally thinking 20, 30, 40, 50 years out.

16:06they can see, especially now with inflation, they don't have rental costs increasing because of that, where IAA went initially with a capital light, going to call capital light strategy, of let's lease these parcels of land. And that may make sense on paper, at least initially, but as time goes on, you can see essentially this, I like to think of it as a railroad fax. They have this incredible infrastructure that's not replicable. If you gave me a couple billion dollars and tried to compete with them, I just couldn't do it. One, just the sheer scale of the business and the network and all that.

16:46But two, the business requires land. And that's just part and parcel to the business. It cannot be capital -light. It's most pronounced in areas where hurricanes, for example, where thousands upon thousands of vehicles need to be towed. These insurance companies have huge claims, and the cars just need to get somewhere. That's somewhere are these yards that co -part owns and manages. It's just a crucial part of the business. As they've built the business, they've gained density. It's one of the reasons why they're taking on some of the risk from the insurance company of towing because as they've gone about building the business, they've filled in their network.

17:33and so more yards, less distance for towing, less towing costs and so forth. Willis Johnson was very attuned to the fact that creating this liquidity on both sides was the key to building the business and that's really the playbook. When I think about overall supply, you were describing some of it there, which brought it to light. Hurricanes could cause all this type of damage. which, what are the biggest drivers of supply? When I came into this conversation, I just assumed it was car accidents, and that was primarily where they were getting their supply of cars. But do you have some sense of they move X amount of cars in a given year?

18:13What percentage is coming from accidents versus natural disaster versus cars that are just old age and being retired? They don't give us that amount of detail. Well, about 80 % of their business is through insurance companies, the market, 5 million cars a year or something. But you sort of have this basic formula of miles driven times accident frequency, times accident severity, times loss, or total rate. Just that one segment of insurance losses, there's two aspects of it. But there's the insurance accident loss rates, which is tied to that formula I just mentioned. But even just purely miles driven is going to cause an increase in supply because cars wear out and it becomes uneconomical, at least in the United States to keep maintaining that vehicle.

19:10They do have another aspect of their business that they're growing. They call it blue car, which is banks and finance companies and fleets and rentals. and it's a different market. It's really interesting when you get into these businesses to see all the little nuances. Okay, a car is a car, but so you have the insurance market again, about 80 % of their business. There's five insurance companies in the United States that control 50 % of the market. So you have quite a strong counterparty there on this blue car business. There are thousands and thousands of different banks and all of them have different procedures for how they go about loan payoffs, title transfer, all of these little needy -gritty things that you have to get into in the back end as part of the business.

19:57But that's an area where co -part will start to leverage this network that it's created. So you have this huge number of buyers on the one side that's going to allow them to track these sellers essentially from banks and dealerships. And even for people, I mentioned at the beginning, they do have a consumer facing front. And recently we replaced one of the cars in our household. And I called the copart for a quote, they were pretty low. They were about $500 higher than the dealer, but pretty low. I ended up selling the car myself because I could get more in a private sale. But they were tenacious.

20:36The guy was just following up very regularly. How's this look? They're just very diligent in, again, just looking at it through that model of gaining liquidity for the system. All these different fronts is how they do it. And in some cases, they'll actually buy cars for their own account. I mean, that's one piece of the business you talked about turnover and so forth. In most cases, they are not buying the cars from the insurance companies. They're just acting as agent. In some markets and even in the US they will buy cars just to increase liquidity of their auctions, but by and large the business capital intensive from a standpoint of needing land and so forth, but not fraction buying these vehicles.

21:20I think that's an important point. Yeah, maybe we can jump into that a little bit. In terms of the actual transaction, you have insurance company, approaches co -part, co -part looking for the demand on the other side of the market. What does that look like in terms of the economics that they would keep from any type of transaction that took place and it sounds like they're not putting up any dollars themselves or taking on any risk with ownership of the vehicle. So what does the cash flow flow through look like for coparts specifically? But yeah, so about 80 % of their revenue comes from buyers fees, actually, and only about 20 % from the sellers.

22:03So on the seller side, they take, again, depending on the arrangement with the insurance company or even in a particular market, they might have a fixed fee or a percentage of the ultimate sale that comes to them. It typically works out to $150 to $200 per car for the typical insurance company. The buyers pay a fee. It ranges based on this selling price. So $25 to $800 up to $15 ,000 sales price. So if you work the percentages out, smaller value purchase would be somewhere between 30 to 50 % of the sale price. But as you get into the higher value stuff, it might be 7%. I think that's where it caps out.

22:51It's about 7 % of the sale's price. I assume that this is just the concentration of the supply base versus the fragmentation of the demand base is what drives that 80 -20. Is there anything else going on there? Makes sense just in terms of logic and finance, but anything else that's driving that big Delta between buyers fees and sellers fees. Just a few on one side and many on the other. In terms of costs, some costs are good sold around salespeople and everything else that runs a corporation. But do they take on additional costs you mentioned, they'll take on the responsibility of towing. Is that something that they get paid back for first?

23:32What other costs do they have associated with the actual sale and movement of the vehicle? So the car will get towed to one of their yards. And so they'll have direct, they have a towing fleet of their own or they'll pay a third party to tow the vehicles to their yards. So it's essentially a function of fuel and labor on the land so they don't have to pay for rent there. Building on site, they might have to pay depreciation essentially. They'll do minor cleaning or minor repairs and cleaning of the cars. They'll have to take photographs of the vehicle. They'll have to post it online. You'll have to do the DMV paperwork, which again is largely electronic these days.

24:15If you look at their balance sheet, I think they have about $100 million investment software, capitalized software that they've created in -house to allow all of this. All of these upfront costs get capitalized into an account. It's called vehicle pooling costs. It's essentially an inventory. They do have an inventory line on their balance sheet for those vehicles that they purchase for their own account. but this vehicle pooling cost is essentially their inventory. These costs that they're fronting up front before the sale is made. It takes about 45 to 60 days all in to get a car through their system, which again is the need for so much land.

24:5445 to 60 days for it to turn over, basically come into their system and then be sold. Mm -hmm. Yep. Could take a couple days. Might sit on their yard, and then the insurance company has to do something with it. Okay, we'll give you the go ahead to do this and just running through the DMV, having the auction, having it shipped to the ultimate buyer, generally a 45 to 60 day window. I know it's going to be somewhat of a blurry metric to calculate. I'm curious how much inventory they typically carry throughout the year, how much of that line item, what that looks like compared to revenue or whatever other metric you'd be looking to use.

25:39How often do they get stuck with inventory that just sits on the lot or in the yard? They can turn it over. The vehicle pulling costs that will get assigned essentially to each vehicle that gets turned over. So that's going to move through the system quickly. If you listen to conference calls, I mean, they'll talk about especially now in particular the volatility in used car prices, they are today less willing to take risks with their own account and own vehicles. So it can fluctuate. They don't have traditional turnover in the sense of having a nice clean cost of good sold line and so forth. If you just do a blunt back of the envelope, total inventory, inventory being inventory and vehicle pooling costs, divided by revenue, it's something like 20 days worth of inventory.

26:30And you don't have a cost of good sold figure there. So that's really the capital requirements of the business, the land, and then you have the capital tied up in inventory and some receivables. That makes sense. And not an unreasonable number to have in terms of days. As you look at the margin profile of the business, maybe you can separate the 80 % versus the 20%. But what does that look like on a normalized basis and if you want to separate the two different business lines that would be helpful as well? Look at it in four quadrants. So they have service revenues which are These auctions for others they're acting as an agent and then they have vehicle sales which are Their own inventory.

27:14They're on inventory and then that is further delineated between the US and international US is about 85 % of the business is international about 15%. US, they make about a 40 % EBIT margin. Internationally, it's about half of that, low to mid 20 % and that's a function of density and the scale that they have in the US. Their international markets range from the UK, Germany, some of the Nordic countries, they have some business in Brazil, they haven't built out that density that they have in the United States, But their GNA expense, really interesting to see the business, it's very clear to see how the business is scaling.

27:5910 years ago, GNA expense was maybe 13 % today. They're a third quarter, I think they were down around 5 .5 % for GNA expense as a percentage of revenues. So that's the playbook, is increased that scale. You see yard operations expense decline less so, but that again is a function of density. and they have more locations, less towing costs and so forth. And then just these investments that they've made over time in the business to make it more efficient. They can stick a little camera, middle of the car, the thing takes all these pictures. That might save a huge amount of time compared to the old days where they had to manually do it or not do it at all.

28:39How does the earnings profile of the business comparative free cash flow, we've talked a little bit about capital intensity of the business? But are you seeing pretty good free cash flow conversion any percentages or ways that you think about it and what does the CapEx budget look like on a year to your basis? Is it some percentage of sales or are they having very lumpy big real estate outlays? What goes into that? Cash conversions is good. Again, you read the financial statements. They're very clean. It fluctuates. It's not a business that's nice and linear. I mean, if you get a hurricane, a hurricaneian recently, they're going to invest a huge amount of time and money to get those cars.