KARs profitability and cash flow benefits from a fee-based business model composed of three
North American operating segments: ADESA Inc. (used-car wholesale auctions, related
services, and internet-based business-to-business auto remarketing through OPENLANE); Insurance
Auto Auctions Inc. (IAAI; salvage vehicle auctions); and Automotive Finance Corp. (AFC; secured
inventory financing to independent used-car dealers that purchase vehicles from ADESAs
auctions).
The industry?whole-car and salvage auction?is mature, but it is a critical feature of the
US light vehicle market. ADESA is the second-largest competitor in whole car auctions (after
Cox Enterprises Inc.s Manheim unit), but a distant second. Still, these two companies have an
estimated 70% of the market share. The remaining market share is highly fragmented, so
market-share gains and meaningful expansion require acquisitions. ADESA and IAAI also
participate in the Internet-based auction market, and virtual auctions could eventually become a
meaningful substitute to the physical auction industry. ADESAs customer base of vehicle sellers
is mainly commercial fleet operators, large banks, and daily rental companies, so its pricing
power is limited. KARs IAAI unit has a solid position in the more concentrated salvage auction
market (around 35%-40% market share) compared to its primary competitor, unrated Copart Inc.
(estimated to have a similar market share). Insurance companies are IAAIs main
customers.
Lease-adjusted leverage was 4.1x for 2011, and some improvement is possible during 2012 if
KAR pays down debt. Since 2007, when KAR was taken private in a leveraged buyout, leverage has
declined from 6.8x to 4.1x. KAR generated about $169 million in adjusted discretionary cash in
2011; for 2012, we assume discretionary cash generation will be at least $200 million.
Revenue rose about 4% in 2011, despite a decline of 5.4% in ADESA revenues on a 7% decline
in whole car auction vehicles sold. IAAI revenues were up about 15% (revenue and volume
increases); AFC revenue was up 19%. For 2012, we assume ADESA auction volume will remain weak as
a lack of off-lease vehicles and high used-vehicle prices persists, but ADESA should manage a
single-digit revenue increase. We assume KARs consolidated revenues will rise in the
single-digit range because of the diversity of revenue sources. We view the mixed performance of
the business segments as still consistent with the rating. Reported gross profit for ADESA was
flat, around 43% in 2011, and we assume margins will be at least at that level in 2012. Gross
margin for IAAI was also flat, at about 41% for 2011, and rose for AFC. We assume consolidated
profitability will remain at or above 2011 levels during 2012.
Liquidity
KARs liquidity is adequate under our criteria. Our assessment of KARs liquidity profile
incorporates the following expectations and assumptions:
? We expect sources of liquidity, including cash and facility availability, to exceed uses
by 1.2x or more over the next 12-18 months.
? We expect net sources to remain positive, even if EBITDA declines more than 15%.
? Compliance with financial covenants could survive a 15% drop in EBITDA, in our view.
? Because of KARs good conversion of EBITDA to discretionary cash flow, we believe it
could absorb low-probability, high-impact shocks.
We expect KAR to generate free cash flow in 2012. Near-term debt maturities and working
capital requirements are minimal. KAR has access to its $250 million senior secured revolving
credit facility, expiring May 2016. KAR reported the revolving facility had $181 million
available at Dec. 31, 2011. KAR was in compliance with covenants as of Dec, 31, 2011.
Unrestricted cash was about $97 million as of year-end.
Because KAR remains highly leveraged, we believe its use of free cash in 2012 will be mainly
for debt reduction. Still, it is likely to pursue small acquisitions when opportunities arise
for market share gains. We do not expect periodic acquisitions to rise to the size of the
OPENLANE acquisition in October 2011 for which KAR paid $208 million funded in part with
borrowings from the revolver.
KARs business typically generates free cash flow on a rolling-12-month basis. The change in
working capital by our calculation (which incorporates our treatment of AFCs securitization of
floorplan finance receivables as working capital) was a use of $66 million for 2011. KAR has
little inventory, given the fee-based character of its business.
We believe near-term maturities are manageable because KARs $1.7 billion secured term loan
B facility (due May 2017) has a 1% amortization until maturity. The next significant maturity is
$150 million of floating rate notes due in 2014.
KARs AFC unit has a $650 million committed securitization program maturing in June 2014, to
fund its floorplan financing of used vehicles for dealers. KARs AFC portfolio was 99% current
as of Dec. 31, 2011. This securitization is recorded on KARs balance sheet. KARs used-vehicle
dealer financing operation, AFC, by necessity has a high-risk customer base and requires tight
management controls. Lending to used-car dealers is risky because they are often
undercapitalized, and loans to values are high. In addition, its Automotive Finance Canada Inc.
(AFCI) has an amended and restated receivables purchase agreement with C$100 million of
committed liquidity and a June 30, 2014 maturity. AFCIs committed liquidity is provided through
a third-party conduit, separate from the US conduit.
We assume capital spending will be about $90 million in 2012; it has grown in recent years
and is related to ongoing information systems projects and integration of Open Lane.
Recovery analysis
For the complete recovery analysis, please see Standard Poors recovery report on KAR
Auction, published April 2, 2012, on RatingsDirect.
Outlook
The stable rating outlook reflects our opinion that KAR can generate earnings and free cash
flow appropriate for the rating during the year ahead because of its relatively consistent
revenue base and tight financial controls. For the rating, we expect lease-adjusted debt to
EBITDA to remain around 4.0x and free cash flow generation to be positive. For this to occur, we
estimate KAR would need to generate reported EBITDA approaching $500 million and continue to use
some excess cash to reduce permanent debt. We assume single-digit revenue growth, flat margins
and successful integration of OPENLANE will lead to this level of EBITDA. We also assume that
KARs competitive position will not be adversely impacted by evolving dynamics in the physical
versus online whole car and salvage auction markets, since the companys seasoned management has
product offerings in both types of auctions.
We could lower our ratings if KARs annualized free cash flow turns meaningfully negative or
if a shortfall in EBITDA in the year ahead prevents expected deleveraging, leading to about 5.0x
lease-adjusted total debt to EBITDA. We estimate that revenues would need to decline by single
digits (perhaps because of a further fall in whole car auction volumes) on some margin
compression for this to occur. We could also lower our ratings if aggressive leveraged
acquisition activity reduces substantially availability under the revolving credit facility.
Although we do not expect to do so in the next year, we could raise our ratings if KARs
lease-adjusted leverage seems poised to decline to 3.0x through a combination of cash flow
generation, permanent debt reduction, and improved EBITDA. Achievement of 3.0x leverage will
require further lease-adjusted debt reduction of about $600 million from 2011 year-end lease
adjusted debt. For an upgrade, we would also need to conclude that any still large private
equity ownership was consistent with our expectations for a modestly higher rating.
Related Criteria And Research
? Criteria Methodology: Business Risk/Financial Risk Matrix Expanded, May 27, 2009
? Key Credit Factors: Business And Financial Risks In The Auto Component Suppliers
Industry, Jan. 28, 2009
? 2008 Corporate Criteria: Analytical Methodology, April 15, 2008
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