Copart, the Junkyard Alchemist

Copart is the leading provider of automotive salvage auctions in the US. The business operates as a utility for the recycling of vehicles damaged in natural disasters or involved in road accidents. Copart manages an online auction service, clipping the ticket between a consolidated set of sellers (insurance companies disposing of customer vehicles) and a disperse set of buyers (parts dismantlers and US/ international used car dealers). The industry structure is attractive, operating in a rational duopoly between Copart and listed competitor IAA, who together command an 80% market share.

The market tailwinds are also favorable, vehicle complexity and a dearth of new entrants in the smash repair industry has driven the cost of repairing crashed vehicles ever higher, incentivizing insurance companies to write vehicles off which pushes more volume through Copart’s and IAA’s auction facilities.

A focus on profitability

Whilst market shares between the two companies are similar, the disparity in financial outcomes is stark with Copart earning a 25% return on its capital compared to IAA’s 12%. We believe the difference can be explained by their ownership structures and the resultant time frames used for decision making.

Copart was formed by a Vietnam war veteran, Willis Johnson, who lived in a trailer with his wife and child within the first “junk yard” he purchased. More conventionally, IAA was founded through a consortium of buyers taking a traditional financial approach to consolidating the industry. The notable difference in operating methods is described in Willis’ book, Junk to Gold.
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“IAA would show up wearing suits and riding in limos. I showed up wearing cowboy boots and driving a rental car. IAA bought companies the Wall Street way—based on pretax or after-tax earnings. I had my own method based on how many cars the auction sold and the value of the land. I knew what didn’t show up on the balance sheet of a private, family-owned company—that many of these business owners used a lot of their profits to buy personal cars or pay salaries and benefits to their family members.

Many of the businesses were undervalued as a result. With my operating systems and business model, I knew we could increase profits almost instantly. The other philosophical difference between Copart and IAA was that IAA purchased the cars from the insurance companies while Copart charged fees to store, clean up, and sell the cars.

The advantage of this was Copart could limit its liability and get a greater percent of earnings per investment, since they were putting out less cash. The downside was IAA could show more revenue on its books, which people on Wall Street saw as having more potential. I didn’t care though because I knew in the long run, it was about earnings. The bottom line is: what percentage are you making on your business? If we are pulling 30 to 40 percent to their 10 percent, we are a stronger company.”

Savvy landlord

Willis’ focus on profitability while simultaneously planning for the long term has appeared in various ways over the decades. For instance, both Copart and IAA possess an almost unassailable competitive advantage in their network of holding yards. The facilities provide a critical service for the insurance company clients, along with lower costs associated with vehicle towing. However, where Copart has purchased land in the outskirts of major metropolitan cities (crimping short term cash flows), historically IAA took a shorter-term view. By leasing property within major cities IAA optimized near term cash flow but ultimately left itself open to disruption as underlying land was periodically re-zoned and sold by landlords. Furthermore, Copart’s more flexible landbanks allow it to better service its insurance company clients in critical times (often at a loss) during major weather events such as hurricanes. This partnership approach has been critical in winning market share, most recently with insurance company GEICO.

Early innovator

Copart was also the first to digitize their business in the 1980’s, investing in computing infrastructure well ahead of the rest of the industry. It was also the first to move its auctions to a digital format in 2003, leaving IAA scrambling at the start of the pandemic as it attempted to shift its hybrid model online. Copart’s investment in a digital infrastructure has also opened an unintuitive but critical advantage - an international buying base. Partially damaged vehicles command a premium pricing overseas compared to domestic channels. What started as a cross-border transaction has now developed into beachheads into international markets. Copart has domestic operations in the UK, Germany and Brazil, amongst others. Where the US has already formed into a duopoly, many international markets are ripe for consolidation.

The Fairlight View

Copart has several attributes we look for in an investment:
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1) aligned ownership structure
2) demonstrable track record of profitability
3) structural and growing competitive advantages
4) pricing power to combat inflation
5) attractive margins
6) high returns on invested capital
7) little or no debt.

Businesses with these characteristics are incredibly rare, so while the position size has been managed over time to account for valuation, the Fund has been holding shares in Copart since its inception. Whilst automated driving provides a long-term risk to the business, this isn’t a “cliff” risk as the changes are likely to impact the car fleet at a glacial pace. Furthermore, crash rates due to distracted driving and the cost of repairs to electric vehicles are so far proving to be a tailwind for Copart’s business.