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Enter Parent Post-Spin and Keep IAA on Watchlist

Delayed from its Q1 2019 targeted Spinoff timing by the US government shutdown, KAR Auction Services, Inc. (KAR) is set to separate Insurance Auto Auctions, Inc. (IAA) on June 28, 2019. This is the first ever Spinoff in the field of salvaged auto auctions, and will create a pure-play insurance auction company with superior EBITDA margins compared to KAR's ADESA segment. The Spin looks fairly valued in when-issued trading, but there is significant upside in the Parent ex-Spin.

What's Happening?
Since the Spinoff announcement (February 27, 2018), KAR’s share price underperformed for the initial year with a negative return of -11.3% compared to the S&P Total Market Cap Index’s (SPTMI) gain of +1.9% in the same period. However, the share price momentum reversed on the news of activist investor Jeff Smith’s Starboard Value taking a 1.9% stake in KAR (2.6m shares, fourteenth largest investor), disclosed on April 16, 2019, and since then KAR has gained +9.1% compared to the SPTMI return of only +0.3% to date.

Furthermore, as this will be the first Spinoff in the insurance auto auction services space and IAA’s higher margin (FY20E EBITDA margin of 29.3%) positioning compared to KAR’s ADESA segment (FY20E EBITDA margin of 16.8%), we expect IAA will command a higher FY20E trading multiple of 15.2x (compared to ADESA’s 10.4x) owing to its superior margin profile and stable cash flow generation post-Spin.

KAR (Parent, ex-Spin) will focus on its niche used vehicle auction services business, with a lower EBITDA margin profile of 16.8% in FY20E, compared to the combined company’s EBITDA margin of 23.4% in the same period. Following the Spinoff, KAR will have two primary business segments: ADESA (Automotive Dealer Exchange Service America) and AFC (Automotive Finance Corp.), out of which we believe AFC is the next divestiture/sale candidate, as it is a floorplan vehicle finance business with a higher risk profile. We expect AFC’s potential divestiture/sale will reduce KAR’s overall credit risk and thereby boost its trading multiple, improving the company’s overall valuation.

The Spinoff announcement did not help KAR’s credit rating, as Moody’s credit rating agency put KAR (Parent, pre-Spin) under review for downgrade due to the increased stress on the company’s financials after the Spinoff of IAA. However, on May 22, 2018, Moody’s announced that KAR’s credit rating remains unaffected and the further review for downgrade is ongoing. We expect that Moody’s will keep the credit rating of KAR unchanged due to the higher debt transfer ($1.3bn) to IAA that will decrease the leverage on KAR (ex-Spin) to 2x from the current 2.5x (combined, pre-Spin).

The Edge View (KAR, Parent Ex-Spin)...
KAR (ex-Spinoff) will have lower leverage of 2x due to the debt transfer to IAA and will be in a better position to further enhance its newly launched TradeRev service for near-term top-line growth. Also, the potential demerger/sale of AFC will reduce KAR’s overall credit risk and will boost its trading multiple, improving the company’s overall valuation in the long-term.

The Edge View (IAA, Spinoff)...
IAA (Spinoff) will be the first Spinoff of an insurance auction company, and it offers a superior FY20E EBITDA margin profile of 29.3% compared to KAR’s ADESA segment’s margin profile of 16.8% in the same period. Therefore, we believe this business demands a premium to the ADESA segment based on its sole insurance auction position and superior margin profile. Moreover, the current veteran CEO and President of the IAA segment (John Kett) will serve as Chairman and CEO of IAA after the Spin, which we view as a positive for the company given his extensive industry experience.