Discussing Copart At Chit Chat Money

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Hi there,

A couple of weeks ago I sat down with the Ryan and Brett from Chit Chat Money and discussed Copart. We discussed the following topics:

1. Sourcing Copart as an idea

2. Copart's business model

3. The financials

4. The impact of used car prices on the company's business

5. Competitive landscape and advantages

6. Ritchie Bros' acquisition of IAA

7. The growth drivers

8. On the risk of autonomous driving

9. Management

10. Valuation

You can listen to the episode below, but you can also read the transcript in this article:

I hope you enjoy it.

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Ryan: Welcome to Chit Chat Money. My name is Ryan Henderson and I am joined by my co-host Brett Schafer. As always. Today we've got our Thursday deep dive episode. On this episode, we interview an analyst to discuss a single stock or industry. And today we have on the show Leandro, and we're talking about Copart.

Leandro's been on the show a number of times, so people that are regular listeners might be familiar with some of his other episodes, but he seems to be a fan favorite as all the episodes that he's come on and discussed companies, we've gotten really strong listeners numbers on those. So, people must love him for a reason and we enjoy listening to him every time we talk to him, and Copart was no exception. So I'm excited for you guys to hear this one.

No ad today. So without further ado, here's our interview with Leandro.

Disclaimer: Welcome to Chit Chat Money on this show host Ryan Henderson and Brett Schaffer, interview industry experts and riff on the world of investing. As a quick reminder, Chit Chat Money is a CCM Media Group podcast. Ryan and Brett are also general partners at Arch Capital and Arch Capital may have positions in the securities discussed in this podcast.

Anything discussed on Chit Chat money by Ryan or Brett, or any other podcast guests is not formal advice or recommendation. Now. Please enjoy this episode.

Sourcing Copart as an idea

Ryan: All right. Welcome to Chit Chat Money. Today we have on...we did the math right before we came on, I think four time guest, Leandro from Best Anchor Stocks. He is the author there, go ahead, check it out. You're probably familiar with him if you've listened to the show on a recurring basis, but I think in our past episodes, we've discussed Adobe, Constellation Software, and ASML.

We're going with another, I guess maybe you could call it high moat business, regarded as high quality. So I guess before we dig into Copart, which we're gonna discuss today, I always kind of find it fascinating to see how people come up with their ideas. So how'd you come across Copart to begin with?

Leandro: Well, first of all, thank you for having me, Ryan and Brett, it's nice to be here for the fourth time. I think actually the last one was a few months ago, so it's great to be here again.

So if I'm honest with you, I don't remember exactly how I came across Copart, but I think it was thanks to Chris Mayer. So sometimes I source ideas by looking at the portfolios of investors who I respect, and I think this might be one of those times. So of course I don't simply blindly buy it after, but the portfolios of people who I respect are actually a great source of ideas. So that was step one.

Then the first thing I did was buy the book from the founder, Willis Johnson, which is called 'From Junk to Gold.'

So, not only I found this book entertaining, but also a great reflection of the founder's vision which obviously still lives today in the company because he's still involved. He's not the CEO anymore, but he has a significant stake. So after reading that book, I decided to start researching the company.

So I think the company had some characteristics that were appealing from the start. It operates in a boring oligopolistic industry with very high barriers to entry, and it has a long runway ahead. So I think just those characteristics called for a closer look. And it's not the typical company that makes headlines, so it's actually very tough to come across it just by scrolling newsfeeds.

But I think that in fairness, this is something that I like about it because it's easy to hold. So for many companies you are going to face a continuous stream of news, but this is not the case for Copart. So separating the signal from the noise in Copart's case is pretty easy because you don't get many news.

You only get news actually like every three months because you're getting the earnings. So I think that's an underrated advantage for any investment because it actually helps investors focus on the company and, and the long term. 

Ryan: Yeah, I agree. I love the companies that we have that don't really seem to care about the quarterly stuff or give us sort of just what we need to know. Always makes me fret or worry a little less.

Copart's business model

Ryan: But I guess let's go through Copart's business model. You mentioned some of the characteristics there. We can talk about those in a second. But can you give us kind of the basics? What does Copart do? How do they make money? And then maybe talk about the different stakeholders within their business.

Leandro: Yeah. So, Copart basically operates on online auction platform where sellers and buyers come together to transact salvage cars. There are also cars that are not salvage cars, so used cars, but the majority of the volume will be salvage vehicles.

So it's a two-sided marketplace and you have buyers on one side and sellers on the other side, and Copart is basically the enabler of the transaction. The sellers are primarily the insurance companies. So when a car is in an accident, it triggers a decision making process for the insurance company, and there are basically two outcomes. One, does it make sense to repair the car? Or two, does it make sense to total the car and pay the pre-accident value to the customer? So you basically have to make a decision between those two.

The pre-accident value is what the car was worth before the accident. So the decision is actually based on a mathematical formula. And it's also important to understand that the insurance company is always going to lose money after an accident, but they are going to try to choose the option based on where they suffer the lowest economic loss.

So, for example, if the repair costs are higher than the difference between the pre-accident value and what the insurer can make for the total car at auction, then the insurer will choose to total the car. So the rationale in this particular scenario is that the insurer loses less money by totaling the car, paying the pre-accident value, and then trying to make up for, I don't know, $3K or $4K through auction.

This might be a bit confusing for listeners. So I'm gonna give a brief example with numbers. So let's imagine that the repair of a car costs $8,000. Okay? So $8,000, their pre-accident value is $10,000, and the insurer could recover $3,000 at auction. In this case, totaling the car is the preferred scenario because the insurer is only going to lose $7,000 because they're going to pay $10,000 in pre-accident value, but then they're going to make $3,000 through the auction. So that when you net those, that gives you $7,000.

So obviously losing $7,000 is better than losing $8,000 that costs to repair the car. So when the repair costs are higher than the pre-accident value, minus the auction value, then that car ends up in Copart because Copart is responsible for the auction or the insurer will sell that car through Copart or IAA, whatever of those two, or maybe through a mom and pop shop, but, probably through those two.

And then you also have the other scenario where, imagine that repair costs are $5,000. The pre-accident value is $8,000 and the insurer can only make $2,000 at auction. In this case, the difference between the pre-accident value and the auction value is $6,000, but the repair costs are just $5,000. So in this case, an insurer will say, okay, I prefer to repair the car because it only costs me $5,000. And the other scenario is $6,000.

So there are of course other sellers like charities and financial institutions. So for example, if a financial institution has a car as collateral for something and that car ends up with a financial institution, in many cases they will choose to sell the car fast through Copart or IAA and get money for it. But well, the majority of the volume is driven by insurers. This is the only the sellers are, do you have any questions? Because the, the buyers is much easier to understand, I think. 

Ryan: Yeah, I think that's good. Makes sense. Yeah, that makes sense. And so it's just, uh, kind of rehash, it's the post after an accident.

Insurance companies basically take the car, assess the value, see whether it's better to repair or total it. And then if it's totaled, it typically goes to Copart. And I guess we're gonna talk about competitors in a second, but is it kind of, is Copart kind of the primary player here or do they have existing relationships with Copart or do they like auction it off?

Or like, are they bidding one of the auctioneers against the other auctioneers? I'm cur curious how the competitive landscape works there.

Leandro: Yeah, so there are two main players in the industry Copart and IAA, which is 'Insurance Auto Auctions'. These two players make up like 80% of the volume of the industry, and they remaining 20% is mom and pop shops that have like independent yards.

And historically this was evenly distributed across both players, but lately we've seen Copart take share from IAA. For example, IAA lost Geico as a customer and the volumes went to Copart. And actually it's funny because reading the IAA earnings call from the moment that happened, management was quoting the volume net of a big customer loss. So that was like a huge red flag for me. It's like saying, "yeah, our volumes are up 4% excluding the loss of this customer." Well, obviously you need that customer because it's a very concentrated space, the seller space for these companies. Because insurance companies are typically very large.

So the relationships are really, really important. And I think that's where Copart has made the difference with respect to IAA.

Ryan: Yeah, I dunno how you can report revenue excluding customer losses. But, logistically here, it's Copart has basically these yards that the insurance providers bring them to. Is that, is that kind of what I'm getting?

Leandro: So, Copart has like a comprehensive service and signs like long-term contracts with some insurers. So when an accident happens, then Copart will be responsible for everything from that moment. So, towing the car to their facility, putting it on the action page, and then they'll, obviously insurers will pay for this, for this service a fixed amount.

And then Copart just takes care of everything. So that's how it goes. It's not like the car stands at the insurer and then they simply auction it. That car has to end up in one of Copart's yards and then from there they take the pictures and they put them to auction.

Brett: So one little follow up on that. How do they manage the inventory on the balance sheet? Is it difficult or do they have, since given their size, is it not really an issue for them? Because I kind of think similar and obviously they're not in as big as trouble as Carvana, but it seems similar to me where you have to take a little bit of inventory risk and it might not be as bad because they're salvage stuff, but you have to take the inventory and then sell it off.

Is that any sort of issue or is it really worth out?

Ryan: But they're not the buyer. 

Leandro: That's it, yep. They don't take the ownership of the car. But, even if they don't, like, it doesn't appear in inventory, having a car stand for too long in your yard, that's also an expense, obviously, because that car is taking the space.

Brett: Yeah, it's like phantom inventory almost. Am I getting that right? 

Leandro: Yeah. The rotation, like I wouldn't be worried here because the rotation is quite fast. Actually, one of the main limitations of the inventory getting sold is the regulation that happens before you can deem a car a total loss.

So until it gets the salvage title, that's actually pretty slow. And if they could speed that up, then Copart would rotate the inventory faster than it does now. 

Brett: Interesting, interesting. Okay. Now let's go through the buyers. I'm assuming they're used, maybe junk. I don't know what they would be. You tell us what it would be, and is there any other big parts of the business that investors should be aware of?

Leandro: So buyers are a much more fragmented group. You can find here car dealers, dismantlers, rebuilds or even the general public, like you can go on Copart and maybe find a car that you like and you think that you're going to be able, maybe it's not in salvage condition and it's just a used car, and you can buy it.

Of course, it plays to Copart's strength that the buyers are fragmented because they don't have leverage against Copart. So one of the main criticisms that Copart gets is that it treats sellers very well, but it doesn't treat buyers as well. And while I think this might be true, like most of the fees are made with the buyers, but, this makes sense.

Like if you have a seller group that your inventory or your volume depends on that seller group, then you're going to do whatever you can to add a lot of value to them. But if your buyers are going to be there because you have a very good inventory, like that's your value add for the buyers. Like, I'm a rebuilder, I need this part and I know that Copart has a car that has this part, so then I'm going to go to Copart and I have no choice because if that car is in Copart, it's not in IAA, then I have to go to Copart to get it.

So obviously Copart focuses on the sellers because it makes much more sense for them. I don't think they treat the buyers bad, but obviously most of the money is made through the buyers and when the price increases are made to the buyers mainly and not to the sellers. 

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The financials

Brett: All right. Yeah, that's a great overview of how the business works.

Let's go through the financials though. Just walk us through that. What are their costs? What kind of margins do they generate? I'm curious because this is such a unique business model. What their major cost structure is. 

Ryan: And then if I can add one more, and I think Leandro you were maybe about to touch on this. Do they just take a percentage of kind of the difference, is that the majority of their revenue?

Leandro: Okay. So the company makes money through several ways. The most relevant is service fees. They, as the enabler of the transaction, they take a fee based on the transaction value.

So they will take a higher fee if the car is being sold for $7,000 than if it's being sold for $2,000. And they also take other fees. For example, buyers to buy on Copart, you need to pay a subscription, so they also take that. Then sellers also pay Copart to take care of all the towing and all the services, the additional services.

So that's the most of the revenue. And then they...but Copart also has a smaller revenue stream that is purchased vehicles revenue. So from time to time, Copart will go to the market, they will buy cars and then they will resell them at a higher price. And they typically...well they do this for two reasons.

The first one is, because sometimes when the used car prices are high, pre-accident values are going to be high and the total loss ratio, so the cars that end up.... going back to the mathematical formula that we talked about for the insurers is going to be to make the probability of a total loss lower when the high use car prices, when used car prices are higher because obviously it makes more sense to repair if the pre-accident value is very high. So sometimes to make up for that loss of volume, they'll purchase cars to have a good inventory for their buyers.

And the other reason is also because Copart, when it's going into international geographies, this model, the service model is very established in the US but in other geographies it's not. So to convince the insurers, for example, in Germany, Copart is taking ownership of the car and reselling them on their webpage just to tell the insurers: "Hey look, this model works" until this insurer trusts it and then they switch to the service model. So those are the two revenue streams, but service fees made up around 80% of sales in 2022.

So that's the majority of the revenue. 

Brett: Makes sense. All right. And then the financials, I guess any relevant context there that you have to share with the listeners and what are their primary costs? What leads down to that net profit margin or cash flow margin.

Leandro: So just to get a grasp for people who don't know of Copart size, the company generated around $3.5 billion in in revenue last year.

The growth was very solid in 2022. It was 30% sales growth, but of course it was also aided by high used car prices because the transaction value in Copart's platform also goes up if used car prices go up. I think we can touch on this later, of how used car prices impact the company.

The pandemic year obviously was a bit more muted in terms of growth because there were less cars on the road. Although actually...this is interesting because Copart is actually a bit also insulated from a recession and the fact that there are less cars, because when there are less cars, people tend to speed more, so accident severity can go up during a recession. But, even during the pandemic, the company managed to grow 8%. So the, the company has basically doubled revenue over the last five years, which is pretty impressive I think, for such a perceived boring industry, so to say, or boring company.

So besides this fast growth, the company also has very strong margins. So the gross profit margin is around 45%. And I know listeners might be saying: "well, that's not high", but this is because the most important costs are embedded here, which are the cost related with the yard operations, and these are towing and labor.

So towing and labor are the two most important costs that go into cost of revenue. So they have been seeing increased costs from both of these due to inflation. But then obviously there's a lot of leverage in operating expenses. So they end up with a net income margin of around 30%.

So you have gross margin of 45%, and then you have net income margin of 30%. So that just tells you that most of the costs are obviously in cost of goods. And so, it's obviously a highly profitable company.

I would say here it's something important to bear in mind, is that margins can be a bit misleading when you compare them to, for example, IAA because Copart buys the land where it has the....like buys its yards and takes ownership of its yards. And yards are not amortized, so they completely bypass the income statement, whereas IAA, leases the yards. So they do see those expenses going into the income statement.

So I would caution against, well you, you can compare them, but you have to make some adjustments. Like if you look, if you get the numbers at face value, you'd say, "whoa, Copart is much, much more profitable than IAA. But then when you adjust those numbers, Copart is still more profitable, but the difference is not so large.

Obviously this bypasses the income statement, but affects the cash flow statement because obviously land is a CapEx expense. And you see that Copart spends significant amount on CapEx and the majority of it goes to land, but they still end up with free cash flow margins of around 16%, which I think is pretty healthy considering also that they're making these investments in an appreciating asset, which is land. It's not like you are making the investment and you are going to lose economic value. 

Ryan: I read some, I forget what blog I read it on. I think it was...I'm blanking on it, but I read something that when they purchased the land, it's sometimes hard to like get the rights to have a salvage yard. Is that right?

Leandro: Yeah. So that's part of the moat because... Well, Copart has been buying land for decades. So obviously many cities, they typically buy these yards in the outskirts of the cities, but many cities have grown and now these yards are pretty close to the city. And it's basically very difficult to get a permit to have a salvage yard because nobody wants the salvage yard on their backyard.

And they're actually known to be like hazardous territory because you have like old cars and there's a lot of pollution from from that. So it's actually quite difficult. Maybe you can get yards, but you cannot get them in the same location as Copart has them because maybe Copart bought it 20 years ago.

The impact of used car prices on the company's business

Ryan: Interesting. You mentioned the used car prices. I saw on one of your recent write-ups, there's kind of positives and negatives to the used car prices. So can you explain how the changes in used car prices affect Copart's business?

Leandro: Yeah, so when I started researching Copart, my first thought was like, "well, this company is going to be like really dependent on used car prices." So it's going to be highly volatile, especially since we've seen a lot of volatility in used car prices coming out of the pandemic. But then when you start to look at the company, you actually see that the company is quite insulated from used car prices in general.

So for example, in the current environment with high used car prices, the total loss ratio, so the percentage of cars that are in an accident and get totaled, is going to decrease because, as I said before, the pre-accident values are going up. So it makes more sense to repair the car. So then they see less volume from high used car prices. But then at the same time as they take a fee from the transaction value, as transaction values and average selling prices are going up, they're making more money because it's a percentage. So they are actually quite insulated.

I would say that if now used car prices start to normalize, then we should see the opposite. We should see volumes go up because the total loss ratio should tick up and we'll see average selling prices go down. So it's a bit unclear how the company will come out of this period because it's difficult to...and even management has said that they cannot predict what will happen when the used car prices go down. So they know that they are somewhat protected, but on the margin side, obviously there can be an impact because it's more profitable if you're growing in price than if you are growing in volume because volume has a lot of costs associated. Like you incur the same cost if you sell a car for $2,000 or $7,000 in your platform.

So it's a bit unclear, but they are quite insulated, I would say from volatility in used car prices. I don't think growth will fall off a cliff if used car prices come down, which they will eventually will.

Brett: Probably, yeah. And it seems like, man, it's a give and take, but they have a bit of a national natural inflation hedge versus their cost. If generally, I think if their input costs are rising, potentially used car prices are rising as well. And they can make up that margin in that way.

Competitive landscape and advantages

Brett: But our next topic here, I think this is an important one for the industry, is competition and competitive advantages.

You mentioned the competitive landscape a bit already. If you have anything else on that follow up please. And then I think what people fall in love with, with Copart are the multiple competitive advantages. So any thoughts on that? You talked about the land, maybe the marketplace. ll that good stuff.

Leandro: Yeah. So I think the company has four competitive advantages, economies of scale, barriers to entry to real estate that we just commented on, then network effects and then the customer relationships.

So economies of scale also have to do a bit with the yard network. So if you have a very large yard network, then you're going to be able to optimize this because the most important cost here is towing. So obviously the shorter the distance you have to tow, the more profit you can squeeze from that vehicle. So as we said, Copart has land close to the cities, and that's obviously an advantage. That is very difficult to match and they maybe have a lot of yards that they can take the inventory to.

So imagine if you're a small player and you have just two yards, then you're going to have all your cars there, and then when you want to tow them, it's going to be probably a long distance. So it's like a network of nodes. It's actually similar to Amazon in this sense, but instead of with like fulfillment networks, this is with the yards.

The second competitive advantage is the one that we talked about... the real estate. So it's very difficult to get the permits, especially in zones that are close to cities.

And then you have the network effects. So Copart has millions of buyers on its platform and they are there because Copart has the inventory. So if a company wants to attract these buyers, they first have to replicate the inventory, which we have just seen that it's almost impossible because to replicate the inventory, you first need the customer relationships and then you need the yards to put those cars in. So you need both things and, and even if you have like the inventory, you're going to have to convince buyers to switch because they are used to Copart's service level.

And customer relationships, I think I wouldn't consider it like a very strong competitive advantage, but I would put it in there. I wouldn't consider it moat, but I would consider it a competitive advantage. Because insurers are known for not being the most flexible customers. So obviously it's very hard that they change something that's already working and all the implications that might have, not only in cost, but also in customer service. So if I am an insurer, I have individuals, I can be the customer of an insurer. So if the process goes smooth, then I'm not gonna switch. But if the process doesn't go smooth, then I might be inclined to go to another insurer. So obviously they care a lot about the service and what they get.

So I would say those are the four competitive advantages, which if you ask me are for an upstart, they're almost impossible to replicate, not only for the regulatory moat, also because it requires a lot of money.

But if you like, if you ask me about the competitive advantage of Copart compared to IAA, which is a rather large player in the industry, I would say that the difference has been purely execution, but execution for a very long period of time. And that's, for me, that's also a moat. So management that knows the business and has the right strategy, obviously it's a moat because every year they are leaping forward compared to the competitors. So that's why Copart through execution and strategy has provided a much better level of service. And that's where they are taking market share.

I don't think that they're going to take all the market share from IAA, but I do think that Copart is a much better company operationally and also financially. But that's another topic. 

Ryan: You just kind of led us into this question that we got from Twitter.

So when we put this out, we got a lot of feedback on questions that people wanted answered and they mentioned that, which was the relationship with insurance customers if they continue to take market share.

So I guess, do you think there's any concern from insurance customers if Copart continues to take market share? How do you, how do you look at it? I guess how do you look at those dynamics?

Leandro: Okay, so right now I would say that there's no concern because it's precisely the insurance companies that are giving the volume to Copart. So obviously right now there's no concern.

But will this evolve to be a monopolistic industry? I highly doubt it because if that's the case, like insurers are not going to give all the leverage to Copart because that can have two bad consequences in my opinion. First, you are subject to price increases and you basically have nowhere to go, and second Copart can get complacent with its service levels, which is even worse because then your customers may leave and go to a to another insurer.

So, I think Copart can continue to take market share from IAA, but I do see this as an oligopolistic industry going forward because insurers know that they cannot be at the mercy of one company. And also looking forward, imagine that something happens to Copart, like Black Swan event, and then you cannot count on them. Then it's going to be...you don't have another option. So I don't think it's going to evolve to a monopolistic industry. 

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Ritchie Bros' acquisition of IAA

Brett: Now I got one follow up on that. We had a few questions on this from Twitter, so I think it just, we need sum it up into one and it is the acquisition of IAA by, I think the company is called Richie Bros correct me if I'm wrong there.

Just your general thoughts on that and how this can affect this industry, because I know that could be, I don't know if it would be disruptive, but it's a big change if IAA becomes a partner with another company.

Leandro: Yeah. So I think I have quite a radical view here because I think it's going to be positive for Copart if the acquisition goes through or if the acquisition doesn't go through.

So if the acquisition doesn't go through, IAA has basically said, "okay, we cannot compete against Copart because like they're winning". We want to get acquired and maybe try to find synergies with another company and try to compete that way." That's if we remain in the status quo, because I think Copart will continue to win there.

Then, if Richie Bros ends up acquiring IAAA, I think they're going to milk IAA because if you listen to the call from the acquisition, it's so obvious that what Richie Bros wants is the land that IAA has for their business. Like they resale uses machinery so the land is also useful for them.

After the call my feeling was, "whoa! All the possible synergies that you're going to find here, they are all going to accrue to Richie Bros. And not to IAA." So they're basically going to milk IAA.

And this happened to IAA already. They were owned by KAR before going public a couple of years ago. And basically the owners milked the company. They started paying dividends to themselves. And so I think it's going to be, they're not going to do it through dividends, but I think all the synergies will accrue to Richie Bros. And it was a bit telling in that call that the Richie Bros CEO said that...so before saying this, I think it's not going to work well because Richie Bros doesn't work with insurers and insurers are the main customer for IAA and Copart. So there's no synergy there. Like they're not going to...insurers are not going to want what Richie Bros has. And it's not going to be easy to penetrate, like, to go and say, "Hey, now that I'm with Richie Bros, I'm a better company." Insurers are going to say, yeah, but I don't care about Richie Bros. Like I don't work with them. 

And the worst thing probably was that the Richie Bros CEO said that she used to work in insurance, so that means that she has good relationships with the insurers. And I was like, "yeah, I don't think that's going to make the difference." Because the service, service is what matters here. It's not that you have a relationship with someone that, or that you used to work in an insurance company.

And obviously I'm not the only one that thinks that that acquisition is not going to go well, because a lot of Richie Bros shareholders are pushing against the acquisition going through, majority shareholders. They think that they are...and they actually put some pretty good bull cases for Copart in their letters because they were saying that IAA is such an inferior asset to Copart and that basically it's impossible to compete against Copart right now.

Ryan: Yeah, that makes sense.

And, and I think you're probably right. I don't think insurance companies are going to get rid of a really good service just to, you know, do a favor for someone who used to be in the industry.

The growth drivers

Ryan: I guess you mentioned that revenue growth has been really strong over the last five years, especially for a business that's probably kind of the narrative is that it's a boring industry.

What do you think will be the big growth drivers moving forward? Is it kind of just more the same or is there any other kind of opportunities that you see down the road?

Leandro: So I'd say there are two main growth drivers. One is international and the other one is the rise of technology in cars.

So Copart started some years ago to tackle international geographies and as the model is kind of new there, it's running into some white space. So that's one, and that's obviously important because right now...so Copart's buyer base is international, but most of the volume right now is being sourced from the US. So when they start to source this volume closer to where the buyers are, then that obviously has implications for buyers and for Copart's margins. So I think that's one of the growth drivers.

The other one, it's kind of a strange one because technology is at the same time a growth opportunity, but at the same time a risk for Copart. But I'm gonna talk here about the growth opportunity and then we'll talk maybe about the risk. So, as cars get more advanced, they get easier to total and thus they drive more volume to Copart. So the rationale here is that if a car today has a minor bump with a car in front, that bump will, that accident, that minor accident is going to break several sensors and cameras, which are pretty expensive components to repair.

And not only are the components more expensive to repair, but repair shops are getting increasingly consolidated. So they have more bargaining power against the insurance companies. And also they need higher skilled labor because the repairs are more "techy", so to say, because you have more sensors, cameras. So repair costs in labor are also going up.

So then going back to the formula I talked about earlier, if repair costs increase, then that's going to make it easier for the cars to end up total. Because the insurer is going to probably lose less money, lose less money by paying the pre-accident value and just total in the car.

It's also true that more technology makes accidents less severe. But Copart doesn't rely on accident severity if, when you have a minor bump, then the repair costs are like $3,000 or $4,000. So I think that's going to be a pretty large tailwind. And management also says that they expect total loss ratio to climb up a lot as the fleet shifts to our more modern vehicle vehicle fleet.

On the risk of autonomous driving

Brett: That's quite interesting. Oh, Ryan, you have Sorry, follow up there.

Ryan: Well, I guess one of the, and maybe this is a quick answer, but one of the big risks driving cars...one of the big risks that people called out on Twitter and they said, you know, what happens in a world where full self-driving prohibits all accidents, or reduces accident frequency?

Do you think that's a risk at all?

Leandro: Well, I think it's obviously a risk. The question here is when does this risk come? And I think that's actually the difference between a bull and a bear on Copart. I think there's no doubt that Copart is a very high quality company, but obviously it commands a high multiple.

And when a company commands a high multiple, then the focus should shift to the terminal value and not what the company's going to do in the next five years. So obviously, we're not going to have autonomous driving and in 100% of the fleet in the next five years, but if the market sees any kind of risk, then the multiple might be cut in half, for example, because obviously it's a risk for the company.

But in my opinion, there are several roadblocks to autonomous driving. So the first is the technology. The technology is still not solved and it's continuously being delayed. I'm not going to say who is delaying it, but I think everyone knows.

Then once this is...once the technology is solved, then you also have a regulatory change to make because who is going to assume the blame of an accident? Is it going to be the company? Is it going to be the individual? And I think this is going to be harder than it looks to tackle, especially because insurers are going to make sure that they don't lose a lot of money with the new regulation.

And then when both things are solved, you have to replace the entire vehicle fleet in the US, which right now is around 13 years old. So that means that it will take around 13 years to replace the whole vehicle fleet at the current replacement rate. This of course assumes that everyone trusts autonomous driving, which I don't think will happen, to be honest. I think when it's introduced, a lot of people won't trust autonomous driving for like, basically you're putting your life on the line. When it gets very, very good, then maybe we'll people will start to trust it.

But the thing is that to make a significant dent to Copart's volumes, you need to have a large majority of the fleet in autonomous, like 10% is not enough. Because obviously other cars can crash against the autonomous cars.

So I think that's obviously, as a Copart shareholder, I have a strong view on this. And I think that in the next 20 years, autonomous driving is not going to be a risk for Copart. So I obviously invest, I don't think, I'm not trying to project project out 20 years, but if I'm going to be invested in Copart for say, 10 years, I need to look 20 years out because obviously the ending multiple is going to take into account the next 10 years.

So, I'd say that it's a risk, but I think it's still very far away. And in the meantime, it's a tailwind for Copart because all of the pre...so you have, ADAS and then you have autonomous driving. And as you advance in ADAS, that's a tailwind for Copart. So if a car becomes a microchip or a semiconductor chip, because that's where we're going. Like you have a lot of sensors, you have a lot of infotainment in the car. If that happens, that's a tailwind. And then you can have terminal risk in autonomous, which I think is very far away.

Brett: Yeah, no, it's quite interesting that the Bear case might be, well, this business is gonna get destroyed in 25 years. It gives the company quite a bit of time to figure out what their business model will be during that in the world can change a ton in that way.

Management

Brett: And then that kind of leads us into the next part here, which is management. Thoughts on the management team. What do you think of the co-CEO structure?

It seems like you think they have built up a great culture here, and I'm curious why you think so.

Leandro: Obviously I think management is great, and I don't think this is only a perception. So if you look at the operational gap that Copart has created with IAA, that has obviously been management. So management has been great for the last years because if not, they wouldn't, they wouldn't have won against IAA.

Willis Johnson, the founder, has a significant stake and he's still involved. He's obviously not the CEO but he's still on the board. And so obviously that's great too because the best alignment of interest is when there's high insider ownership.

Management undoubtedly thinks long-term. I mean, when you listen to a Copart earnings call, you'll listen to the word "decades" quite a bit. I think that's not normal in Corporate America, to listen to the word decade or 20-30 year periods because that's where Copart is aiming at. Like, for example, when they have the significant cash position and no debt, it's not because the business model cannot weather a bit of debt. Obviously Copart could be more efficient with its capital structure. But that's management saying that they want the company to survive for a long period. And I know that there's a lot of discussion around the efficient capital structure theory or whatever, but yeah, a Black Swan doesn't care about your capital efficiency structure.

Like, yeah, look at COVID. I mean, yeah, a black swan can wipe you out even if you think you're prepared for it. Like who would've thought, who would've made a capital efficient structure like the perfect capital structure thinking that we would have a pandemic...like nobody. So obviously if you actually want to be protected against everything, then you have a lot of cash and you don't have debt and that's what management has done.

In fact, when they saw that interest rates were going to climb, they retired $400 million in debt. I think that they have the debt that they had and they incurred a prepayment penalty. But they said that it was the best thing considering where interest rates were going.

So the the co-CEO structure, I think it makes sense, although I'm pretty sure that the Co-CEO structure is mainly on paper. Because Jeff Liaw is basically running the company and Jay is more on the strategic side of things and on the international business. So I would say that most of the CEO tasks are falling on Jeff and not on Jay.

And also there's a bit of criticism because Jay Adair may retire soon and many are criticizing this move because he's quite young. But I mean, he has been working for Copart since he was 19 and he has created a lot of shareholder value. So my take is that I think he deserves to retire whenever he wants. And actually his compensation structure is quite interesting because the company pays him $1 in salary and then stock options, but only if on the vesting date the stock is above a certain price. And the price...I cannot remember exactly the numbers, but they are quite aggressive.

So if the company does...if the company stocks doesn't do well, then he gets no stock options. And the rational behind this was that the board argued that it was basically impossible to compensate someone that has almost a 1$ billion stake with a salary of say, $10 million. And I agree here because the best alignment is to have a large stake.

And obviously if you have $1 billion in stock and you're getting paid $10 million in salary, you're not going to do to care much about the salary, you care about the stock that can make you a lot of more money than your salary.

So I think management is great. And the best thing is probably the long-term thinking and also that they are very humble, and I think that's very important for a company that is already leading the industry because complacency is the worst thing that can happen to you.

Ryan: What do you think of the buyback program? Do, I guess, do you care about it much that they're more periodic it looks like, than kind of putting it on the back burner and just doing a certain amount every quarter. Do you prefer that?

Leandro: Um, I actually do. Because when I see periodic buybacks, that just tells me that management is buying when they have to be buying. So it's like that they are taking the responsibility for those buybacks. 

But Copart, I think, has been very aggressive twice with buybacks, and I think they won't do buybacks unless the stock craters. And I think this is also a positive because that means that you're somewhat protected from a stock drop.

So, for example, I'm gonna put here another case. Texas Instruments now has $20 billion approved for buybacks. So you know that if the stock goes down a lot, management is going to turn the buybacks on because they remain also profitable during the downturns. So you are kind of...you don't need to buy the dip cuz management is going to buy the dip for you. So I think that's pretty positive.

Although management did say that they have the cash position, just in case in the future they will have to use that cash to buy back stock or whatever. But I prefer this to a more software approach where the software companies just buy every quarter.

Brett: Yeah. And then somehow their shares outstanding still go up, but that's a conversation for another day.

Valuation

Brett: This is one of those classic, as some people might call it, the compounder stocks, where people looking for competitive advantages, people looking for high quality love. This company is a never sell. I can see why never sell team, you know, all that type of narrative around that.

However, when you look at the stock, clearly it is at a high earnings multiple. So how do you balance that when kind of valuing a company like this? Is it one where you have to be very patient and say, look, you might not be...there might not be buying opportunities. It might be, they might be few and far between, but this is one where you get a good buying opportunity and then you never sell.

How, how do you kind of look at it?

Leandro: Yeah. So valuation is always a bit a controversial topic. I think in many cases when you see high valuation multiples, in some cases they might be inflated because actually the company's competitive position or the returns that the company's generating, they don't have a high probability, but there's a reasonable probability that they might be competed away in the future.

Here, I think that we have to...I don't think right now the company is a screaming buy obviously, but we have to take into account that Copart is reinvesting a large chunk of its excess cash and is doing it at high returns. And those returns are quite insulated from competition from what we've discussed.

Like even when IAA and Copart, were both with an equal market share. The returns were good. So obviously you can look ahead and think that Copart, 10 years from now will still be generating significant returns, especially because it's not a company that AI can maybe impact a lot. So most likely they would benefit from AI more than, more than suffer an impact.

And then if you couple a large reinvestment rate with high returns and a long runway ahead, then that's actually the essence of compounding, right? So you need, you don't only need high returns and and a high rate investment rate, but also to be able to maintain that reinvestment rate in the future. I think Copart has all three.

Also I think the multiple is a bit misleading because Copart has also seen a lot of an impact from inflation from towing and labor. So the earnings are a bit...so revenue has been growing at a nice pace, but earnings have not kept up due to this margin compression. But I don't doubt that margins can get to where they were.

So, but it's what I said before, when one is investing at such high multiple, the most important consideration is the one of terminal risk. Like, I don't think if you're investing a company that's at 30 times earnings, you should care about what the company is going to do next year. Well, maybe the market is going to make the stock price drop if earnings are not good but if the long term intact, then that's not gonna be a real driver of your returns. But if you invest at a company at 30 times earning and there's a terminal risk that appears and your multiple resets to 10 times or 15 times, then over a 10 year period's going to be quite hard to have good returns because basically you're getting the multiple cut in half.

So the difference between seeing Copart, okay, like right now, I wouldn't say it's a screaming buy, it was a screaming buy maybe a couple of months ago just like mostly every company, I think Copart,  in the bottom in October was $50 and it's right now at $80. So that's a significant run, but I think that if an investor wants to hold this company, they need to have a very strong opinion on autonomous driving, because if not, it's going to be very difficult to hold this. Like at the minimum doubt of autonomous technology being solved, then you're probably going to get scared, like you're gonna be probably sell the position.

So, that's what I think. I think that if Copart for the next 10 years continues to reinvest at the same rate and at the same returns, which I think it can because they're very protected from competition. then I think it's not as expensive as many people think. But if terminal risk shows up, then obviously the margin of safety is not very high.

So I think if you have a strong view on autonomous, then you might be comfortable paying a premium. And if you don't, you're going to wait for a better opportunity, which might come. I mean, there are people that have been waiting for Copart for a lot of years, and obviously the pandemic was a perfect scenario because there was no driving, so Copart dropped quite a bit, but the company doesn't typically drop that much, even if there's like during GFC.

I don't remember how much it dropped, but I think it dropped less than the indices and then it doesn't suffer very, very large drawdowns. So I know for example, that, in my conversation with François Rochon, he told me that he had been waiting for Copart, he missed Copart and he had been waiting for a long time for it, but obviously he didn't get to his buying point. 

Ryan: I mean, you mentioned the ability for them to reinvest at high rates is kind of, I think reflective of the stock price. For people that haven't ever seen Copart stock, it's more than a hundred bagger all time. I think the proof's kind of in the pudding there but I guess, based off this conversation, I think most people can probably tell this is a pretty high quality business.

Obviously there's the one kind of looming pie in the sky risk, which is, you know, no accidents anymore. But, it seems like that's not really happening cause there's a lot of accidents every year.

What would it take for this to be a bad investment? I guess, what's the pre-mortem here?

Leandro: So, besides the fact that autonomous might arrive earlier than expected, and this is a risk that Copart has, so you're, you're betting against, well you're betting up more than against Moore's Law, but you are betting against, Moore's Law and then obviously that all the time that it gets to like the vehicles, the vehicle fleet takes to get replaced.

That would be probably the main risk. And then the other risk for me is complacency, which I think is...this is the risk for any company that's leading an industry. When you're the leader, then obviously the probability of falling complacent is much higher. And if they fall complacent, then maybe, who knows, IAA might take market share in the future. Right now it seems like impossible, but you never know if management gets complacent.

I think probably another risk would be Copart diversifying or diworsifying to other sectors because I think there's plenty of opportunity to grow in the industry that they excel at. And there are obviously some adjacencies that make sense? So, for example, this is interesting because IAA. If it gets acquired by Richie Bros, then Richie Bros is saying that they are diversifying to to the salvage market, which I think it's very difficult for them to do. But at the same time, I think that Copart would be better diversifying like the probability of Copart diversifying to the used machinery market and being successful is higher than someone going into into their terrain. And management, in the last earnings call, they asked them obviously about diversifying and, and they said that they don't say no, that they're exploring things, but right now they're not going to do anything. But when you have yards, you have towing. Obviously, the business models are pretty similar.

The most difficult part is that you have...you're not going to have insurers as customers, so you have to go to against another customer group. But I think diversification will probably make the business worse. Especially because there's no need to do it with the runway that you have right now in your core market.

Ryan: All right. Well, I think that's pretty much all the questions we have. Brett, do you have any other ones? Looks like you're shaking your head, so that is gonna do it.

I guess Leandro, our listeners are probably familiar with you already, and I have to say you are a listener favorite among the Chit Chat Money regulars, so ASML number one show the last year, go check that out.

Leandro: That's, no, that's due to the stock price performance right now.

Brett: Of course. Well, we do get a little, I mean, NVIDIAs number two with, with Luke Howard, so Yes. The, uh, the, we we need to listen to our listeners. Yeah. The, in the, the listeners are a bit of a momentum indicator, but, uh, yeah.

Ryan: All right. Uh, I guess for anyone that doesn't know you or they're unfamiliar, where can they follow along with any of your work?

Leandro: Yeah, so on Twitter, it's @invesquotes or on Seeking Alpha, Best Anchor Stocks. That is my Investment Research service.

Ryan: Awesome. All right, well that is gonna do it.

We wanna remind listeners that Brett and I are not financial advisors. Anything we say or discuss here on Chit Chat, money is not formal advice or recommendation. We are, however, general partners at Arch Capitals, clients may have positions in the securities discussed in this podcast. Thank you all for listening.

Thank you Leandro, for coming on the show again, and we'll see you all next time.