If you are looking for the best ideas for your portfolio you may want to consider some of Merion Road Capital Management's top stock picks. Merion Road Capital Management, an investment management firm, is bullish on IAA Inc. (NYSE:IAA) stock. In its Q2 2019 investor letter – you can download a copy here – the firm discussed its investment thesis on IAA Inc. (NYSE:IAA) stock. IAA Inc. (NYSE:IAA) is a used car dealers company.
In July 2019, Merion Road Capital Management had released its Q2 2019 investor letter. IAA Inc. (NYSE:IAA) stock has posted a return of 31.4% in the trailing one year period, outperforming the S&P 500 Index which returned 13.1% in the same period. This suggests that the investment firm was right in its decision. On a year-to-date basis, IAA Inc. (NYSE:IAA) stock has risen by 12.3%.
In Q2 2019 investor letter, Merion Road Capital Management said the Long Only fund posted a return of 4.6% in the second quarter of 2019, outperforming the S&P 500 Index which returned 4.30% in the same period. Let’s take a look at comments made by Merion Road Capital Management about IAA Inc. (NYSE:IAA) stock in the Q2 2019 investor letter.
"During March of this year I initiated a new holding in KAR Auction Services and have increased our ownership over the past three months. Up until a few weeks ago the company consisted of three businesses that serve the used auto industry: salvage auctions, whole car auctions, and dealer floorplan financing. At the end of June they spun off their salvage auction business as a standalone company called Insurance Auto Auctions (“IAA”). While I am optimistic about both IAA and remainco (“KAR”), I particularly like IAA and have directed the majority of our exposure to this entity.
When an insured vehicle is in an accident, an estimator makes an economic comparison of the cost to repair the vehicle with the cost to replace it offset by any salvage proceeds. Cars that are determined to be too costly to fix are declared a total loss and sent to a salvage auction where they are sold for parts and materials. Enter IAA. IAA provides the two sided network that brings together sellers (insurance companies, dealerships, rental companies) with buyers (dismantlers, scrap dealers). Marketplaces are considered to be excellent businesses as increased participation from one side of the network increases the value proposition to the other side, and this dynamic continues in a reflexive manner. The salvage auction industry, however, has several other factors that make it nearly impossible to penetrate. A dense network of salvage yards is critical to reduce transportation costs thereby putting smaller operators at a disadvantage; these yards are hard to come by given permitting requirements. Furthermore, the physical and technical complexities of managing the end-to-end transportation / storage / auction process are immense. To boot the industry benefits from predictable demand that is driven by the number of cars in an accident and the salvage rate. Many factors will lead to volume growth including an expanded and aging vehicle fleet, increases to miles driven, and greater car complexity which typically makes a total loss declaration more attractive. IAA and its primary competitor, Copart (“CPRT”), each have an approximate 40% share of the North American market.
IAA has the opportunity to significantly improve its operations as a standalone entity. When the company was combined with KAR, prior management chose to return cash to shareholders instead of growing the business. I think we can all agree that reinvesting capital in an industry with large barriers to entry, stability of earnings, and high returns on incremental invested capital seems like a better use. New IAA management has outlined that its cash priorities are first debt reduction, followed by strategic growth, and then and capital returns. Given the significant cash generation of the business and the fact that the company is nearly within its target ratio of 2.0-3.0x (currently at 3.1x), I think we will see greater investments sooner rather than later.
CPRT has emphasized reinvestment and its trajectory provides a good roadmap for IAA. For instance, over the last 3 years CPRT has added 30 salvage yards to their base and currently has a presence in Canada, Brazil, Finland, Germany, the UK, Ireland, Spain, the UAE, Oman, and Bahrain. During the same period IAA has only increased its footprint by 12 and its international operations are relegated to Canada and the UK. Geographic expansion is an obvious opportunity for IAA as auctions are a global business (30% of IAA U.S. volume is exported) and the strength of a marketplace is determined by the depth of its suppliers/buyers. There remains a large margin differential between IAA and CPRT as well. Many factors can impact a like-for-like comparison including IAA’s lack of owned real estate, customer mix, dual physical/online auctions, and service revenue. Some of these factors are structural while others are not. Improvements to IAA’s customer facing technology solutions, ancillary service offerings, and operating structure should lead to margin enhancement. Management has said that they will provide more details on their margin expansion plan at an investor day early next year.
IAA is currently trading at 15.0x consensus 2020 EBITDA while CPRT is at 19.5x. Importantly these multiples do not give IAA credit for potential operating improvements. Taking a step back, IAA is a newly traded company that is valued at a meaningful discount to its closest peer with the market giving little credit for the potential of earnings improvement. I like these types of situations as it seems like the company is in the double penalty box with a discounted multiple on discounted estimates."
In Q2 2020, the number of bullish hedge fund positions on IAA Inc. (NYSE:IAA) stock increased by about 10% from the previous quarter (see the chart here), so a number of other hedge fund managers seem to agree with IAA's growth potential. Our calculations showed that IAA Inc. (NYSE:IAA) isn't ranked among the 30 most popular stocks among hedge funds.
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Video: Top 5 Stocks Among Hedge Funds
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Disclosure: None. This article is originally published at Insider Monkey.