Insurance Auto Auctions (IAA) priced its spinoff bond and loan tight to talk yesterday as investors bought into the company’s growth potential, ample free cash flow, and prospects for a higher valuation as a standalone, said five sources following the deal.

In particular, the increasing number of cars in operation over the last several years, and related car accidents, present tailwinds for the company’s core business, which focuses on salvage auctions for damaged vehicles, the sources noted.

Lead JPMorgan yesterday priced the upsized B2/B USD 500m senior unsecured notes due 2027 at 5.5% and par, the tight end of revised price talk of 5.5%-5.625%. Talk circulated Tuesday in 5.75% area, tight of earlier whispers in the 6% area, two buyside sources following the deal said.

The notes traded up today to 101 to yield 5.3%, according to an analyst.

Along with a term loan facility, proceeds from the notes are slated to fund GCP, and distribute a USD 1.25bn dividend to KAR Auction Services as a part of the company’s spinoff from KAR. The downsized USD 800m TLB due 2026 priced yesterday at Libor+ 225bps with a 99.75 OID, following initial talk at L+ 275bps and a 99 OID, and is quoted today in the 99.375/99.75 context, according to a trader.

IAA will be 3.3x-levered pro forma, based on USD 1.323bn of total debt and USD 396m of LTM adjusted EBITDA. However, when accounting for USD 677m of operating leases, leverage rises to 5x, according to two of the sources.

On a relative value basis, sources comped IAA to Ritchie Bros. Auctioneers, which carries slightly lower leverage at 2.8x, and yields slightly less as well. Ritchie’s Ba3/BB USD 500m 5.375% senior unsecured notes due 2025 last traded yesterday at 102.263 to yield 4.69%, in line with recent levels, according to MarketAxess.

Driving forward

Pro forma the deal, liquidity totals USD 350m through a new USD 225m revolving credit facility due 2024 and USD 125m of cash on hand.

Sources expect the company to generate roughly USD 210m – USD 225m of free cash flow (18.8%-20% of total debt) in 2019, based on USD 400m-USD 415m of EBITDA, USD 50m of capex, and roughly USD 75m of interest expense, as well as cash taxes.

In an email to Debtwire, KAR CFO Eric Loughmiller estimated the cash taxes at roughly USD 65m.

Going forward to 2020, adjusted EBITDA is expected to rise to roughly USD 425m, two of the sources estimated. Free cash flow would remain at about USD 210m-USD 225m, assuming that capex, interest, and taxes would remain relatively constant, and the company would pay down USD 9m of its loan, and have a USD 14m use of working capital, one of the sources continued.

IAA aims to reduce leverage, net of operating leases, to roughly 2x-3x through a strategy that includes debt reduction using excess free cash flow, along with strategic acquisitions, according to the company presentation, which did not specify a timeframe.

The company did not provide its own EBITDA projections in its marketing materials. However, some buysiders viewed its growth trajectory as less important than the fact that its business generates strong free cash flow and should be resilient to economic cycles, said two bond investors. “From a fixed income perspective, in this market environment, we are leaning on stable operating performance and therefore stable price performance for the bonds,” one of the sources said.

Strong backdrop

IAA provides auction services for total loss, damaged and low-value vehicles, operating online and physical marketplaces for buyers and sellers of salvage vehicles. Sellers include insurance companies, charities, dealers and financial institutions, while buyers include dismantlers, resellers, recyclers and international buyers, according to deal documents. The company generally earns a fixed fee from the seller and a tiered fee from the buyer, which increases as the final transaction price increases.

Approximately 60% of revenue is generated from buyer fees, 33% from seller fees and the remaining in fees associated with ancillary services, such as providing transportation, inspection, valuation and tilting, according to company documents.

The company and its main competitor CoPart each control roughly 40% of the market share in the North American market, according to company documents. CoPart holds online-only auctions, while IAA facilitates both physical and online auctions. IAA receives roughly USD 500m-USD 550m of revenue for each vehicle sold, according to two of the sources.
 

Auction volume is heavily correlated to how many vehicles are deemed total losses by insurance companies. More than 80% of the volume that clears IAA’s marketplace is connected to insured total loss vehicles, including vehicles impacted by natural disasters such as hurricanes and floods, the sources noted.

Working in IAA’s favor is that total loss classifications for automobiles by insurance companies have risen over the last five years, hitting 18% in 2018 from 14% in 2013, according to the sources. A possible kicker that might extend this trend is the fact that over the last five years, the average age of a vehicle in the US has increased 2.6% to 11.7 years old in 2018 from 11.4 years in 2013. The uptick in ageing vehicles is expected to contribute to more total loss vehicles because the cost of repairs outweighs the residual value of older vehicles, according to four of the sources.

Another positive sector trend for IAA is an increase in driving activity across the US. The USD 3.22 trillion miles driven in the US in 2018 marked an 8% spike from 2013, indicating there are more cars in the market as potential candidates for future salvage auctions.

The higher rate of total loss claims and the increase in cars on the road were both cited by Moody’s in its 13 May IAA report as potential tailwinds for the borrower. “While we expect growth in miles driven to moderate over the next 12-24 months and become a weaker revenue driver, a modest increase in accident frequency combined with an increased percentage of total losses creates a strong backdrop for IAA’s growth” Moody’s wrote.

Go your own way

In 2006, IAA merged with ADESA’s whole car auction services to create KAR.

In February 2018, KAR announced that it planned to spin off IAA, leaving its remaining whole car auction business. The transaction will create two separate, publicly-traded companies, KAR and IAA, and is expected to close in June 2019.

The dividend payment to KAR is expected to repay debt at the KAR entity, decreasing debt at KAR to roughly USD 1.55bn from around USD 2.8bn, assuming the full dividend is applied to debt repayment, according to two of the sources.

Pro forma the spinoff of IAA and the dividend payment, KAR would be 3.1x-levered with roughly USD 492m of LTM IAA-excluded adjusted EBITDA, according to a source following the situation.

While the spinoff will decrease the benefits of a diversified and expansive revenue and market base for both companies, it should help IAA capture a greater valuation with more growth potential and higher margins driven by its focus on the salvage auction market, according to two of the sources.

“On a sum of the parts basis, IAA is expected to achieve a higher valuation, closer to Copart’s 15x 5-year average EBITDA multiple, compared to KAR’s combined lower 13.1x valuation,” according to the Moody’s report.

Spinoff risk

A potential downside is that IAA could face transition risk associated with a spinoff, the sources said, advising caution to avoid Adient’s playbook. The automotive seating supply company was spun off from Johnson Controls in 2016, with an additional turn of leverage and the promise of an operational turnaround, as reported by Debtwire.

Adient’s unsecured notes have declined substantially since their issuance, especially after the company returned to the market to issue priming first lien notes in April 2019 to pay down its TLA. Management once again pitched a turnaround story with a focus on operational headwinds.

Adient’s B3/B USD 900m 4.875% spinoff senior unsecured notes due 2026 traded yesterday at 76.75 to yield 9.374%, down from trades in the 79-80 range in early May. Its USD Ba2/BB- 800m 7% first lien notes due 2026 traded yesterday at 99.875 to yield 7.021%, down slightly from trades in the 101 area in mid-May, according to MarketAxess.

For its part, IAA has been operating as a separate subsidiary under KAR, so some of that transition risk could be muted, the sources added.

JPMorgan did not respond to a request for comment.

2019 Debtwire