We all know someone who's had their car totaled. It's no fun, but did you know there are businesses built entirely around buying and selling totaled cars? In this episode of Industry Focus: Energy, Motley Fool contributor Luis Sanchez joins host Nick Sciple to take a look at Copart (NASDAQ:CPRT) and how the automotive auction industry profits from totaled cars.

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This video was recorded on March 10, 2021.

Nick Sciple: "It's totaled." Even if you've never been through it yourself, we all know at least one person who has gotten that call from their insurance company. The call that explains that your car costs more to fix than it's worth and that they've decided to pay you a chunk of cash and send you on your way. But that's not the end of the story for your car. What happens to your car after the insurance company hulls it away? I'm Nick Sciple, and this week on Industry Focus, we're taking a look at the business of car auctions to understand how some companies make money selling cars that cost more to fix than they're worth. Here to help me take a look at that is Motley Fool contributor Luis Sanchez. Luis, great to have you back on the podcast.

Luis Sanchez: Happy to be back.

Sciple: It's a fun topic for us today, What happens to your car after it gets totaled? Before we get into that, Luis, have you ever totaled a car? Have you ever had that phone call: "Listen, dude. Your car, it's broke, man, it ain't coming back."

Sanchez: Yeah, I had fender benders, I had scratches here and there. It's funny. I live in New York City, I don't even own a car anymore. [laughs] Hard for me to total a car if you don't own a car.

Sciple: You and me both. I actually don't own a car anymore, either. I got rid of mine after I moved up to the D.C. area. The car I had owned was a 1997 4Runner I got after I totaled senior year of high school my 2001 Honda Accord. It wasn't my fault, I was driving to school one day, I remember distinctly because we had a field trip to the International Food Festival Day. I had paid my $15 to get out of school for the day and go eat the free international food. I'm on my way to the field trip, this lady in a Suburban, I guess I'm in her blind spot, she decides to change lanes, crunches the car, totals the car, I miss out on the field trip, and I lose my car and I had to go buy the car that I had. I've been through that experience, it throws you for a loop. Luis, high-level, I mentioned the insurance company decides to total your car when it costs more to fix than it's worth. What goes into that calculus for the insurance company? How do they decide, "Listen, we're not going to bother with this thing."

Sanchez: It's really interesting. I refer to this as the economics of a car crash. There's a lot of factors that go into it, the primary one is what you mentioned up top, which is if it costs more to repair the car than what the car is worth, then it's not worth repairing the car basically. If you need to put more into it than you're going to get out of it, it's not worth it. There's a lot of factors that go into that, but a big one is the used car price index, which is basically a benchmark for what the car could be worth.

Sciple: Absolutely. If you look right now, that index is near an all-time high, maybe added buying pressure from the pandemic and things like that. How is that affecting the rate at which cars are being totaled, and I guess the underlying business that goes into this?

Sanchez: First, you got to think about why is the used car price index so high? I think that's interesting in and of itself. It does go back to the pandemic. If you recall when the lockdown started, one of the first things that were shut down were the car factories, and so there's been a shortage of cars out there on the road. Compounding that, there's been an increased demand for cars in certain parts of the country as people left the cities and started to adapt to more of a suburban lifestyle. A lot of people are also taking vacations that require driving instead of flying, so there's also been demand for rental cars. It really boils down to supply and demand. Supply is low, demand is high. You don't really think about it on its face, but it actually has a knock-on effect to all the companies that are in that ecosystem.

Sciple: Absolutely. I want to go into the companies in that ecosystem that we wanted to talk about today. One of the main ones is Copart. When the insurance company decides they want to auction off your car, Copart assists them with that, ticker CPRT. Well, where does Copart fit into this process? After you total your car, you've decided it costs more to fix that it's worth, what happens to your car after that and where does Copart come into that process?

Sanchez: Copart is an industrial marketplace, essentially. Their clients are essentially the guys who are trying to get rid of their cars, so really, insurance companies. There's a few other potential sellers of cars, but insurance companies are the vast majority that take possession of the totaled cars. Essentially, totaled cars get transported to these massive lots that are located outside of major urban areas, and they basically just run an auction, it's done online, it's done in person, and there's all sorts of people who are trying to buy these broken cars. I guess the other question is, who are the buyers and why might they be interested in the car? It's really all sorts of participants. There's a large participation of foreign buyers, it's roughly a quarter of the people who are buying totaled cars. There's an interesting reason for that, because the definition of a totaled car, it could actually be different in the U.S. versus another country. It might actually be more economical for a buyer in another country to buy a broken or totaled car in the U.S., and there might be a lower cost to repair it in that other country, or it might just be harder to buy that brand of car in that other country. There's also what are called dismantlers, who will actually buy the car, sell all the auto parts that still retain value, and then just scrap the car. There could also just be some scrappy repair shops who just know that they could fix the car and sell it for a profit.

Sciple: So fundamentally, what Copart is doing is connecting these sellers who have cars they don't want, or insurance companies, with all these different disparate buyers out there in the market who have some interest in these products for whatever reason. Whether it's because you're going to arbitrage repair costs in different countries, or you're searching for some vintage car that only comes up for sale because you get one totaled off the back of a truck, or something like that. Copart really helps connect those buyers and sellers in that market. Where does Copart extract value for themselves from that operation?

Sanchez: The primary way they make money is by taking a commission from the auction. It's roughly a 10% commission that they take, and that's based on whatever the car goes for. The really interesting thing about that is, as we mentioned up top, the value of used cars has gone up a lot, and that's actually been a benefit to Copart because they benefit from a higher auction purchase. So their interests are aligned with their customers, I guess you could say. That's the primary way they make money. There's also some ancillary things. They sell access to the data to potential buyers, they sell technology that could be used to bid at the auctions. An example of that could be if you're a foreign buyer and you want to use more-advanced techniques to bid for cars, say you want to have a price monitor, almost like an algorithmic trading bot, they might charge a little bit extra for that. They also do inspection or handling the title, transfer the car. Another thing that's interesting is they have a service that will automatically pay back the car loan once the proceeds have cleared from the sale of the car. They'll help the insurance company automate the process of closing out the car loan and transferring the title. So there are some little ancillary services here and there that they can make some extra money from, but the vast majority of their financials, really, are driven by the proceeds of the sales.

Sciple: Absolutely. So it's the more cars that are getting sold off and the higher value of those cars, then the better it is for Copart. I guess part of the driver of that is the rate at which vehicles are being totaled, and that has been somewhat of a tailwind for the business. If you look back over the past 10 years or so, the rate at which cars are being totaled or taking a full loss, that's been a benefit to them. In addition there could be some fluctuations in used car prices. One other thing I wanted to talk about, Luis, this may be interesting, is just the barriers to entry in this market. You'd mentioned having lots all over the country to be able to take this inventory, connecting all these different buyers and sellers. What do you think about the moat that Copart has in the market in which they operate?

Sanchez: There's a few sources of a potential moat here. I use that word "marketplace" up top. There's a lot of terms that get thrown around, like online marketplaces and flywheels, and this is like an old-school marketplace. They benefit from liquidity. There's a network effect. Buyers pay attention to this auction and they want to come and bid at this auction because they know that there's going to be a good source of cars, and the insurance companies want to take their cars to this auction because they know that there's going to be a lot of bidders and they're going to get the best price. The other thing, too, is that there's geographic monopoly, so just where these lots are located, they're very strategically located outside of metropolitan areas, where there's a lot of car traffic, where there's urban density, and frankly, these lots are huge. So just having the space to hold literally thousands of cars is not nothing. It costs money to set up that lot. I think probably the bigger barrier, really, is any marketplace or auction, it's really tough to get started if you don't already have buyers and sellers. It'd be really, really, really hard for us to set up a Copart competitor tomorrow because who's going to bring us the cars, and how can we assure them that there's going to be enough buyers to sell their cars at competitive prices?

Sciple: Absolutely. It's one of those things where once you set up in a geography and up and running and then have these relationships, it's really hard to see why do I need another lot across town? Why do I need two different logistics infrastructures, to think about bringing different things if I'm the insurance company, or anything like that? It's one of these businesses where the physical infrastructure really helps them out. It reminds me of, it's a different business, but Vulcan Materials, they own aggregate, they have locations all over the country, the same type of thing, because of the cost of shipping their stuff, they only need so many in certain locations. When you talk about, Luis, part of the driver of the business for Copart, you need totaled cars to go to auction. A lot of people will talk about this rise of autonomous vehicles, improved safety technology in vehicles, and the idea that maybe sometime in the future we have far fewer accidents, far fewer fatalities, those sorts of things. What do you think about that risk for Copart's business?

Sanchez: Cars are getting safer, and that's great for everyone. But the reality is that we're still going to have accidents, even if cars are safer. There's a couple of long-term trends that are actually working in our favor. The biggest one is really just that the population is growing and there's more people driving. The total miles driven in the U.S. and around the world has steadily gone up every year, about like 1% to 2% per year. Just logically, the more cars that are on the road, the absolute number of accidents is going to be higher. The other interesting thing that actually specifically relates to autonomous and electric cars is that as you put more technology into the car, it makes it harder to repair the car. It makes it more expensive to repair the car. The parts in the car are worth a lot more money, so there's an increasing rate of totaled cars. If you go back to the 1980s, and you look at the car crashes that happened in literally, like 1980, only about 5% of cars that were in a car crash in 1980 were considered total. Fast-forward 40 years, and now, more than 20% of cars that are involved in accidents are totaled, and it's because of that gap between the value of the car and the cost to repair it. I don't know if you have any insight into this, but I've heard that repairing a Tesla is [laughs] extremely expensive. It's probably more expensive than repairing a Camry that you can probably source at a local mom-and-pop repair shop.

Sciple: Yeah, certainly. There's puts and takes with Tesla because they run all their own service operations and make all their own parts and all those sorts of things. But certainly, as you put more tech in a vehicle, it stands to reason that the cost of repair goes up. Just an example to think about: We're entering this world where many more cars are going to have a standard feature similar to Tesla Autopilot, so advanced driver assistance systems for the highway and that sort of thing. Part of that is that you see lots of automakers putting things like cameras, and radars, and lidars in their bumpers and all around the car. It turns from a fender bender that damaged a cheap piece of plastic to a fender bender that damaged a cheap piece of plastic with lidar and cameras and radar embedded in it. Of course, auto companies are going to take steps to protect that type of technology, but again, that technology is sensitive and mistakes still happen. I think one other thing to think about as well is, as autonomous technologies rollout, one of the first places they're going to be rolling out is to places like highways, so Tesla Autopilot highway, GM Super Cruise highway. Now, Tesla is trying to push out into some other areas, but predominantly, guided for use on the highway. Most accidents, the highway is much safer than the traditional surface streets. It makes sense; they were designed that way. You don't get a curve over a certain gradient, you never make an unprotected left turn, all those sorts of things.

I think there's an argument you made that in the near term, as some of these autonomous technologies roll out and their use case is applied in some of these areas that are already pretty safe, that on a margin, you see some net effects of total loss going up, because people are still driving and making those same mistakes when they turn left in the intersection or what have you. Now, there is going to be a certain point you would think where crashes go down enough across the board that it impacts somebody like Copart, but I would say that in the near term, there may actually be a little bit of a tailwind to go off with what Luis just said about we're on this long-term trend toward higher total-loss rates for vehicles, and with more tech going into the vehicle, I don't think that's going to turn in reverse in the super near term, like next five years.

Sanchez: Right. If you look at the data back 30-40 years ago, the rate of fatality in a car crash was like 3 times, 4 times what it is today. If you look at just the past 10 years, we've started to have some of these safety technologies. The rate of accidents doesn't go down every year. I think it's been pretty flat over the last few years. Maybe on the margin, as autonomous vehicles come on line, like you said, it does get lower, but this is already a headwind that the company has theoretically been facing for a long time. There's actually some tailwinds to that, because now you have this whole issue of distracted drivers. Potentially, they're using a Tesla Autopilot, but they're misusing it because they are doing their makeup, or watching Netflix on their phone because they think the car is going to keep them safe, when as we just learned, Tesla is only a level 2 autonomous-driving car at this point. Then, the other factor, too, is just that it's going to take probably a couple of decades once we have the technology to fully replace the fleet that's currently out in the world of driving.

Sciple: Absolutely. I think it's something to monitor, but at least the current trajectory of what it looks like the technology is playing out, I don't think it's something that's thesis breaking for the company. I still think there's opportunities in the future for Copart. I want to talk briefly, in addition about some of these other companies in the industry, Copart isn't the only operator in this car auction subsector. What are some other companies that we should be paying attention to, and how do they compare to what Copart is doing?

Sanchez: For sure. So, Copart is like a 300-pound gorilla. They have +50% market share in this industry, which is great. That's one of the reasons why it's been such a fantastic business. It's really been a duopoly though. There's this other company called IAA, which is a little bit smaller. They have somewhere between 30% or 40% market share, so it's actually still very sizable. It's really just been a duopoly between Copart and IAA. IAA, two-years ago, spun off of KAR, which is KAR Auction Services, which is another car auction company that we could talk about in a minute. But basically, IAA is like a mini-Copart. The way that I would frame the difference between IAA and Copart other than just sheer scale, is that Copart has been more on the leading edge of technology. Copart, heading into this pandemic, one thing that has really helped Copart is they were already fully online with virtual bidding and virtual auctions, whereas IAA wasn't fully online at the start of the pandemic, so they probably lost a little bit of market share this past year. But now, going through the pandemic, they certainly got to 100% online.

The other thing that's interesting about IAA and Copart is Copart is also an international business. Copart has really been growing in international locations; IAA is primarily in North America, although if you look at their recent earnings calls, and management statements, IAA is basically looking at Copart, and they're following the Copart playbook. So now, IAA, they're aggressively going into international markets, they're aggressively investing in technology, and they're aggressively putting into place the best practices that Copart has operated with and just trying to close the gap. I think that's actually a really interesting story. If you like this industry, and maybe you think Copart is too expensive, maybe take a look at IAA, and that's more of a discounted way to play the theme.

Sciple: So, would you say that IAA is like the Lowe's to Copart's Home Depot, or the Pepsi to Copart's Coke [Coca-Cola] in this situation?

Sanchez: Yeah. It's the No. 2, it's the underdog. It also operates at half of the profit margin as Copart. There's a potential investment story there, if you think that IAA can execute on this plan to raise their margin and grow internationally. Potentially, IAA can push through a lot of, actually, a higher rate of earnings growth than Copart. It also trades at a very slight discount to Copart. So that's why I think that IAA is very analogous to Copart and it's potentially an interesting investment if you like Copart.

Sciple: Absolutely. So the question is: Is there enough of an execution difference between the businesses to justify that difference in valuation? Because if IAA can execute, the room to improve gives them a lot more upside relative to Copart, which was already executing well.

Sanchez: I think what a lot of people would say is, Copart's already generating a good amount of earnings growth and it's not too crazy. The valuation isn't too crazy and Copart's definitely rich, so going with Copart is like going with the best-of-breed, lower execution risk, kind of way to play the sector, where IAA is like the higher risk, but probably higher reward if they do a good job.

Sciple: Absolutely, yeah. Lowe's and Home Depot just keeps ringing in my head as you make that comparison there. One other company we did mention, maybe we can talk about briefly, are KAR Auction Services, ticker KAR, and they are in a little bit different niche relative to what IAA and Copart are doing.

Sanchez: For sure. So, KAR Auction Services, you mentioned the ticker, KAR. They are in what's called a whole car auction, so that's nontotaled cars. It's really just used car auctions. The way to think about where they sit is, they source inventory from all sorts of interesting channels. So, when rental car fleets turn over, when rental cars want to replace their used cars with brand-new cars, they'll take it to auction through KAR. Or when people who are leasing cars abandon their leases, assuming the cars are still in good condition, they'll offload to KAR. Or charity auctions, people who donate their old used cars to charities. Then, what KAR really does is they're a B2B business. Basically, the people who are buying on the car auctions are primarily used car dealerships who will then sell to a retail channel. There's also some individual buyers who will also shop on KAR. But it's really a B2B business. I'd say there's really interesting differences, though, between the total-car auction market and the whole-car market. Namely, it's that this is a more competitive channel because there's just a lot more places to source used cars, right? eBay, Craigslist being one. Some used car dealerships will actually buy used cars from other dealerships, right? There's other B2B used car channels, it's not just the auction. You can do private brokerage or just direct. That's on the demand side.

On the supply side, the inventory is less guaranteed. I think that's really the story of the last year with KAR is, they've really suffered from the shortage of used cars. So because there haven't been new cars to purchase, rental car fleets aren't getting rid of their existing fleet. Because the price of a used car has gone up so much, this is actually a really interesting situation where people who are sitting on leased cars, they're not abandoning the lease. They are actually buying the cars because the price of the buyout option is set at the beginning of the lease. So there's a little bit of an arbitrage now that used car prices have gone up so much. Yes, KAR has actually suffered and they've actually seen their revenue decline quite a bit in the last year as a result of these factors. They also did get squeezed, to the extent that KAR needs to buy inventory, they're going to have to pay the higher price for those used cars.

Sciple: Absolutely. So they may have been a little bit more victim of what has gone on over the past year, whereas if you look at Copart reporting record numbers across the board in the most recent quarter, they've been a beneficiary in this way. Do you see KAR as being a potential reopening play? People are going to start traveling again, getting rental cars when they go to Hawaii and places like that. Do you see this as a business that could potentially benefit from a recovery?

Sanchez: Absolutely. I think KAR, of all these three companies I've mentioned, I think KAR is probably going to benefit the most from a recovery. But what you would need to see for them to really benefit from a recovery is some kind of normalization of the value of used cars, the used car index. It's also interesting to think about whether Copart or IAA are reopening plays because that's actually really hard to know. The answer is yes or no. Because Copart and IAA have seen their volume of cars sold decline, but they've seen the value go up. So if we get into a situation where the volumes of used cars go up, but the prices of the used cars also remains higher elevated, then IAA and Copart can continue to benefit. But we could also see the opposite, like what happens if the value of used cars goes down? Well, that might become a headwind and that might potentially benefit KAR. KAR also, the way they make money is a little bit different from Copart and IAA, which is also worth mentioning. KAR makes about half of their money from, half of their revenue from auction proceeds. But the majority of KARS' earnings are actually from the ancillary services that they provide. More than a third of KARS' earnings are actually from financing. So they're really involved in helping people complete that purchase. That's actually really KARS' competitive advantage. They're basically financing these used car dealerships, they're financing the floors. In a lot of cases, that's the reason why used car dealerships are doing business with KAR because not only can they source the inventory, but they can finance it at a reasonable rate.

Sciple: Absolutely. So the relationships, it sounds like in this business, are very different when you're talking about the customers that you're working with. Because those customers have different needs, different services are offered.

Sanchez: A really interesting part of the story too is Carvana and CarMax and some of these other high-flyer used car companies like Vroom, and I think there's a few others. They're actually some of KAR's biggest customers. The primary way that Carvana is sourcing its cars is actually from these whole-car auctions. That actually is a really interesting part of the story because Carvana is having to pay the higher prices for used cars because the used car index has gone up so much, and one of the things that Carvana and some of these other companies are doing is they're trying to get more trade-in business so that people trade in their existing cars so that they can kind of get more beneficial pricing. That's a whole.

Sciple: Luis, when you talk about that relationship with Carvana, do you see that as an opportunity or threat? Obviously, a potential customer to sell the product to, but as Carvana gets more involved in this trade-in business, then they are a threat to their sourcing, right? I mean, to their supply.

Sanchez: The word that comes to mind is frenemy. They're one of the biggest customers, but at the same time, Carvana wants to lower its cost as much as possible, and part of Carvana lowering its cost is not paying car auctions' markup and not paying the auction fees. If Carvana can just get everyone to do trade-ins, that actually is a very proprietary way for Carvana to source inventory and actually can give Carvana a competitive advantage over a CarMax or another e-commerce player.

Sciple: Yes. Something to watch there. We'll add Carvana to the list for a future podcast, because I'm sure we could do a good half-hour on that one alone. But as we wrap up this show on the car auction business, as you think about these three companies we talked about today, so Copart, IAA, and KAR Auction Services, K-A-R, which company gets you most excited today and why?

Sanchez: For sure. Yeah, I think I laid out that thesis for IAA. If I was going to make a position in this group of companies, that's probably the one that I would start with because if you believe that they can basically replicate the Copart model, and IAA has been a fine business. It's not quite operating at the level of Copart's margins and hasn't quite generated the same level of revenue growth as Copart. But a lot of that probably stems from the fact that it was a part of KAR as of three years ago and it didn't have full control over its destiny. Now that IAA is out on its own, there is this thought that it can potentially execute better because it's more focused. So I think that's a really interesting story. But again, I think it's a higher risk, higher reward situation, where if I was just really more focused on just getting exposure to this theme because I like the idea, it's a fairly counter-cyclical or encyclical business, just the way that the different forces balance out against each other.

Right now, as we said, we're in this part of the cycle where the value of used cars is really high, but the number of used cars is low. The interesting relationship between that is, when the value of used cars is lower, you're going to see a lot more cars coming to market because more cars are going to be considered totaled. It's a really interesting dynamic that makes us a very stable industry as long as you don't believe that autonomous cars and self-driving cars are going to completely disrupt the concept of people getting into car accidents, which I think that certainly is something on the margin that matters, but I think that requires a leap of faith to believe.

Sciple: Right. Fundamentally, if you think people are going to keep making mistakes behind the wheel of a car and we're not going to solve those with technology in the immediate near term, these companies continue to have a role and arguably could have a bigger role in the future.

Sanchez: Absolutely.

Sciple: All right, Luis, as always, love having you on the podcast. Can't wait to have you on again in the future.

Sanchez: Thanks, Nick. I had fun.

Sciple: As always, people on the program may own companies discussed on the show and The Motley Fool may have formal recommendations for or against the stocks discussed, so don't buy or sell anything based solely on what you hear. Thanks to Tim Sparks for mixing this show, for Luis Sanchez, I'm Nick Sciple. Thanks for listening and Fool on!

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.