Junk Cars Driving Copart's Growth

They still look cheap. Copart turned up recently on our Midcap screen, which searches for stock bargains among companies whose market capitalizations (share price times number of shares outstanding) are between $1 billion and $5 billion. Plenty of companies in that range combine the financial strength on big companies with the fast growth potential of small ones. Copart is one, producing the generous cash flow most often associated with mature businesses, while aiming to increase its profits this year twice as fast as the broad market. More on that in a moment.

Size alone didn't earn Copart and seven other companies a spot on our list of screen survivors. All of them produce enviable returns on the shareholder capital they invest. Bosses of each company own shares. All the stocks are up year-to-date. And all look less expensive than the broad market based on the combination of their price/earnings ratios and the rate at which their earnings are expected to grow over the next several years. (See our screen recipe for details on all the demands and use our stock screener anytime to run the search for yourself.)

Copart operates 124 salvage yards in the U.S. and Canada and this year is expected to process 1.1 million "totaled" cars. Those are considered a total loss for insurance or business purposes, including stolen vehicles that are recovered after insurance payments have been made. America will produce 2.5 million to three million of such junkers this year. Insurance companies are the primary supplier. Car-rental companies, banks and churches also contribute. Buyers include remodelers, parts dealers and scrap metal processors.

Most junk-car dealers still host on-site auctions, but Copart uses an Internet auction system called VB2, which stands for virtual bidding second-generation. Think eBay, only for uglier cars. The virtual auctions draw more bidders than in-person ones and make for fatter profits for Copart. Since the software was launched in 2004, gross margin has swelled 10 percentage points to 45% while the percentage of out-of-state bidders has increased eightfold to 40%.

Last November this column recommended shares of Chicago-based Metal Management (MM), noting that, given the difficulty in securing permits for new scrap metal facilities, its nationwide network would be all but impossible for competitors to copy. Shares have since advanced 22%, vs. 4% for the S&P 500 index. Copart enjoys a similar barrier to entry into its business. Together with its nearest rival, the private-equity-owned Adesa, Copart handles about 60% of totaled cars in the U.S. New permits for car salvage yards often take five years or more to secure.

Wrecked car production is hopefully not set to surge, and so Copart's business is a mature one in the U.S. The company is expected to generate $150 million in cash profits this year. But analysts say it earns incremental returns of more than 25% on the cash it invests, in part by putting its lucrative model to work overseas. Over the past three years the company has bought two large but barely profitable U.K. salvage operators at a fraction of the valuation of its own shares. Rochedale Securities analyst Jaison Blair, whose initiation of coverage of the stock with a Buy recommendation on Aug. 7 helped boost the price, compares the company with Dress Barn (DBRN), the women's clothing merchant. Dress Barn produced heaps of cash but had little means of growth before buying Maurices, a teen clothing seller, in early 2005. Profits and shares have since surged. The overseas expansion should likewise give Copart a good place to deploy its 6% cash flow yield.

Investors will pay 20.8 times forecast 2007 earnings for Copart's shares right now. That's a premium of about a third over the S&P 500 index, but seems well worth the price, considering the growth potential. The company is seen increasing its profits 16.5% this year, about double the rate projected for the S&P 500 index. And the business of brokering junk seems more resistant to an economic slowdown than most.