I love a good small business turned mega success story. Copart is just that. Willis Johnson started the business in the 80s by buying his first junkyard for $75,000. The company grew by pursuing a lucrative rollup strategy that scaled to the $30bn behemoth that it is today.
Let’s take a closer look at the business and what made it so successful.
What I love about Copart’s business is that it’s simple and easy to understand. They source wrecked cars from insurance companies, store them at one of their junkyards and then sell them (either whole or by parts) via their online auction. Since its inception in 1982, Copart rapidly grew by acquiring other junkyards using a combination of debt, equity, and seller financing. The company went public in 1994, and the stock has appreciated by 195x since then.
An interesting aspect of Copart’s business is that it’s one of the rare companies that own both its physical and digital infrastructure. Physical infrastructure being their junkyards and digital infrastructure being their online auction. This gives Copart a significant competitive advantage, which I will explain in further detail below. But to hear Copart eloquently described by its founder:
We’re a utility. Nothing can get rid of us – nothing. Two of the biggest businesses in the world are car manufacturers and insurance companies. If insurance companies don’t write insurance policies on cars, then they’re out of business. If manufacturers don’t make cars, then they’re out of business. They’re always gonna make cars and they’re always gonna insure them. We’re the guy in between. As long as we’ve got the land in the right place to put the cars on, we can’t fail. We are like the septic tanks of the sewer system. You can’t have the system without us.”Willis Johnson, Junk to Gold
What is a Rollup
A rollup is an inorganic growth strategy where a company acquires many small and or local businesses within a single vertical. The acquired businesses are merged into a single brand and several functions are centralized. The end result, if successful, is a single large national (or global) enterprise with professional management, a unified strategy, an efficient cost structure, and better offerings for its customers.
Rollups have been around for decades, and just about every single industry has either been rolled up or attempted to be rolled up. Industries include dental clinics, car washes, pest control companies, IT services, funeral homes, HVAC services, and many more.
The portfolio companies at Atlasview Equity pursue inorganic growth, but our approach is different from that of a rollup. We pursue a “buy-and-build” strategy. It can be best described as buying a larger platform and then subsequently making add-on acquisitions to gain access to new customers, geographies, intellectual property, and product lines. If you’re interested in learning more about Atlasview’s strategy, subscribe to our newsletter.
Why So Many Rollups Fail
On paper (or in an Excel spreadsheet), rollups look fantastic. Many smaller businesses come together to form a larger one. You get to share functions and professional management. You work in a cohesive manner to increase your competitiveness, alignment and reduce costs. But the reality is that many rollups fail, and end up delivering subpar returns for investors. Here are some of the common reasons why.
Overestimating Economies of Scale
Integrating small disparate companies is no easy feat. Many of the employees are used to certain processes, structures, technologies, and may be reluctant or refuse to switch. A lack of alignment and cooperation has led many rollups to become nothing more than a bureaucratic mess. Systems that work well for a small-sized business don’t always fit that of one that is 10x of its original size.
As well, many rollups never scale large enough to be able to exercise buying power over suppliers.
Overpaying for Acquisitions
Once small mom-and-pop shops know that there is a big corporate acquirer interested in their business, guess what happens? Their sale price expectations go up. While most rollups might be able to get the first few acquisitions done for reasonable prices, eventually they may need to accept higher acquisition prices in order to continue the strategy. There was a recent article about medical practice rollups in Canada, where one veterinary rollup was paying 28x EBITDA for local vet clinics in Quebec.
Many rollups employ an obscene amount of debt, which is how they finance their acquisitions. The debt service puts a massive hamper on the cash available inside these rollups and makes the organization fragile. In many cases, the return on the overpriced and underearning acquisitions does not exceed the cost of capital. Value gets permanently destroyed.
Short term incentives
Despite the above reasons, many rollups steam forward anyways. This is largely due to the short-term incentives involved. Inside value-destroying rollups, there are plenty of people who still make out like bandits. M&A lawyers, accountants, investment bankers, mom-and-pop owners, and even the PE firms still get to collect their fees. Sadly, it’s the investors who end up holding the bag.
In many rollup scenarios, senior executives don’t really care about capital allocation. They’re hired to execute acquisitions. Even if it would be best to return capital to equity/debt holders instead, its just not in their DNA to do so.
If you’d like to read further on rollup failures, there is a chapter dedicated to it in the book Billion Dollar Lessons.
5 Key Ingredients For Rollup Mega Success
In studying Copart’s success I noticed there were 5 key ingredients that made their rollup a mega success. Most rollups have ingredients 1-3 below, which may be enough to drive above-average returns for investors. But Copart had 2 additional ingredients which transformed it into a unicorn of a rollup. The ingredients are, in increasing order of importance, as follows:
1) Fragmentented Industry
The target industry must have many smaller mom-and-pop players. There have to be many targets available to merge into the parent brand. This is also how you can (at least initially) acquire at a reasonable multiple, since the smaller the business, the lower the acquisition multiple. Junkyards were extremely fragmented in the early days of Copart. There was no shortage of local mom-and-pop junkyard owners that were willing to transact.
2) Strong Platform
The acquirer needs to employ a winning strategy/process that is executed by a sharp and disciplined management team. At Copart, Willis & Co. were obviously a strong management team but more importantly, they had a unique strategy. They employed a consignment-based approach to selling the wrecked cars, which meant Copart never actually took inventory risk. This improves economics, cash flow and better aligns incentives with insurance companies compared to their competitors.
3) Economies of Scale
There should be significant cost savings as more and more targets join the rollup. Centralizing overhead and back office functions, exercising buying power over suppliers, and concentrating efforts around sales/marketing initiatives are key to driving economies of scale. One of the ways that Copart benefited from economies of scale is lower transportation costs. The more junkyards they had, the smaller the distance the wrecked car had to be transported.
4) Constrained Supply
The number of businesses in the industry are stagnant, so the supply of the service/product is constrained. New mom-and-pop entrants aren’t able to open up with relative ease. This is usually a result of a large barrier to entry for new entrants (costs, regulatory, etc). When this exists, a rollup can successfully reduce the supply and thus capture significant value.
As Copart started to rollup junkyards, it became increasingly difficult (actually impossible) for anyone to open new junkyards near major metros. A combination of startup costs and regulatory barriers prevented new junkyards from opening up. So the supply of junkyards remained stagnant as Copart aggressively rolled them up. They were so effective at reducing the supply of junkyards that today, the industry is a duopoly (its just Copart and IAA). That’s right, the industry went from a bunch of fragmented mom-and-pops to just 2 remaining players controlling the entire industry. That is what you call an accretive value-capturing rollup.
5) Network Effect
The network effect refers to the concept that the value of a product or service increases when the number of people who use that product or service increases. Facebook is a great example of a business that has a network effect, in that, each new user that joins the platform increases the value for all existing users. Similarly, rollups can have network effects too (albeit very rare). Each additional acquired business enhances value for its existing customers and network. In Copart’s case, their online auction is the quintessential example of a network effect. Each additional junk yard acquisition increased the value of the network. The more salvaged cars on their auction platform, the more buyers. The more buyers, the more salvaged cars insurance companies gave to them.
Copart’s digital infrastructure layered on top of their physical infrastructure creates an impenetrable moat.
I hope this post illuminates why their rollup was so successful and also why many rollups fail. Copart is a truly fascinating business and is perhaps the most successful rollup of all time. If you’re interested in reading more about their business, I highly recommend Junk to Gold written by its founder Willis Johnson.