KAR Auction Services, Inc. (KAR) on Q3 2022 Results - Earnings Call Transcript
Operator: Good day, and welcome to the KAR Auction Services Third Quarter 2022 Earnings Conference Call. All participants will be in a listen-only mode . Please note this event is being recorded. I would now like to turn the conference over to Mr. Mike Eliason, Treasurer and Vice President Investor Relations. Please go ahead, sir.
Mike Eliason: Thanks Matt. Good morning. And thank you for joining us today for the KAR Global third quarter 2022 earnings conference call. Today, we will discuss the financial performance of KAR Global for the quarter ended September 30, 2022. After concluding our commentary, we will take questions from participants. Before Peter kicks-off our discussion, I'd like to remind you that this conference call contains forward forward-looking statements within the meaning of the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. Investors are cautioned that such forward-looking statements involve risks and uncertainties that may affect KAR's business, prospects and results of operations, and such risks are fully detailed in our SEC filings. In providing forward-looking statements, the company expressly disclaims any obligation to update these statements. Let me also mention that throughout this conference call, we will be referencing both GAAP and non-GAAP financial measures. Reconciliations of the non-GAAP financial measures to the applicable GAAP financial measures can be found in the press release that we issued last night, which is also available in the Investor Relations section of our Web site. Now, I'd like to turn this call over to KAR Global's CEO, Peter Kelly. Peter?
Peter Kelly: Thank you, Mike, and good morning, everybody. I'm delighted to be here this morning to provide you with an update on KAR Global. During today's call, I'll provide you with additional information and detail relating to the following; our third quarter performance, our view of the current market factors that continue to impact the automotive industry, and a summary of our capital allocation activities. I'm going to speak about our business in two segments, our Marketplace segment, which we formally call the ADESA segment, and the Finance segment, which we formally called the AFC segment. To begin, Q3 was an important quarter in the history of our company. It was our first full quarter since we completed the divestiture of the ADESA US Physical Auction business in May and in fact, the true beginning of what I believe will be a bright future for KAR as a more asset light digital marketplace company. I'm pleased with the results that we produced across the organization, especially given what continues to be a very challenging industry and economic environment. During the quarter, we increased revenue, total gross profit and adjusted EBITDA. We met our cost reduction targets to $283 and we also increased gross profit per vehicle to $320. This was an increase of 14% over the third quarter of last year. In our Finance segment, we experienced another solid quarter of performance as AFC continues to grow its core finance business. Our Finance segment generated revenue of $99 million in the quarter, an increase of 31% over Q3 of last year. This was driven by 13% growth in the number of transactions and 16% increase in revenue per transaction, which increased to $250 for the quarter. Interest income represented 54% of AFC revenue for the quarter, that is 700 basis points of an increase from Q3 of last year and is consistent with the higher interest rate environment that we see today. This also demonstrates that a higher interest rate environment can be positive for AFC. So overall, I think there's a lot to be pleased about in the third quarter performance, particularly in light of what has continued to be a challenging environment. The proactive steps that we have taken to transform our operating model, reduce our cost structure and advance our digital vision, beginning to take shape within our results. To be absolutely clear, I do not believe that our third quarter results reflect the high level of performance that I'm confident this company is capable of delivering in the future. However, I do believe we are demonstrating our ability to execute on the fundamentals of our business. And as a whole, I believe our results provide an outline of even stronger performance as the industry turbulence settles and as we continue to advance our digital strategy. So now I'd like to highlight a few areas of progress from the quarter where we are advancing that strategy, and I believe will benefit our performance in the future. The first is platform consolidation. One of our primary objectives is to simplify the customer experience and increase engagement across our marketplaces. In the United States, we have now successfully combined the BacklotCars and CARWAVE marketplaces into one digital venue. In October, we deployed a new auction format within the BacklotCars platform, which builds upon the previous CARWAVE format and complements the existing marketplace formats within BacklotCars. So we now offer our sellers and buyers the choice and flexibility of two distinct formats, a marketplace format where vehicles can be offered and purchased throughout the day immediately as they're loaded and an auction format where groups of vehicles are set for time sales, which are currently scheduled for twice every week. We're focused first on deploying the auction format in the markets where CARWAVE already existed. Once this is complete, we expect to begin a national rollout of this format to all remaining markets in the United States. In Canada, we've also made significant progress on our effort to consolidate the TradeRev and ADESA marketplace. We launched a beta version of that combined marketplace in July to a limited number of customers, and the feedback has been positive. In October, we began expanding that beta to a broader base of dealers with additional new features and capabilities added. As these consolidation efforts progress, we expect increased engagement from our dealers, increased efficiency within our technology development and operations, and improved results across our marketplace business. The second strategic focus area I'd like to cover is pricing. We continue to make some adjustments to pricing in the third quarter, and we were successful in getting a number of fee increases and new revenue streams put in place in both our dealer and commercial business. Some of these had a positive impact in Q3 and are reflected in our unit economics. We expect others to become effective in Q4. To be clear, regular price increases are not a key component of our strategy for growth. However, the fact that we've been able to make these price increases demonstrates the strength of our offerings and the strength of our longstanding customer relationships. The last focus area I'd like to speak to is cost management. The ADESA transaction created a catalyst to restructure our business to reflect a more asset light digital operating model, and to help respond to the current realities of our market. We made a commitment to reduce our annual SG&A run rate by $30 million and we are on track to achieve that goal ahead of schedule. This positions us to exit the year below $400 million in terms of an annual SG&A run rate. We do expect some quarter over quarter fluctuation as certain cost reduction initiatives may require short term cost increases to help achieve sustained savings thereafter. It's also important to note that achieving our 2022 cost savings target was only a starting point. Disciplined cost management and a focused investment strategy will remain a priority for this business going forward. We have a roadmap in place for continued improvements in our efficiency and effectiveness, and these will deliver further cost reductions in Q4 and into 2023. Those savings should help us continue to focus our investments into the technology, talents and resources necessary to PAR KARâs long term vision and strategy. I'd like now to look towards the future and provide some details around the industry outlook, the macro environment, particularly in the areas of new vehicle production, used vehicle pricing, wholesale use vehicle supply, as well as the outlook for commercial volumes. And my comments are based on our assessment of publicly reported data, as well as recent discussions with some of our largest customers. New vehicle production and supply continues to be a challenge, and it's taking OEMs longer than expected to solve their supply chain issues. In Q3, some OEMs did show increased production and new vehicle sales, but a significant number of them still had fewer sales than a year ago. My assessment remains that the supply side issues appear to have bottomed out when viewed on an industrywide basis. However, I also think the recovery and production will be more gradual than most experts had predicted. Increased new vehicle production coupled with a higher interest rate environment and a weakening economy will likely put downward pressure on new and used vehicle pricing. Over the course of Q3, we observed a steady decline in used vehicle values in the industry, and at a rate that is above normal for this time of year. We expect this decline in used vehicle values to continue through at least year end. Ultimately I believe that a decline in used vehicle pricing will be a long term positive for our business, as I believe it will allow more vehicles to flow into the wholesale channel. In the near term, however, declining market is often characterized by lower conversion rates and this can be a near term headwind to the business. An industry wide lack of wholesale used vehicle supply also remained evident in Q3. For example, physical auction volumes, which remain a good proxy for industry volumes, were down 8% below the third quarter of last year and were 37% below the pre-COVID levels of Q3 2019. In fact, Q3 of 2022 was the second lowest quarter for physical auction volume since the pandemic began. So I'm very encouraged by the fact that we can deliver a strong performance in this environment where industry volumes are still well below normal levels. I do expect those volumes to increase over time, although, I think it's prudent to expect that this will be a gradual increase and not a step function. And I believe that our focus on being a digital marketplace will enable us to grow faster in the longer term as volumes recover in our industry. A key driver of the anticipated volume increase will be the supply situation relating to the volume of vehicles being offered by commercial sellers, particularly in the off lease segment. We continue to see fewer off lease vehicles being returned compared to one year ago, but the level of that decline has lessened. From our own analysis, the equity gap, which is the difference between the market value of maturing lease and the residual value in the lease contracts, has declined meaningfully in the third quarter. However, a further decline is likely needed in order for more of those vehicles to start to flow into the wholesale channel. I'm confident that leasing will remain an important element of OEM and dealer sales strategies, and that our strong footprint with off lease vehicles will be a significant positive for this company in the years to come. Through my ongoing discussions with our customers, I believe that in the future our customers will seek to sell an even larger percentage of their portfolios digitally than they did pre-pandemic. I also want to comment on how the current environment impacts AFC. As used vehicle prices continue to decline and as interest rates increase, this may tend to increase risk within our finance business. However, AFC has best in class safeguards and processes in place that utilize all of the data that we capture to flag dealers that maybe under stress within their business. So while we do anticipate some level of increased risk as we enter 2023, we do not expect it to return to pre-COVID levels. And we believe that AFC will continue to produce strong results through year end and into next year. I'd now like to provide some insight on my expectations for the fourth quarter relative to Q3. On the positive side, we expect a benefit from the full quarter impact of our cost and pricing actions that we took in Q3. We also have additional cost and pricing actions that will become effective in Q4. On the negative side, Q4 industry volumes have historically been weaker than Q3 volumes. Also, foreign currency was a negative in Q3, and that is expected to be even more evident in Q4. Irrespective of the Q4 outcome, I am highly focused on executing our strategy, building on the positive momentum of the third quarter and positioning the company for growth in 2023 and beyond. I'd now like to provide a recap of our capital allocation activities. As I mentioned on the last call, the ADESA transaction itself generated approximately $1.7 billion of cash net of taxes and fees. In the second quarter, we utilized over $900 million to repay our Term Loan B as well as amounts outstanding on our revolver at that time. During the third quarter, we repurchased through a tender offer $600 million of our senior notes. This leaves us with $350 million of senior notes that are still outstanding. Also, since the closing of the ADESA transaction, we have repurchased approximately 12.6 million shares of KAR stock at a total price of $182 million. I want to emphasize that our projections show that KAR will continue to generate cash going forward. With an asset light model and considerably lower debt, we have less need to use our cash for CapEx that is tied to physical facilities or for servicing our debt. This should be a positive for us given the current macro environment. So to summarize my key messages for today, in Q3, we delivered an improved performance compared to a year ago and also compared to Q1 and Q2 of this year. I was generally pleased with this performance and I believe that it begins to outline what this company is capable of delivering as volumes recover. In our marketplace segments, we increased revenue and gross profit compared to one year ago. We also increased our revenue per unit and our gross profit per unit sold. We experienced another solid quarter of performance in our Finance segment, with AFC meaningfully growing revenue and revenue per unit. In addition to the financial results, we made significant progress in areas of platform consolidation, pricing and addressing our cost structure. Volumes continue to be a challenge in our industry. However, as we look to the future, we expect new vehicle production to increase, used vehicle pricing to decline and a gradual increase in wholesale used vehicle volume overtime. I believe that our digital focus will enable faster growth in that type of environment. I'm excited and energized by the many opportunities ahead and I believe that we have a significant opportunity for long term growth. We have a differentiated offering, a diverse and expanding customer base and a large addressable market in which to innovate and invest. So with that, Eric will now provide you with a more detailed review of the financial results for the third quarter. Eric?
Eric Loughmiller: Thank you, Peter. First, I would like to point out that foreign currency had a negative impact on our third quarter results. Revenue was negatively reduced by $12 million, net income was reduced by approximately $1 million and adjusted EBITDA was reduced by $1.5 million in the third quarter as compared to the prior year. I would also like to give more color on our SG&A and the evidence of improvement in our cost structure that is not obvious in the third quarter financial statements. We have provided a schedule of SG&A by quarter for 2022. This schedule provides additional detail for SG&A by segment, what SG&A was added due to acquisition and the noncash and other costs that are recorded in SG&A that do not impact our reported adjusted EBITDA. When we speak of eliminating over $30 million in annual SG&A, we are focused on adjusted SG&A. All add backs in computing adjusted SG&A are the same as the add backs for computing adjusted EBITDA. We have provided a schedule of adjusted SG&A for our continuing operations in the Q3 earnings slides that were posted yesterday. The headline result is we have reduced the adjusted SG&A run rate in Q3 to $96 million per quarter from $104 million in Q2 and $102 million in Q1. We are excluding noncash compensation in this analysis of SG&A. As you can see in the earnings slide, there was an increase in noncash compensation in Q2. This relates to the recognition of the impact of the gain on the sale of the US Physical Auction business on the expected award of the 2020 and 2021 PRSU grants to employees. There have been no increases in total annual noncash equity grant value. However, the timing of recognizing expense in our financial statements was impacted by the timing of our financial performance. We also have significant severance associated with the termination of certain employees as a result of the sale of the US physical auction business and the realignment of our organization to match the asset light digital marketplace business that remains at KAR. This severance is recognized in the other adjustments included in the SG&A reconciliation. I expect we will have additional severance going forward as well. However, that severance will be related to additional cost savings actions and not the impact you see in the Q3 run rate. In addition to severance, we also incurred consulting fees and contract termination costs in the second and third quarter related to separation and reorganization activities following the sale of the US Physical Auction business. These fees and expenses are included as SG&A but we have included them in other adjustments in the reconciliation of adjusted SG&A in our earning slides. One major initiative that has been announced to our employees and will provide additional savings and adjusted SG&A in future quarters is related to establishing a global shared services organization. We have recently agreed to terms with two offshore firms to provide resources to support our back office functions for KAR Global. This will impact over 300 positions in the US and Canada. We have notified the affected employees and provided appropriate severance packages that are payable upon transition of their roles to the Global Shared Services Organization. We expect to begin the migration of these roles over the next three quarters. The impact of this initiative is not included in our realized savings in SG&A for 2022. The fact that our marketplaces are digital and generally not tied to a specific location allows us to move a number of support functions offshore without impacting the customer experience. In fact, we believe the use of a global shared services organization will improve efficiency and consistency of handling transactions and ultimately improve the customer experience. Our initial Global Shared Services program is expected to generate over $10 million in annual savings from our current cost structure. We expect this to be realized as we migrate to the offshore model in 2023. Another topic I would like to cover in more detail is the amendment and extension of our securitization facilities at AFC. In September, we completed the amendment of the US and Canadian securitization facilities. As part of the amendment, we increased the capacity of the US securitization by $300 million to a total of $2 billion. The Canadian facility remains at CAD205 million. The amendments extend the securitization facilities to January 31, 2026. As part of this process, we successfully negotiated changes to terms that allowed us to reduce the company's funding of certain receivables. Although, the funding did not occur until the first week of October. This reduced the on balance sheet portion of loans by $70 million, freeing up additional working capital that was locked up at AFC. While the credit markets overall are quite challenging right now, the performance of the AFC portfolio and the discipline demonstrated by the AFC team made the amendment process fairly easy. Most importantly, the financial terms of the agreement remain consistent with the terms prior to the amendment. The sizing of the facility is sufficient to fund the growth expected in the portfolio over the next two to three years. As Peter mentioned and we disclosed in an earnings release, we have purchased $100 million of KARâs stock in the open market over the past four months. Earlier this year, we put in place a 10b5-1 plan as part of our existing share repurchase program. In October, we completed the remaining approved purchases under that 10b5-1 plan. As of today, we have $126.9 million remaining on our share repurchase authorization that expires on December 31, 2023. Given the challenges in the debt capital markets and our previously disclosed intent to repurchase or redeem an additional $150 million in KAR bonds, we do not expect to acquire additional shares over the next quarter or two. At this time, we are focused on building our cash balances and conserving capital. We will be looking for opportunistic windows in the debt markets to extend our revolver maturity date and put in place a more permanent debt structure for the company going forward. Most importantly, we continue to focus on maintaining minimal net debt that is more appropriate for an asset light business like KAR. As we continue to rightsize our business and align with the asset light marketplace business that is KAR today, I am pleased to announce that on Monday of this week, we closed on the sale of 57 acres of excess land in Montreal. This transaction will result in a gain of approximately $32 million. This gain will be taxed at 50% of the statutory rate in Canada or about 13%. This transaction will generate approximately $35 million of net cash proceeds after income taxes. The realized gain will be reflected as a separate line item in operating expenses in our financial statements in the fourth quarter. For clarity, this will be a reduction in operating expenses. Also, there is not a requirement that the net proceeds from this transaction be used to reduce debt. As I wrap up my comments, let me reiterate our focus as we are faced with a challenging supply situation in a period of transformation for our industry and our company. KAR is rightsizing its operations with a focus on being asset light, strong cash generating digital marketplace focused businesses. As we continue to transition away from the ADESA US physical auction business, we will have opportunities to further reduce our overhead cost structure. We have paid down over $1.5 billion in debt this year, reducing our annual cash interest payments by approximately $70 million. This is particularly important as we face a period of increasing interest rates. Had we not repaid our Term Loan B in its entirety, we would've been looking at an increase in cash interest expense next year of nearly $30 million. Having our balance sheet in a great spot, transforming our business to focus on digital asset light marketplaces and reducing the SG&A to support these businesses is timely given the changing economic environment we are facing. I am confident KAR is prepared for the road ahead. That concludes my prepared remarks. Peter has one more item to cover before we go to Q&A.
Peter Kelly: Thank you, Eric. And before we get to Q&A, I want to formally announce that Eric will be retiring at the end of 2022, making this his last earnings call as the Chief Financial Officer of KAR Global. Eric has been an incredible leader and CFO for more than 15 years. He has led the company through many complex acquisitions and divestitures, and advanced the capital investment strategy that has helped KAR navigate change, capture great opportunities and create meaningful shareholder value. Eric has also always been a positive cultural leader here at KAR, a skilled and transparent financial operator and a tireless advocate for the interests of our investors and shareholders. We are conducting a national search for Eric's replacement and hope to fill the role prior to Ericâs retirement. If these timelines do not align, we have a strong internal bench strength at KAR to lead the function on an interim basis until a permanent CFO is named. We will provide additional details and updates in due course. But for now, let me just thank you Eric for your incredible service to this company and to our investors. I wish you all the best for relaxing and enjoyable retirement. You've certainly earned it. And with that, let's turn to the group for questions. Thank you.
Operator: And our first question will come from John Murphy with Bank of America.
John Murphy: Good morning, guys. And Eric, congratulations. I hope you get to rest, because I know you have been working hard for a long time, so congratulations.
Eric Loughmiller: Thank you, John.
John Murphy: A first question here, there is a lot going on here in the industry and there is a lot going on in the transition of the company. So there is a lot of moving pieces. So it's I think a bit tough as people are looking at this to try to get a sort of a constant variable or something to kind of work off of understanding exactly how the company and the industry is going to look in 2023 plus. I mean, when do you think we are going to get an outlook for 2023? And what do you think the major sort of focal points are going to be for you as you communicate that, not looking for specific answers, but as you communicate this, people are looking for sort of some guideposts and ways to think about things structurally for this company, the industry going forward and there is a lot of moving parts. So when will we get that and how do you think about that?
Eric Loughmiller: And I guess you are correct, there is a lot going on. We have got a pandemic that led to production issues, which the industry it seems to be struggling to recover from in terms of new vehicle production. We have got declining used vehicle values, we've got everything thatâs going on with off lease and so on and so forth. Obviously, we are deep in our planning efforts for 2023. I remain optimistic for the prospects for the business. I don't plan to go into specific detail on this call, but I would expect to provide more detail in our next earnings call, which I think is early February. Weâll talk about expectations for 2023 at that point. Again, I think if I look at our Q3 results, in my view, they demonstrate an underlying level of performance in a challenging environment that I think we can build on for the future. That's kind of how I view it. We have got a finance business that's performing well. I expect that to continue to perform well in the future and through all of 2023 and we've got a Marketplace business that has obviously faced significant volume challenges. I expect that overtime those volume challenges will ease, but I expect it to be a gradual change. And then in the midst of that, we have obviously got platform consolidation, we have got cost actions, pricing actions, where I think we are building in sort of -- we are taking actions that will benefit us quarter after quarter after quarter as we look at the future. So I see this kind of, at least endeavoring to build upon that and obviously growing the business sustainably overtimse. But I think when I look to the macro perspective, I think the new vehicle production impacts, the recovery in wholesale volumes, those changes will be, I would say, gradual changes, not a step function.
John Murphy: And then just a follow-up on your comment on pricing, with the backdrop of those kinds of constraints on wholesale volumes and the automakers clearly not being able to ramp up production even as much we might have thought a couple months ago, supply will remain constrained on the new vehicle side and we'll see the one to six year old car fleet shrink probably for the next three or four years. So I'm just curious as you look at that backdrop, how do you think about pricing, first, because it seems like it shouldn't go down if there's that kind of supply constraint and then second, your opportunity set in that kind of environment to gain incremental revenue per unit as well as maybe gain market share?
Peter Kelly: I think, John, by pricing you mean the pricing for our services, not the value of used vehicles?
John Murphy: Actually both opportunities. I mean first on the vehicle pricing and then second your opportunity to drive revenue through pricing and other actions.
Peter Kelly: So in terms of used vehicle values, we've seen a fairly substantial decline in used vehicle values in the wholesale market in Q3. Prices declined pretty much every single week of the quarter. If anything, the rate of decline accelerated later in the quarter, continues to decline here in Q4. And we're seeing that pricing decline now show up in -- first I started to show up in used vehicle pricing at the retail level, and now I believe it's beginning to show up in new vehicle pricing at the retail level. So I think the combination of a slight increase in production but also increased interest rates has been putting downward pressure on vehicle values, I think that will continue. I don't expect used vehicle values to fall down to pre-pandemic levels, because of the constraints you talked about. But I do think they'll continue to decline at least till the end of this year and then we'll see what happens after that. As those values decline, that creates an opportunity for more vehicles to start to flow into our channels. Again, particularly off lease where you've got this equity gap, which is the difference between the residual value and the market value of the vehicle. As those numbers come closer together, I think incrementally more vehicles can start to flow. And again, I expect that to be very gradual. So again, I think, used vehicle prices continue to decline gradually at least through the end of this year. In terms of the pricing for our services, obviously, we've taken some actions there. We have a mix of commercial and dealer business. Some of this requires a negotiation with some customers or conversation with some customers. I'd say generally, John, what we look for, first, is there an opportunity for us to potentially do more for the customer in exchange for a greater revenue opportunity, right? So we look at those types of opportunities and I think some of it reflects that and some of it we just look at -- what is the appropriate pricing given current volumes, and that might be different to what it was three years ago when volumes were higher. So we have that discussion. So again, we've been, I think, strategic and disciplined around that, but have been pleased with the progress we've made.
Operator: Our next question will come from Ryan Brinkman with JP Morgan.
Rajat Gupta: This is Rajat on for Ryan. And Eric, I wanted to convey my best wishes as well. So maybe like to start with OPENLANE. Looks like just following-up on John's comments, looks like the volume -- the outlook for volume there is likely to be tough for a while. Cox Automotive put out some estimates where they expect another step down in off lease volumes before growing again. So curious like if you think that's the case as well, and is there an opportunity to rightsize or restructure that business even further going forward, or has some of that already happened? Any thoughts on that would be helpful, and I have a follow up.
Peter Kelly: I guess, thanks Rajat, first of all. And as I mentioned in my remarks, commercial volumes declined in the third quarter but the rate of decline was less than prior quarter. So I expect that to bottom out here is my expectation. I'd say on the -- we've talked about cost action, purely we've looked at businesses like OPENLANE and other businesses, so some of the cost actions that we've taken are in those parts of the organization. So that's something we continue to look at. Obviously that's also an area where we've had conversations with customers on with respect to pricing and services. So that's the situation with respect to that. I would say that, I think the key determinant of the future performance of that business, I'd say there are two factors. One is the rate of decline of user vehicle values and do off lease vehicles start returning into their marketing funnel in greater volumes. I'd say we're seeing the very beginning of some evidence of that, but it's very small, it's not yet material, but it certainly has started to trend in that direction as vehicle values have come down. And the second one is the new lease originations and obviously, 2025 there will be fewer releases -- 2022, there will be few releases written in 2022 than there were in prior years. And that reflects, I'd say two things, Rajat. One is fewer new vehicles produced and manufacturers feeling that they don't need to put incentives on vehicles, which often drive the lease attach rate. Again, I expect both of those things to start to change as well. I expect production of new vehicles to start to increase, albeit more slowly than experts have predicted. I also expect that in a more challenging economic environment, manufacturers will at some point have to start increasing their incentive spend on vehicles as well. And that will likely, I think, start to drive an increased lease attach rate over time. So again, I think leasing will remain a very important area for our business. I think it's one where we are significantly differentiated vis-a-vis our competition given our strong footprint with that segment. I would agree that that's not impacting our financial performance today like it was when the volumes were stronger. But I think we're sort of at or very, very close to the bottom, and I think it will improve over time.
Rajat Gupta: And maybe just on the GPU increase in the quarter, you cited mix of the factor as well but you also cited some price actions. Could you give us some more color on that, were there any other factors also that drove the uptick from 2Q to 3Q on that GPU? And how should we think about the GPU trends into the fourth quarter and maybe early next year, based on all the price actions and the mix changes that have happened?
Eric Loughmiller: GPU is very -- gross profit per unit sold in the marketplace business is very strong in Q3 $320, that's well above the sort of target we established in our Analyst Day presentation, which was in the sort of 260ish kind of range. I'd say a couple of things. When the volume is transacted is low, the GPU tends to increase because of service revenue on vehicles that were not, we have other services that aren't attached to actually selling vehicles. So that can drive some of the GPU increase. I think the pricing actions as well, obviously, have a positive impact there. So that's for sure. I guess what I would say is the strong GPU performance in Q3 gives me confidence that the numbers we put in place in our Analyst Day are very, very achievable and sustainable overtime, although, I don't necessarily expect that they would stay at the sort of $320 per unit level that we saw in the third quarter. But I think we are sort of -- we have a significant cushion above the range that we discussed in our Analyst Day.
Operator: Our next question will come from Gary Prestopino with Barrington Research.
Gary Prestopino: A couple of questions here. Can you give us some level of the decline in conversion rates in the quarter? And how -- if the conversion rates were the same as last year, what would that have done to your lift in vehicles sold?
Peter Kelly: I spoke on the last earnings call about our conversion rates, which were lower. But I would say in essence of that situation for the most part continued through all of Q3. We did see I think a little bump in conversion rate in August. But for the most part, it has been below last year. I would say conversion rates vary by channel, but I'd say something like 10% below. So if a channel had 60% last year, it's 50% this year, as a sort of a rough order of magnitude of it. I also would say that is very consistent with what I've seen, certainly, when I've looked at sort of physical auction data, conversion rates have been low low there as well pretty much for all of the quarter, lower than normal. Gary, you may know, we also see typically higher conversion rates on commercial versus dealer, so some of it may be mix related. But I would say roughly 10 points. And if you think of a channel where conversion rate was 60% and that has declined to 50% and that is -- is that something like 18% headwind to sales volume, something like that. So it's pretty significant. Now I would also say, candidly, with the benefit of hindsight, last year's conversion rates were characterized by a very tight market for used vehicle supply and significant used vehicle appreciation. So I would say, last year's conversion rates were somewhat above normal and this year's conversion rates are below normal and a normal conversion rate is somewhere in between and I'd say, close to halfway between the two would be my best guess.
Gary Prestopino: Then just a couple of more. You talked about what you are doing with BacklotCars and CARWAVE. You've said two formats, one of which I wrote down as a marketplace and then you go to an auction. Could you just maybe elaborate on that? Are you getting a buyers the opportunity pre-auction to buy these cars through a listing service and if so, how is that price determined?
Peter Kelly: So I guess to sort of provide a little bit more detail on that. The CARWAVE business, their sale format was an auction format. It ran two days a week and vehicles were sort of preloaded into the auction where dealers could view them and research them, place advanced bids, but they actually couldn't buy them, okay? And then the bidding opens for a two or three hour window on a Monday and a Thursday, and then the cars are sold at the end of that window. That's essentially how the format works. It works very, very well. Dealers really liked it. It got great results for their customers. And we felt it was important to replicate that capability in our platform. So that's what we've done and that complements the existing BacklotCars bid ask marketplace. So now when a dealer loads a car, they choose which format do they want to load it into. They want to load it into the marketplace where it's available immediately if we bought at any time or they want to put it in the next scheduled auction, that's the choice they make. And obviously, if the car is unsold at the end of the auction, they can push it over into the marketplace. But that's essentially how it works. And again, as I said, our focus right now is consolidating that migration in the markets where CARWAVE already existed, that's principally California but also Arizona and Texas. And then we look to roll that format across the remaining 48 states in 2023. So we're excited about that. We think this will be a positive for the business and we'll enable us to address an even bigger segment of the market.
Gary Prestopino: And then just one last question here. I just want to make sure, in terms of what you had guided before for EBITDA 245 to 265, and given how you discussed, do you think the impacts of what's going on will impact Q4? Is that range still good and more tended towards the low end of that range?
Peter Kelly: I guess, Gary, first of all, Iâd just say our policy is not to provide quarterly guidance, but I will provide some remarks here just on how I see the situation. So if I think about the year overall, 2022 overall, purely the environment environment's been a challenge for the entire year. And again, I believe our Q3 results show we're responding well to those challenges. I would also say, in most years there is some seasonality and Q4 is often a little weaker from a volume perspective than Q3, that's not unusual. It doesn't always happen but it is more common that that's the case. As Eric also reported, we have foreign currency headwinds in Q3. We expect those to continue in Q4. They may even be a little bit more material to us in Q4 than they were in Q3, to be honest. Now I'd also say helping offset those, our fourth quarter will benefit from the cost, the full quarter impact of the cost savings taken in Q3, as well as the pricing actions taken in Q3. And we'll also have further cost and pricing actions that become effective in Q4. And finally, as Eric mentioned, our digital strategy has enabled us to take advantage of some ex-real estate in Montreal and divest some excess land up there with a gain of $30 million. So I guess with this gain included, I'm very comfortable with our previously issued guidance. I will say we are focused on finishing the year strong and I look forward to reporting the final numbers in the new year and obviously, we'll do that with and without the gain.
Operator: Our next question will come from Bob Labick with CJS Securities.
Bob Labick: Good morning. Thanks, and congratulations to Eric from us as well. I wanted to talk about what you're seeing at the dealer level. The provision for credit losses at AFCs has remained low, it's been low throughout the pandemic and everything. And you mentioned you may not expect it to get back to the typical kind of 1.5% to 2% long term expectation. Maybe give us a sense of what you expect, I guess, over the next year or two for those provisions and where you see that trending and what the drivers are there?
Peter Kelly: There's no question, in the past couple of years, AFC has been a very strong performer. And I'd say we have seen lower than historical levels of risk, both in terms of frequency and severity in that business. I'd say given the changing macro environment, I'd say specifically higher interest rates and also declining used vehicle values, I think it's prudent to expect some increase in the risk environment there. But I will say that our expectations are that that will be relatively moderate and something that's manageable in the context of the numbers and projections that we've shared previously. And as you mentioned historically AFC -- the historical risk was somewhere in the range of 1.5% to 2% of the outstanding loan balance. We've been well below that this year. I think with a more digital model and with I'd say greater access to data and I think stronger controls, I think it's possible that the new normal will be below that historical range. I guess time will tell, we'll have to see how it plays out exactly. We are modeling a modest increase in risk in our preliminary 2023 projections but we think it'll be very manageable, and we think it'll also be offset by just the underlying growth in the business.
Bob Labick: And then just trying to get a sense, I know there's a lot of moving parts in the macro. But excluding, if you can for a second, kind of used car value index, so to speak, impact on GMV. How are the mix of units trending, where's the sweet spot for , CARWAVE and how are those units relative to kind of pre-COVID on a normalized used car value index?
Eric Loughmiller: I just want to clarify your question. Are you talking about the vehicle values themselves or are you talking about the mix in our volume between dealer and commercial?
Bob Labick: The vehicle values at dealer. If you're still -- say a car pre-COVID was, you know, I think the numbers that we had before $5,000 to $7,000 GMV pre-COVID . And then you've added both the value of vehicle with the used car prices going up and then increased mix as you've moved the mix of the dealer vehicles in that marketplace. So trying to get a sense of the mix of the vehicles within the dealer marketplace and how that's trending adjusting for the massive change in used car values.
Eric Loughmiller: So I guess what I'd say generally we have seen in all our marketplaces an appreciation in the value of the vehicle themselves really kicked off early last year. It sort of peaked out in probably March of this year and has been flat lined and ultimately started to decline from about May to the present. And I'd say today, rule of thumb, probably vehicle values are still 30ish percent, maybe a little more above their pre-COVID level. So that has sort of generally increased GMV in all our marketplaces. From a mix perspective, different marketplaces have had a different mix of vehicles. So BacklotCars probably point to the way it sort of started and also its specific format that had a real focus on, I'd say, sub $15,000 vehicles, okay, with probably a median GMV today of around, I donât know, $9,000 or $10,000. Whereas Trade Rev and CARWAVE would probably have a broader mix of vehicles and a median GMV that's higher, I don't know, $15,000, $16,000, $17,000. So with the merging of Trade Rev -- BacklotCars and CARWAVE, we're now combining those, that will bring up the median GMV there as well. So that maybe would give you a sense of the sweet spot of these marketplaces. When I look at our dealer to dealer business, one of the interesting facts is the vast majority of vehicles that are sold between dealers are in that sort of sub $15,000 category. That is where most of the volume is. So I think we are very well positioned in that marketplace and really deliver exceptional value to the -- and exceptional outcomes to those customers in that segment. But I will say, we are in time also focused in increasing the GMV and bringing more high value vehicles into that channel as well.
Operator: Our next question will come from Daniel Imbro with Stephens.
Unidentified Analyst: This is Joe on for Daniel. Thanks for taking our question. So I was wondering about the strength in the services revenue line, saw a $12 million sequential increase this quarter. I was wondering if you could provide any color there and if this was driven by the Carvana services agreement?
Peter Kelly: Joe, thank you. I'll let Eric take that question.
Eric Loughmiller: Joe, yes, the services revenue has driven a couple of things. First, I would point to repo volumes. While we aren't selling the repos in the US through our digital marketplace at the same level we used to, we have RDN and PAR as key contributors to the growth in the revenue, and that's really helped us as they begun -- the capital finance companies and banks have begun processing more delinquencies, and there are more defaults on auto loans. Second, we did see some increases in transportation. And I would argue that a little of it was probably related to the Carvana commercial agreement, most of it was related to attach rates and how we have been able to penetrate more on the dealer-to-dealer space and have some strong growth in the transportation revenue during the quarter compared to a year ago. Those were the two big drivers.
Unidentified Analyst: And then as a follow-up, as volumes recover next year, I was wondering if you have to bring back any of that headcount you have temporarily reduced, whether it's in support staff or at AFC, or should the offshoring of some of that back office functions take out the need for this?
Peter Kelly: I think one of the great advantages of a more digital model is the scalability you get from a digital platform. So I don't foresee that in the context of the assumption certainly we're making about the industry. I think these businesses will scale incredibly well. We have got evidence of that from the past. And unfortunately, we have been hurt on the downside of that as volumes have declined over the last couple of years. I think as those volumes come back, they'll flow through a business model that is more scalable and more efficient than it ever has been before. So I don't foresee that happening. And I would view the GSS initiative, as Eric said, incremental savings versus our current sort of run rate.
Operator: Our next question will come from Ali Faghri with Guggenheim.
Ali Faghri: And first, Eric, congrats on the retirement. That was a lot of miles between Chicago and Carmel, so well deserved. So I actually have a few questions on AFC. So loan volumes were up 11% in an environment where your marketplace volumes were down 12%. I think historically, ASC loan volumes have at least directionally correlated pretty well with your auction volumes. Why have they decoupled more recently and what's driving that outperformance versus what we are seeing in the broader wholesale auction industry?
Peter Kelly: It's true that in the past it correlated more with auction volume. But I'd also say that even when we looked at it historically, the amount of transactions within AFC that were generated through the KAR platforms was always a relatively small amount, I think it was about 30% of their total transactions came from KAR or even less. I would say essentially it's market share. AFC has been focused on expanding itâs dealer footprint, the number of dealers using the system. They've been doing that in a very disciplined way and they've been effective at doing that. So we kind of win the business at the dealership level. And then we commit to fund those dealers -- that dealer's purchases irrespective of what channel the dealer buys them on. So I'd say principally that's the focus. Now I will also say we have been focused as well on increasing attach rates within our existing digital marketplaces. We've put focused initiatives on that with TradeRev and with BacklotCars, and those are bearing positive results. But that's not what's driving the significant change that you alluded to. So I think it's really just a focus on the customer and ultimately increased market share within the segment.
Ali Faghri: And then maybe just a follow-up on AFC. Maybe you can remind us how interest rates benefit the business? It was obviously a sizeable tailwind this quarter. Maybe a refresh on how you price your loans would be helpful.
Peter Kelly: Eric, do you want to speak to that?
Eric Loughmiller: Well, the first slide we speak to -- the pricing typically is going to be, we use a prime rate quote plus a spread. Typically it's 300 to 400 basis points above prime and prime has been moving up. And Ali, the reason the performance is improved with that because there is a corresponding increase in cost of funds is we're only funding through the securitization about 70% of the total loans when you look at our balance sheet. So about 30% of that is in equity and that's where we get the increased performance in the AFC business is no corresponding cost. Equally important to that though is that we have a very efficient structure for the financing. It's a cost of funds. It actually is a lower cost of funds than it is charges to our customers. In other words, the prime rate has grown more than our cost of funds. So we've gotten a little bit of spread enhancement on that. So those are the two things. And as we look at today's expectation that interest rates will be increased by the Fed going forward for the rest of the year, that probably becomes a bit of a tailwind in the short term. But as Peter mentioned, it puts stress on the dealer. So you've got to balance that out with what it does to the risk side of the portfolio. Peter, anything to add?
Peter Kelly: No, I think you've got there, Eric. I think, there are some pros, there are some cons. I think generally we're confident in the AFC business model and that it'll be a strong contributor in 2023 and beyond.
Ali Faghri: Great, thanks for taking my questions.
Peter Kelly: I think we're pretty much at time. So Matt, unless there's other questions, I'll just move to closing remarks.
Operator: No, this concludes our question and answer session. I'll go ahead and turn the conference back over to management for any closing remarks.
Peter Kelly: Thank you, Matt. Thank you everybody for your time this morning and also for those questions. I just want to close my remarks by reinforcing some of the key messages from today. Again, I'm pleased with the Q3 performance. We delivered improved performance versus a year ago and also compared to Q1 and Q2 of this year in a challenging environment. In our marketplace segment, we increased revenue and gross profit compared to one year ago. We also increased our revenue per unit and our gross profit per unit sold. In our finance segment, we delivered another solid quarter of performance with meaningful growth in both volume and revenue per unit. In addition to those financial results, we made significant progress in terms of platform consolidation, pricing and addressing our cost structure. Obviously, volumes continue to be a challenge in this industry. However, as we look at the future, we expect new vehicle production to increase gradually. We expect used vehicle pricing to decline and we expect a gradual increase in wholesale used vehicle volume over time. And I believe that our digital focus will enable us to grow faster in that type of environment. I'm excited and energized by the many opportunities ahead. I believe we've got a significant opportunity for long term growth in this company. We have a differentiated offering, a diverse and expanding customer base and a large addressable market to in which to innovate and invest. So with that, we'll end today's call. I look forward to reconnecting with you all in the new year. Thank you all very, very much. And again, Eric, best wishes for a very, very happy and successful retirement.
Operator: The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.
