Earnings Call Transcript
CarGurus, Inc. (CARG)
Earnings Call Transcript - CARG Q3 2022
Operator, Operator
Greetings, ladies and gentlemen. And welcome to CarGurus, Inc. Third Quarter of 2022 Earnings Results Conference. At this time, all participants are in listen-only mode. Question-and-answer session will follow the formal presentation. As a reminder, this conference is being recorded. It’s now my pleasure to introduce your host, Kirndeep Singh, Vice President, Investor Relations. Please go ahead.
Kirndeep Singh, Vice President, Investor Relations
Thank you, Operator. Good afternoon. I am delighted to welcome you to CarGurus third quarter 2022 earnings call. We will be discussing the results announced in our press release issued today after the market closed and posted on our Investor Relations website. With me on the call today are Jason Trevisan, Chief Executive Officer; and Sam Zales, President and Chief Operating Officer. During the call, we will make statements regarding our business that may be considered forward-looking within applicable securities laws, including statements concerning our outlook for the fourth quarter and full year 2022, management’s expectations for our future financial and operational performance, our business and growth strategies, our expectations for our CarOffer business and acquisition synergies, the value proposition of our current product offerings and other product opportunities, the impact of the semiconductor chip shortage and other macro-level industry issues and other statements regarding our plans, prospects and expectations. These statements are not promises or guarantees and are subject to risks and uncertainties, which could cause them to differ materially from actual results. Information concerning those risks is available in our earnings press release distributed after market close today and in our most recent reports on Forms 10-K and 10-Q, which along with our other SEC filings can be found on the SEC’s website and in the Investor Relations section of our website. We undertake no obligation to update forward-looking statements, except as required by law. Further, during the course of our call today, we will refer to certain non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in our press release issued today, as well as in our updated Investor Presentation, which can also be found on the Investor Relations section of our website. With that, I will now turn it over to Jason.
Jason Trevisan, Chief Executive Officer
Thank you, Kirndeep, and thanks to everyone joining us today. This year has been a pivotal time in the evolution of our company as we have been transforming from a Listings business to a transaction-enabled platform at a swift pace, which has enabled us to provide our dealer partners and consumer audience a portfolio of offerings for every stage of the automotive purchasing and selling life cycle. While we are still early in the journey of fully integrating Digital Retail and Digital Wholesale with our core Listings business, I am proud of the progress we have made this year as we put in place the building blocks for long-term success. Regarding our most recent quarter, while there were business areas that exceeded our expectations, our third quarter financial metrics fell short of the low end of our guidance range as we did not adapt our wholesale operations to the rapidly evolving macro market challenges. The shortfall from our guidance is driven exclusively by our Digital Wholesale business, as our marketplace results were either in line or well ahead of our expectations. Our Digital Wholesale business was impacted by unpredicted intra-quarter volatility, which worsened as the third quarter progressed, where we saw a decline in used car retail demand and wholesale volumes, as well as relatively rapid wholesale unit price declines. These market volume and unit price declines resulted in two disappointing trends, compressed wholesale transaction volumes and sell-through rates within our dealer-to-dealer and Instant Max Cash Offer businesses, as well as higher arbitration rates during the third quarter. In addition to these market challenges, we identified operational issues within our CarOffer business, which negatively contributed to an already tough dynamic. Simply put, the processes and operations, which worked well in a rising wholesale price environment were not effective enough in a declining price environment. Despite the wholesale challenges faced this quarter, we are proud of our foundational Listings business, and importantly, our Digital Retail offering, as they continue to demonstrate their resiliency and performed above third quarter revenue and operating income expectations, highlighting the strength of our platform. While it will take time to work through our Digital Wholesale operational challenges, we remain committed to delivering on our long-term strategy. We are putting in place heightened operational rigor to create a business that’s adaptable, stable and scalable regardless of market conditions. Significant thoughtful changes have and will continue to be made to position the company for sustained innovation-driven growth. And we remain confident in building an automotive ecosystem that holistically serves both our dealer partners and the largest consumer audience. With that, let me walk through our third quarter results. Our foundational Listings business continues to demonstrate value, innovation, resiliency and growth. Though dealer behavior during these difficult times has varied based on each dealer’s individual business needs and objectives, we grew our listings revenue and exceeded our expectations for the quarter. Total paying dealers globally grew to 31,286, up 532 from the prior year. In the U.S., paying dealers were 24,691, up 712 compared to the prior year. Despite seasonality in the second half of the year, compounded with softening consumer demand, we are proud of dealer subscription revenue growth driven by maintaining record high client retention and expansion. In fact, our listings churn this year has improved more than 50% compared to our prior five-year average. As a result, U.S. quarterly average revenue per subscribing dealer or QARSD for short grew approximately 4% year-over-year to $5,800. Third quarter performance was driven by dealer wallet share expansion through listing upgrades, as well as greater adoption of product add-ons. We believe expansion of wallet share is due to our continued commitment to provide our dealer partners with an exceptional ROI through our consistent formula, large volumes of high-intent shoppers at attractive pricing. Internationally, total paying dealers for the third quarter were 6,595, down 180 dealers compared to the prior year. Each market is experiencing different macro conditions, which contributed to the decline this quarter. For example, in the U.K., dealers are faced with even higher inflation and fears of a recession, limiting demand and overall sales volumes. These types of factors, coupled with dealer churn, resulted in a decline in International QARSD by $17 year-over-year to $1,507. Despite the decline in QARSD, our recently introduced digital display, otherwise known as RPM in the U.S., saw strong adoption in the U.K. and Canada, nearly doubling quarter-over-quarter. Furthermore, in August, we introduced another new product to our International dealers called Highlight. Highlight helps dealers target ready-to-buy shoppers by showing a selection of promoted vehicles in new sponsored slots beyond the first page. As we continue to demonstrate success in our listings products in the U.S., we plan to further expand these features internationally to enhance our growth, provide our dealer base an exceptional ROI and give our consumer audience the best experience while utilizing our end-to-end transaction-enabled platform. A key element of our transformation to a transaction-enabled platform is our Digital Retail business, which empowers our customers to complete more of the transaction online. In our recently released 2022 Consumer Insights report, the share of consumers who prefer to do more from hold to their next vehicle purchase has risen from 60% to 70%. CarGurus’ Digital Retail platform addresses these needs by providing consumers a convenient self-selective purchasing journey, all while providing trust, transparency and the best pricing from the largest selection of inventory among major online automotive marketplaces in the U.S. The key to success on the customer experience front is the choice for consumers to buy their next car precisely the way they want, whether fully online or with an in-person interaction with a dealer. Sixty-seven percent of those surveyed say the in-person test drive is very or extremely important to their buying process, further highlighting the power of CarGurus’ Digital Retail offering known as Digital Deal. Consumers can build a near penny perfect deal with either dealer or vehicle-specific finance and insurance products and then place a deposit on their vehicle of choice with a seamless online to in-store experience. Our dealers utilizing Digital Deal are not only capturing high-intent consumers, but are also streamlining the sales process by allowing these consumers to complete more elements at home. Since the end of last quarter, we have more than doubled the number of dealers utilizing Digital Deal, ending this quarter with 963 dealers representing approximately 100,000 Digital Deal listings, greater than any online-only retailer in the U.S. This quarter led to Digital Deal enabled inventory increasing by 30%, and of those leads, 54% were high-value leads, meaning the lead included prequalification, hard-pull, deposit and/or an appointment with the dealer. We realized a 13% increase quarter-over-quarter in leads that had an element of financing and a 100% increase during the same period from shoppers who scheduled an in-person appointment. Clearly, consumers are craving these transaction elements. Of the consumers who went even further in their online shopping journey and placed a deposit, 60% of those shoppers ultimately purchase their vehicle through the digitally enabled dealers. For the first time, many of these dealers are able to serve consumers far beyond their immediate geographic footprint to reach ready-to-purchase shoppers, all while streamlining the sales process with Digital Deal. We remain focused on growing the adoption of Digital Deal and are pleased with the early results. Offerings like Digital Deal were developed by working closely with our dealer partners to provide the right tool sets to compete more effectively. These toolsets ultimately drive a smoother consumer experience, which is the reason we have been able to effortlessly maintain such a high Net Promoter Score of 8. While the revenue generated from this new and innovative product is relatively small today, as we continue to build out the framework to allow consumers to transact fully online, we expect our Digital Retail business to grow meaningfully. Turning to our Digital Wholesale business. During the third quarter, public industry data cited wholesale prices for used vehicles declined dramatically by approximately 7% from the end of June to September. Throughout this period, transaction conversion rates also declined as dealers faced greater price uncertainty and rental fleet participation as anticipated remained relatively muted during the quarter. Gross merchandise sales or GMS was approximately $1.12 billion for the third quarter, up 27% from the previous year and declining 41% quarter-over-quarter due to a reduction in total transactions and declining average selling prices. Total third quarter wholesale and product revenue, inclusive of our dealer-to-dealer and Instant Max Cash Offer businesses was $261.1 million in Q3, an increase of 314% year-over-year, but down 25% quarter-over-quarter. Similarly, combined wholesale and product non-GAAP gross margin was not only challenged by a reduction in transactions and declining average selling prices but also due to operational challenges. In a declining market, dealers are more likely to arbitrate a vehicle and our operating systems and controls related to inspection, arbitration and transportation, which were built and scaled in a rising price market were not sufficient to operate an efficient business. For example, in a transaction where a vehicle is unwound and we take brief possession, we are holding a depreciating asset in a declining wholesale price environment, which further magnifies the issue. Unfortunately, we did not have rigorous processes in place to manage arbitration and loss effectively this quarter. So we saw increased losses on arbitration in the number of vehicles and per vehicle, as well as greater expenses related to transportation for multiple vehicle unwinds and rematches. Digital Wholesale grew tremendously as dealers and rental fleets faced inventory challenges due to the semiconductor chip shortage. Because of this, we over-indexed on meeting the needs of rental fleets as they bought aggressively in a rising price environment. We are now readjusting our operations to focus and support dealers regardless of rental fleet participation to better balance our concentration in the future. These combined factors also led to a contraction in our adjusted EBITDA. We are working to quickly address these structural deficiencies by putting processes, systems, data and incentives in place. Clearly, the wholesale market trends this quarter caught us by surprise and exposed weaknesses in our offering and operations and we are maniacally focused on fixing those issues and serving our wholesale customers well, but we don’t believe that this quarter’s results should alter our longer-term strategic view or our ability to realize it. Given these challenges, our focus at CarOffer has been largely operational and execution-based. In Q3, unique buyers on the platform grew by mid-single digits as our emphasis was on sell-through rates, arbitration mitigation and increasing productive activity from existing dealers. We expect that this strategic focus of activating dealers and thereby growing transactions per dealer will bolster our Digital Wholesale business once macro and operational challenges are aside. Dealer-to-dealer revenue for the third quarter was $70.7 million, up 23% year-over-year, but down 27% quarter-over-quarter. We saw a reduction in transactions both quarter-over-quarter and year-over-year as a result of a deteriorating wholesale backdrop, which, when coupled with other transaction-based revenue streams, such as transportation, inspection and ancillary products served as the root cause of the quarterly decline. As for our consumer-facing wholesale offering, Instant Max Cash Offer, we now have coverage in approximately 93% of the U.S. population. At this stage, we are comfortable with our penetration and any further expansion will be based on the cost and earnings potential of servicing those geographies. Instant Max Cash Offer generated $190.4 million in revenue for the third quarter, growing 3,450% from a standing start year-over-year, but decreasing 24% quarter-over-quarter. The decline in revenue quarter-over-quarter was due to a reduction in transactions and average selling prices. Within the quarter, our business saw a 10% decline in monthly average offers made, an important top-of-funnel data point. Instant Max is powered by the CarOffer matrix, as a result, both businesses are highly correlated and affected by the same macro challenges. During this period of slower consumer demand, inflation and retail seasonality, we see compounded effects for Instant Max Cash Offer. While the business has ample runway for growth in an exceptionally large addressable market, we are choosing to remain thoughtful about offer competitiveness to maintain healthy margins and operational integrity. With 73% of consumers wanting to sell their car online, we continue to provide an excellent consumer experience. In the third quarter, we further optimized our offering by expanding our customer drop-off pilot to a few additional locations in states. At Instant Max Cash Offer, we aim for convenience and optionality, providing the consumer the ability to sell their car when they want, the way they want. With 66% of sellers also in the market to buy a car, we are focused on marrying the capabilities of our transaction-enabled platform for consumers by promoting Sell My Car to the default homepage tab, providing material upside to Instant Max Cash Offer without a negative impact on leads. By leveraging our largest consumer audience across the platform, we continue to realize cross-platform synergies with Instant Max campaigns, generating listing leads whose value covered 25% to 30% of marketing. In spite of the contributing macroeconomic factors and operational obstacles impacting our business, we continue to believe that the combination of our innovative Digital Retail offerings, our resilient foundational Listings business and our differentiated Digital Wholesale business will enable us to persevere through these transitory headwinds and march towards fulfilling our vision of creating the only platform where dealers can source, market and sell and consumers can shop, finance, buy and sell. Further, our long-term market potential and non-GAAP gross margin targets for each of our business offerings disclosed at our Investor Day earlier in the year are unchanged, highlighting the confidence we have in our business model for the future. Through the announcements of our line of credit, acquisition decisions and strategic focus areas, we have demonstrated that we will remain prudent in our decision-making for the company’s long-term growth, while also remaining judicious in our spend to manage profitability. The hurdles faced this quarter represent an opportunity to move quickly to make the transformations necessary to achieve these long-term goals and while that will require some time and focus to realize, I believe our team can accomplish all that we have set out to achieve and that our portfolio strategy is the right one. None of this would be possible without our employees, and I am extremely grateful for their commitment and unwavering dedication to not only our company but to our customers as well. Now let me walk through our financial results. I will provide a detailed overview of our third quarter performance, followed by our guidance for the fourth quarter and full year 2022. Total third quarter revenue was $426.5 million, up 91% year-over-year and down 17% compared to the previous quarter. As I stated earlier in the call, our total revenue for the third quarter was below the low end of our guidance range by $34 million. Marketplace revenue was $165.3 million for the third quarter, up 3% from $159.9 million in the prior year and up 1% compared to the prior quarter. The increase in marketplace revenue compared to both the prior year and quarter was primarily due to the increase in our high-margin foundational subscription Listings revenue, driven by the increase in U.S. paying dealers on the platform and increased adoption of our add-on products. This increase in U.S. marketplace revenue was offset by a decline in advertising and consumer finance revenue, as well as International subscription revenue, in part due to the decline in paying dealers, but also due to foreign exchange rate declines in both markets. Wholesale revenue was $47 million for the third quarter of 2022, up 4% from $45.2 million in the prior year. The year-over-year growth in wholesale revenue is in part due to increased transportation revenue related to our dealer-to-dealer and Instant Max Cash Offer businesses. Additionally, there was an increase in buy and sell fees at the beginning of the year. As a reminder, transportation and its associated costs for Instant Max Cash Offer are recorded within the wholesale line items within the income statement. Despite an increase in transportation revenue per transaction compared to the prior year, we incurred incremental transportation costs due to increased arbitration and unwound transactions for both businesses. As a result, the incremental cost of transporting arbitrated and unwound vehicles exceeded the increase in transportation revenue, compressing margins in the quarter. Compared to the previous quarter, wholesale revenue declined 38%. The decrease in wholesale revenue compared to the prior quarter is mostly due to the continued market softening we began to see in the second quarter, which resulted in decreased transaction volumes for our dealer-to-dealer business. Lastly, product revenue was $214.1 million for the third quarter, up 1,105% from $17.8 million in the prior year and down 21% from the previous quarter. The year-over-year growth is primarily due to the increase in Instant Max Cash Offer transactions as the offering has expanded to approximately 93% of the U.S. population in just a year since its formal launch. Quarter-over-quarter, however, we saw a decrease in revenue due to decreased transaction volumes and declining average selling prices associated with Instant Max Cash Offer, which generated $190.4 million in revenue, roughly $35 million behind our most recent guidance range. In this challenged market, we are remaining prudent and thoughtful to find the most efficient frontier for this business, evaluating each geographic area, as well as offer competitiveness to ensure we are executing decisions that derive the highest return for our investments. I will now discuss our expenses and profitability on a non-GAAP basis, which backs out our stock-based compensation expense, amortization of acquired intangible assets, acquisition-related expenses and net income or loss attributable to redeemable non-controlling interest. Third quarter non-GAAP gross margin was 37%, compared to 73% in the year-ago quarter and 38% from the prior quarter. The change in non-GAAP gross margin year-over-year is primarily due to naturally lower gross margins in wholesale and product. While non-GAAP gross margin declined roughly 100 basis points quarter-over-quarter, the composition of non-GAAP gross margin shifted. With a decrease in average selling prices, we saw an increase in transactions that were unwound during the quarter, resulting in higher than expected arbitration losses in our Digital Wholesale business, more so than the previous quarter. As we mentioned earlier in the call, both our dealer-to-dealer and Instant Max Cash Offer businesses experienced decreased transaction volumes and average selling prices, which coupled with increased transportation and arbitration costs compressed margins below expectations for the quarter. Total third quarter non-GAAP operating expenses were $127 million, up 27% year-over-year. Non-GAAP sales and marketing expense was up 30% year-over-year to $83.2 million and was down 9% compared to the previous quarter. Non-GAAP sales and marketing expense represented 20% of revenue, down from 29% of revenue in the year-ago period. The increase in marketing expense compared to the prior year and decreased compared to the previous quarter reflects our previous commentary that we are remaining thoughtful with our spend as we continue to grow the business and increase our brand awareness, but are not making material incremental marketing spend increases for the remainder of the fiscal year. Our third quarter non-GAAP product, technology and development expenses grew 24% versus the year-ago period to $26 million. Similar to previous quarters, the increase is primarily due to an increase in employee-related costs as a result of a 17% increase in headcount and continued investment in our technology teams to grow Digital Wholesale and Digital Retail. We generated non-GAAP operating income of $29.4 million, representing a margin of 7% and we generated $32.9 million consolidated adjusted EBITDA for the quarter. Consolidated adjusted EBITDA was $12 million behind the low end of our most recent guidance range. This was due to the reduced revenue and reduced profitability associated with our Digital Wholesale business. Non-GAAP diluted earnings per share attributable to CarGurus were $0.21 for the third quarter, $0.04 below the low end of our most recent guidance range. On a GAAP basis, we generated third quarter gross margin of 35%, compared to 73% in the year-ago period. The contraction in gross margin is primarily due to the impact of Instant Max Cash Offer. We incurred total operating expenses of $122.1 million, down roughly 1% year-over-year. The slight decrease in operating expenses reflects our ability to remain judicious in our spend while investing in key initiatives that we believe will grow our business for the long term. Looking ahead to 2023, we do expect our expenses to increase once our lease officially commences for our new corporate headquarters in Boston, Mass. Third quarter GAAP operating income decreased 28% year-over-year to $28.7 million. Third quarter GAAP consolidated net income was $18.8 million. Net income attributable to CarGurus totaled $20.4 million and third quarter GAAP net income attributable to common shareholders of $107 million. We ended the third quarter with $404.4 million in cash and cash equivalents, an increase of $36.2 million from the end of the second quarter. We generated $73.2 million in cash from operations in the third quarter and $68.9 million of non-GAAP free cash flow, which includes capitalized website development and capital expenditure costs of $4.3 million. Cash provided by operations in the third quarter was primarily driven by a decrease of $75.5 million in accounts receivable, offset by a $19.3 million decrease in accrued expenses, accrued income taxes and other liabilities. Additionally, we announced on September 29, 2022, that we entered into an agreement with credit lenders for a $400 million revolving credit facility. We have the ability to draw on the revolving credit facility from time to time for a variety of general corporate purposes, which, along with our cash on hand, provides us the flexibility to invest in growth regardless of macroeconomic conditions. We also announced in the third quarter that the Board elected not to proceed with acquiring additional equity in CarOffer, otherwise referred to by us as Step 2 in our acquisition agreement. As a reminder, we have the ability to purchase up to an additional 25% stake of CarOffer at 7 times their trailing 12 months gross profit as of June 30, 2022, in the form of cash or stock. The decision to not acquire additional equity does not impact our confidence in CarOffer as we continue to optimize the business for long-term sustained success. Further, in the second half of 2024, there is a put call option, otherwise referred to by us as Step 3 in our acquisition agreement, where the enterprise value is based on 12 times trailing 12 months adjusted EBITDA. As we did not elect to purchase additional equity in CarOffer for Step 2, the Step 3 calculation would be calculated based upon the 49% of the company we do not own. I will close my prepared remarks with our outlook for the fourth quarter and full year 2022. Automotive sales typically experience seasonality in the second half of the year, but especially in the fourth quarter as retail demand slows. We expect that our marketplace business will continue to post increasingly strong top and bottom line results. We are also anticipating a contraction in fourth quarter transactions in our Digital Wholesale business, coupled with further declines in wholesale prices. As a result, we expect our fourth quarter revenue to be in the range of $270 million to $300 million and we expect our fourth quarter revenue for Instant Max Cash Offer to be in the range of $65 million to $85 million. For the full year 2022, we expect our revenue to be in the range of $1.68 billion to $1.68 billion and our full year Instant Max Cash Offer revenue to be in the range of $667 million to $687 million. With wholesale prices continuing to decline, we expect increased losses from vehicles arbitrated at the end of the third quarter, which have since depreciated further, as well as greater arbitration in the first part of the quarter as we clear out the inventory that was accumulated on returns at the end of September. We anticipate increased arbitrations, combined with reduced transactions will compress profitability in the Digital Wholesale business in a more pronounced way than what we experienced within the third quarter. With that said, we expect our non-GAAP consolidated adjusted EBITDA for the fourth quarter to be in the range of $6 million to $14 million and non-GAAP earnings per share in the range of $0.13 to $0.16. We are estimating full year non-GAAP consolidated adjusted EBITDA to be in the range of $166 million to $174 million and we are anticipating non-GAAP earnings per share in the range of $1.02 to $1.05. While we expect the next few quarters will continue to be challenging for our Digital Wholesale business, we believe our foundational Listings business will continue to achieve growth, deliver positive results and our Digital Retail business, which is in its infancy, will set the stage for significant evolution to retail transactions and the associated long-term revenue and earnings growth. In the near-term, we will rigorously work through operational issues in our Digital Wholesale business. We firmly believe these operational issues, together with the macroeconomic headwinds we are experiencing are temporary. We are ultimately focused on achieving our long-term objectives as an end-to-end automotive transaction-enabled platform for dealers and consumers. With that, I will open the call up for Q&A.
Operator, Operator
Yes, sir. Our first question comes from Chris Pierce of Needham.
Chris Pierce, Analyst
Hey, there. I was just curious, you talked about operational procedures you have put in place, what are some things you guys can do to lower the arbitration rate, especially where wholesale prices or used car prices might come in even further? Is it switching third-party services you are using? I am just kind of curious how you can kind of get on top of the arbitration rate a little better?
Sam Zales, President and Chief Operating Officer
Chris, I will take that. Sorry about that, Jason. Chris, Sam Zales here. Thanks very much. Arbitration rates will always increase in a down market. We know that with prices declining for a seller. They are in that product, that vehicle for a higher price and hoping to get it back up for buyers. It’s a decision of is the bottom of the market there already. So those numbers will go up. But we have those operating challenges and we are being direct about how we are changing that process going forward. It starts with inspections, Chris. We just didn’t have enough discipline in our inspection process for the scrutiny that goes on in a down price market. So what we are doing right now is working with new partners on an inspection basis. One, we are getting scans for frame damage, which is really important in a market where prices are declining; number two, mechanical inspections; number three, electrical inspections; number four, vehicle history doing more scrutiny on vehicle history. We are doing that in comparison to what was external, more an external look at the vehicle for damage on the outside of a car and needing to have much more rigor on the inside of the vehicle. So we are enrolling new partners to do that from an inspection perspective and it certainly advanced rigor on those vehicles that have much higher mileage or older model vehicles. That’s number one. It starts with the inspection. Number two is our rematch process and the arbitration process. We, again, didn’t have enough operational rigor at CarOffer around that arbitration process. What happened was, if a dealer who was buying said, I don’t like the vehicle, the process of either creating a concession and stopping that arbitration process right at the beginning as opposed to rematching that vehicle to the next buyer in the marketplace on the matrix. Instead of going directly to auction and taking a loss right away, that would have limited our losses in that part of the business. Number three is on the arbitration process is managing our customer experience. So we have dealer sales managers who had the ability to say, make a decision on a specific customer and say that we wouldn’t remove them from the program. They were incented on getting more transactions through the system. Our focus is, how do we get those transactions to be the right and profitable transactions. So it’s removing the sellers and buyers who have over arbitrated on our system and making sure we have the right partners following our policies into the system overall and that will lower our percentage of arbitration as we go forward. All of that ties to our transportation system as well. If we rematch a vehicle from one buying dealer to another, that can be a lost or dead transaction, and we could lose money on that as well. So our efforts on inspection, refining the processes and the data and systems around arbitration, and managing transportation to a single transport and a close of the sale that is arbitrated will lower all of those losses per vehicle, and we should have had those processes in even in a rising tide market as it is now a declining market.
Chris Pierce, Analyst
Okay. Thanks for the detail.
Operator, Operator
Next question comes from Jed Kelly of Oppenheimer.
Jed Kelly, Analyst
Hey. Great. Thanks for taking my question. My first question, given the higher arbitration rate and can you talk about sort of the lift that’s going to be to sort of eventually bring dealers back to the platform or can you talk about churn that you have seen? Thanks.
Sam Zales, President and Chief Operating Officer
Yes, it's Sam Zales. I wouldn't say we actually had churn in the business. In fact, our buyer rate of dealers on the marketplace increased quarter-over-quarter. We are pleased to report that dealers continue to find the platform to be a valuable tool for acquiring and selling vehicles, and we experienced an increase in buyers this quarter, which is great. However, in a market where prices are declining and buyers are scrutinizing vehicle purchases more closely, our operating systems haven't been as effective as they could be. Moving forward, we will take a firmer stance with our buyers and sellers regarding our policies. We need to ensure that if the damage is below a certain threshold, we stick to our policies and collaborate effectively. We were somewhat lenient in this regard, trying to satisfy every customer, which led to unprofitable transactions. As we progress, with increased scrutiny during inspections by examining frame damage, mechanical and electrical issues, and the vehicle's history more thoroughly, we anticipate that our fail rates may increase. This means we will not allow certain transactions to proceed, which will help us avoid arbitration later on. Nevertheless, we have not experienced churn on the platform; in fact, we've seen an increase in buyers in the last quarter.
Jed Kelly, Analyst
Okay. And then my follow-up, I guess. The Instant Max Cash Offer, it makes a ton of sense. I guess, can you talk about how you are thinking about marketing investments and sort of wanting to introduce this more to consumers? I mean, you have to fix some of the operational issues before you kind of feel comfortable marketing this on a more broad basis?
Sam Zales, President and Chief Operating Officer
Sorry, Jed. I didn’t hit the unmute button. Sam here, again, good question. We will be more careful about how aggressively we market. Remember that we have had this tremendous consumer experience where consumers are saying it’s the best process I have seen for Instant Max in the market. But we are going to be careful about marketing too much until we fix and make our operating process more disciplined. What we did see in the third quarter is more aged vehicles and a lower price point on the consumer transactions they were trying to sell through the Instant Max capability, and because of that, you have to have the disciplined operating processes to manage the inspections at a finer level. So if older vehicles are coming through from consumers, you have got to have those more rigorous inspections. Number two, the arbitration processes I just went through have to be much more disciplined in the way we allow that with our customers and also how effectively we speed that arbitration process to not take losses by rematching to another customer. So you will see a slowdown to speed up again in the future. This whole effort is to say, slow down the marketing. IMCO is still a fantastic consumer experience, but it’s got to be a profitable operation for us. So while we fix those operational issues, we will then ramp up again and increase the marketing as we go forward.
Operator, Operator
Thank you. The next question comes from Nick Jones of JMP Securities.
Nick Jones, Analyst
Great. Thanks for taking my question. If I could sneak in two here. I guess, one, I think, Manheim used value vehicle index came out and the declines in October may be moderating a little bit. I mean, do you have any sense of kind of the rate of change and what the impact on transaction volume is? Is it potentially improving into 4Q? So that’s the first question. And then the second question is, I guess, back to arbitration. I mean is something kind of structurally different than how the fleets arbitrate versus kind of now indexing away from the fleets, is that potentially underpinning some of the challenges you are feeling today? Thanks.
Sam Zales, President and Chief Operating Officer
Nick, we have indexed away from the fleets and that’s important. I think that was my point to Jed that more buyers from a dealer perspective are on the platform. So we are really pleased with that. I don’t think it’s one customer or another. I really put it on ourselves at CarOffer that the operational rigor, the systems, and the data we use has to be more rigorous in that process. I will give you an example, we are sending a CarGurus team of data analysts and engineers and project managers to join with the CarOffer team to improve the data processes to allow us to systematically reduce that arbitration as we go forward. The data just wasn’t available to a manager to say, let’s stop that arbitration right at one point as opposed to allowing it to go to a remet situation or move it through with a more economically bad outcome for us. So it really is more on us than the market and I think just in a declining market, and you pointed to the wholesale prices. It’s continued down. The drop in the numbers went through September. October has not looked better. I think the wholesale pricing market is continuing downward. But I hope at a much less aggressive rate as it did through the third quarter. So we think things will stabilize at some point, but more importantly, for us, it’s the operational rigor and execution that we take going forward to ensure that we are ready to eliminate the unprofitable transactions and get back to the full percentage of profitable transactions.
Jason Trevisan, Chief Executive Officer
Yes, this is Jason speaking. To add to what Nick mentioned, there was a significant drop in used car unit pricing from July to September. Even if the decline moderates in October, looking at the past couple of years, prices remain at high indexed levels. We are planning for some form of ongoing decline until prices approach what I consider normal or expected. While inflation is a factor and prices won't revert to previous levels, there remains considerable room for adjustment, especially considering the 45% increase from 2021 to 2022.
Operator, Operator
Thank you. The next question comes from Brad Erickson of RBC Capital Markets.
Brad Erickson, Analyst
Hi. I guess just a couple more on the super fun topic of arbitration. You mentioned you saw the average prices come down through the quarter. I guess, back to an earlier question around potentially being structural. Do you ultimately just have to focus on higher value cars, maybe a bit more to protect the economics? I know you clearly are doing a lot from an operational efficiency standpoint. But just curious if you have to sort of focus and segment the market a little bit more narrowly to protect the economics there? And then I have a follow-up.
Sam Zales, President and Chief Operating Officer
In a declining price market, the entire business tends to go down. I don’t believe we can control that. We have always been focused on our goals. When Jason talked about the rising market, our model and operational processes worked well when prices were at their peak. As prices drop, we need to apply more rigor to minimize unprofitable transactions. We will always be recognized as a platform catering to high-priced vehicles. However, as the market declines and consumer demand decreases, we are adjusting accordingly. I believe that once we integrate our inspection partners for mechanical, electrical, and frame damage, we will be equipped to handle the current market conditions while maintaining our strength in high-value vehicles.
Brad Erickson, Analyst
Got it. And then just one other one in looking to maybe unpack the EBITDA outlook for Q4. But I think it looks like if you back out the CarOffer drag in Q3, it implies the core is running maybe around 30% or so in terms of EBITDA margins. But obviously, that’s worse in Q4. I understand CarOffer’s clearly going to be a bigger drag. But just curious if in Q4, the EBITDA guidance contemplates margins maybe getting hit on something incrementally or if they are going to continue running in those ranges? Thanks.
Jason Trevisan, Chief Executive Officer
I can address that. No, I don’t believe there are any additional impacts in the core business. Our major expenses are headcount and marketing, which can vary. While marketing expenses can change, headcount generally increases steadily. We have slowed our hiring process but are still adding personnel to invest in Digital Retail and drive innovation in Listings. So, there are no unexpected developments there. As for revenue, there are no surprises with subscriptions, but advertising and consumer finance may see some fluctuation, which typically follows seasonal trends, especially slower in the fourth quarter.
Operator, Operator
Thank you. The next question comes from Ralph Schackart of William Blair.
Ralph Schackart, Analyst
Good evening. Thanks for taking my question. Jason, in the prepared remarks, you talked about the focus on increasing operations to sort of work through the near-term challenges with Digital Wholesale, just curious how much can you operate and execute through a declining sort of environment or where the macro is tough. I guess in other words, will the base or the business continue to run at this profitability level for the foreseeable future until you can get the controls you are trying to put in place, or will there be sort of like an immediate or more pronounced operational focus that could hopefully return the business to increase profitability going forward post Q4?
Jason Trevisan, Chief Executive Officer
Sure, I will start, and then Sam can add if he wants. Thanks for the question, Ralph. What you are seeing in EBIT for Q3 and Q4 EBITDA is us addressing the operational issues from August and September. You can think of this as clearing out the higher volume of vehicles we took in for arbitration, and there’s a part of Q3 and Q4 that you can consider somewhat one-time as we correct the mistakes from a few months ago. When you look at steady-state operations, Sam has mentioned several improvements we’ve already made. Some are simply about enforcing policy, while others involve procedural changes within the company. You can start to notice those changes immediately. However, transitioning and implementing these operational changes will take time. As Sam mentioned, we have team members at CarGurus from various functions working closely with the CarOffer team to make daily improvements and changes. Even in a declining price environment, which I mentioned earlier, we're assuming for lack of a clearer forecast, even if prices continue to drop, we are putting in place operations that will establish a profitable and efficient asset-light business similar to what we had six months ago. This goal is completely achievable. We understand what needs to be done, and we just have to work through it.
Operator, Operator
The next question comes from John Colantuoni of Jefferies.
Unidentified Analyst, Analyst
Hey, guys. Curious to know what you are seeing in terms of used vehicle demand from the rental fleet on CarOffer to a little bit more depth. What is your view kind of on the magnitude of the impact that’s slowly recovering sort of new vehicle supply will have on the fleet’s appetite for used cars going into Q4 and 2023? And then what is your outlook for the percentage of kind of CarOffer transactions that will end up being comprised by the rental fleets going forward next year? And I have a quick follow-up as well.
Sam Zales, President and Chief Operating Officer
Hey, John. I...
Jason Trevisan, Chief Executive Officer
I was just going to give you a break from talking to him. So, John, we mentioned earlier that rental activity was subdued as we anticipated, and we believe that it will continue to be that way. They are receiving more allocations from new vehicles, and there is a possibility they might return significantly to the wholesale market. However, that is not included in our forecast, and we are not planning our business around that. In short, while they might come back, we are not projecting it, and we did not observe it in any significant manner in this last quarter.
Unidentified Analyst, Analyst
Thank you for the opportunity to speak. This is Vincent standing in for John. I would like to ask how the exit of the rental players has impacted the bid-ask spread you are experiencing on CarOffer. Has it widened significantly, and to what extent has this change occurred due to the departure of the fleets? Thank you.
Jason Trevisan, Chief Executive Officer
I think that largely worked itself out at this point and meaning we had that sort of bid-ask spread hangover from when the fleets were bidding so aggressively, and I think that has worked its way through and sort of normalized. Where you see that, I think now in any residual way is that in Instant Max Cash Offer, the offers made to the consumers are not nearly as compelling on a relative basis as they were when the fleets were involved. But from a dealer-to-dealer perspective, I think the market has come back to a reasonable bid-ask spread. I think what you are seeing, which has led to lower volumes in the wholesale market in general is that you see a lot of dealers that have cars that they are underwater on and they are reluctant to sell those wholesale and take the write-down. They are instead often trying to hold on to those and sell them in retail. And so I think that’s a different form of a bid-ask spread. That’s where you have a seller that is unwilling to accept what is the new market value for that depreciated asset and instead hoping that they can get out from under the underwater dynamic that they are in.
Operator, Operator
Thank you. The next question comes from Doug Arthur of Huber Research.
Doug Arthur, Analyst
Thanks, Jason. Regarding your point, what are you observing on the consumer side? Clearly, based on your guidance for Instant Cash and Max Cash in Q4, interest in selling cars at lower prices has decreased significantly. Is there a genuine hesitation because prices are now roughly 15% lower than they were three or four months ago, and the market is not swiftly adjusting to that reality? Are you seeing a lot of reluctance to sell?
Jason Trevisan, Chief Executive Officer
I believe there are a few key factors at play. First, when someone is selling a car, they often plan to buy one as well, so these actions are interconnected. We recognize that retail demand has decreased, largely due to a recession, increased auto loan rates, and thus fewer individuals are looking to buy cars; consequently, fewer people are selling them. Second, car prices are lower now. If someone had heard about a great offer on their used car six months ago or checked its price then and sees it has dropped, they may feel discouraged. This reflects the demand side of the market. Internally at CarOffer, we need to enhance our operations before ramping up growth again. We have specifically reduced marketing for Instant Max and decided to intentionally slow down our approach. Additionally, while arbitration rates are elevated in a market where assets are depreciating, we need to implement a buffer to address potentially higher arbitration rates until we can reduce them. In this cautious mindset, we are also hesitant to accept cars that are much older or have high mileage due to their increased likelihood of arbitration. So, several factors from both consumer demand and our growth strategy are influencing this situation.
Operator, Operator
Hey, Doug. Does that conclude your question.
Doug Arthur, Analyst
Yeah. I am all set. Thank you.
Operator, Operator
Thank you. The next question comes from Naved Khan of Truist Securities.
Naved Khan, Analyst
Thank you for taking my questions. First, could you clarify the breakdown between fixed and variable costs in your advertising spending? Additionally, how should we view ad expenditures related to the Listings business as you address other areas? My second question pertains to cash usage. With the added flexibility from your revolver, what are the Board's thoughts on potentially increasing share buybacks, especially considering the recent decline in stock value?
Sam Zales, President and Chief Operating Officer
Yeah. Hi. Can you repeat the very last thing you said, Naved?
Naved Khan, Analyst
Yeah. Just on share buyback and putting the increased financial visibility to use to buy back shares more aggressively?
Jason Trevisan, Chief Executive Officer
In terms of our sales and marketing strategy, especially for our Listings business, most of our marketing expenses are variable rather than fixed. If I understand your question correctly, you are referring to locked-in media placements compared to more flexible performance-based options. A very small portion of our media commitments is locked in through contracts. Regarding our cash position, we are pleased to have secured our line of credit, which puts us in a comfortable position. This isn't something we necessarily need at this time. Generally, as we consider options for utilizing our capital, we can invest more in operations, pursue mergers and acquisitions, or initiate a share buyback. We have consistently been executing net share settling, buying back between $15 million to $20 million worth of shares each year in recent years. This is one of the three primary uses of our cash, along with capital expenditures.
Naved Khan, Analyst
On the sales and marketing, you said it’s mostly ad spend, it seems like. So is it fair to assume that it’s primarily the Listings business where it’s going, because we saw a sequential sort of downtick, but it still is roughly 50% of your marketplace revenue. Is that the right way to think about it in terms of go forward?
Jason Trevisan, Chief Executive Officer
I wouldn’t consider it a steady state. It has decreased significantly over time. Firstly, I would look at sales and marketing as separate entities, which is our approach. Secondly, within marketing, we have various types including performance marketing and brand marketing, along with different messages targeted to specific audiences. Regarding Listings and driving activity, that’s what creates value, generates Digital Deal leads, and provides leads to dealers and consumer finance. We see this as very low funnel, offering high ROI for our dealers. Performance marketing is adjustable daily, while brand advertising, especially television-based, is the only large-scale execution that requires upfront purchasing with some moderate commitment for a few quarters ahead. We evaluate all our marketing based on ROI and closely monitor our return on advertising spend, which we believe is at a very high ratio.
Operator, Operator
Thank you. Our final question comes from Tom White of D.A. Davidson.
Tevis Robinson, Analyst
Hey. This is Tevis Robinson on for Tom. Thanks for taking the question. I am curious whether you guys can comment or quantify the extent to which you may be seeing meaningful growth in the number of vehicle listings from the dealers that show their inventory on your marketplace?
Jason Trevisan, Chief Executive Officer
So are you asking, Tevis, if you want to know the volume of dealers who have any inventory in our marketplace?
Tevis Robinson, Analyst
Yeah.
Jason Trevisan, Chief Executive Officer
We will need to follow up on that, as I haven't reviewed it. For everyone's awareness, we categorize dealers into paying and freemium, with both types of inventory being included. Our freemium model currently limits the number of leads that a free dealer can receive each month. However, we believe that this inventory still adds value for consumers. Used inventory has started to recover, which was previously down by 20% to as much as 40%, but is now approaching pre-COVID levels. New inventory took a significant hit, dropping by 70%, but is also beginning to improve. This resurgence is likely more related to the number of vehicles per dealer rather than an influx of new dealers joining our platform. We have around 25,000 paying dealers in the U.S., and the total dealer count exceeds this. While we don't usually share that number or trend, we can investigate further and provide you with an update.
Tevis Robinson, Analyst
Got it. Okay. Thank you.
Jason Trevisan, Chief Executive Officer
Sure. Thanks.
Operator, Operator
Thank you. Ladies and gentlemen, we have no further questions on the line. I will now turn the call over to Mr. Trevisan for closing remarks.
Jason Trevisan, Chief Executive Officer
Thank you very much. We’d just like to thank everyone for joining us this evening. And most importantly, I would like to thank our employees and our customers and our partners. And in particular, I’d like to thank all of our veteran colleagues and customers in light of Veterans Day holiday that we are celebrating all this Friday. So, thanks, everyone. I hope you have a good evening.
Operator, Operator
Thank you. Ladies and gentlemen, this concludes today’s conference. Thank you for your participation. You may now disconnect your lines.
Kirndeep Singh, Vice President, Investor Relations
Good-bye.