OPENLANE, Inc. Q1 FY2022 Earnings Call

Good morning. Thank you for standing by. Your conference call will begin momentarily. Again, please continue to stand by. Thank you. Good day, and thank you for standing by. Welcome to the KAR Auction Services Q1 2022 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speaker presentation, there will be a question-and-answer session. Please be advised today's conference is being recorded. I would now like to hand the conference over to your speaker today, Michael Eliason, Treasurer and VP Investor Relations. Please go ahead.

Thanks, Amanda. Good morning. And thank you for joining us today for the KAR Global First Quarter 2022 Earnings Conference Call. Today, we'll discuss the financial performance of KAR Global for the quarter ended March 31st, 2022. After concluding our commentary, we'll take questions from participants. Before Peter kicks off our discussion, I would like to remind you that this conference call contains forward-looking statements within the meaning of the safe harbor provision 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 measure can be found in the press release that we issued yesterday, which is also available in the Investor Relations section of our website. Now, I'd like to turn this call over to KAR Global CEO, Peter Kelly. Peter.

Thank you, Mike, and good morning, everybody. I'm delighted to be here this morning with all of you to provide an update on our performance at KAR Global. So on today's call, I will detail our first quarter results and provide you with some guidance in context around our expected performance for the remainder of 2022. But first I would like to update you on the status of our divestiture of the ADESA U.S. physical auction business. Our transaction is expected to close within the next week. It is a significant, even historic milestone in KAR's history and a transaction that will be transformative for our company, our customers, our employees, and our stockholders. And I believe that the rationale for the transaction, as we outlined on our investor call back in February, remains intact. Together with our customers, we're driving a channel shift from physical to digital marketplaces. This transaction allows us to more rapidly develop and deploy the digital solutions that our customers need and value the most. In doing so, this transaction would advance the digital transformation of our industry and fuel future growth. And with approximately 350,000 vehicles sold on our platforms in the first quarter, we have plenty of opportunity to grow. This transaction will also simplify our business. It will enable us to focus our strategy, energy and investments on expanding our capabilities, growing our volumes and increasing our market share. We believe this focus will help us generate the greatest benefits for our customers and deliver the greatest value to our stockholders. And as we outlined in our February announcement, the transaction enhances our financial profile. It helps us streamline our operating structure, becoming a more asset-light company. We believe it will enable us to increase our gross profit margins and our EBITDA margins and drive a faster long-term growth rate of KAR. The transaction enables us to pay down debt, creating more flexibility in terms of future capital allocation. And KAR will continue to generate strong cash flows going forward. We look forward to sharing more with you about our strategy, at an Analyst Day Update Call that we would likely schedule for June, and I will provide more details around that later on this call. So for the remainder of our time, I'd like to discuss our first-quarter results and our outlook for the rest of this year. Consistent with our earnings release last night, the results that Eric and I discuss today exclude the divested ADESA U.S. physical auction business, which is treated as a discontinued operation in the financial reports. Also in my remarks I'm going to speak about our business in two segments. Our Marketplace segments, which we formerly called the ADESA segments, and the AFC segments. The first quarter was challenging. Our volumes continue to be negatively impacted by the vehicle supply and used vehicle pricing issues that are affecting the broader industry. This is certainly the case with commercial vehicles, particularly off-lease vehicles. But it's also the case to a lesser extent for dealer consigned vehicles as well. Notwithstanding all of that, we made important gains across many aspects of our business. For KAR overall, and again this does not include the ADESA U.S. physical auction business, the performance highlights in the first quarter include: we generated $369 million in revenue, that was flat with the same quarter of the prior year. And we also increased our auction fee per vehicle sold. We generated a total gross profit of $159 million, that was a decrease of 4% from Q1 of 2021. This gross profit represented 49.1% of revenue, excluding purchased vehicles. We generated $49 million of adjusted EBITDA, a decrease of 36% from the same quarter last year. However, it's important to note that our Q1 2021 results included a $17 million realized gain on the sale of marketable securities. Within the Marketplace segment, we facilitated the sale of 351,000 vehicles. This represented over $6.5 billion in gross auction proceeds. Those volumes were down 23% versus Q1 of the prior year, driven by the continued strain on commercial sector volumes; our commercial volumes declined by 46% or 146,000 units. I'll provide more detail on that in a few moments. In our Dealer Consignment business, volumes increased by 39,000 units, representing 28% growth over the prior year. This positive growth was driven mainly by organic growth of BacklotCars and TradeRev, and by our acquisition of CARWAVE. We generated $285 million in revenue, a decline of 6% versus Q1 of 2021. And we generated $255 in gross profit per vehicle sold in the Marketplace segment. That was an increase of $7 per unit versus Q1 of last year. In our AFC segment, we experienced another solid quarter performance with revenue of $84 million in the quarter, an increase of 28% over Q1 of last year. So as I mentioned a few moments ago, our first-quarter performance was negatively impacted by the ongoing supply chain challenges, semiconductor shortages, and the lagging new vehicle production and new vehicle sales. This principally impacted us in terms of off-lease transactions. With used vehicle prices at all-time highs, consumers have significant equity in their off-lease vehicles. And this means they're more likely to retain those vehicles than to return them when the lease ends. This led to a 61% reduction in the number of off-lease vehicles returned to our OPENLANE platform compared to Q1 of 2021. This reduction in supply at the top of the funnel materially impacted the performance of that business. I want to be very clear, this is not a loss of share or of customers and also conversion rates within the channel remained very strong. In fact, it was stronger than one year ago. We believe that these factors ultimately are temporary. And while neither we nor our commercial customers can accurately predict when these factors will resolve, I'm confident that our continued investments in OPENLANE and in our off-lease solutions in general, positions us well to retain and grow share when the new vehicle production increases and when off-lease vehicle volumes return to more normal levels. Vehicle production shortages and reduced new car sales were also a headwind to growth in our dealer-to-dealer category. Fewer new vehicle sales by franchise dealers result in fewer trade-ins, and that flows through to our business. So while we grew our seller count on BacklotCars, CARWAVE and TradeRev, we saw fewer vehicles posted per seller versus the same quarter prior year. That said, we're pleased with our performance of our dealer-to-dealer business in the quarter; in addition to growing our volume by 28%, we increased our revenue per vehicle sold by over 25% versus the same quarter last year. While significant uncertainties still exist across our industry, there are now four months into 2022 and we're able to provide guidance that we expect to deliver $265 million in adjusted EBITDA for 2022. This would represent approximately 11% growth in adjusted EBITDA year-over-year, had we applied the same discontinued operations accounting to our 2021 results and had we excluded the realized gains from the sale of marketable securities during 2021. I believe that delivering this growth in the face of the uniquely challenging set of circumstances is encouraging as we continue to focus on the factors that are within our control and the opportunities that do exist. The key drivers in delivering these results in 2022 are the following. As I noted earlier, AFC performed well in Q1. Given our current visibility into this business, I expect to see continued strong performance from AFC throughout the balance of this year. Although we do not report separately on ADESA Canada, we expect it to contribute meaningfully to our 2022 results through strong market share, its digital operating model, and strong operating economics. We also expect our digital dealer-to-dealer business to be a growing contributor in 2022. We also believe that our diligence and consistent efforts to manage our cost structure will contribute meaningfully to our success in 2022 and to our improved performance beyond 2022. We believe that once the ADESA U.S. physical auction business transaction closes, we will have an additional opportunity to streamline our organization and make meaningful progress towards a cost structure reflective of a fully digital business. We're targeting a material reduction in SG&A. By the end of 2022, I expect our cost reductions at an annual run rate to be at least $30 million per year. One important area of our business that we expect to underperform prior years will be the OPENLANE business, as well as some of the related services businesses that service the off-lease vehicle in particular — businesses such as CarsArrive and AutoVIN. The fact is, it is impossible for these businesses to deliver their historical level of earnings contributions given top-of-funnel off-lease supply is down by approximately 60% versus normal levels. However, OPENLANE remains a very important and very valuable asset. It represents an essential and deeply integrated capability, and is key to some of our largest customer relationships. I am confident that OPENLANE will be an important driver of our future profits. As I look past 2022, I'm encouraged by our prospects for growth, and I believe that our growth will be driven by a number of important factors. Firstly, by a secular shift towards digital marketplaces across our entire industry, which is driving increased volume in both the dealer and commercial parts of the business. Secondly, by recovery in commercial volumes. Given the continued supply chain issues with new vehicles, this will likely take place over a longer time frame than I would have hoped for six months ago. But I'm confident that ultimately it will recover towards historical levels. So I see it as a question of when, not if. Third, the continued strong performance by businesses like AFC and ADESA Canada, where we have differentiated offerings in a strong market position will support our performance going forward. And finally, our continuous focus on cost efficiency and being an asset-light company. I'd like to make a few remarks as regards future capital allocation. As I mentioned earlier, the completion of our divestiture will allow us greater flexibility in terms of capital allocation. We expect to pay down a substantial amount of our outstanding debt. We will continue to invest in the technology and platforms that create the most value for our customers, and position us to capture the opportunities ahead and expand our addressable market. Following this transaction, KAR's capital structure will allow it to be more nimble and more strategic in deploying capital to drive growth. And if our stock continues to be undervalued, as I believe it currently is, we have the ability and capacity to repurchase shares. Eric will speak to that in a few moments. As we committed to you when we announced the ADESA U.S. physical auction transaction, we intend to update our previous Investor and Analyst Day materials to reflect our new company and an updated set of assumptions. We're currently targeting June for this update, and we will send a save-the-date after the deal closes. During this meeting in June, we will go more deeply into KAR strategy, and our expectations for growth, and our future performance. I'm looking forward to that discussion, and we will publish details as soon as the date is set. So in closing my remarks here this morning, I'd like to summarize some of my key messages for today. Our ADESA U.S. physical auction transaction is expected to close within the next week. The transaction will be transformative for KAR and for our customers, and I remain very optimistic for our future. With a smaller, nimbler and more asset-light company, we intend to execute a focused digital strategy to capture what we believe to be considerable opportunities for growth, both in and beyond our current market. This includes meaningful growth across both our commercial and dealer solutions, both in terms of increased market share and an expanded portfolio of services to support our customers. For 2022, we expect to deliver $265 million in adjusted EBITDA, representing 11% growth on a like-for-like basis, in spite of a uniquely challenging set of circumstances facing our industry. And as we look to the future we're excited and energized by the opportunity ahead. We believe we have a significant opportunity for growth, exceeding the 15% adjusted EBITDA CAGR that we spoke to in our Analyst Day last September. We have differentiated platforms, a diverse and expanding customer base, and a large addressable market space in which to innovate and invest. Ultimately, we believe that the combination of our assets and the opportunities ahead will drive strong revenue growth and margin improvements. And we look forward to discussing these opportunities and our strategy to capture them on our call with you next month. So with that, I'll hand it over to Eric who will provide a more detailed review of the financial results for the quarter.

Thank you, Peter. I would like to start by explaining the basis for the presentation of the ADESA U.S. physical auction business in various filings. First, we're required by GAAP to treat ADESA U.S. physical auction businesses as a discontinued operation. This results in removing all activity from the ADESA U.S. physical auction business from the financial statements for our continuing operations. For clarity, I will refer to our continuing operations as KAR RemainCo throughout this discussion. The first impact of discontinued operations is we remove all detailed activity for the discontinued operations from our income statement, balance sheet and statement of cash flows. As you can see in our financial statements in the press release, the financial information for discontinued operations is presented in aggregate in each of the various statements. We do not present line item detail. For example, revenue, cost of services, SG&A and so on in the income statement. It is presented in a single net line item, income from discontinued operations, net of income taxes. In each category of the balance sheet, we present the aggregate activity in a single line item, asset or liability held for sale. And then the statement of cash flows, we present the cash flow activity for each category of cash flows as a net cash provided or used by discontinued operations. And all financial statement presentations, we restate prior year financial statements in this manner to reflect the ADESA U.S. physical auction business as a discontinued operation. We have completed this restatement for the first quarter financial statements. We will be determining the impact of discontinued operations of each quarter of 2021 after we complete the transaction. We do not have that information to share with you today, but will provide it as soon as it is available so you have comparisons for each quarter going forward. We have other financial information that has been provided or discussed as part of the ADESA U.S. physical auction transaction. Carve-out financial statements for the business were provided to and were published in an 8-K by Carvana. You will likely notice that the basis of presentation for the carve-out financials is substantially different than the presentation of discontinued operations. The carve-out financials include allocation of costs from KAR to the U.S. physical auction business that are not part of our transaction with Carvana. GAAP requires the statements to reflect the operations of the business from the perspective of KAR not Carvana. Accordingly, the carve-out statements include $42.6 million in allocated corporate costs in the financial statements. The allocation of these costs was primarily based on revenue and headcount for the ADESA U.S. physical business in relation to KAR RemainCo. Some of these costs will be retained by KAR RemainCo for the duration of the transition services agreement with Carvana. Some of these costs relate to contractual relationships with third-party technology providers and the costs will be retained until the termination of existing contracts. As Peter mentioned, reducing costs at KAR RemainCo is a priority in 2022, following the closing of the sale of the ADESA U.S. Physical Auction Business. I also want to comment on our outlook for $265 million of adjusted EBITDA for 2022. This represents our estimate of reported results for continuing operations of KAR RemainCo for the full-year. This expectation does not include any pro forma adjustments. For example, we have a commercial agreement with Carvana as part of this transaction. Our expectations include expected revenue from the commercial agreement actually billed and collected from the date of the close of transaction to the end of 2022. To the extent KAR RemainCo incurs any non-recurring expenses like severance or contract termination payments, these will be included in our reconciliation of net income to adjusted EBITDA, consistent with our treatment historically. We will not be including pro forma activity as if the transaction closed on January 1, 2022. Given the expectation that our transaction will close in the near future, let me summarize this transaction for you. The total proceeds from the sale of the ADESA U.S. Physical Auction Business will be $2.2 billion. Up to $49 million of this purchase price will be held back until consent to assign leases are received from certain landlords. We expect to receive these consents on all of the properties before or shortly after the closing of the transaction. This transaction will result in a substantial gain. We expect the net gain to be taxed at a rate of approximately 26.5%, including applicable state taxes. We estimate that the gain net of taxes, fees, and expenses will be approximately $1.65 billion. We expect this gain will be realized in the second quarter of 2022 upon closing of the transaction. As we had previously disclosed, we will utilize the proceeds to repay existing debt. Upon closing of the transaction, our credit agreements require the repayment of term loan B6 within three days of closing. After repaying our senior debt, the remaining net proceeds will be used to redeem or repay senior unsecured notes. We expect within 365 days of closing to apply remaining net proceeds to redeem or repay the senior unsecured notes. We will not be redeeming the senior unsecured notes prior to June 1, 2022 as the redemption premium on the notes steps down on June 1st. In our balance sheet as of March 31, 2022, we have classified our term loan B6 borrowings as current, given the expected timing of the closing of the transaction and the requirement to repay this debt within three days. The senior unsecured notes are classified as non-current as of March 31, 2022 because there is no requirement to repay this debt within one year from the balance sheet date. We expect a portion of the senior notes to be reclassified as current obligations as of June 30, 2022 in accordance with our expectations, and the terms of the senior notes indenture. As mentioned in our release last night, the Board of Directors has increased our share repurchase authorization by $200 million, and extended this authorization through December 31, 2023. Following the closing of the Carvana transaction, we expect to have attractive cash-generating businesses with an expectation for profitable growth over the next several years. We anticipate purchasing KAR shares in the open market opportunistically. We believe the repositioning of our company as a digital marketplace business combined with the growth we expect over the next several years as we increase volumes in our digital Dealer-to-Dealer Business and experience the recovery of commercial volumes is not yet reflected in our stock price. We have the flexibility to repurchase KAR shares if the market does not properly value KAR in the near future. A few quick comments on our performance in the first quarter. First, our cash from operations for the quarter was negative, both continuing operations and discontinued operations. This is due to the timing of quarter-end. As you can see in the balance sheet, the net impact of Trade Receivables and Payables was the use of cash. This is not a change in cash patterns for our transactions, but a reflection of the quarter ending on a Thursday. The cash use reversed over the next several days following quarter-end. This was not impacted by the ADESA U.S. physical Auction transaction or any changes in terms with our customers. KAR RemainCo's marketplace businesses, OPENLANE, BacklotCars, CARWAVE, ADESA Canada, TradeRev, and ADESA Europe all experienced low supply of wholesale vehicles, especially in January and February. We saw some recovery in March, although supply still remains constrained. In our volume disclosed in the Earnings Release Supplement and what will be disclosed in our 10-Q, only the volume of KAR RemainCo is reflected. Our auction fees per vehicle sold increased 29% in the first quarter. A major contributor to this increase was fee increases implemented at BacklotCars in early March. This contributed to an increase in gross profit per vehicle sold to $255 from $248 in the prior year. Overall performance in our marketplace businesses was challenged by the supply situation. However, we saw March results that were significantly better than January and February. To put it in perspective, our March performance represents approximately 45% of the adjusted EBITDA for the quarter. The improved March performance was driven by the growth in digital dealer-to-dealer volume combined with fee increases and improved gross profit per vehicle sold. The AFC business continued a strong performance in the first quarter. Although the number of loan transactions was flat year-over-year, this was against the backdrop of decreased volumes in all channels of wholesale transactions. The strong performance was driven by strong revenue per loan transaction, including the impact of low credit losses and increasing interest rates. The low levels of dealer inventories across all segments of the retail market drive positive performance at AFC. We continue to see elevated used car prices that drive higher average loan values per car floor. Low inventory levels for dealers drives improved payoffs as cars are sold. The challenges in the wholesale supply of vehicles is a positive for our AFC operations. So that concludes my remarks. I'm sure you have plenty of questions today. So I will ask Amanda, our Operator, to begin the Q&A portion of our call. Thank you.

Thank you. Our first question is from the line of Ryan Brinkman with JPMorgan. Your line is now open.

Great. Thanks for taking the question. This is Rajat Gupta on for Ryan. Just a first question on the EBITDA guidance for the year. Could you give us a sense of the trajectory from 1Q to the full-year in terms of what's driving the sequential movement? How much of it was volume versus GPU, or SG&A improvements and if you could also give us a sense of how much of the commercial services agreement is embedded in that guidance, as well? That was the first question I have a follow-up.

Thank you, Rajat. Let me take that question. In terms of the bridge from our Q1 performance to $265 million for the full year, there are a number of factors that are additive to our Q1 performance. Let me outline what those are. And I would say that the factors that affected our Q1 performance, I expect to continue. So I see the Q1 performance as a base for these additives to it. We expect an improving EBITDA contribution in the digital dealer-to-dealer businesses. Eric spoke about some of the changes on the monetization side that we made in March. So those weren't really fully reflected in Q1, but these will be reflected every month going forward. So that's an important aspect. We expect to see some improvements in the OPENLANE performance and corresponding services businesses. We have a number of new programs going live with certain customers, and we expect these to have a positive impact starting as soon as May and some of them going live in June and July. And I'd also say these programs don't require incremental top-of-funnel volume. So we expect incremental positive movement there at OPENLANE, which will be positive for us as well. There will be a contribution from the Carvana commercial services agreement. I'd say it's relatively modest, but it is incremental and helpful. And then, as you mentioned, SG&A reductions do play a role, although those will tend to ramp up over the course of the second half of the year. But they will be incremental to the Q1 story as well. So essentially that provides the bridge, Rajat, from Q1 to the $265 million.

And Rajat, if I could add something on the commercial agreement. We have a contract minimum volume in the commercial agreement. Our guidance assumes only the minimum is achieved. So there is no downside risk to the number we've assumed in there because of a contractual minimum. We will not disclose the specific terms of the transaction, but I wanted everyone to know while it is a volume-oriented number, there is a minimum and we have used the minimum in our expectations.

Understood. That's helpful. So maybe just following up on that. We have obviously heard of many dealer customers deciding to look at alternatives due to the physical platform. And you also see a lot of public announcements from the OEM partners, so moving away from ADESA, the physical business, can you give us a sense of how this is impacting OPENLANE or Backlot? How the customer conversations have been, maybe from the OEM side for OPENLANE and then just dealers — are you seeing more of a shift to the digital because of that or are you seeing some kind of a backlash, maybe because competitors are acquiring the platform and maybe just if you can give us an update on that. Thanks.

Thanks, Rajat. Obviously, my focus is on, as Eric described it, RemainCo and the platforms that stay with KAR post-transaction, so I'll confine my remarks to that. And no, we haven't seen backlash in that regard. I think our customers understand the strategy and I think they are enthusiastic about working with the new KAR. They, whether it's Commercial or Dealer, whether it's Seller or Buyer, most customers see more digital transactions in the future than in the past, and understand the strategy and are very interested to see what we can do for them and the solutions we can bring to them in that regard. Let me provide a little bit more context on that. For sure the announcement of the transaction was a big event in our industry. It did take a little bit of time to digest and there was some, I'd say, confusion in the very initial stages as to exactly what had been acquired or divested. Given all of that, it's important for us — certainly in those early days and weeks post-announcement — to spend a lot of time with our customers which we did and frankly which I did personally. And I guess I'd characterize the response as regards RemainCo as follows: our customers understand the strategy, they understand the rationale, and I think they're enthusiastic about working with the new KAR. They see more digital transactions in the future and many customers are keen to sustain the strong conversion rates we've demonstrated. I think our customers are very interested to see how this transaction enables us to focus our investments on digital solutions and what types of offerings we can bring to them, and we've had some initial discussions of those. I think there will be exciting product development opportunities in that direction, which I'm excited to start to bring to market. So I think there's a lot of opportunity and I think there's a good alignment between our strategy and what our customers are looking for going forward.

Understood. Thanks a lot for the details, and I'll get back to the queue.

Our next question is from John Murphy with Bank of America. Your line is now open.

Good morning, everyone. This is Aileen Smith on for John. So I wanted to ask you another question around the $265 million outlook — just make sure I understood it correctly in the context of some of the prior comments you've made. I think your last comment when the sale of the ADESA physical auctions was announced was that the transaction was going to reduce 2022 adjusted EBITDA by $100 million, which I'm assuming is held constant outside of any changes in the market or the business more broadly. Within that new $265 million outlook, is it fair to assume the $100 million reduction from the ADESA physical sale holds and the remaining incremental negative, particularly on a year-over-year basis versus pro forma results is just due to persistent industry headwinds in the secondary market?

Yes, I think that's a reasonable assumption. I think that indication of the $100 million impact is still valid. And I would say candidly, the new vehicle supply issue and the challenges that our OEM customers are facing in getting their production back to normal levels has proven more challenging than perhaps what we would have expected six months ago. So I think the way you summarized it there is accurate.

Okay. Great. And then I wanted to follow up on Rajat's second question. Specifically whether dealers continue to send vehicles to auction houses owned by competitors. I wanted to ask, rather than whether you are or not seeing change in traffic or shifts, how do you actively change the discussion with some of those dealer customers about moving to the online marketplace offered by KAR. Is there an extensive education process that you need to go through? I think you mentioned that your customers are interested and they understand the industry shift is happening. But is there any incremental costs of time or resources that you need to make to catalyze customers to shift from physical to digital? Or is it happening relatively quickly?

Let me answer that. I would say no, because we have been with our customers. Part of our company culture is to stay in very close communication and close partnership with our customers. We've been in communication with them for many years around digital transformation. I think our customers understand that we're a company that has helped to drive the digital transformation of the industry both on the Commercial and on the Dealer-side, and on the sell and buy sides of the business, so that's something we're obviously very experienced in. I think our customers, like our digital solutions; they find them very effective and powerful. In the case of many of our customers, our digital solutions represent their highest performing channels. So I would see it as a redoubling of that effort. The advantage to us is being exclusively focused on that, which enables us to be fully committed and not ambiguous in terms of messaging. We're going to have a very focused message of, these are the solutions we bring to market. We think these are the best. What can we do that would make these solutions better? And how would we deliver that for you? So that's kind of the discussion we want to have with our customers.

Okay. Got it. That's very helpful commentary. And then one bigger question if I may on AFC since I'm sure we're going to get a lot around ADESA. Does the sale of the ADESA physical auctions have any near- or longer-term implications to AFC that we should be thinking about? Obviously, the customer side is in many cases dealers that are using ADESA Auction Services, and then getting financing from AFC. I'm not even sure if that financing capability is something Carvana can offer as they acquire the physical auction. So as you divest the physical sites, is there any risks to AFC going forward that we should be thinking about from a modeling perspective?

I don't believe that there is a risk that AFC will be hurt by the sale of the ADESA U.S. physical auction business. To provide some context on that: AFC serves independent used car dealers who are purchasing cars in the wholesale market, including at KAR's marketplaces, at ADESA, but also at our competitors' marketplaces whether digital or physical. So when AFC establishes a relationship with a dealer, it's very important that they support that dealer's vehicle purchasing irrespective of where the dealer acquires the inventory. So that's very much part of their strategy. As a result of that, only a relatively small percentage of AFC's total loans were purchased from KAR's marketplaces or from ADESA. So I think AFC really has a channel-agnostic point of view. As long as the dealer wants to buy a car, AFC will finance the vehicle. So we don't see any risk. We haven't seen any risks show up in the numbers. We haven't seen any erosion of the customer base whatsoever in the past 60 days since announcing this transaction. So I don't think there's any knock-on effects there.

And Aileen, let me add: As part of our commercial agreement with Carvana, the AFC personnel that are on-site at ADESA U.S. physical auction locations will remain on-site through the duration of that contract at no rent costs to KAR RemainCo. So that's an attractive logistics arrangement for us relative to having the AFC resources still available to the customers at those locations.

Okay. Fantastic, thanks for taking the questions, guys.

Our next question is from Gary Prestopino with Barrington Research. Your line is now open.

Hey, good morning, everyone. Hey, Peter, Eric, when you talk about, over time reducing your SG&A as a percentage of sales, what do you feel would be an optimal percentage number there? I mean, it was running at 32% versus 29% year-over-year, but what would be an optimal number for you?

I guess what I'd say is we have two businesses, if I described the segments, the Marketplace segments and the AFC segments. They have somewhat different characteristics when it comes to SG&A as a percentage of revenue and margin structure. So to some extent, the total number for KAR is ultimately how those two blend together and it might make more sense to look at them separately in terms of that analysis. But I do see a significant opportunity to reduce SG&A in absolute terms relative to what it is today, and then as our revenue and volumes grow, which we fully expect they will, SG&A will grow at a much slower rate. I do have some targets that I'd rather speak to in our Analyst Day with the broader group, but I look forward to going into more detail. For sure, SG&A as a percent of revenue declining is part of our expectation and part of our modeling. We'll go into more detail on that in June.

Okay. And then just a second question. You mentioned in your commentary some new programs with OPENLANE. Could you — my understanding is you had most of the OEM programs there, so could you maybe elaborate where these new programs are coming from?

I would characterize these, Gary, as new programs with existing customers. So we've deployed a number of programs that address how vehicles are selling today. I talked about conversion rates being higher, but also where vehicles are selling within the channel is a little different. So we had some programs that address some of those aspects and are being implemented with customers. Those are the programs I referenced earlier going live in May, June and July.

Okay. Thank you.

Our next question is from Bret Jordan with Jefferies. Your line is now open.

Hey. Good morning, guys.

Good morning, Bret.

Could you talk a little bit about the integration of CARWAVE, just give us an update as to where that is? And maybe how you're seeing it merging into the Backlot business?

Thank you. Yes, good question. So that is on track. From an integration perspective, we've broken it into what we call two waves, Wave 1 and Wave 2. Wave 1 is now complete and included a number of key attributes. First was the deployment of a new and improved common inspection format for both Backlot and CARWAVE, so that the intake point of the vehicle into either channel would be the same and consistent across both. That new inspection platform was deployed within the first quarter. We're pleased with how that has gone, and that's an improved inspection capability relative to what BacklotCars had before. So it's an improvement and a consistent experience. The second aspect was addressing a lot of the policy and the pricing aspects of the programs. As Eric talked about the improvement in monetization of BacklotCars, really what that was was the deployment of a common policy and revenue framework that can apply to both platforms. That has been done and that has a number of impacts. In terms of customer benefits, it provides both the seller and the buyer increased protection in terms of the transaction. There are guaranteed-type products or increased protections the buyer has and the seller has that the vehicle is not what was expected — there's protection — but then we monetize that protection. That has the impact of doing both of those things; we wanted to complete that and we're pleased with how it's gone. It's expected to have a positive impact on our performance past Q1 with further deployments towards Wave 2 currently tracking towards Q3, and that's the deployment of the more integrated technology solution. More to come on that; our team is working hard on that and looking to get that done by the end of Q3.

Okay. Great. And then I guess you commented that AFC continues to do well regardless of the ADESA relationship, but could you give us an idea maybe what percentage of loan originations of AFC came at physical ADESA sites or was most of this digital or didn't really dependent upon that ADESA salesperson?

Just in general terms, across KAR it's about 30% of their floor planning that comes from ADESA sites and KAR platforms in aggregate. I do not have a detailed breakdown at my fingertips that would separate Canada and the U.S. Although the U.S. would be a substantial amount of that.

To clarify, approximately 12% to 13% would be specifically ADESA U.S. and roughly 30% across the broader KAR properties including BacklotCars, CARWAVE, TradeRev, OPENLANE and ADESA Canada.

Okay. Great. Thank you.

Our next question is from Bob Labick from CJS Securities. Your line is now open.

Great. Good morning. Thanks for taking my questions.

Good morning, Bob.

I wanted to just pick up a big-picture step back in terms of the free cash flow profile of the business now with this transformation. Can you discuss a little bit the kind of conversion from EBITDA to free cash flow? What's the CapEx profile going forward? And what's the targeted leverage — so what's the kind of interest expense we should expect going forward a couple of years out?

I'm going to let Eric speak to a little more specifics. Let me offer a couple of perspectives. First of all, the strong cash flow generation characteristics of the business will continue. The business will continue to be a strong cash flow generator. If I also look at areas where we have reduced cash expenses or cash outlays, there is a reduced need for capital investments given that we have a reduced physical auction footprint, which was a meaningful amount of our annual CapEx. So that has diminished. And I'd say also, obviously, cash to service debt — those expenses will be reduced as well. I'll ask Eric to provide a little more color on some of that.

Bob, we have not set a specific leverage target with our board yet, although it's understood we will operate at substantially less than the three-times leverage target that we've had for many years. So it will be significantly less than that. It will take us a little while to get there because of some of the mechanics of repaying the senior unsecured notes that I described in my discussion. But we've disclosed and you'll see it in the 10-Q filed today that our expectations for CapEx will be $75 million to $80 million for RemainCo for 2022. That will be down from the previous expectation of about $115 million for KAR Global prior to announcing this transaction. The reduction in cash interest expense is likely to be $70 million to $80 million per year once the bonds are repaid. I don't know the exact timing of that. There's several factors that will influence the timing of that redemption. As we look at it, the free cash flow conversion actually will be slightly improved once we get past the transaction. One qualifier on that: I am excluding from ongoing cash taxes a substantial tax payment that will be due on the gain from the sale of the ADESA U.S. Physical Auction Business. I am not including that in my ongoing cash tax outlook, and that tax payment in '22 will likely be in excess of $400 million, so I'm excluding that when discussing ongoing free cash flow.

Certainly fair enough. And thank you for the details there. And then two, dealer-to-dealer, digital-dealer questions. I'm not sure how much you will say now, maybe we have to wait, but hopefully you can give us a little insight. In terms of what is the brand strategy going forward, what are the advantages and disadvantages to having multiple U.S. dealer-to-dealer brands, Backlot and CARWAVE. Is that going to continue indefinitely or might you consolidate brands or how should we think about that going forward?

Bob, I would expect with Wave 2 of the integration that we will consolidate brands. We may see the CARWAVE format live on as a format within the BacklotCars model, but ultimately a digital marketplace business benefits from scale and network effects. Fragmenting that marketplace doesn't make sense.

By the way, Bob, the strategy goes further than that. We have dealer-to-dealer vehicles, off-lease vehicles that also flow into upstream open marketplaces, and we have the potential to get other types of commercial vehicles. As vehicles of any type flow into an upstream digital marketplace, it makes sense to get them into a single marketplace. So I think you'll see that as an important part of our strategy going forward, and we will provide more details on that in our June update as well.

Okay. That's super and appreciate that as well. And then maybe last one: I think the goal for the digital dealer-to-dealer was maybe a million to two million units by 2025 and maybe $100 per unit in EBITDA. Are those still the general parameters of how you're thinking about the opportunity set? And if so, what's the path to profitability in terms of getting to that — is it linear? Is there an investment phase now for market share with profits turning on at the end or how should we think about the trajectory of growth for the digital dealer-to-dealer?

I think as a target, and again we will provide a more specific update in June, that target is still in the zone of what we think is appropriate. So I think we're still looking at a similar volume target and the EBITDA per vehicle target is also reasonable. I will say that we saw EBITDA per vehicle in our TradeRev marketplace that exceeded that in Q1. So that gives me confidence that that level of EBITDA per vehicle is possible in this marketplace and maybe even possible to exceed. In terms of how we get there, we need to continue to invest in these businesses in terms of product development and so on. But the businesses are now generating substantial revenues and gross profit, so I think we're out of the phase of having losses and being a cash drain. My expectation is we're going to see more of a linear progression in terms of profitability. Maybe it ramps up a little bit over time. But frankly this year, certainly at the business unit level if we exclude a bucket of corporate costs, these businesses will be profitable this year. I think their contribution in absolute terms will increase from here.

Okay, super. Thank you very much.

Our next question is from Daniel Imbro with Stephens. Your line is now open.

Hey, good morning, guys. Thanks for taking our questions.

Morning.

I wanted to talk about the core ADESA gross margin first, maybe excluding purchased vehicles, that I think it was down pretty materially year-over-year despite the fee increase. Can you talk about the drivers of that? And if it was just driven by lower volume, is this really the high 30s the right way we should think about quarter gross margin until we see volume where OPENLANE picks back up?

Daniel, one of the things I'll point out is there's a substantial impact from purchased vehicles. When you look at net of purchased vehicles, it was about 49% consolidated gross margin from 52% net gross profit the prior year. But it does look in the ADESA segment the impact was more substantial. So as I look at it, there was a lack of scale in the first quarter especially in January and February. The gross profit in March was much stronger, much more consistent with what we've been experiencing, so I don't think there has been a change in the business model. We just suffered from extremely light volumes in the first two months of the quarter. As I look at it, I don't think anything is broken. I think you had a mix issue in Q1, including a higher impact of purchased vehicles, which was a little bit unusual given the platforms. So all in all, you'll start to see the prior-year dynamics reassert as the year moves on and volumes normalize from the very low January/February levels.

Got it. And then a bit more of a conceptual question: I know over the last year most transactions have been fully digital, but how much of that is a function of just the environment with the lack of inventory? Just trying to think that as prices declined, in prior cycles you guys have said how the reconditioning and physical assets pick up when prices decline, so why wouldn't commercial sellers need reconditioning similar to past cycles? Or how do you plan to meet those needs for your customers given the pending sale of the ADESA U.S. physical locations?

There is continued need for those services but the fundamental secular trend is towards more digital selling. I don't think the need for physical reconditioning goes to zero, but it has been diminishing over time and I think it will continue to diminish. When I look at vehicles that sell across our portfolio, they range from high-end off-lease vehicles to $1,000 vehicles that are quite heavily damaged and sell in a purely digital format. So there is an element of customer choice here, but I believe the overall trend favors digital and that trend will continue.

And Daniel, let me add: out of necessity we've had to look at our capabilities and capacity. We started selling reconditioning services through the buyer, which we call retail-ready recon. It would not surprise me if sellers continue to believe that buyers can handle some responsibility for reconditioning the car. They've learned they can get full value for the vehicle even if it needs reconditioning. Our marketplace and the buyer base are more willing to do reconditioning of the vehicle after they've purchased it and I think that will continue.

Got it. That's not just a function of the inventory shortages right now. That's helpful. And then just a follow-up to clarify on the guidance quickly. Peter, I think you mentioned in the remarks the $265 million of EBITDA this year would be 11% growth if we excluded the equity gains from last year. Does the $265 million exclude the equity gains this year or would that include the $17 million in 1Q and then any equity gains going forward?

No, it does not include any equity gains this year. There are no equity gains in this year's expectations. So the $265 million excludes that. On a like-for-like basis had we excluded that $17 million from last year's performance then the comparison would be approximately 11% growth.

Got it. The $265 doesn't include the $17. Got it. Thanks.

Amanda, we're out of time. I believe there may be one more question. If we could make it one quick question, I think we'll try to fit it in.

Our final question comes from Ali Faghri from Guggenheim. Your line is now open.

Awesome. Good morning, thanks for squeezing me in. Just a more specific question on the implication on OPENLANE from the sale of the U.S. physical business to Carvana. Over the years, management has talked about the advantage around OPENLANE being the company's physical asset and the ability to offer OEMs vehicle reconditioning and storage. With the sale of the U.S. physical auction business to Carvana, how do you see that impacting your value proposition to the OEMs, and competitive differentiation versus digital-only competitors who are increasingly focused on the commercial segment?

Thanks, Ali. I appreciate the question. I don't recall making the argument that OPENLANE's value proposition depended on physical assets. If I look at the vehicles that actually sell on OPENLANE, close to 99% of them sold from dealership lots, not our physical properties. So I don't think the physical assets are a necessity for OPENLANE. The key is building great digital products that work for the seller and the dealer and provide a very effective digital marketplace that transacts a high percentage of vehicles quickly and at low cost. That's what OPENLANE has focused on for 20 years. I think our customers are very pleased with the service we offer. I think this divestiture enables us to redouble our focus on OPENLANE and bring more innovation to that channel. I don't see this as a dependency problem; I see a lot of opportunity and differentiation versus competitors.

Thank you.

You're welcome, Ali. So, hey, I appreciate — I know we're a little over — I'm just going to conclude with a few closing remarks. Again, the ADESA transaction is expected to close within the next week. I believe the transaction will be transformative for KAR and for our customers, and for our stockholders. I remain very optimistic for the future of our company. With a smaller, nimbler and more asset-light company, we intend to accelerate a more focused digital strategy to capture what we believe to be considerable opportunities for growth, both in and beyond our current market. The first quarter was challenging. There's no question about that. When you're facing a 61% decline in off-lease supply relative to the same quarter last year, that's a significant headwind. That said, I believe we made meaningful progress in many areas of our business, particularly in our Dealer-to-Dealer Business and in AFC. We have guidance to deliver $265 million in adjusted EBITDA this year, that represents 11% growth on a like-for-like basis, and that'll be accomplished in spite of what I'd characterize as a very adverse environment that affects our industry and our business. So I don't love the number, but I'm pleased with the performance in the face of the headwinds we have. As I look past this year, I'm very excited and I think the team is very excited about the opportunities that lie ahead for our business. We intend to capitalize on what is a secular shift towards digital marketplaces by both Commercial and Dealer customers and both on the Seller and Buyer side of our industry. In addition, we expect to see a recovery in commercial seller volumes that will play out in the years to come. So I believe we have a significant opportunity for growth. We have differentiated platforms, a strong customer base, and a large market space in which to innovate and invest. I'm looking forward to providing more details on that at an Analyst Day update; we'll send out a save-the-date after we close the transaction and we're targeting sometime in June. And with that, we'll end today's call. I look forward to reconnecting on our next conversation. Thank you all for attending and thank you all for your questions this morning.

This concludes today's conference call. Thank you for participating. You may now disconnect.