OPENLANE, Inc. Q3 FY2022 Earnings Call

Good day, and welcome to the KAR Auction Services Third Quarter 2022 Earnings Conference Call. All participants will be in a listen-only mode (operator provided instructions). Please note this event is being recorded. I would now like to turn the conference over to Mr. Mike Eliason, Treasurer and Vice President Investor Relations. Please go ahead, sir.

Thanks Matt. Good morning. And thank you for joining us today for the KAR Global third quarter 2022 earnings conference call. Today, we will discuss the financial performance of KAR Global for the quarter ended September 30, 2022. After concluding our commentary, we will take questions from participants. Before Peter kicks off our discussion, I'd like to remind you that this conference call contains forward-looking statements within the meaning of the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. Investors are cautioned that such forward-looking statements involve risks and uncertainties that may affect KAR's business, prospects and results of operations, and such risks are fully detailed in our SEC filings. In providing forward-looking statements, the company expressly disclaims any obligation to update these statements. Let me also mention that throughout this conference call, we will be referencing both GAAP and non-GAAP financial measures. Reconciliations of the non-GAAP financial measures to the applicable GAAP financial measures can be found in the press release that we issued last night, which is also available in the Investor Relations section of our Web site. Now, I'd like to turn this call over to KAR Global's CEO, Peter Kelly. Peter?

Thank you, Mike, and good morning, everybody. I'm delighted to be here this morning to provide you with an update on KAR Global. During today's call, I'll provide you with additional information and detail relating to the following; our third quarter performance, our view of the current market factors that continue to impact the automotive industry, and a summary of our capital allocation activities. I'm going to speak about our business in two segments, our Marketplace segment, which we formally call the ADESA segment, and the Finance segment, which we formally call the AFC segment. To begin, Q3 was an important quarter in the history of our company. It was our first full quarter since we completed the divestiture of the ADESA US Physical Auction business in May and in fact, the true beginning of what I believe will be a bright future for KAR as a more asset light digital marketplace company. I'm pleased with the results that we produced across the organization, especially given what continues to be a very challenging industry and economic environment. During the quarter, we increased revenue, total gross profit and adjusted EBITDA. We met our cost reduction targets, reducing SG&A to $283 million, and we also increased gross profit per vehicle to $320. This was an increase of 14% over the third quarter of last year. In our Finance segment, we experienced another solid quarter of performance as AFC continues to grow its core finance business. Our Finance segment generated revenue of $99 million in the quarter, an increase of 31% over Q3 of last year. This was driven by 13% growth in the number of transactions and 16% increase in revenue per transaction, which increased to $250 for the quarter. Interest income represented 54% of AFC revenue for the quarter, that is 700 basis points of an increase from Q3 of last year and is consistent with the higher interest rate environment that we see today. This also demonstrates that a higher interest rate environment can be positive for AFC. So overall, I think there's a lot to be pleased about in the third quarter performance, particularly in light of what has continued to be a challenging environment. The proactive steps that we have taken to transform our operating model, reduce our cost structure and advance our digital vision, beginning to take shape within our results. To be absolutely clear, I do not believe that our third quarter results reflect the high level of performance that I'm confident this company is capable of delivering in the future. However, I do believe we are demonstrating our ability to execute on the fundamentals of our business. And as a whole, I believe our results provide an outline of even stronger performance as the industry turbulence settles and as we continue to advance our digital strategy. So now I'd like to highlight a few areas of progress from the quarter where we are advancing that strategy, and I believe will benefit our performance in the future. The first is platform consolidation. One of our primary objectives is to simplify the customer experience and increase engagement across our marketplaces. In the United States, we have now successfully combined the BacklotCars and CARWAVE marketplaces into one digital venue. In October, we deployed a new auction format within the BacklotCars platform, which builds upon the previous CARWAVE format and complements the existing marketplace formats within BacklotCars. So we now offer our sellers and buyers the choice and flexibility of two distinct formats, a marketplace format where vehicles can be offered and purchased throughout the day immediately as they're loaded and an auction format where groups of vehicles are set for time sales, which are currently scheduled for twice every week. We're focused first on deploying the auction format in the markets where CARWAVE already existed. Once this is complete, we expect to begin a national rollout of this format to all remaining markets in the United States. In Canada, we've also made significant progress on our effort to consolidate the TradeRev and ADESA marketplace. We launched a beta version of that combined marketplace in July to a limited number of customers, and the feedback has been positive. In October, we began expanding that beta to a broader base of dealers with additional new features and capabilities added. As these consolidation efforts progress, we expect increased engagement from our dealers, increased efficiency within our technology development and operations, and improved results across our marketplace business. The second strategic focus area I'd like to cover is pricing. We continue to make some adjustments to pricing in the third quarter, and we were successful in getting a number of fee increases and new revenue streams put in place in both our dealer and commercial business. Some of these had a positive impact in Q3 and are reflected in our unit economics. We expect others to become effective in Q4. To be clear, regular price increases are not a key component of our strategy for growth. However, the fact that we've been able to make these price increases demonstrates the strength of our offerings and the strength of our longstanding customer relationships. The last focus area I'd like to speak to is cost management. The ADESA transaction created a catalyst to restructure our business to reflect a more asset light digital operating model, and to help respond to the current realities of our market. We made a commitment to reduce our annual SG&A run rate by $30 million and we are on track to achieve that goal ahead of schedule. This positions us to exit the year below $400 million in terms of an annual SG&A run rate. We do expect some quarter over quarter fluctuation as certain cost reduction initiatives may require short term cost increases to help achieve sustained savings thereafter. It's also important to note that achieving our 2022 cost savings target was only a starting point. Disciplined cost management and a focused investment strategy will remain a priority for this business going forward. We have a roadmap in place for continued improvements in our efficiency and effectiveness, and these will deliver further cost reductions in Q4 and into 2023. Those savings should help us continue to focus our investments into the technology, talent and resources necessary to advance KAR's long-term vision and strategy. I'd like now to look towards the future and provide some details around the industry outlook, the macro environment, particularly in the areas of new vehicle production, used vehicle pricing, wholesale used vehicle supply, as well as the outlook for commercial volumes. And my comments are based on our assessment of publicly reported data, as well as recent discussions with some of our largest customers. New vehicle production and supply continues to be a challenge, and it's taking OEMs longer than expected to solve their supply chain issues. In Q3, some OEMs did show increased production and new vehicle sales, but a significant number of them still had fewer sales than a year ago. My assessment remains that the supply side issues appear to have bottomed out when viewed on an industrywide basis. However, I also think the recovery and production will be more gradual than most experts had predicted. Increased new vehicle production coupled with a higher interest rate environment and a weakening economy will likely put downward pressure on new and used vehicle pricing. Over the course of Q3, we observed a steady decline in used vehicle values in the industry, and at a rate that is above normal for this time of year. We expect this decline in used vehicle values to continue through at least year end. Ultimately I believe that a decline in used vehicle pricing will be a long term positive for our business, as I believe it will allow more vehicles to flow into the wholesale channel. In the near term, however, declining market is often characterized by lower conversion rates and this can be a near term headwind to the business. An industry wide lack of wholesale used vehicle supply also remained evident in Q3. For example, physical auction volumes, which remain a good proxy for industry volumes, were down 8% below the third quarter of last year and were 37% below the pre-COVID levels of Q3 2019. In fact, Q3 of 2022 was the second lowest quarter for physical auction volume since the pandemic began. So I'm very encouraged by the fact that we can deliver a strong performance in this environment where industry volumes are still well below normal levels. I do expect those volumes to increase over time, although, I think it's prudent to expect that this will be a gradual increase and not a step function. And I believe that our focus on being a digital marketplace will enable us to grow faster in the longer term as volumes recover in our industry. A key driver of the anticipated volume increase will be the supply situation relating to the volume of vehicles being offered by commercial sellers, particularly in the off lease segment. We continue to see fewer off lease vehicles being returned compared to one year ago, but the level of that decline has lessened. From our own analysis, the equity gap, which is the difference between the market value of maturing lease and the residual value in the lease contracts, has declined meaningfully in the third quarter. However, a further decline is likely needed in order for more of those vehicles to start to flow into the wholesale channel. I'm confident that leasing will remain an important element of OEM and dealer sales strategies, and that our strong footprint with off lease vehicles will be a significant positive for this company in the years to come. Through my ongoing discussions with our customers, I believe that in the future our customers will seek to sell an even larger percentage of their portfolios digitally than they did pre-pandemic. I also want to comment on how the current environment impacts AFC. As used vehicle prices continue to decline and as interest rates increase, this may tend to increase risk within our finance business. However, AFC has best-in-class safeguards and processes in place that utilize all of the data that we capture to flag dealers that may be under stress within their business. So while we do anticipate some level of increased risk as we enter 2023, we do not expect it to return to pre-COVID levels. And we believe that AFC will continue to produce strong results through year end and into next year. I'd now like to provide some insight on my expectations for the fourth quarter relative to Q3. On the positive side, we expect a benefit from the full quarter impact of our cost and pricing actions that we took in Q3. We also have additional cost and pricing actions that will become effective in Q4. On the negative side, Q4 industry volumes have historically been weaker than Q3 volumes. Also, foreign currency was a negative in Q3, and that is expected to be even more evident in Q4. Irrespective of the Q4 outcome, I am highly focused on executing our strategy, building on the positive momentum of the third quarter and positioning the company for growth in 2023 and beyond. I'd now like to provide a recap of our capital allocation activities. As I mentioned on the last call, the ADESA transaction itself generated approximately $1.7 billion of cash net of taxes and fees. In the second quarter, we utilized over $900 million to repay our Term Loan B as well as amounts outstanding on our revolver at that time. During the third quarter, we repurchased through a tender offer $600 million of our senior notes. This leaves us with $350 million of senior notes that are still outstanding. Also, since the closing of the ADESA transaction, we have repurchased approximately 12.6 million shares of KAR stock at a total price of $182 million. I want to emphasize that our projections show that KAR will continue to generate cash going forward. With an asset light model and considerably lower debt, we have less need to use our cash for CapEx that is tied to physical facilities or for servicing our debt. This should be a positive for us given the current macro environment. So to summarize my key messages for today, in Q3, we delivered an improved performance compared to a year ago and also compared to Q1 and Q2 of this year. I was generally pleased with this performance and I believe that it begins to outline what this company is capable of delivering as volumes recover. In our marketplace segments, we increased revenue and gross profit compared to one year ago. We also increased our revenue per unit and our gross profit per unit sold. We experienced another solid quarter of performance in our Finance segment, with AFC meaningfully growing revenue and revenue per unit. In addition to the financial results, we made significant progress in areas of platform consolidation, pricing and addressing our cost structure. Volumes continue to be a challenge in our industry. However, as we look to the future, we expect new vehicle production to increase, used vehicle pricing to decline and a gradual increase in wholesale used vehicle volume over time. I believe that our digital focus will enable faster growth in that type of environment. I'm excited and energized by the many opportunities ahead and I believe that we have a significant opportunity for long term growth. We have a differentiated offering, a diverse and expanding customer base and a large addressable market in which to innovate and invest. So with that, Eric will now provide you with a more detailed review of the financial results for the third quarter. Eric?

Thank you, Peter. First, I would like to point out that foreign currency had a negative impact on our third quarter results. Revenue was negatively reduced by $12 million, net income was reduced by approximately $1 million and adjusted EBITDA was reduced by $1.5 million in the third quarter as compared to the prior year. I would also like to give more color on our SG&A and the evidence of improvement in our cost structure that is not obvious in the third quarter financial statements. We have provided a schedule of SG&A by quarter for 2022. This schedule provides additional detail for SG&A by segment, what SG&A was added due to acquisition and the noncash and other costs that are recorded in SG&A that do not impact our reported adjusted EBITDA. When we speak of eliminating over $30 million in annual SG&A, we are focused on adjusted SG&A. All add backs in computing adjusted SG&A are the same as the add backs for computing adjusted EBITDA. We have provided a schedule of adjusted SG&A for our continuing operations in the Q3 earnings slides that were posted yesterday. The headline result is we have reduced the adjusted SG&A run rate in Q3 to $96 million per quarter from $104 million in Q2 and $102 million in Q1. We are excluding noncash compensation in this analysis of SG&A. As you can see in the earnings slide, there was an increase in noncash compensation in Q2. This relates to the recognition of the impact of the gain on the sale of the US Physical Auction business on the expected award of the 2020 and 2021 PRSU grants to employees. There have been no increases in total annual noncash equity grant value. However, the timing of recognizing expense in our financial statements was impacted by the timing of our financial performance. We also have significant severance associated with the termination of certain employees as a result of the sale of the US physical auction business and the realignment of our organization to match the asset light digital marketplace business that remains at KAR. This severance is recognized in the other adjustments included in the SG&A reconciliation. I expect we will have additional severance going forward as well. However, that severance will be related to additional cost savings actions and not the impact you see in the Q3 run rate. In addition to severance, we also incurred consulting fees and contract termination costs in the second and third quarter related to separation and reorganization activities following the sale of the US Physical Auction business. These fees and expenses are included as SG&A but we have included them in other adjustments in the reconciliation of adjusted SG&A in our earning slides. One major initiative that has been announced to our employees and will provide additional savings and adjusted SG&A in future quarters is related to establishing a global shared services organization. We have recently agreed to terms with two offshore firms to provide resources to support our back office functions for KAR Global. This will impact over 300 positions in the US and Canada. We have notified the affected employees and provided appropriate severance packages that are payable upon transition of their roles to the Global Shared Services Organization. We expect to begin the migration of these roles over the next three quarters. The impact of this initiative is not included in our realized savings in SG&A for 2022. The fact that our marketplaces are digital and generally not tied to a specific location allows us to move a number of support functions offshore without impacting the customer experience. In fact, we believe the use of a global shared services organization will improve efficiency and consistency of handling transactions and ultimately improve the customer experience. Our initial Global Shared Services program is expected to generate over $10 million in annual savings from our current cost structure. We expect this to be realized as we migrate to the offshore model in 2023. Another topic I would like to cover in more detail is the amendment and extension of our securitization facilities at AFC. In September, we completed the amendment of the US and Canadian securitization facilities. As part of the amendment, we increased the capacity of the US securitization by $300 million to a total of $2 billion. The Canadian facility remains at CAD205 million. The amendments extend the securitization facilities to January 31, 2026. As part of this process, we successfully negotiated changes to terms that allowed us to reduce the company's funding of certain receivables. Although, the funding did not occur until the first week of October. This reduced the on balance sheet portion of loans by $70 million, freeing up additional working capital that was locked up at AFC. While the credit markets overall are quite challenging right now, the performance of the AFC portfolio and the discipline demonstrated by the AFC team made the amendment process fairly easy. Most importantly, the financial terms of the agreement remain consistent with the terms prior to the amendment. The sizing of the facility is sufficient to fund the growth expected in the portfolio over the next two to three years. As Peter mentioned and we disclosed in an earnings release, we have purchased $100 million of KAR’s stock in the open market over the past four months. Earlier this year, we put in place a 10b5-1 plan as part of our existing share repurchase program. In October, we completed the remaining approved purchases under that 10b5-1 plan. As of today, we have $126.9 million remaining on our share repurchase authorization that expires on December 31, 2023. Given the challenges in the debt capital markets and our previously disclosed intent to repurchase or redeem an additional $150 million in KAR bonds, we do not expect to acquire additional shares over the next quarter or two. At this time, we are focused on building our cash balances and conserving capital. We will be looking for opportunistic windows in the debt markets to extend our revolver maturity date and put in place a more permanent debt structure for the company going forward. Most importantly, we continue to focus on maintaining minimal net debt that is more appropriate for an asset light business like KAR. As we continue to rightsize our business and align with the asset light marketplace business that is KAR today, I am pleased to announce that on Monday of this week, we closed on the sale of 57 acres of excess land in Montreal. This transaction will result in a gain of approximately $32 million. This gain will be taxed at 50% of the statutory rate in Canada or about 13%. This transaction will generate approximately $35 million of net cash proceeds after income taxes. The realized gain will be reflected as a separate line item in operating expenses in our financial statements in the fourth quarter. For clarity, this will be a reduction in operating expenses. Also, there is not a requirement that the net proceeds from this transaction be used to reduce debt. As I wrap up my comments, let me reiterate our focus as we are faced with a challenging supply situation in a period of transformation for our industry and our company. KAR is rightsizing its operations with a focus on being asset light, strong cash generating digital marketplace focused businesses. As we continue to transition away from the ADESA US physical auction business, we will have opportunities to further reduce our overhead cost structure. We have paid down over $1.5 billion in debt this year, reducing our annual cash interest payments by approximately $70 million. This is particularly important as we face a period of increasing interest rates. Had we not repaid our Term Loan B in its entirety, we would've been looking at an increase in cash interest expense next year of nearly $30 million. Having our balance sheet in a great spot, transforming our business to focus on digital asset light marketplaces and reducing the SG&A to support these businesses is timely given the changing economic environment we are facing. I am confident KAR is prepared for the road ahead. That concludes my prepared remarks. Peter has one more item to cover before we go to Q&A.

Thank you, Eric. And before we get to Q&A, I want to formally announce that Eric will be retiring at the end of 2022, making this his last earnings call as the Chief Financial Officer of KAR Global. Eric has been an incredible leader and CFO for more than 15 years. He has led the company through many complex acquisitions and divestitures, and advanced the capital investment strategy that has helped KAR navigate change, capture great opportunities and create meaningful shareholder value. Eric has also always been a positive cultural leader here at KAR, a skilled and transparent financial operator and a tireless advocate for the interests of our investors and shareholders. We are conducting a national search for Eric's replacement and hope to fill the role prior to Eric’s retirement. If these timelines do not align, we have a strong internal bench strength at KAR to lead the function on an interim basis until a permanent CFO is named. We will provide additional details and updates in due course. But for now, let me just thank you Eric for your incredible service to this company and to our investors. I wish you all the best for relaxing and enjoyable retirement. You've certainly earned it. And with that, let's turn to the group for questions. Thank you.

(operator provided instructions) And our first question will come from John Murphy with Bank of America.

Good morning, guys. And Eric, congratulations. I hope you get to rest, because I know you have been working hard for a long time, so congratulations.

Thank you, John.

A first question here, there is a lot going on here in the industry and there is a lot going on in the transition of the company. So there is a lot of moving pieces. So it's I think a bit tough as people are looking at this to try to get a sort of a constant variable or something to kind of work off of understanding exactly how the company and the industry is going to look in 2023 plus. I mean, when do you think we are going to get an outlook for 2023? And what do you think the major sort of focal points are going to be for you as you communicate that, not looking for specific answers, but as you communicate this, people are looking for sort of some guideposts and ways to think about things structurally for this company, the industry going forward and there is a lot of moving parts. So when will we get that and how do you think about that?

And I guess you are correct, there is a lot going on. We have a pandemic that led to production issues, which the industry, it seems, is struggling to recover from in terms of new vehicle production. We have declining used vehicle values and everything that’s going on with off-lease vehicles and so on. Obviously, we are deep in our planning efforts for 2023. I remain optimistic about the prospects for the business. I don't plan to go into specific detail on this call, but I would expect to provide more detail in our next earnings call, which I think is early February. We’ll talk about expectations for 2023 at that point. Again, if I look at our Q3 results, they demonstrate an underlying level of performance in a challenging environment that I think we can build on for the future. That's kind of how I view it. We have a finance business that's performing well, and I expect that to continue to perform well through all of 2023. We have a Marketplace business that has obviously faced significant volume challenges. I expect that, over time, those volume challenges will ease, but I expect it to be a gradual change. In the midst of that, we have platform consolidation, cost actions and pricing actions, and I think we are taking actions that will benefit us quarter after quarter as we look to the future. So I see this as endeavoring to build upon that and grow the business sustainably over time. From a macro perspective, the impacts on new vehicle production and the recovery in wholesale volumes will be gradual changes, not a step function.

And then just a follow-up on your comment on pricing, with the backdrop of those kinds of constraints on wholesale volumes and the automakers clearly not being able to ramp up production even as much we might have thought a couple months ago, supply will remain constrained on the new vehicle side and we'll see the one to six year old car fleet shrink probably for the next three or four years. So I'm just curious as you look at that backdrop, how do you think about pricing, first, because it seems like it shouldn't go down if there's that kind of supply constraint and then second, your opportunity set in that kind of environment to gain incremental revenue per unit as well as maybe gain market share?

I think, John, by pricing you mean the pricing for our services, not the value of used vehicles?

Actually both opportunities. I mean first on the vehicle pricing and then second your opportunity to drive revenue through pricing and other actions.

So in terms of used vehicle values, we've seen a fairly substantial decline in the wholesale market in Q3. Prices declined pretty much every single week of the quarter. If anything, the rate of decline accelerated later in the quarter, and it continues to decline in Q4. We're now seeing that pricing decline first start to show up in used vehicle pricing at the retail level, and I believe it's beginning to show up in new vehicle pricing at the retail level as well. I think the combination of a slight increase in production and higher interest rates has been putting downward pressure on vehicle values, and I think that will continue. I don't expect used vehicle values to fall back to pre-pandemic levels because of the constraints you talked about, but I do think they'll continue to decline at least through the end of this year and then we'll see what happens after that. As those values decline, that creates an opportunity for more vehicles to start to flow into our channels, particularly off lease where there's an equity gap—the difference between the residual value and the market value of the vehicle. As those numbers come closer together, incrementally more vehicles can start to flow, and I expect that to be very gradual. So again, I expect used vehicle prices to continue to decline gradually at least through the end of this year. Regarding pricing for our services, we've taken some actions. We have a mix of commercial and dealer business, and some of this requires negotiation or conversation with customers. Generally, John, what we look for first is whether there's an opportunity to do more for the customer in exchange for greater revenue. We look at those opportunities, and some of our pricing changes reflect that. Other changes reflect what we believe is appropriate pricing given current volumes, which may be different from three years ago when volumes were higher. We've been strategic and disciplined around that, and we've been pleased with the progress we've made.

Our next question will come from Ryan Brinkman with JP Morgan.

This is Rajat, filling in for Ryan. Eric, I wanted to convey my best wishes as well. I'd like to start with OPENLANE. Following up on John's comments, the outlook for volume there looks likely to be tough for a while. Cox Automotive released estimates saying they expect another step down in off-lease volumes before they grow again. I'm curious if you agree, and whether there is an opportunity to rightsize or restructure that business further going forward, or whether some of that has already occurred. Any thoughts would be helpful. I have a follow-up.

Thanks, Rajat. As I mentioned, commercial volumes declined in the third quarter but the rate of decline was less than the prior quarter, and I expect that to bottom out. We have taken cost actions across the business, including in areas like OPENLANE, and we continue to evaluate additional actions. We've also been talking with customers about pricing and services. I see two key factors that will determine future performance. One is the rate of decline in used vehicle values and whether off-lease vehicles start returning to the market in larger volumes. We’re seeing the very beginning of that, but it’s still small and not yet material. The second is new lease originations — fewer leases are being written now than in prior years. That reflects fewer new vehicles being produced and manufacturers feeling they don’t need to put incentives on vehicles, which often drive the lease attach rate. I expect both of those things to change. Production of new vehicles should start to increase, albeit more slowly than some experts predict, and in a more challenging economic environment manufacturers will likely increase incentive spending at some point, which should drive a higher lease attach rate over time. Leasing will remain an important part of our business and we’re well differentiated versus competitors given our strong footprint in that segment. It’s not impacting our financial performance today the way it did when volumes were stronger, but I believe we’re at or very close to the bottom and that the situation will improve over time.

And maybe just on the GPU increase in the quarter, you cited mix of the factor as well but you also cited some price actions. Could you give us some more color on that, were there any other factors also that drove the uptick from 2Q to 3Q on that GPU? And how should we think about the GPU trends into the fourth quarter and maybe early next year, based on all the price actions and the mix changes that have happened?

GPU, or gross profit per unit sold in the marketplace business, was very strong in Q3 at $320, well above the target we set at Analyst Day of roughly $260. A couple of things drove that. When volume transacted is low, GPU tends to increase because service revenue from vehicles that weren’t transacted and from other services that aren’t tied to selling vehicles can boost the metric. Pricing actions also had a positive impact. The strong GPU performance in Q3 gives me confidence that the numbers we put in place at Analyst Day are very achievable and sustainable over time, although I don’t necessarily expect GPU to remain at the $320 per unit level we saw in the third quarter. We do, however, have a significant cushion above the range we discussed at Analyst Day.

Our next question will come from Gary Prestopino with Barrington Research.

A couple of questions here. Can you give us some level of the decline in conversion rates in the quarter? And how, if the conversion rates were the same as last year, would that have affected your lift in vehicles sold?

I spoke on the last earnings call about our conversion rates, which were lower. In essence, that situation continued through most of Q3. We did see a small bump in conversion rate in August, but for the most part it has been below last year. Conversion rates vary by channel, but roughly they were about 10 percentage points lower. So if a channel had 60% last year, it's about 50% this year, as a rough order of magnitude. That is consistent with what I've seen in physical auction data, where conversion rates were also low throughout the quarter, lower than normal. We typically see higher conversion rates on commercial versus dealer, so some of the decline may be mix related. Roughly a 10-point decline in conversion rate in a channel that went from 60% to 50% is about an 18% headwind to sales volume, so it is pretty significant. Candidly, with the benefit of hindsight, last year's conversion rates reflected a very tight market for used vehicle supply and significant used vehicle appreciation. Last year's rates were somewhat above normal, this year's are below normal, and a normal conversion rate is somewhere in between — my best guess is roughly halfway between the two.

Then just a couple of more. You talked about what you are doing with BacklotCars and CARWAVE. You've said two formats, one of which I wrote down as a marketplace and then you go to an auction. Could you just maybe elaborate on that? Are you getting a buyers the opportunity pre-auction to buy these cars through a listing service and if so, how is that price determined?

So I guess to sort of provide a little bit more detail on that. The CARWAVE business, their sale format was an auction format. It ran two days a week and vehicles were sort of preloaded into the auction where dealers could view them and research them, place advanced bids, but they actually couldn't buy them, okay? And then the bidding opens for a two or three hour window on a Monday and a Thursday, and then the cars are sold at the end of that window. That's essentially how the format works. It works very, very well. Dealers really liked it. It got great results for their customers. And we felt it was important to replicate that capability in our platform. So that's what we've done and that complements the existing BacklotCars bid ask marketplace. So now when a dealer loads a car, they choose which format do they want to load it into. They want to load it into the marketplace where it's available immediately if bought at any time or they want to put it in the next scheduled auction, that's the choice they make. And obviously, if the car is unsold at the end of the auction, they can push it over into the marketplace. But that's essentially how it works. And again, as I said, our focus right now is consolidating that migration in the markets where CARWAVE already existed, that's principally California but also Arizona and Texas. And then we look to roll that format across the remaining 48 states in 2023. So we're excited about that. We think this will be a positive for the business and we'll enable us to address an even bigger segment of the market.

And then just one last question here. I just want to make sure, in terms of what you had guided before for EBITDA 245 to 265, and given how you discussed, do you think the impacts of what's going on will impact Q4? Is that range still good and more tended towards the low end of that range?

I guess, Gary, first of all, I’d just say our policy is not to provide quarterly guidance, but I will provide some remarks here just on how I see the situation. So if I think about the year overall, 2022 overall, purely the environment's been a challenge for the entire year. And again, I believe our Q3 results show we're responding well to those challenges. I would also say, in most years there is some seasonality and Q4 is often a little weaker from a volume perspective than Q3, that's not unusual. It doesn't always happen but it is more common that that's the case. As Eric also reported, we have foreign currency headwinds in Q3. We expect those to continue in Q4. They may even be a little bit more material to us in Q4 than they were in Q3, to be honest. Now I'd also say helping offset those, our fourth quarter will benefit from the cost, the full quarter impact of the cost savings taken in Q3, as well as the pricing actions taken in Q3. And we'll also have further cost and pricing actions that become effective in Q4. And finally, as Eric mentioned, our digital strategy has enabled us to take advantage of some excess real estate in Montreal and divest some excess land up there with a gain of $30 million. So I guess with this gain included, I'm very comfortable with our previously issued guidance. I will say we are focused on finishing the year strong and I look forward to reporting the final numbers in the new year and obviously, we'll do that with and without the gain.

Our next question will come from Bob Labick with CJS Securities.

Good morning. Thanks, and congratulations to Eric from us as well. I wanted to talk about what you're seeing at the dealer level. The provision for credit losses at AFCs has remained low, it's been low throughout the pandemic and everything. And you mentioned you may not expect it to get back to the typical kind of 1.5% to 2% long term expectation. Maybe give us a sense of what you expect, I guess, over the next year or two for those provisions and where you see that trending and what the drivers are there?

There’s no question that in the past couple of years AFC has been a very strong performer. We have seen lower-than-historical levels of risk, both in frequency and severity. Given the changing macro environment, specifically higher interest rates and declining used vehicle values, it’s prudent to expect some increase in the risk environment there. Our expectation is that the increase will be relatively moderate and manageable within the numbers and projections we’ve shared previously. Historically AFC’s risk was in the range of 1.5% to 2% of outstanding loan balances, and we have been well below that this year. With a more digital model, greater access to data, and stronger controls, it’s possible the new normal will be below that historical range. Time will tell. We are modeling a modest increase in risk in our preliminary 2023 projections, but we think it will be very manageable and offset by the underlying growth in the business.

And then just trying to get a sense, I know there's a lot of moving parts in the macro. But excluding, if you can for a second, kind of used car value index, so to speak, impact on GMV. How are the mix of units trending, where's the sweet spot for Backlot, CARWAVE and how are those units relative to kind of pre-COVID on a normalized used car value index?

I just want to clarify your question. Are you talking about the vehicle values themselves or are you talking about the mix in our volume between dealer and commercial?

Regarding vehicle values at dealers, if you're trying to compare, say, a car pre-COVID, I think the numbers we had before were $5,000 to $7,000 GMV for pre-COVID Backlot. Then you've added both the increase in vehicle value from used car prices rising and an increased mix as you've shifted toward more dealer vehicles in that marketplace. So I'm trying to get a sense of the mix of vehicles within the dealer marketplace and how that's trending, adjusting for the massive change in used car values.

So I guess what I'd say generally is we have seen in all our marketplaces an appreciation in the value of the vehicles themselves that really kicked off early last year. It sort of peaked, probably in March of this year, then flatlined and ultimately started to decline from about May to the present. Today, as a rule of thumb, vehicle values are still roughly 30 percent, maybe a little more, above their pre-COVID level. That has generally increased GMV in all our marketplaces. From a mix perspective, different marketplaces have had different mixes of vehicles. BacklotCars probably points to the way it started and its specific format, which had a real focus on sub-$15,000 vehicles, with a median GMV today of around $9,000 or $10,000. TradeRev and CARWAVE have a broader mix and a higher median GMV, maybe $15,000 to $17,000. With the merging of TradeRev, BacklotCars, and CARWAVE, we're now combining those, which will bring up the median GMV as well. That gives you a sense of the sweet spot of these marketplaces. In our dealer-to-dealer business, the vast majority of vehicles sold between dealers are in that sub-$15,000 category; that is where most of the volume is. We are very well positioned in that marketplace and deliver exceptional value and outcomes to those customers in that segment. Over time, we are also focused on increasing GMV and bringing more high-value vehicles into that channel.

Our next question will come from Daniel Imbro with Stephens.

This is Joe on for Daniel. Thanks for taking our question. So I was wondering about the strength in the services revenue line, saw a $12 million sequential increase this quarter. I was wondering if you could provide any color there and if this was driven by the Carvana services agreement?

Joe, thank you. I'll let Eric take that question.

Joe, yes, the services revenue has been driven by a couple of things. First, repo volumes. While we aren't selling repos in the U.S. through our digital marketplace at the same level as before, RDN and PAR have been key contributors to revenue growth. That has helped as capital finance companies and banks have begun processing more delinquencies and there are more defaults on auto loans. Second, we saw increases in transportation. Some of that was probably related to the Carvana commercial agreement, but most was due to higher attach rates and our greater penetration of the dealer-to-dealer space, resulting in strong growth in transportation revenue this quarter compared to a year ago. Those were the two big drivers.

And then as a follow-up, as volumes recover next year, I was wondering if you have to bring back any of that headcount you have temporarily reduced, whether it's in support staff or at AFC, or should the offshoring of some of that back office functions take out the need for this?

I think one of the great advantages of a more digital model is the scalability you get from a digital platform. So I don't foresee that in the context of the assumption certainly we're making about the industry. I think these businesses will scale incredibly well. We have got evidence of that from the past. And unfortunately, we have been hurt on the downside of that as volumes have declined over the last couple of years. I think as those volumes come back, they'll flow through a business model that is more scalable and more efficient than it ever has been before. So I don't foresee that happening. And I would view the GSS initiative, as Eric said, incremental savings versus our current sort of run rate.

(operator provided instructions) Our next question will come from Ali Faghri with Guggenheim.

And first, Eric, congrats on the retirement. That was a lot of miles between Chicago and Carmel, so well deserved. So I actually have a few questions on AFC. So loan volumes were up 11% in an environment where your marketplace volumes were down 12%. I think historically, AFC loan volumes have at least directionally correlated pretty well with your auction volumes. Why have they decoupled more recently and what's driving that outperformance versus what we are seeing in the broader wholesale auction industry?

It's true that in the past it correlated more with auction volume. But I'd also say that even when we looked at it historically, the amount of transactions within AFC that were generated through the KAR platforms was always a relatively small amount, I think it was about 30% of their total transactions came from KAR or even less. I would say essentially it's market share. AFC has been focused on expanding its dealer footprint, the number of dealers using the system. They've been doing that in a very disciplined way and they've been effective at doing that. So we kind of win the business at the dealership level. And then we commit to fund those dealers' purchases irrespective of what channel the dealer buys them on. So I'd say principally that's the focus. Now I will also say we have been focused as well on increasing attach rates within our existing digital marketplaces. We've put focused initiatives on that with TradeRev and with BacklotCars, and those are bearing positive results. But that's not what's driving the significant change that you alluded to. So I think it's really just a focus on the customer and ultimately increased market share within the segment.

And then maybe just a follow-up on AFC. Maybe you can remind us how interest rates benefit the business? It was obviously a sizeable tailwind this quarter. Maybe a refresh on how you price your loans would be helpful.

Well, on the first slide we talk about pricing: we use a prime rate quote plus a spread, typically 300 to 400 basis points above prime, and prime has been moving up. The reason performance improved is that while there is a corresponding increase in cost of funds, we only fund about 70% of total loans through securitization on our balance sheet. About 30% is equity, and that equity portion sees no corresponding cost, which is where we get the increased performance in the AFC business. Equally important is that we have a very efficient financing structure—our cost of funds is actually lower than the charges to our customers. In other words, the prime rate has grown more than our cost of funds, so we’ve seen some spread enhancement. Those are the two main drivers. If the Fed continues to raise interest rates for the rest of the year, that will probably be a short-term tailwind, but as Peter mentioned it also puts stress on the dealer side, so you have to balance that against portfolio risk. Peter, anything to add?

No, I think you've got there, Eric. I think, there are some pros, there are some cons. I think generally we're confident in the AFC business model and that it'll be a strong contributor in 2023 and beyond.

Great, thanks for taking my questions.

I think we're pretty much at time. So Matt, unless there's other questions, I'll just move to closing remarks.

No, this concludes our question and answer session. I'll go ahead and turn the conference back over to management for any closing remarks.

Thank you, Matt. Thank you everybody for your time this morning and also for those questions. I just want to close my remarks by reinforcing some of the key messages from today. Again, I'm pleased with the Q3 performance. We delivered improved performance versus a year ago and also compared to Q1 and Q2 of this year in a challenging environment. In our marketplace segment, we increased revenue and gross profit compared to one year ago. We also increased our revenue per unit and our gross profit per unit sold. In our finance segment, we delivered another solid quarter of performance with meaningful growth in both volume and revenue per unit. In addition to those financial results, we made significant progress in terms of platform consolidation, pricing and addressing our cost structure. Obviously, volumes continue to be a challenge in this industry. However, as we look at the future, we expect new vehicle production to increase gradually. We expect used vehicle pricing to decline and we expect a gradual increase in wholesale used vehicle volume over time. And I believe that our digital focus will enable us to grow faster in that type of environment. I'm excited and energized by the many opportunities ahead. I believe we've got a significant opportunity for long term growth in this company. We have a differentiated offering, a diverse and expanding customer base and a large addressable market to in which to innovate and invest. So with that, we'll end today's call. I look forward to reconnecting with you all in the new year. Thank you all very, very much. And again, Eric, best wishes for a very, very happy and successful retirement.

The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.