OPENLANE, Inc. Q4 FY2022 Earnings Call

Good morning and welcome to the KAR Auction Services Inc. 2022 Year End Earnings Conference Call. All participants will be in a listen-only mode. Operator instructions were provided. Please note this event is being recorded. I would now like to turn the conference over to Mike Eliason, Treasurer and Vice President, Investor Relations. Please go ahead.

Thanks, Kate. Good morning. And thank you for joining us today for the KAR Global fourth quarter 2022 earnings conference call. Today, we will discuss the financial performance of KAR Global for the quarter ended December 31, 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 for 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 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'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 additional information and detail relating to the following items: our fourth quarter and full year 2022 performance, our view of the current market factors impacting our industry, our outlook for 2023 and beyond, 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 our finance segment which we formerly called the AFC segment. To begin Q4 with our second full quarter as a more asset-like digital marketplace company. Against the backdrop of an unusual and still very volume-constrained industry environment, we increased revenue and total gross profit while reducing our overall cost structure. We made significant progress to position our company for improved performance in 2023 by simplifying our business and consolidating a number of our platforms and operations. And we positioned our company for growth in 2023 and beyond. So let me touch on some of the specific highlights of the fourth quarter and full year performance. For the fourth quarter, we generated $373 million in revenue, a 4% increase versus the same quarter of the prior year. Purchase vehicle revenue represented 12% of total revenue in the quarter. We generated a total gross profit of $171 million, an increase of 4% from Q4 of the prior year. Gross profit represented 62.1% of revenue excluding purchase vehicles. This resulted in adjusted EBITDA of $56.5 million in Q4. For the full year 2022 KAR generated over $1.5 billion in revenue, that was a 5% increase compared to 2021. Purchase vehicle revenue represented approximately 12% of total revenue for the year. The company generated total gross profit of $685 million, an increase of 4% over the prior year. Gross profit represented 51.3% of revenue excluding purchase vehicles. And that resulted in 2022 adjusted EBITDA of $231 million, which was below the lower end of our guidance range at $245 million. Specific to our marketplace segment, we sold approximately 289,000 vehicles in the quarter and 1.3 million for the full year. We again saw solid marketplace participation from both buyers and sellers. But used vehicle values declined throughout the quarter and conversion rates remained lower than the prior year. As a result, revenue in the marketplace segment decreased 2% compared to Q4 of 2021 and also 2% compared to the full year of 2021. In our finance segment, we experienced another strong quarter performance as AFC closed out a successful 2022. Q4 revenue in the finance segment was $101 million; that was an increase of 27% over Q4 of the prior year, driven by a 15% growth in transactions and an 11% increase in revenue per transaction. For the full year 2022, the finance segment generated $376 million in revenue, that was a 30% increase versus 2021 and that was driven by a 10% growth in transactions and an 18% increase in revenue per transaction to $241. I'd now like to highlight a number of areas where we made important progress in the quarter, progress that I believe will benefit our performance in 2023 and beyond. The first of these is platform consolidation. As I mentioned in prior calls, one of our primary objectives here at KAR is to simplify our business and the customer experience. We have now completed the integration of BacklotCars and CARWAVES and have retired the CARWAVES platform and branch. The new auction format within BacklotCars has been successfully rolled out in BacklotCars' core markets and we are now focused on the national rollout of this auction format across the United States over the course of 2023. In Canada, we also continue to make progress consolidating the trade, revenue and data marketplaces. Using feedback and input from our pilot customers, we're finalizing the development work to connect all of our Canadian sellers, buyers and vehicles into a single digital marketplace. By mid-2023, we expect to have one Canadian platform and one simplified customer experience. To support this change we've also consolidated the leadership of Canadian operations to better align our growth strategy, product roadmap, as well as our sales, marketing and customer support functions. And in our European business, we've successfully migrated the standalone ADESA UK technology and our dealer-to-dealer platform in Germany onto our ADESA Europe platform. This consolidates our technology processes and customers onto a single platform in that market and the early feedback has been very positive there also. Now we anticipate making additional progress on these consolidation and simplification efforts in 2023. We will also be extending this work across our other brands, products and services to better align them with our marketplace strategy. Ultimately, we believe that simplification will improve the customer experience and generate higher levels of customer engagement; internally it will also help reduce our IT maintenance costs, better focus our sales and marketing efforts and accelerate new products and feature development. This brings me to a second strategic focus that I'd like to cover, which is cost management. Last year, we committed to reducing our costs by $30 million by the end of 2022. I'm pleased that we achieved that goal. But our work in this area is not complete. Cost management remains a key part of our agenda and cost consciousness will be a key part of our culture here at KAR. The savings that we achieved in 2022 are part of ongoing initiatives that will continue through all of this year. We have a detailed roadmap in place that we believe will deliver an impact of a similar scale to what we achieved in 2022. One of the primary levers that will help us achieve these additional savings is the expansion of a global shared services model and leveraging it to improve the efficiency, consistency and cost structure in our technology and business operations. This initiative is already well underway with partners and locations selected in India and the Philippines. And we will continue building this out through the remainder of 2023 and into 2024. The nature of this work involves wrapping up resources in one area while other resources are still in place. So while we do expect to see some in-year benefits during 2023, we will also see some overlapping costs and the full impact may not be apparent until next year. What excites me more than our cost management activities, however, are the many opportunities that KAR has for growth. First, I believe that there is a secular shift towards digital underway in our industry, affecting both commercial and dealer-owned inventory. Digital channels have gained share in the past number of years. We are positioned on the right side of that shift, and we will continue to benefit from that. We are also highly focused on growing our market share within our current offerings. We have a strong differentiation as a digital leader with a uniquely strong position with both commercial sellers and dealers, along with the scale, profitability and cash flows to support our investments. We have mapped out several priority areas for innovation that will deepen our product portfolio, expand our customer relationships and unlock new revenue streams for our company. To give you a few examples of these: First, we plan to roll out the auction format on BacklotCars to all U.S. markets within the current year. We see this as a lever to drive further customer adoption and additional volume in that channel. Second, we plan to integrate our commercial vehicles—mainly off-lease vehicles and rental vehicles—with our dealer-owned vehicles into one digital marketplace venue before the end of this year. This will increase the scale and breadth of our offering. It will increase the selection for buyers and also improve network effects. One marketplace for all of our open-sale vehicles and for all of our sellers and buyers will be very powerful indeed. Third, AFC has gained share over the past number of years and we see further opportunity for AFC to grow its customer base and its portfolios, particularly as dealers have more inventory on their lot and more inventory to finance. And finally, also in relation to AFC, we plan to increase the attach rate of AFC financings in our marketplaces through a combination of cross-channel sales and marketing efforts, and also a simplified customer experience at the checkout. We have teams working on all of these initiatives and on many others, and I look forward to updating you on our progress on future calls. I'd now like to look towards the future and provide some details around the industry outlook and macro environment. From a macro environment perspective, we're beginning to see some positive signals of improvement. First, many of our commercial customers have indicated an expectation of increased new vehicle production in 2023. Also, we are now seeing new vehicle inventory on dealer lots starting to increase with increased steady supply. These two factors are the necessary ingredients to balancing supply and demand in the used vehicle market. Shifting to used vehicle values, we expect the significant price declines that we witnessed in the second half of 2022 to abate in the spring market conditions that typically prevail from January through May. However, we expect some downward pressure on used vehicle values will become evident again in the second half of this year. This may cause short-term pressure on conversion rates. But I believe that in the long run it will ultimately lead to greater transaction volume in the wholesale marketplace. Looking at the dealer-to-dealer space, according to industry data in Q4 physical auction dealer-to-dealer volumes fell to the lowest quarterly levels since the onset of the pandemic. And while volumes are also down in our digital channels, I was encouraged that we continue to grow new dealer registrations, and increase our buyer and seller participation. It's also worth commenting that our CARWAVES migration likely cost us some volume in Q4 as some dealers had to learn a new platform. But we believe these effects were limited to Q4. Currently adoption continues to improve and dealers have been positive about the increased choice and flexibility that our platform now provides. I'm excited about the opportunities ahead as we introduce this format to more dealers in new markets. In terms of the off-lease segments, in recent discussions with commercial customers, a number of them have signaled that we should expect a meaningful increase in off-lease volumes later in 2023. While that would undoubtedly be a positive for our business we're being conservative for now and not modeling in any significant increase since we've had signals before that proved incorrect. A key question will be how many of the off-lease vehicles that are scheduled to mature later this year will enter our marketing channels when those leases end. According to our data, the average amount of equity value—that is, the difference between the market value of a maturing lease and the residual value of the lease contract—has declined by approximately 50% since it peaked in April of last year. This decline should help increase the volume of vehicles flowing into the wholesale marketplace over time. I would point out that in these first weeks of this year, we're starting to see the first evidence of this happening in some but not all of our customers' portfolios. And then finally, though our footprint is smaller in the rental and repossession categories, we're also starting to see some positive signs. I believe this is a positive signal for our business as well. Rental customers are beginning to take delivery of more new vehicles, and this should generate increased sales of older vehicles in their fleets. Repossession activity is increasing nationally, which many view as a leading indicator for the return of a more normalized industry environment. Looking at our finance segment, we see an opportunity to continue to expand our customer base and our book of business. AFC has gained share over the past number of years, but it has done so in a disciplined way, enabling AFC to manage risk and limit losses. We plan to continue in the same manner. We anticipate an increased risk environment in 2023 due to the combination of used vehicle price declines and also a higher interest rate environment. AFC actively monitors that risk through a combination of technology, data and feed on the street and works directly with dealers to mitigate the impact of these business pressures. The bottom line here is that we believe AFC will continue to make a meaningful and positive contribution to KAR's overall performance. So I'd like to provide some insight on my expectations for 2023. First, as we enter 2023, I believe KAR is positioned very differently than we were at the beginning of last year. We have a clear digital focus. We have paid down the majority of our debt. We have meaningfully reduced our cost structure. We are consolidating our platforms and simplifying our business. We're beginning to see the first signs of a commercial volume recovery. We have a broad pipeline of innovation and growth initiatives. And we're able to support these investments from the cash flows and profits that this business generates. While these are all positives, at the same time some of the market challenges that existed in 2022 are still present today to varying degrees. New vehicle production remains below normal with modest increases expected this year. Volumes in the wholesale marketplace are expected to remain below normal in 2023 and while we believe that lower used vehicle values will help drive more volume and will be a long-term positive for us, an environment where used vehicle values are declining may put short-term pressure on conversion rates before those longer-term benefits are realized. And lastly, those price declines coupled with high interest rates may create a higher risk environment in our finance business as I've already mentioned. Based on all of these factors and our internal analysis, we believe that for the full year 2023 KAR can deliver adjusted EBITDA in the range of $250 million to $270 million. The management team and I are committed to delivering these results. This level of performance will also enable us to invest in the people, platforms and technology necessary to support our customers and our strategy for growth. Our guidance is based on similar marketplace volumes to last year. Upside scenarios to our range would include faster-than-expected commercial volume recovery and an acceleration in dealer-to-dealer volumes. Downside scenarios include further contraction in wholesale supply below last year's levels and/or an increased risk beyond our expectations at AFC. As we look beyond 2023, we recognize that the commercial volume recovery has been more delayed than we anticipated. For example, lower lease originations during 2022 will present a headwind to off-lease volumes in 2025. This leads me to conclude that our previous estimate of $500 million in adjusted EBITDA in 2025 is likely unachievable. However, I do believe that we can grow our consolidated adjusted EBITDA by a compound annual growth rate of between 15% to 20% over the next several years. I believe that we can achieve this through a combination of organic growth in our volume and share, continued cost management, and the strategic expansion of our products and services offerings. As I stated earlier, there are a lot of new opportunities available to KAR and I believe that our strategy and capabilities position us well to capture those. I'd now like to provide a brief recap on our capital allocation activities. During 2022, we made no material acquisitions and our primary focus was integrating the platforms, teams and technologies acquired in prior years. Also in 2022, we completed a major divestiture that greatly simplified our business. This allowed us to reduce our cost structure while utilizing the proceeds to pay off debt, invest in the business and repurchase KAR shares at an attractive price. Scott will provide more specifics around these activities in the next portion of this call. Looking to 2023 we expect our business will continue to deliver strong positive cash flows. At the guidance range that I've stated we expect the cash generated by our business after allowances for CapEx, interest payments, taxes and preferred dividends could reduce our company's net debt by approximately $80 million to $85 million over the course of this year. Scott will provide more details. Any excess cash flow would follow our stated capital allocation priorities which include paying off debt, repurchasing KAR shares and exploring strategic acquisitions should they arise. So to summarize my key messages for today: in Q4, we performed well against a backdrop of a still challenging economic and industry environment and we experienced another solid quarter performance in our finance business. We are consolidating our platforms and executing on a multiyear plan to simplify our business. We achieved our 2022 cost savings targets, and we have a clear roadmap to realize significant additional savings in 2023 and beyond. We're highly focused on long-term growth. We have a differentiated offering and a diverse and expanding customer base that includes commercial sellers and dealers with strength and scale in both. We have a large addressable market in which to innovate and invest and we have several exciting initiatives on our growth agenda for 2023. I will update you on the progress in future calls. Overall, I'm energized by the progress we've made in 2022 to transform our company and to position KAR for future success. I believe that this will translate into improved performance in 2023 and for many years to come. So that concludes my prepared remarks. As I mentioned in our last call we're currently conducting a national search for a new chief financial officer. Joining me today is our interim Chief Financial Officer Scott Anderson. Scott will provide further detail on our financial results. Scott?

Thank you, Peter. As Peter has already commented on many of our financial metrics, I only have a couple of additional areas to review. We made one disclosure change: we will no longer be providing on-premise and off-premise vehicle sold amounts for a marketplace segment because we have moved to a digital business model and we believe the breakdown is no longer needed to measure the success of our business. Looking at the fourth quarter, consolidated revenues excluding purchase vehicle sales increased 7% in the quarter to $327.8 million. Marketplace segment revenues excluding purchase vehicle sales were flat with the prior year at $227.1 million and generated approximately 69% of the consolidated amount. Marketplace vehicles sold declined 15% to 289,000 units due to the market conditions Peter highlighted. Auction fees per unit declined approximately 5% to $280 as a result of lower vehicle values. Service revenues increased 16% due to increases in repossession, transportation and technology services provided. Not only did attachment of these marketplace services increase but it's important to note that not all services are attached to our marketplace transactions. For example, repossession services provided through our RDN Empathy platforms grew and generally do not attach to the marketplace transaction. Increased service revenues generated in a challenging industry environment highlight our diversified revenue streams that can be generated in varied market conditions. Service revenues generally are lower margin compared to auction fees and therefore our consolidated gross margins excluding purchase vehicle sales declined to 52% from 54% in the fourth quarter of 2021, largely due to increases in the lower margin services provided. In addition, finance segment revenues accounted for $100.7 million or 31% of consolidated revenues, excluding purchase vehicle sales. Finance segment revenues increased 27% in the quarter due to strong volume fee and interest income growth. AFC's provision for credit losses increased to 1.1% of the average managed receivables for the quarter. Long term, the provision for credit losses is expected to be under 2% annually. However, the actual losses in any particular quarter could deviate from this range. Although we anticipate increased credit losses from historically low amounts due to an economic slowdown and declining wholesale used car prices, we believe the floor plan business has room for additional volume and fee growth as industry supply returns. Next, let me provide some additional color on SG&A. Fourth quarter SG&A was $93 million, which was $16 million lower than the third quarter due to execution of our cost saving initiatives and an approximate $9 million reduction in non-cash compensation amounts compared to Q3. Non-cash compensation decreased as a portion of the performance awards are no longer expected to vest. As Peter mentioned, we have initiatives to continue to reduce long-term SG&A spend, and will provide updates as we progress. One item that did affect fourth quarter performance was the sale of excess land in Montreal which resulted in a pre-tax gain of approximately $34 million. The gain is segregated on a separate line item in the income statement, and this gain is excluded from adjusted EBITDA. On the other hand, the gain is included in our net income from continuing operations per share and operating adjusted earnings per share amounts. In addition, when comparing 2022 results with 2021 prior year, adjusted EBITDA included $5 million quarter-to-date and $32 million year-to-date of realized gains on the sale of strategic investments. As a reminder, we occasionally invest in certain early stage auto-related enterprises. In 2021 some of those companies went public and we monetized a portion of our investment. Going forward we continue to hold a small amount of these investments but do not anticipate monetizing any amounts in the near term. Next, I will highlight our strong capital structure. We ended the year with $180 million in available cash and $161 million of available revolving line of credit, which provides ample liquidity to execute our strategy. In terms of capital allocation activities, let me summarize the significant items for the full year 2022. Our capital expenditures aggregated to $61 million. In 2022 we also repurchased 12.6 million shares of KAR stock, which accounted for approximately 10% of our common stock outstanding for $182 million. Most importantly, the company generated $2.2 billion of gross proceeds from the sale of the U.S. physical auction business. Under terms of our credit agreement, net cash proceeds from the transaction were used to repay $926 million of our term loan B6. The terms of the senior note indenture specify that excess proceeds must be reinvested or used to pay down debt within one year of the transaction. Therefore, we repurchased $600 million of the senior notes in August 2022, in a tender offer and approximately $140 million of the remaining senior notes are classified as current debt at December 31, 2022. Because we have lowered our outstanding obligations, we expect our net leverage target to be approximately one to two times adjusted EBITDA going forward, which is more appropriate for an asset-like business. Within that framework, we'll be looking for windows of opportunity in the debt markets to extend our revolver maturity date, and put in place a more permanent debt structure. Let me close with some comments on guidance. As Peter mentioned, we expect 2023 adjusted EBITDA to be between $250 million and $270 million. We will also continue to invest in our digital strategy and as a result, we expect capital expenditures of approximately $65 million in 2023. In addition, with leverage of one to two times net debt to adjusted EBITDA we expect cash interest on corporate debt of approximately $35 million to $45 million. We also expect cash taxes of approximately $25 million to $30 million. Cash dividends on preferred stock are expected to be $11 million per quarter, or $44 million for the year. This could result in a reduction of net debt by approximately $80 million to $85 million assuming no other capital allocation activity and working capital changes. We believe these assumptions will generate operating adjusted earnings per diluted share of $0.37 to $0.47. The midpoint of this range is similar to $0.43 earned in 2022. However, 2022 included a $0.16 per share nonrecurring benefit from the Montreal real estate gain. No such recurring items are included in our 2023 guidance. I have one housekeeping item. We will be filing our 10-K within the next week. That concludes my remarks and I will turn it over to Kate to begin Q&A.

We will now begin the question-and-answer session. The first question is from Rajat Gupta of J.P. Morgan. Please go ahead.

Great, thanks for taking the questions. This is Rajat on for Orion. Maybe first question on the fourth quarter: the gross profit per unit took a step down sequentially more than the revenue per unit declined. Would you be able to elaborate on the drivers of that? How should we think about that trajectory into 2023? I have a follow-up. Thanks.

Yes, Rajat. I think gross profit—I mentioned it was a declining used vehicle value environment. So, in that environment as vehicle price came down there was some negative on buyer fee revenue, so that probably flowed through into gross profit per unit. So I think that was a factor. We had also some other, more technical accounting items that impacted gross profit in the fourth quarter, but I don't think those would recur. But I think I'd say vehicle values would be the principal one, and then when you have lower conversion rates this is another factor; it puts pressure on gross profit, because if you think about it you're inspecting a greater number of vehicles per every vehicle sold, for example when conversion rates are lower. So we generally find when conversion rates are lower, which they were, gross profit per unit would be a little bit under pressure. The other metric I look at on gross profit, though, is the greater-than-50% of consolidated net revenues; if anything, maybe a more important metric that we use internally to manage the health of the business. And I was pleased that we delivered gross profit above the 50% target for the quarter.

Got it. Got it. Thanks for that color. You mentioned 15% to 20% EBITDA CAGR going forward—can you help us with the confidence around that? How should we think about volume recovery and how that flows through to gross profit and SG&A? And maybe just on SG&A based on the cost savings action and the overall cost you actually just took, how much of that should now be treated as fixed versus variable in nature? Thanks.

Rajat, there is a lot packed into that question. So first, if I look at the go-forward growth, yes, I believe a 15% to 20% consolidated adjusted EBITDA compound growth rate over multiple consecutive years is what we believe this business can deliver. And we're focused on delivering that organically. I think the company has opportunities for growth across the entire business. If I look at our commercial volumes, we've got a strong presence with commercial — as you know, these volumes have been under pressure. We see opportunities to see volume growth in that category, but also, I think, strong conversion rates in that category over the long term as well. So opportunities there. In digital dealer-to-dealer, my fundamental belief is that there is a secular shift underway from physical towards digital, offsite, off-premise channels. We're strong in that category. We intend to grow in that category and, frankly, intend to gain share in that category. So I think we're going to grow in that segment. I think our services businesses—inspections, logistics, etc.—have been under a lot of pressure the last couple of years. Some of them have been losing money because of very low volumes. We've been addressing that; I think there's a chance for those businesses to get back toward and ultimately above historical levels of profitability as well over time. And even AFC, which has been a strong performer for several years, I think there are opportunities for growth there. It will be more modest growth in that part of the business and AFC will be a smaller percentage of our total earnings over time, because the marketplace business we expect to grow much faster. But we think AFC will also grow modestly and will continue to be a strong performer. So all of those things give me confidence in the growth opportunity for this company. Switching to the SG&A question: I'm pleased with the progress we made. The progress we made in 2022 was part of a much larger program that we've been executing across the business since the divestiture and that roadmap will continue into the early part of next year. So we have numerous initiatives in the works this year to continue on that vein. I expect to make more progress. As I mentioned, some of the benefits won't be fully apparent until next year, because we have overlapping costs in the context of 2023. But we'll work through that. Ultimately, SG&A as a percentage of our total revenue—or potential net revenue—we view that declining over time. In terms of what percentage of SG&A is fixed versus variable, I think one of the characteristics of a more digital business is that they do tend to operate more as a fixed-cost kind of business. There is less variable tied to each incremental transaction. So that's why they scale so well. That's why when you add in more volume on top, you get outsized performance further down the P&L. So that's a fair assessment that over time, our SG&A structure will start to look a little bit more fixed in nature with less variable cost. But in the long run, all costs are variable, so we'll create the right cost structure for the business that we have.

Thanks for all that color.

The next question is from John Murphy of Bank of America. Please go ahead.

Good morning, guys. Peter, as you think about this — I mean, there's a lot going on in the industry and the flow of vehicles is hotly debated — many folks are looking for '23 and '24 to be sort of flattish years in remarketing. As you think about this transformation, what are the KPIs that you look at to gauge progress? Because a lot of investors may be frustrated because volumes might not recover, and progress may be tough to see in that kind of environment. Is it simply the EBITDA CAGR of 15% to 20% that people should be looking at? Are there other KPIs over the next year or two in what might be a tough industry backdrop so people can really understand the progress that you're making?

Thank you, John. A couple of things: all of our modeling is based on the industry volumes remaining below normal for the next number of years. The growth I'm talking about is in the context of an industry that remains below normal. Wholesale industry volumes are still down 30-plus percent, maybe as much as 40%, from pre-pandemic levels, and our assumptions on volume inherent in our guidance are essentially flat volumes relative to last year. I think if we see faster recovery or an acceleration in digital dealer-to-dealer that would represent upside versus our guidance. So I think we're being conservative in our modeling. My personal belief is we're at or near the bottom in terms of industry volumes, and we're going to see a gradual but sustained recovery over time. In terms of KPIs: volume sold per quarter is a key driver. Volume sold is essentially vehicles offered times conversion rate. So we obviously look at both of those metrics. Then volume offered is a function of participating sellers and conversion rate is a function of participating buyers, so we look at seller and buyer participation in our digital marketplaces. We also look at price attainment or marketplaces indexed against some benchmarks. We look at all these metrics and many others as functions of the health of our business. I mentioned simplification earlier and trying to have a simpler business: one challenge the company has had is that our marketplaces have been fragmented. We had 1.3 million total volumes last year fragmented across multiple different digital venues. That creates two challenges: one, a cost challenge supporting multiple platforms; the other, more impactful, is a network effect challenge where you're fragmenting your demand and scale across multiple marketplaces. So a real driver of simplification has been to consolidate volumes, consolidate all participating sellers and buyers into one marketplace. That creates benefits for all marketplace participants. If you can put your car into a location where all the buyers are, you're likely to get a better outcome. That's behind a lot of our simplification work. I mentioned the CARWAVES migration we completed last quarter. It was a challenging migration in the moment, but now that it's done I can see the benefits of having those vehicles in a bigger marketplace with considerably more buyers. Bringing our commercial vehicles and our dealer-owned vehicles into one marketplace will improve the health, performance and outcomes for customers, and that will help us scale and grow our business and increase customer adoption. This company has a tremendous amount of opportunity and we're focused on executing that. I believe the opportunity for growth we talked about is attainable.

Right. And just two quick housekeeping items: can you remind us what the services are on the agreement and the expectation from what you're offering or what you're getting on the tech side? And what kind of fees are you getting here in your guidance for 2023? And then also, you mentioned AFC losses would stay under 2%. But 2% sounds like a reasonable, normal level. When do you think we re-creep up there? And should you be taking more risk in AFC if losses stay lower to grow the business significantly more than where it is right now?

Thanks, John. I don't want to comment too much on the Carvana arrangement, but it's the same arrangement as we had last year. We provide some services and there are some fees attached. It's a small percentage of our total revenues. We're also very focused on the separation activities that continue and that's generally going well. On AFC, the 2% would be above our historical mean or median for that losses number. Our budget doesn't reflect 2% this year, but I think you could see 2% in a quarter. For the year, we expect it to be less. AFC has always been cautious and conservative in its approach to growth and we plan to continue that approach. There's a bigger opportunity to grow, but we want to run the business conservatively and keep losses below that level as part of our stewardship of the business.

The next question is from Gary Prestopino of Barrington Research. Please go ahead.

Good morning, Peter. Just a couple of questions. Could you comment on the year-over-year change in conversion ratios? How much were they down versus last year at this time? And if they had stayed at the level where they were, would you have hit the low end of your guidance? I'm trying to get a sense of the impact conversion ratios are having on your volume portfolio.

Gary, thank you. Conversion rates are very important. In a digital business they're arguably even more important than in the physical model, because in a digital marketplace if you don't sell the car it may move on to a physical channel. Conversion rates were down across the entire industry. Physical auction conversion rates in Q4 were the lowest since Q2 of 2020. It was a very weak quarter from conversion rates across the industry. Generally conversion rates were down 5 to 10 percentage points across our markets—from roughly the mid-50s to the mid-40s to 50 level—depending on the marketplace. If you've got a market converting at 50% and that drops to 40%, that's effectively a 20% drop in sales. So conversion rates were weak. I think if conversion rates had been the same as the prior year, we probably would have hit the lower end of our range. The one thing I'll say is as soon as we turned into 2023 it's almost like a page turned: conversion rates and demand have really picked up and conversion rates are back at strong historical levels, aided by the spring market. How long that continues remains to be seen, but currently in the spring market we're seeing strong conversion rates.

When you say it's back to historic levels, is that somewhere close to 60%? Or is that too high?

Because we have different venues, I'd say in some of our marketplaces it's around 60% and in a couple it's a little below that. I'd characterize it as in the 50% to 65% range.

Okay. And could you comment on how far you've penetrated the franchise dealer market overall with your digital dealer-to-dealer product?

Our industry is past the early adopter phase; many dealers are using these platforms and channels. But total dealer-consigned vehicle volume at physical auctions is still approximately three times the total volume of the combined digital channels. So we have strong penetration in terms of the number of dealers using the platform and that is increasing, but it's still a minority of all vehicles being sold in the marketplace. That said, digital channels have clearly gained share over recent years and I expect that to continue. Our digital offering inspects the car at the dealership, lists it immediately on our marketplace, and the car is likely sold within 24 hours and moved quickly; funds flow follows. It's a very efficient process with a national buyer base ready to bid, as opposed to waiting for a scheduled physical sale with local buyers. So the digital offering is strong and will gain share, and we expect to gain share with it.

One last quick question: on the digital dealer-to-dealer auctions versus typical physical auctions, what kind of price differential are you seeing on realization—digital versus physical?

We benchmark every car we offer and sell in the channel versus market. We believe our digital offerings perform extremely well on price attainment metrics—at least as good as, and in many cases better than, the alternatives. Making that apparent to our customers is a key part of our sales and marketing process.

Right. Okay. Thank you.

The next question is from Pete Lucas of CJS Securities on behalf of Bob Labick. Please go ahead.

Hi, good morning. It's Pete Lucas for Bob. You guys covered a lot; just wanted to touch on platform consolidation in terms of the dealer-to-dealer strategy. Have you settled on a single type of auction? In terms of what types of cars are better for timed auctions versus the bid/ask marketplace? Is that something that's segregated by price of vehicle? How do you think about that?

Pete, that's a great question and there are some things that have become apparent now that we have both offerings in the market. Essentially today we have two offerings: a 24/7 marketplace where buyers and sellers interact and price discovery happens continuously—that's what BacklotCars historically has been. That performs very well, with strong conversion rates and strong price attainment, and it's particularly strong on lower-value vehicles—sub-$15,000 and certainly sub-$10,000. Its weakness historically has been higher-value vehicles. Now that we've got the auction format live, currently we're running that auction two days a week as a purely digital auction. Cars are inspected; they're available in a pre-auction process and then visible bidding takes place in a window currently Mondays and Thursdays. I imagine that over time we'll increase frequency and have different days in different markets for different sellers. What we're seeing is very strong conversion and very strong price attainment in the auction format, and it's performing particularly well on higher-value vehicles. So we have an offering that addresses different vehicle segments: the marketplace is very strong for lower-value cars and also does well across the board; the auction format is very strong and particularly effective for higher-value vehicles. Another big differentiation for us is our deep footprint with commercial sellers. As more of those vehicles flow into open-sale channels, we'll integrate that volume into one combined marketplace so buyers will see a large selection of both dealer-owned and commercially owned vehicles with easy-to-use digital tools and checkouts. I think that's going to be a unique differentiation for us and very compelling to customers.

Very helpful. Thanks. One more: on the open-lane outlook, what are you seeing in terms of mix change at auction? Are dealers auctioning lower-priced cars and holding onto higher-priced ones, and how is that helping or hurting you?

On open-lane, the cars there are commercially owned vehicles and by far the majority are new off-lease. Currently volume is similar to last year but we're seeing a slightly better mix: a lower percentage of vehicles selling to the grounding dealer. Last year that percentage was in the high 90s; we're seeing that percentage drop and consequently more vehicles are flowing deeper into the marketing funnel where we generate greater revenue per vehicle. It's nothing close to normal yet, but it's started to move away from the unusually distorted position it has been in over the last 12 months. Also, as I mentioned earlier, a number of our commercial sellers have indicated we should expect significantly more volume later this year. We haven't reflected that in our models because we want to be cautious, but when it happens we will benefit from it.

The next question is from Bret Jordan of Jefferies. Please go ahead.

Hey, guys, this is Patrick on for Bret Jordan. Thanks for taking our questions. Could you talk a little bit more about the cadence of how you see the marketplace progressing in '23? Just trying to model out auction versus finance contributions throughout the year—should we expect finance to continue being the main driver at the bottom line?

Thanks, Patrick. If we think about our guidance for this year, we expect AFC to continue to be a strong contributor, but slightly lower than its contribution in 2022. We expect AFC to grow its volumes but vehicle values may be lower than last year; ARPU may be in line or slightly lower than last year and we are expecting some level of higher risk. So AFC contribution, while remaining strong, will be slightly lower than last year. The growth for 2023 is expected on the marketplace side of the business: commercial volumes similar to last year with a stronger mix, and dealer-to-dealer modeled for a small level of growth. We hope to do better but we've modeled conservatively. Couple that with reasonably strong margins and lower SG&A overall and that's how we see the cadence.

Got it. That's helpful. And a bit more on the AFC side: what have been the primary drivers of growth beyond loan counts and what are your expectations for those progressing in 2023?

AFC is the number two in its industry and has been that position for many years. Over the last three to four years AFC has gained share and the gap to the number one has reduced somewhat. AFC has done this by increasing its dealer base and the number of dealers using AFC has been the principal driver. AFC differentiates on strong service and a culture of service to the dealer. We try not to compete solely on price; service matters. We have also expanded the product portfolio to take on activities that benefit the independent dealer, turning those into revenue and profit-generating opportunities. That combination has driven AFC's growth and will continue to do so.

The last question is from Daniel Imbro of Stephens Inc. Please go ahead.

Hey, guys, this is Reed on for Daniel. With the return of off-lease in the coming year, how do you foresee your ability to handle those units as the market normalizes and units need more reconditioning work?

Reed, one of the good things about a digital business is it scales. As volume returns, scaling the business is not a significant challenge from a technology platform standpoint. We do need to process more titles and funds, but we don't have to build a second technology platform. For parts of our business like audit and inspection, we may need to hire more inspectors if volumes increase and we'll do that as needed. On reconditioning: in a typical portfolio, a small percentage of vehicles benefit from reconditioning before they're sold—perhaps around 20% of vehicles that mature, though that's a rough estimate. Before the pandemic, off-lease conversion rates on our marketplaces were about 55% and those vehicles generally were not reconditioned. During the pandemic conversion rates increased into the low 80% levels, and again most of those vehicles were not reconditioned. My view is that as off-lease volumes return conversion rates will drop back from the 80% level but I don't think they'll revert to pre-pandemic levels. Sellers generally prefer to find ways to increase upstream conversion and reduce remarketing costs. Every off-lease vehicle is inspected and gets a condition grade; the vehicles that really need reconditioning are typically those with more significant damage grades, which dealers often handle. I'm expecting strong conversion rates going forward in the off-lease channel—stronger than pre-pandemic. So, again, I think that's all the questions we have time for. Thanks, everybody, for your time this morning and for those questions. I just want to close out my remarks by reinforcing some key messages from earlier today. First of all, 2022 was a challenging year across our entire industry. I'm pleased about what the team at KAR accomplished and how we positioned ourselves for success in the future. We are a digital marketplace leader with differentiated offerings and strength with both commercial sellers and dealers. We have simplified our business, consolidated platforms and improved our customer experience. We have meaningfully reduced our cost structure and we've set ourselves up to operate more efficiently in the future. We paid down over $1.5 billion in debt and repurchased approximately 10% of our outstanding common stock. The progress made in 2022 should help us deliver improved performance in 2023 even if industry volumes remain weak. Our guidance is to deliver adjusted EBITDA of $250 million to $270 million in 2023 and the management team and I are fully committed to achieving that goal. Looking to the future, I believe the secular shift to digital will continue and digital platforms will continue to gain share, which will be to our benefit. However, we're not waiting for this to happen. We are charting our own course and we have many initiatives in play that we believe will enable us to grow our customer base, increase our market share, and expand our product and service offerings for our customers. I look forward to updating you on our progress in future calls. If you look past 2023, I believe KAR has a compelling opportunity to deliver top-line growth and improve bottom-line performance. I believe we can grow consolidated adjusted EBITDA by a compound annual growth rate of 15% to 20% over the next several years. I'm excited and energized by the opportunities that lie ahead for this company. We have a differentiated offering, a diverse and expanding customer base and a large addressable market in which to innovate and invest. With that, we'll end today's call. I look forward to reconnecting in less than 90 days to update you on our first quarter performance. Thank you all very much.

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