OPENLANE, Inc. Q2 FY2023 Earnings Call

Good morning, and welcome to the OPENLANE Second Quarter 2023 Earnings Conference Call. All participants will be in listen-only mode. Please note, today's event is being recorded. I would now like to turn the conference over to Michael Eliason, Treasurer and Vice President of Investor Relations. Please go ahead, sir.

Thanks, Rocco. Good morning and thank you for joining us today for the OPENLANE second quarter 2023 earnings conference call. Today, we'll discuss the financial performance of OPENLANE for the quarter ended June 30th, 2023. After concluding our commentary, we'll take questions from participants. Before Peter kicks off our discussion, I would like to remind you that this conference call contains forward-looking statements within the meaning of the Safe Harbor provision of the Private Securities Litigation Reform Act of 1995. Investors are cautioned that such forward-looking statements involve risks and uncertainties that may affect OPENLANE'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. The reconciliations of the non-GAAP financial measures to the applicable GAAP financial measure can be found in the press release that we issued last night, which is also available in the Investor Relations section of our website. Now, I'd like to turn this call over to OPENLANE 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 OPENLANE. Joining me on today's call is our Chief Financial Officer, Brad Lakhia. I'm going to begin with OPENLANE second quarter performance. As usual, I will speak about our business in two segments: our marketplace segment and finance segment. I'm very pleased with our solid performance in the second quarter, particularly given an industry environment where volumes remain tight. Compared to the second quarter of 2022, we increased volumes in our marketplace and finance segments, growing our consolidated revenue and total gross profit. We reduced SG&A through our cost management efforts and delivered strong growth in adjusted EBITDA compared to one year ago. It was also another strong quarter in terms of cash flow generation by the business. To summarize some of our key results for the second quarter. Volumes in our marketplace business increased to 344,000 units for the quarter, a total gross merchandise value of approximately $6.4 billion. This represented the first year-on-year volume growth since early 2021. Volumes also increased 4% over the first quarter of 2023, making this the first sequential first-quarter to second-quarter volume increase in any year since before the pandemic. We believe that second-quarter volume performance supports our view that volumes have bottomed out and are beginning to grow. We generated approximately $417 million in revenue, a 9% increase versus the second quarter of last year. We delivered revenue growth in both marketplace and finance segments. We generated a total gross profit of about $94 million, an increase of 13% from the second quarter of last year. Gross profit represented 55% of revenue, excluding purchased vehicles. Marketplace gross profit performance was particularly strong, increasing 17% year-on-year and representing almost 44% of revenue excluding purchased vehicles. And we generated adjusted EBITDA of $84 million in the second quarter, $44 million from our marketplace segment and $40 million from our finance segment. It is important to note that the $84 million in adjusted EBITDA included a $20 million one-time benefit associated with the termination of a contractual agreement. Excluding this one-time benefit, consolidated adjusted EBITDA would have been $64 million, and that would have been an increase of 14% versus the second quarter of last year. Excluding the one-time benefit, marketplace adjusted EBITDA would have been $24 million. That's a $19 million improvement compared to the second quarter of last year. So, when viewed together with our first quarter performance this year, marketplace adjusted EBITDA has improved by $45 million in the first six months of 2023 versus the same period last year. That is excluding both the $20 million benefit this quarter and the $11 million one-time charge that was incurred in the first quarter. I am very encouraged that net of those two items, our marketplace business is currently operating at an adjusted EBITDA run rate of approximately $100 million per year despite the industry volume challenges. Given the scalability of our asset-light digital model, I believe that OPENLANE is now very well-positioned to grow our business and build on that positive operational and financial performance. Brad will discuss cash flow generation and capital allocation later in this call, but I do want to highlight the strong cash flow characteristics of our business that were again evident in the second quarter. OPENLANE generated cash flow of $47 million from operating activities in the second quarter. The company has a strong balance sheet, a low leverage ratio and ample liquidity to invest in innovation and growth while still delivering profits and strong cash flows. In addition to achieving these positive financial results, we also made progress advancing a number of our key strategic initiatives during the quarter. Initiatives that I believe will help position OPENLANE for sustained longer term growth. As I've outlined on previous calls, we are highly focused on simplifying our business, making it easier for customers to do business with us and enabling our organization to move faster in terms of innovation and growth. We made significant progress in the second quarter, starting with the successful rebranding of the company to OPENLANE. As we discussed when we announced the brand change, we believe that consolidating our marketplaces under a single brand will improve outcomes for our customers. With all of the buyers, all of the sellers and all of the vehicles all in one place, our marketplace will offer a highly differentiated mix of inventory from off-lease sellers, from off-lease vehicles that are not available on any other digital platform, older higher-mileage vehicles and all types of vehicles in between. I want to thank our team for the creativity and effort they've put into executing a near flawless launch. The response from our customers has been very positive, perhaps even more positive than I had expected. Our employees are rallying around our new brand and our new one-company culture. I'm very excited for the future of this company under the OPENLANE brand. Following our corporate announcement, we successfully launched our OPENLANE-branded marketplace in Canada in late June. We migrated customers from the ADESA and TradeRev marketplaces over a four-week period, and we plan to retire those legacy marketplaces within the coming weeks. We saw strong customer engagement leading up to the launch with thousands of dealers attending our educational webinars. While still early, we've seen sustained levels of buying and selling with some cohorts increasing purchases over their pre-migration volumes. To be clear on what this means, we now have one combined digital marketplace in Canada, where all of our open-sale vehicles from commercial sellers and all of the vehicles offered for sale by dealers are available and where all of our customers can interact and do business with each other. Looking ahead and consistent with the vision that I outlined on the last earnings call, we have finalized our plans to integrate our commercial and dealer open-sale inventory into a single OPENLANE-branded marketplace in the United States, our largest market, during the fourth quarter of this year. We also intend to rebrand our European marketplace before year-end. So, we intend to start 2024 with all of our marketplace platforms operating under a single unified OPENLANE brand and all of our marketplaces having fully integrated commercial and dealer inventory. In addition to providing a better marketplace experience for our customers, consolidating our marketplaces will also allow us to get greater leverage from our engineering resources and accelerate innovation. I'd like to highlight a few examples of innovations that we delivered in the second quarter. We introduced an automated AI-driven negotiation tool that eliminates the need for human intervention to close deals where sellers and buyers are within some threshold percentage on price. Instead of facilitating multiple phone calls between sellers and buyers and our representatives, our system can digitally interact with both parties to help achieve a mutually acceptable outcome more often and more quickly. We believe this technology will lead to higher conversion rates and ultimately, higher levels of customer satisfaction. Over time, it also has the potential to help reduce our cost as well. We also continue to invest in our leading vehicle history and inspection capabilities to ensure that our marketplace remains fast, transparent and efficient. In the second quarter, we further enhanced our inspection process in the United States to provide vehicle-specific guidance to the inspector during the inspection process based on our historical experience with similar makes and models. The enhancement also automatically supplements inspection disclosures on known high-failure-rate items and strategically selects the most risk-prone vehicles for an independent review for posting to the marketplace. The objective here is to continue to increase buyer and seller confidence in the inspections themselves, while also improving our gross margins by lowering arbitration expenses and other direct costs. When we launched our new OPENLANE-branded marketplace in Canada, we also deployed new and enhanced market and pricing insights that will help dealers make more informed buying and selling decisions. We have automated the registration and checkout processes, giving new dealers almost instant access to Canadian inventory and helping buyers take delivery of their vehicles more quickly after they purchased. These enhancements and the pipeline of innovative products and features still to come are all aimed at accelerating growth and advancing our purpose, which is to make wholesale easy so our customers can be more successful. I also want to highlight our continued focus on cost management. Our diligence in this area is positively impacting our gross profit margins by reducing our direct costs. It is also helping reduce our SG&A expenses. In the second quarter, total SG&A declined $13 million or 10% compared to the second quarter of last year. We continue to advance our global shared services model and have expanded the effort to include additional areas across our organization. Additionally, our technology teams recently completed the migration of our remaining technology infrastructure across the organization to a common cloud provider. This was a significant undertaking and was accomplished with zero disruption to our customers. The completion of this migration, coupled with the marketplace consolidations associated with our rebrand, are important catalysts that will enable us to eliminate duplicative systems within our existing technology infrastructure. This will be an important area of focus going forward. Over time, we will continue to make progress towards a single remarketing platform which will increase the efficiency of our technology development and business processes. Doing so will enable us to get greater leverage from our technology investments, reducing the spend required to maintain fragmented legacy technologies while increasing our ability to make focused investments that drive innovation and improve the customer experience. I've always believed that digital models are inherently more scalable, and I believe this is becoming increasingly evident in OPENLANE's current results. As we focus on the items that I've just described and as we grow our volumes, I believe we'll see more evidence of this in the years to come. I'd now like to provide some updates on the macro environment and our perspectives on the remainder of this year and into 2024 and beyond. We believe there is increasing evidence that industry volumes have bottomed out and are now beginning to rebound, particularly as it relates to commercial seller volumes. I believe this is supported by the following factors. First, new vehicle production, new vehicle sales and new vehicle inventory on dealership lots continue to grow. As new vehicle inventory increases on dealership lots, we are starting to see evidence of increased incentive spending by OEMs. This is now once again driving increased volumes of new lease originations. In fact, based on third-party data, lease penetration rates in the second quarter were materially higher than in the second quarter of last year. This is a very positive indicator for our commercial seller volumes. I believe leasing will remain a very important part of the way new vehicles are brought to market in North America. Shifting to used vehicle values, the surprisingly strong run-up in used vehicle prices that we saw in the first quarter has ended, and prices declined during most of the second quarter. I expect continued downward price pressure for the balance of 2023. While downward pressure on used vehicle values can put downward pressure on conversion rates in our markets, I am pleased with the strong conversion rate performance that our marketplace segment demonstrated in the second quarter. I believe it speaks to the resiliency of our asset-light model. While used vehicle values are declining again, the majority of off-lease vehicles still remain in a strong equity position versus their residual values. So, while we did not see any meaningful increase in off-lease volume supply in the second quarter, we do expect that the combination of lower used vehicle values and higher residual values for the cohorts of vehicles that were leased in 2021 and 2022 will cause the equity position to narrow and more off-lease volumes to start to flow over time. I believe that all of these factors point to a steady improvement in total wholesale volumes in 2024 and beyond. Taking all of this into account, I believe that the two primary pieces of our growth equation remain intact. First, we believe that digital channels will continue to gain share and that we are very well positioned to gain more of that additional share over time. Second, I believe there will be a recovery in commercial volume, which, given our existing market share and deep commercial relationships, will result in increased off-lease commercial vehicles in our marketplaces. In terms of our performance outlook for the remainder of this year, in our marketplace segment, I expect OPENLANE's volumes in the second half of 2023 to increase compared to the second half of 2022. This year-on-year volume growth, coupled with the strong unit economics that are currently being demonstrated by our marketplace business, should drive improved financial performance in this segment in the second half of 2023 when compared with the same period last year. In the finance segment, we expect continued strong volumes and revenue. We believe the current market conditions point to a more normalized risk environment, similar to the industry benchmarks that we experienced pre-pandemic. Our second quarter losses at AFC were at the higher end of what we believe to be the normal range of 1.5% to 2% of the portfolio. We believe that this is still the appropriate range for the business as we look to the future. Overall, we expect a solid performance from AFC in the second half of this year, although our full year results would be below last year's record performance. Brad will provide a more detailed update on how these factors impact various aspects of our guidance for the remainder of 2023. As we look beyond 2023, we believe that our strategy and our outlook on the market conditions can support 15% to 20% annual growth in adjusted EBITDA off of our 2023 guidance range for the next several years. While we believe that the majority of this growth will be driven by our marketplace segment, the finance segment will also grow over 2023 levels and will remain a strong contributor to our overall results. In summary, I believe that OPENLANE has a unique and differentiated offering for the market, a compelling business model and a sound strategy for growth. We're a pure-play digital marketplace leader with deep and growing strength in both commercial sellers and in the dealer-to-dealer business. We have access to a large addressable market in North America and in Europe, and we intend to grow our share while unlocking new opportunities in those markets. We have a robust pipeline of innovation that supports our growth strategy. By consolidating platforms, we will get greater leverage from our technology and product investments. We will focus our energy, resources and investments on building the greatest digital marketplace for our customers. We're profitable and deliver strong positive cash flows. This was clearly evident again in the second quarter. We can invest in our business while generating additional cash that can be used to pay down debt, return capital to shareholders and make strategic investments. With that, I will now turn the call over to Brad, who will provide a more in-depth update on our second quarter financial performance. Brad?

Thank you, Peter and good morning everyone. Before I comment on our operating and financial results, I'd like to take a moment to briefly share a couple of reflections based on my first 100 days with OPENLANE. First, I share Peter's optimism for the future. Not only do we have significant opportunities to create and capture value, we have an impressive, dedicated and industry-leading management team. For me, professionally and personally, I feel very fortunate to have assumed my position at a very unique time in the history of the company and our industry. OPENLANE has undergone a tremendous transformation, one that created a highly valuable asset-light digitally focused business model. This, along with the opportunity to work alongside our leading management team, is what attracted me to the organization, and my experience the first few months has only reinforced my confidence that OPENLANE will be well positioned to grow and succeed. Our second quarter and year-to-date results are the best evidence of this reflection. With that, I'll provide more detail on our segment results. Compared to last year, although volumes were relatively flat in the second quarter, marketplace revenues, excluding purchased vehicle sales, increased 5% to $259 million and generated 73% of our consolidated net revenues. Auction fees per year increased 4% driven by select fee increases and marketplace service revenues were up 6%, driven by select fee increases and higher volumes in our repossession and technology-related service businesses. As we've mentioned previously, these service-related businesses provide highly complementary critical solutions to our customers and allow OPENLANE to capture higher share of wallet. Excluding purchased vehicle revenue, the improvement in marketplace revenue resulted in a 17% increase in gross profit or a 250 basis point improvement compared to the second quarter of last year. This also represented a 120 basis point improvement sequentially when compared to the first quarter of this year. Gross profit benefited from improvements in our service-related businesses and our cost savings initiatives. Marketplace adjusted EBITDA for the quarter was $44 million, inclusive of the one-time $20 million benefit related to the early termination of a contractual agreement. Marketplace adjusted EBITDA was $24 million, excluding this item, representing a $19 million increase compared with the second quarter of last year. This was driven by the improvement in revenues and gross profit highlighted earlier, and also a reduction in SG&A, reflecting the successful execution of our cost management initiatives. Looking at the first half of 2023 and when excluding the $20 million one-time benefit this quarter and the $11 million one-time charge in the first quarter, our marketplace adjusted EBITDA was $49 million in the first half, representing an improvement of $45 million compared to the first half of last year. This first half result and the improvement supports the $100 million adjusted EBITDA run rate that Peter highlighted earlier. It also demonstrates the potential benefits related to volume scalability, further structural cost reductions and provides a window into future margin improvements. Turning to our finance segment. Revenues in the quarter were $98 million, a 6% increase over prior year and accounted for approximately 27% of our consolidated net revenues, excluding purchased vehicles. Finance revenues increased despite overall flat loan transaction units compared to last year. Revenue per loan transaction was $243 per unit, an increase of $14 per unit or 6% and was driven by increased fee income and interest rate yields. These increases were partially offset by increased credit losses and a decline in loan values. Finance segment adjusted EBITDA in the quarter was $40 million compared to $51 million last year. This $11 million decrease is more than explained by a $12 million increase in our provision for credit losses. I'd like to emphasize a few things we have noted in prior earnings calls and disclosures. First, our finance business has a very strong service offering, which leverages a high-touch customer relationship model to manage risk while enabling growth. Second, as we move through the remainder of the year and are faced with changing and sometimes volatile used-car fundamentals, we will continue to manage a conservative portfolio. Our provision for credit loss was 2% for the quarter. As mentioned last quarter, this represents a more normalized rate when compared to the favorable fundamentals that enabled a much lower loss rate over the last two years. Long-term, the provision for credit losses is expected to be 2% or lower annually. However, actual losses in any particular period could deviate from this expectation. Turning to SG&A. As Peter mentioned earlier, consolidated SG&A declined $13 million compared to the second quarter of last year, and is largely reflected in our marketplace segment results. Overall, compensation costs and professional fees declined driven by our cost savings initiatives. In addition, non-cash stock compensation expense comprised $9 million of the $13 million decrease. Non-cash stock compensation expense was elevated in the second quarter of last year due to the gain on the sale of the US physical auction business. That said, our first half SG&A is representative of our expectations for our near-term run rate. We also had a number of non-recurring items reflected in income and expense during the quarter. First, as mentioned earlier, we agreed to accelerate the termination of a contractual agreement, which resulted in a cash gain of $20 million. This is included in the company's reported adjusted EBITDA of $84 million and for modeling purposes, please note, in the third quarter of last year, we recognized approximately $5 million of income related to this agreement. Therefore, this will not reoccur in the third quarter of this year or in future years. Second, as a direct result of our OPENLANE rebranding and the implementation of our one-marketplace strategy, we assessed the intangible carrying value of our ADESA tradename. This resulted in a non-cash impairment charge of $26 million before tax in the quarter. In addition, this tradename now has a defined life which will result in approximately $16 million of additional annual amortization expense over the next six years and will begin in the second half of this year. Finally, consistent with our second quarter annual requirement, we formally evaluated our reporting units to test the carrying value of our goodwill. This evaluation resulted in a non-cash charge of $225 million before tax and was primarily driven by lower estimated fair value of our U.S. dealer-to-dealer reporting unit. The combined tradename and goodwill impairment charges generated a net tax benefit of $29 million, which included a $30 million tax valuation allowance. Therefore, the after-tax related charge, inclusive of the tradename and goodwill impairment charge, was approximately $221 million in the quarter. The net impact of the tradename and goodwill impairments are excluded from our adjusted EBITDA and our operating adjusted net income per share. Turning to the balance sheet and capital allocation. First, I would like to highlight our strong cash flow. Cash flows from operating activities in the quarter were $47 million and stand at $143 million year-to-date. This level of cash generation validates the fact that our asset-light digitally focused strategy and business model are delivering meaningful results. In addition, during the quarter, we repaid $140 million in senior notes and executed a new $325 million revolving credit agreement that will now mature in 2028. Our operating cash flow performance, our debt repayment and our revolver maturity extension, when taken together, notably improved our overall liquidity position and further strengthened our balance sheet. This is evidenced by a first half net reduction of approximately $118 million and a meaningful improvement in our consolidated net leverage ratio, which now stands below one times adjusted EBITDA. Continued improvement in our marketplace business, coupled with the strengthened capital structure, provides enhanced flexibility to fund our organic growth plan and improves our ability to deliver shareholder returns. As highlighted in our disclosures, we have $127 million remaining on our share repurchase authorization. I'll wrap up by addressing a few annual guidance items. We're confirming our previously stated adjusted EBITDA guidance of $250 million to $270 million and believe we are trending to the upper end of that range. We have lowered our estimated 2023 capital expenditures from $65 million to $60 million and, consistent with recent performance and when normalizing for seasonal changes to working capital, we expect to continue to generate positive cash flow from operations over time. Finally, we are increasing our per share operating adjusted net income to a range of $0.60 to $0.70 per share and this compares to a range of $0.37 to $0.47 provided earlier this year. With that, I'll turn the call back over to our operator for questions.

Thank you. We will now begin the question-and-answer session.

Great. Good morning and thanks for taking the question. First, related to the marketplace business: if you look at the second quarter trajectory relative to the first quarter, volumes were up sequentially roughly 5%. But adjusted EBITDA, excluding the one-time items, was flat to down slightly. How should we think about that cadence? With volumes expected to recover here in the second half and into 2024, what sort of rule of thumb should we apply in terms of incremental EBITDA per unit as those volumes recover? Any clarity on the second quarter versus the first quarter would be helpful for modeling the EBITDA going forward. I have a follow-up after that.

Thanks, Rajat. I'm certainly pleased with the performance of the marketplace business over the entire first half of the year: $45 million EBITDA improvement versus the same period last year, and approximately $25 million adjusted EBITDA in both quarters. One of the things your question gets to is the scalability of this model. That improvement was delivered with, I would say, flattish volumes relative to prior years, so it's really a focus on how we optimize the gross profit structure, direct costs, SG&A, etc. Digital business models are inherently more scalable. These businesses are extraordinarily scalable, and I'm seeing that in our results. One difference between the first and second quarters is conversion rates were, in general, lower in the second quarter. That's not unusual; the spring market tends to have the strongest conversion rates in the first quarter. High conversion rates also translate into higher gross profits and overall improvement in results. Notwithstanding that, I think the second-quarter results are very strong and give me increased confidence in the scalability of this model. Some of the cost savings will not be fully realized until 2024. For example, the cloud migration of our remaining infrastructure to a common cloud provider actually cost us additional money in the first half of the year because we were maintaining infrastructure in the old environment while executing the migration with contractors and employees. Now that that's done, those costs can be reduced. That's just one example among several. So, I am confident that in the quarters and years to come, this business will demonstrate excellent scalability. Digital business models operate on a more fixed-cost basis and the marginal cost per incremental car sold is relatively small, though it varies depending on whether it's a dealer car or commercial car.

Got it. That's helpful color. As a follow-up, on the ARPU trajectory going forward, particularly as used car prices start to move lower in the second half, how should we think about auction ARPU? Any way to model that while layering in the commercial mix coming in as well? Do you think the industry can still drive fee increases year over year to offset some of the headline decline in used car prices?

Some fraction of ARPU is tied to vehicle values because buy fees are often stepped in value bands. If used vehicle prices decline, there could be downward pressure on that component. Sell-side fees are more fixed and less dependent upon vehicle value. We've seen competitors increase their prices in this industry, so we have room to do so if needed, though we're being cautious. We've optimized pricing in various parts of the business over the last 12 months and that's been reflected in the numbers. Fees should increase at a minimum at the rate of inflation. There is a mix component: if off-lease volumes return in greater numbers and sell in the upstream channel, those have a lower ARPU but generally a higher gross profit percentage than other transaction types in our marketplaces.

On a gross profit per unit perspective, should we expect any meaningful change with that mix shift, or do you think that remains consistent as the lease mix comes in?

I've been pleased with how that metric has trended. We've done a good job of gross profit per unit. We also generate gross profits that are not directly tied to transaction volumes, so as transaction volumes increase, not all components will increase at the same rate. The metric I focus on more candidly is gross profit as a percent of net revenue in the marketplace, which helps insulate against mix shifts. From a management perspective, we aim to optimize and maximize gross profit as a percent of net revenue; that's the key KPI I look at each month, and we've been doing a good job with it.

Got it.

Today's next question comes from John Murphy with Bank of America. Please go ahead.

Good morning. Peter, you mentioned the migration of customers to a single platform and you were doing some training. Can you talk about that process a bit more? Is there any leakage as you're transitioning to the single platform, or are you potentially making gains of new customers as you consolidate?

I was speaking specifically to our Canadian migration and the launch of OPENLANE Canada, which happened at the very end of the quarter. It was the last two weeks of June, but there was a lot of planning and execution work earlier in the quarter. It went really well. We delivered a marketplace with new features and functionality, so we put a lot of effort into training, webinars and other activities to help customers understand the new site. We migrated customers in cohorts, starting with TradeRev dealers because they were likely more digitally adept, then focused on migrating ADESA customers. There was no measurable leakage. Canadian results remain strong and customers are benefiting from having all vehicles in one place. Some dealers who weren't TradeRev buyers are now looking at those cars and purchasing them, which is positive for market position. Our U.S. plan is different: it's largely a rebranding of the backlog cars marketplace to an OPENLANE brand and integration of commercial inventory into that marketplace. That de-risks the U.S. migration because the thousands of dealers logging in every day will see little change in feature functionality—mainly the logo and color palette will change—but they will gain access to an increasing volume of off-lease vehicles. That should be completed by the end of the fourth quarter, and we have a plan in place to execute that carefully.

You expect volumes are bottoming out and recovering in 2024 and beyond. What are the key channels you expect to recover? Repo is recovering now. Is there a tape delay on lease returns and dealer lease returns? How do you see the progression of bottoming and recovery by segment?

Specifically, I feel confident that volumes in the second half of this year will be higher than the second half of last year. Looking to 2024 and 2025, we expect further volume growth, perhaps accelerating into 2025 and 2026. Segment by segment: dealer volumes benefit as dealers have more cars on their lots and are more likely to put cars into wholesale than they were a year ago. We're seeing growth in the volume being posted by dealers and cars posted per dealer starting to increase meaningfully in the second quarter. The dealer-to-dealer segment was never as badly impacted as some others, but it's trending positively. Repo volumes have been up and our business services in the repo segment benefit us, although most repo sales still occur in a physical model. We're seeing more rental sellers and other changes over time. Regarding lease returns: we didn't see an increase in lease returns in the second quarter. Some of our customers' models show lease volumes increasing later this year and into next year, but importantly, we're seeing an increase in lease originations, which is positive for future off-lease supply. Lease originations increasing is a positive indicator for the retail environment and supports the view that leasing will remain important.

About the $20 million early termination payment, can you tell us exactly what that's for? Is it one-time, or should it be spread over periods?

It's a one-time early termination of a contract associated with a 2019 transaction. Over the past number of years, that contract generated about $5 million a year, paid in the third quarter. That contract would have continued through roughly the third quarter of next year. So, effectively, we traded a $20 million one-time payment for two roughly $5 million payments—one this third quarter and one in the third quarter of next year. It was done by mutual agreement and both parties are satisfied with the outcome. For modeling purposes, treat it as a one-time item.

Our next question comes from Bob Labick with CJS Securities. Please go ahead.

Good morning and thanks for the comprehensive answers. Given the weak industry volumes, how are you going to gauge success of the platform consolidation? Are there new metrics you can share—traffic on the new site—or how are you internally gauging success of platform consolidation, given we're at the bottom of a cycle?

Good question. One of the advantages of a digital business is the wealth of data available. The five metrics I look at most in the marketplace are: volume sold, volume posted, conversion rate, participating sellers, participating buyers, and retention rates of the customer base. Those metrics feed into volume sold, which drives revenue, but the others are important inputs. I'm pleased with what we're seeing: increased customer participation, increased vehicles posted per selling dealer, conversion rates that have been quite resilient despite Q2 price pressure, and strong retention rates. These marketplaces build a habit—customers return regularly—so these fundamentals give me confidence in the consolidation strategy.

In the auction fee discussion there was mention of a slight increase in auction fees from a smaller mix of lower-fee commercial off-premise vehicles. Can you give a sense of what drives that and how that trend may change over the next several quarters?

I'm looking forward to an improvement in off-lease maturity volume. Over the last couple of years, we had a substantial reduction in cars flowing into the funnel, and the transaction mix migrated upstream toward dealer-to-dealer transactions, which are lower revenue per transaction. That combination created revenue compression. I expect both factors to unwind over time: volumes should increase and mix should shift back toward higher ARPU transactions. We started to see some positive mix movement in Q1 as used vehicle prices appreciated, and although Q2 saw price declines, in the last month or two we've started to see a modest mix improvement again. It wasn't material in Q2, but the trend is encouraging and should help ARPU as upstream channel supply increases.

Super. Thanks very much.

Our next question comes from Bret Jordan with Jefferies. Please go ahead.

Good morning. Looking two to three years out, how do you see lease returns? Leasing probably troughed in the second quarter of 2020 when dealerships were closed. How do you see annual lease return cadence in 2024 and 2025? When is the cyclical growth year?

If you look at lease originations, the lease origination percentage declined from 2020 to 2022, which means fewer off-lease vehicles are in the portfolio. A rule of thumb is three-year maturity. Vehicles leased in 2022 would mature in 2025, which is the top of that funnel. I expect that number to reduce into 2025 and then increase post-2025. The other important factor is the percentage of leases actually returned, which depends on vehicle equity. Over the last 18 months, off-lease vehicles were in strong equity positions and consumers tended to keep their cars. Over the next two years we'll see two forces: fewer off-lease vehicles at the top of the funnel, but a higher percentage of that inventory being returned as equity positions narrow. I expect a modest increase in lease volumes in the next two years, with a more favorable mix and accelerating volume and mix improvements toward the end of 2025 and beyond. Long-term, I believe leasing will be an important part of the market, and I expect leased units to be in the 3 million to 4 million units a year range with high consumer return rates, which will be good for our off-lease business.

A quick question about the goodwill/tradename impairment: you noted lower long-term revenue growth associated with the cycle. Is the size of that market different than you were projecting back in 2019, or is it really the lack of dealer consignment cars that's impacting that longer-term view?

I don't think the size of the long-term market is different. In the past, industry data sources put dealer-to-dealer at the low end around 6 million units, not counting informal dealer-to-dealer transactions, with high-end estimates above 10 million units. It's a large segment and a big opportunity for us. We're on the right side of a physical-to-digital secular shift, which is positive long-term. Our improved EBITDA performance in the first half was driven in part by the digital D2D model; we had our best ever financial performance from that segment in the second quarter with strong customer adoption, more volumes posted and strong conversion rates. The goodwill adjustment is technical and accounting-driven and does not change my view of the long-term opportunity in this space.

Okay, great. Thank you.

Our final question comes from Daniel Imbro with Stephens. Please go ahead.

Thanks. Brad, on the SG&A side: marketplace SG&A has been pretty consistent in the low 30% range. As volumes come back, would you expect to add back expenses to handle that volume? Peter said it's scalable—should we expect further SG&A leverage into the high 20s? How would you think about marketplace SG&A margin going forward?

Thanks for the question. The marketplace business is very scalable with a largely fixed-cost structure. Incremental SG&A dollars needed to support incremental volume are fairly modest. So, as volumes increase, we would expect to see leverage in SG&A rather than a proportional increase in SG&A dollars.

Got it. Quick follow-up on AFC: last few quarters loan originations outpaced marketplace volume growth, but this quarter they were closer to parity. How do you feel about the loan origination outlook for AFC? Any change in the health of your core independent used auto dealer customers? And how do you feel about the 2% charge-offs going forward with more used price pressure or pressure on independent used dealers?

Independent dealers are an important part of the retail ecosystem and will be in business for the foreseeable future. They provide a unique offering and there's strong demand for that. In the first and second quarters, AFC's loan loss ratio was at the higher end of our 1.5% to 2% range. Given that, we've focused on managing risk and running a more conservative portfolio. Signing up new customers and generating new loans remain important, but it's a balancing act. We believe we have a good handle on the risk environment and expect solid performance from AFC. With hindsight, AFC benefited from historically low loss ratios in prior years that we should not expect to recur. We expect to continue growing the AFC business, but most of the growth for the company going forward is expected to come from the marketplace side. AFC will remain a contributor, but we are taking a conservative view on the market and focusing on the right portfolio.

Great. Appreciate the color.

This concludes our question-and-answer session. I'll turn the conference back over to the management team for any final remarks.

Thank you. To the participants, thank you for your time today and for your questions. Before we close, I'd like to leave you with a few takeaways from the quarter. I believe our second-quarter results demonstrate a significant improvement in the business and provide increased confidence in our digital asset-light model as we look to the future. Our company has strong cash flow characteristics, improved liquidity, and increased flexibility in terms of capital deployment. I believe our one-brand, one-marketplace strategy will increase our differentiation in the marketplace and will enable us to continue to increase efficiency and reduce costs. Finally, the macro factors I see point to an improving outlook for commercial off-lease volumes. I believe the headwinds of the last two years look set to become tailwinds in the years to come. Thank you all for joining today's call. I look forward to updating you on our progress on our next call three months from now. Thank you very much.

Thank you. This concludes today's conference call. We thank you all for attending today's presentation. You may now disconnect your lines and have a wonderful day.