KAR Auction Services, Inc.
Q2 2022 Earnings Call Transcript

Published: 3 Aug 2022

[Operator:]

Good morning, and welcome to the Q2 FY2022 Earnings Conference Call of KAR Auction Services, Inc. All participants will be in listen-only mode. [Operator Instructions]. After today's presentation, there will be an opportunity to ask questions. [Operator Instructions]. Please note this event is being recorded. I would now like to turn the conference over to Mr. Mike Eliason. Thank you. And over to you, sir.

[Mike Eliason:]

[Technical Difficulty] and uncertainties that may affect KAR's business, prospects, and results of operations. And such risks are fully detailed in our SEC filings. In providing forward-looking statements, the company expressly disclaims any obligation to update these statements. Let me also mention that throughout this conference call, we will be referencing both GAAP and non-GAAP financial measures. Reconciliations of the non-GAAP financial measures to the applicable GAAP financial measure can be found in the press release that we issued yesterday, which is also available in the Investor Relations section of our website. Now, I'd like to turn this call over to KAR Global CEO, Peter Kelly. Peter?

[Peter Kelly:]

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 will provide you with additional information and detail in three areas

[Eric Loughmiller:]

Thank you, Peter. I want to spend most of my time talking about our actions around managing capital, separating KAR's continuing operations from the recently discontinued operations, and provide a viewpoint on where opportunities exist to improve our cost structure going forward. I believe our financial results that were released last night do not need a lot of additional commentary. Let me start by pointing out information we are providing this quarter to assist with the analysis of our business. First, we have provided the annual results of continuing operations for 2020. It is extremely complex and costly to restate the individual quarters for 2020, so we will not be providing quarterly information for that year. We have provided the quarterly results for each quarter of 2021 in our earnings materials. This will allow you to make comparisons of our results for the remainder of the year for our continuing operations. We have updated our datasheet for the marketplace business to present key metrics for the continuing operations of KAR Global. There were no changes to the previously reported metrics for the finance segment datasheet. We also have provided line items in our segment reporting for the finance business that separate fee revenue and interest revenue. We believe this additional disclosure will allow the analysis of changes in revenue as interest rates are increasing. We have provided this additional information in our data schedule for the finance segment for all previous quarters. Now, I would like to cover more specifics on our capital transactions following the close of the sale of the U.S. physical auction business on May 9. We received $2.186 billion in cash at closing. We have $14 million of expected proceeds that will be received after receiving consent for two remaining property leases. As part of the transaction, we transferred approximately $70 million of cash to the U.S. physical auction business to provide adequate working capital for the business to continue operating. As required by the purchase agreement, we have reconciled working capital as of the close date and $13.9 million of this cash has been remitted back to KAR following our quarter end. We have paid approximately $40 million in fees and expenses directly related to the transaction and expect cash income taxes of approximately $430 million to be paid with our 2022 federal and state income tax returns. We have already remitted approximately half of these taxes prior to June 30, 2022, and expect the remainder to be remitted in the second half of the year. We are required to use a portion of the net proceeds of the transaction to repay the senior notes due 2025. We have 365 days from the date of the close of the transaction to redeem the senior notes. Yesterday, we announced a tender offer to redeem up to $600 million of senior notes at a redemption price of 100.75. This offer to redeem the senior notes earlier than the date required will be completed in the month of August. The detailed terms of the tender offer are included in a press release issued by the company yesterday. We have sufficient available cash to fund the redemption later this month. Upon completion of the tender offer, we will reduce our available cash balance by approximately $600 million. Included in income from discontinued operations is the gain from the sale transaction of approximately $534 million before taxes. The reason for this significant difference from the net proceeds from the sale of the U.S. physical auction business and what the book gain is, is because we were able to allocate significant goodwill and other assets to the discontinued business that reduces that book gain. The assets that reduce the book gain generally relate to the purchase accounting for the LBO transaction in 2007, when KAR Global was formed. Another item in our financial statements that needs some explanation is the increase in total SG&A in the second quarter as compared to the prior year. The items accounting for the increase are $10.3 million in non-cash stock-based compensation, $4 million in SG&A for CARWAVE, an acquisition that occurred after the second quarter of 2021, and $1.4 million in non-recurring severance as we exited headcount following the close of the sale of the U.S. physical auction business. One last housekeeping item that I would like to address is the dividend on the convertible preferred stock. Today, this dividend has been paid in kind as required by terms of the preferred stock. The requirement to pay this dividend in kind was for the first eight quarters following the investment. The third quarter of 2022, this dividend will be paid in cash. All future preferred dividends may be paid in cash, stock or any combination of the two at the discretion of the company. Now, let me comment on some of the ongoing transition activities for separating the U.S. physical auction business from the continuing operations of KAR Global. We have a significant number of contracts that are in the name of KAR Global that provide services to both the discontinued and continuing operations of KAR. We are working urgently with the parties to these contracts, to separate certain of these agreements and allow each entity to go-forward independently. This is proving to be time consuming and we are prioritizing the most significant contracts. Until we are able to separate the contracts, KAR Global remains the party to the contract and is required to provide the benefits of the arrangements to the discontinued operations. As we separate the parties to these contracts, we continue to look for opportunities to reduce the cost incurred by KAR with many of these vendors. Another area we are addressing is our corporate office space. Following the transaction, we have determined that we can reduce our corporate office footprint in several locations, including our corporate headquarters. We are currently looking for an appropriate sublet opportunity for each of our corporate locations where we no longer need the existing space. We have early interest in our Carmel, Indiana and Toronto offices that would provide a significant reduction in our current cost structure going forward. At this time, we are looking for opportunities to be more efficient in our cost structure without impacting our core businesses. In summary, we are moving with a sense of urgency to address as many areas of cost as we can. With inflation, increasing interest rates, deteriorating consumer confidence, and uncertainty around retail demand for used vehicles in the near-term, it is important to run our business for the circumstances of today. We have taken the opportunity to eliminate substantially all of our debt, reducing future cash interest payments by approximately $75 million per year once we complete the redemption of the senior notes. We are streamlining our SG&A to have a lower fixed cost structure as we move forward with an asset-light digital marketplace business model. And as Peter mentioned, we are using this unique opportunity to reposition KAR Global with our longtime customers who have acknowledged that the business of KAR Global has evolved. Things are very uncertain for a lot of businesses, and we are not immune from this type of uncertainty. The good news is the cash generated characteristics of our business remains strong and could in fact be improved following the sale of the U.S. physical auction business. And I know for sure, we have reduced the cash interest payments for KAR and will continue to significantly reduce future interest obligations as we repay additional debt. And last, we believe, we have sufficient capital to invest in the organic growth of our digital marketplaces. Our customers are excited about the opportunity we have described for them, and this is an exciting time for KAR Global to accelerate the pace of transformation of the wholesale used car industry. That concludes my remarks. And so I'll turn it back to Jacob and we will now take your questions.

[Peter Kelly:]

Jacob, you can open the line for questions.

[Operator:]

Thank you. We will now begin the question-and-answer session. [Operator Instructions]. The first question comes from John Murphy with Bank of America. Please go ahead.

[John Murphy:]

Good morning, guys, and thanks for all the restatements and info here. I had two questions. First, Peter, as you look at what's going on right now, you alluded to the market being sort of in a disequilibrium at the moment then we certainly would agree and there's a huge issue on the supply side that may not get worked out for another year or two to somewhat normal levels. As you're transitioning the business amidst sort of this mayhem it's really kind of toughly to gauge your progress in how successful you're being in transitioning the business to pure digital or almost pure digital ex-Canada. I mean, what are the key metrics that you're looking at and how are you thinking about understanding progress on KPIs or which direction you should drive into? I mean, there's just a -- there's a lot of moving pieces here, so it's a very difficult time to manage your business. So just curious how you're thinking about KPIs and how to -- how to manage the volatility in the near term?

[Peter Kelly:]

Yes. Thank you, John, good question. You're right first of all it is a time of a lot -- continues to be a time for a lot of change. I do feel that's, as I mentioned, I think the supply side issues have, kind of, bottomed out, that doesn't mean I expect the recovery in Q3, but I think I'm starting to see a little light at the end of the tunnel, which I do feel encouraged about. But you're right; we have, with the transition of the business, an opportunity to think about our KPIs. Obviously, at a high-level we focus on total volume sold, revenue generated, some of the metrics we talked about here, gross profit as a percentage of revenues are sold, et cetera. When we look a little deeper, obviously, conversion rate is an important metric in the health of any marketplace. And our conversion rates differ by marketplaces. OPENLANE is perhaps our highest converting marketplace certainly right now and given the very great, scarcity of all these vehicles. But conversion rate is a important metric. Customer participation, both on the sale and buy side. Are we growing our customer base, customer levels of participation, et cetera, are important metrics around the health of the business. So we certainly measure and focus on that. And then, obviously, we measure the progress against our initiatives. As I spoke about on this call and another call, we're focused on consolidating platforms. We're focused on migrating to fewer sort of technology stabs -- stacks to addressing our cost structure. So progress on all those metrics is something we're very focused on as well. And I think while it's not perhaps yet fully apparent in our metrics, I think a lot of these, the work we've done around the cost structure that I think will become more apparent here in coming quarters, the work around the consolidation and creating -- ultimately creating greater efficiency in system, I think will be very, very powerful for us as volume starts to recover because again, you know this business, like most businesses has a scale effect. I think the scale effect is even more magnified in a digital model than in a physical or a hybrid model. So I'm very encouraged that the work we're doing and the metrics I'm seeing and the progress we're making is going to really be very, very positive for us as we start to see volumes increase. Now, obviously, we're going to have to prove that out. We recognize that, but ultimately we're trying to lay a foundation to future success.

[John Murphy:]

That's helpful. And then just a second question on pricing. It sounds like you're adjusting from right now or June to August pricing or through September for all your customers. I'm just curious what the receptivity is to this and what you mean? I mean, is it just simply higher auction fees or --I mean how are you going about this? And it sounds like you're not having any real pushback the way you talked about it, so just trying to understand that that's pretty unique?

[Peter Kelly:]

Well, a couple of things. In late Q1 actually we increased some pricing in our dealer-to-dealer marketplace, so I think we're seeing some of the impacts on that in Q2 results. I mentioned how the volumes were relatively flat, actually slightly down versus Q1, the financial metrics were somewhat improved. So I think we see that showing up there and that will have the benefit of that over the rest of the year. As it -- I referenced in more depth in this call was more on the commercial side of our business. And what I'd say, John, is, and it's actually less related to auction fees if you want to call them that, buy fees and sell fees, it's more related to the services we're providing around inspection, in some cases logistics and other types of services for our commercial sellers. And frankly, as you can imagine, we've had a situation here over the last 12 months where our volumes, in some cases have been down like 90% in certain areas of these services. But it has not been possible to take our cost down to that degree, but we need to continue to provide service on a national basis, and we've addressed the costs where we can. So I think what we've really tried to do is for those services speak to our customers about just the current reality around volumes and how the unit economics don't support these very, very low volumes. And the customers have been very understanding of that. And essentially, what we've put in place are instead of a sort of a fixed price structure at all levels of volume we've kind of converted to a tiered price structure, which has higher pricing at current volumes. And then as volumes increase over time, returns generally towards the pre-existing price if volumes get all the way back. So if you can imagine that type of a scenario, they've been very supportive. I take from that, that they value us as a business partner. They value the services we provide and they completely understand the volume picture that affects their business in ours. So I'm encouraged by that. And these are -- so I would say John, these are meaningful changes at current volumes. What I'm actually perhaps even more encouraged about is that that volumes sort of increase the impact of these changes may actually be more meaningful as volumes start to trend back up towards normal. And as you mentioned, that's probably going to take time. So we may get that benefit over a considerable period of time.

[John Murphy:]

Yes. No, it seems like from a revenue side and a cost side, you're setting up well as volumes recover, there'll be a lot of a tremendous amount of operating leverage. So it seems like you're doing all the right stuff. So we appreciate it. Thank you so much, guys.

[Peter Kelly:]

Thank you, John.

[Operator:]

Thank you. The next question is from the line of Bob Labick with CJS Securities. Please go ahead.

[Bob Labick:]

I wanted to start with conversion rate. You gave us some interesting statistics on that and I'm assuming the lower conversion rate relates to the softening of used car prices. And it's kind of seen more broadly than just you guys. And that could last a while if prices continue to soften. So my question is a) is that right? And b) what are you doing to encourage the selling dealers kind of to lower their limit price or to get more in line with reality? And how data driven is this decision on that limit price and how long does it take to normalize to get back to regular conversion rates?

[Peter Kelly:]

Bob, thank you. Good question. So first, if I can comment on just the metrics themselves and then what are we doing about it. So first, I'd say the decline in conversion rate, if you think about it, so relative to a year ago. There are two factors. One factor is just a straight mix shift. The percentage of vehicles sold from commercial sellers a year ago was higher relative to Q2 of this year. And again, as I mentioned, the conversion rates on like for example, the OPENLANE platform are our highest of our marketplaces right now. So just a straight mix shift, less OPENLANE, more dealer-to-dealer in relative terms will tend to reduce conversion rates. So there's that impact, which is not a market factor. It's just -- it's more of a mix factor. And then I -- and I'd say that has had some impact, but I'd say most of the impact we've seen has been more the market factor of the relative seller and buyer sentiment. And again, if I was to contrast it with Q2 of a year ago, I'd say Q2 a year ago was unusually strong because if you recall, we were in a sort of an environment where prices were running up. Demand was very strong and buyer appetite was sort of higher was increasing every month, right? And we've kind of had the opposite set of facts here over the last three months or so. Where sellers are kind of holding on for high prices and buyers are sort of recognizing that’s the consumer demand is weakening and for that reason their appetite are weakening. So that's a set of facts. I think you are correct that if we're anticipating an extended period of steadily declining prices, conversion rate could remain under pressure. None of us can predict precisely, right? But I think that's one of our reasons for being cautious in terms of our revising our guidance, if these are conversion rates persist then that that will show up in our numbers. So what are we doing about it? Obviously, trying to get sellers and buyers aligned on what the true value of the vehicle is a key-key factor. And we can candidly, Bob, we don't have perfect control over that, but we do have some ability to influence that through data, offering the seller, typically it's a seller, a guide on the fact that these offers that they have, or these bids that they have are strong in the large market in our opinion. We've also launched some technologies around in certain of our marketplaces requiring the seller to put a definitive price on the vehicle before it's launched. So in TradeRev in Canada, for example, sellers can launch vehicles with no floor price, if they want and see how the market performs. And what we find is those cars typically convert at less -- at a lower rate. So we're trying to get more of our sellers to have to put a floor pricing. We're also frankly limiting the number of reruns that they can run the same VIN through the marketplace because if they run the vehicle two or three times then we believe they've got the benefit of what the current market sentiment is and running a fourth or fifth time isn't of great value. So these are things we're looking at, but I'd say those impacted sort of on the margin, the principle driver of it is, is the market. I was encouraged by a number of factors, Bob, just to say, we haven't seen any worsening of the conversion rate in July relative to June, so that's encouraging. And I did see a market report actually yesterday from Black Book that said, by their metrics sellers are finally starting to respond and lower the prices and there was a significant, sort of, down, step in used vehicle prices last week by sellers to, sort of, release more vehicles and get higher conversion. So I think ultimately buyers and sellers learn pretty quickly. And these phenomena tend to be temporary because ultimately the cars have to sell. And it's in everybody's interest to have to move through the marketplace very quickly.

[Bob Labick:]

Okay, great. That's super helpful color on that. Very much appreciated. And then just one other and I'll get back in queue. Obviously the shift to digital began before COVID was accelerated by need during COVID. Given the lack of I guess public physical options out there right now, my question is, how is it settling out since we can't really see these volumes? Has there been a partial switch back to physical just by virtue of everything opening up or where are we on what we all believe to be this long journey towards digital? And how are -- how's the share going and where is volume right now?

[Peter Kelly:]

Yes. Good question. Again, I don't have perfect data, but I do have some data. I think we're still on that journey. Maybe the rate -- the pace of that journey may have moderated a little bit, but through our analysis of some data that's available to us, I believe that there are consigned volumes at physical auctions also declined in the second quarter. And I think on a year-to-date basis have -- I still see evidence of a share shift, sort of, away from physical and towards digital generally in the industry, but the data sources are imperfect. There's other companies that you have to report, so we'll have to see what the totality of that data looks like. But I think that that shift continues, albeit the pace of the shift has moderated a little.

[Operator:]

Thank you. The next question is from the line of Bret Jordan with Jefferies. Please go ahead.

[Bret Jordan:]

On the pricing initiatives, sort of, offset in the lower volumes what are you seeing sort of in the competitive landscape? Are peers basically following the same trend just given their volumes are down as well? I think you commented that you had slightly lower volumes and Q2 from Q1. Is that a competitive issue or just a market issue?

[Peter Kelly:]

I think the volume issue is a market issue, Bret, is my assessment, again, based on just seeing the volumes, physical were down. I don't have all the competitive data, but I think there's no question that volumes have just been under pressure industry-wide will be my assessment. On the pricing, I mentioned the digital dealer-to-dealer channels we do benchmark our pricing versus competition. We think we're well-positioned there. I think we're competitive. Maybe slightly, very comparable, maybe slightly less on some prices than others, so I feel good about our pricing structure there. And then in terms of what I spoke about on the commercial side of the business, I don't have perfect visibility, but I know the volume challenges aren't unique to us. So I wouldn't be surprised if others are having similar discussions with customers, but I can't comment from a position of knowledge.

[Bret Jordan:]

Okay, great. And then, obviously, big success with AFC. When you look at the conversion and the other issues you faced this year in the second half, and relative to your guide, in the $245 million to $265 million, what do you see that the credit contribution of that versus the auction operations contribution?

[Peter Kelly:]

Well, obviously, AFC has been a significant contributor to the overall profit performance in the business here over the last period of time. And we expect continued strong performance from AFC. But we also expect that, and this is I guess similar to the messages on the Investor Day, we expect over time the Marketplace segment to drive the majority of the growth as we look to the future. But I guess, we very encouraged by the performance of AFC. We continue -- we expect to see continued strong performance. We -- the environment's changing a little bit. Interest rates are going up that actually has some benefits to AFC. The risk environment may be -- we need to just stay focused on that. We've had a very low risk experience over the last period of time. But AFC is a strong business and will continue to be a strong contributor we believe.

[Operator:]

Thank you. The next question is from the line of Daniel Imbro with Stephens. Please go ahead.

[Daniel Imbro:]

Hopped on late, so apologies if you discussed this, but I wanted to start on the SG&A side. When we look at 2Q, Eric, I appreciate the color on kind of the non-cash in the CARWAVE numbers, but one, were that non-cash number is $10.3 million, is that one-time or is that going to continue is that part of the run rate cost basis here? And then I think at the Analyst Day, you guys talked about $30 million of run rate cost savings that you were targeting this year. How many of those were captured in the second quarter? And how many of those are still on the sum?

[Eric Loughmiller:]

Daniel, let me take the first part of that question. The $10.3 million in stock-based compensation is a catch-up, as a result of the gain on the sale transaction, our long-term incentive plan, which is tied to PR issues. Had operating adjusted EPS cumulative get to a point where we have to -- we are accruing a cost. It had been below threshold for the ninth -- for the 2020 grant year and the 2021 grant year. And we're now accruing as our gain has reflected in our EPS. Relative to the other things, as the business has transformed, it's very difficult to see, even for me as to what's the impact of the -- we have made a number of actions that reduce our costs, but at the same time, we've had a transition of a major part of our business where there's costs that's temporarily associated with the activity of breaking things apart. So I don't think it's shown up yet in the cost structure. And as I look forward, I think and Peter mentioned this, you'll see it in the second half of the year, Daniel. Peter, why -- Peter and I have been talking about this, I'll let Peter analyze, how do we look at the $30 million? How do we plan to see evidence of that?

[Peter Kelly:]

Yes.

[Eric Loughmiller:]

As we go into this year, where we were and where we think we'll end the year. Peter, why don't you share that with him.

[Peter Kelly:]

Yes. I'll comment as well here, but generally to agree with Eric's comments. I don't think it's shown up yet. And frankly, we had a sort of a cost agenda taking shape, but then we entered a negotiation around this transaction and I felt it was -- it would -- we had to sort of get through the transaction because that was going to dictate the shape of cost actions that we could take. We couldn't -- didn't want to take cost actions within the business we were selling. And I also felt we need that transaction to be closed before we could fully address our own operations. So in reality, most of this work sort of started after the deal closed. So mid-May and onwards and these actions have continued since then and will continue. So I expect them to be more visible in the second half. I guess what I'd say is I'm expecting us to end the year with an SG&A run rate, something around $400 million give or take, I don't want to give a precise number, but I think something around that and that, that will be obviously down on what we've seen certainly in a number of a prior quarters. So that's -- that's my expectation and we are very focused on that work.

[Daniel Imbro:]

All right. Thank you guys for that color. And then, Peter, I wanted to ask one of the integration of CARWAVE, began at the Analyst Day, sounded like you were making progress, kind of curious how the integration is going. And I know volume is pressured on the dealer-to-dealer side right now, but have the price increases allowed that portion of the business to remain EBITDA positive in this environment or had anything changed in your outlook there? I think when you bought CARWAVE, you had said that business was now profitable, but things are changing there, just wanted any update there.

[Peter Kelly:]

Yes. Thanks. Thanks, Daniel. The first of all -- well, first of all, CARWAVE has continued to be profitable. So that is -- that is positive. You're right, volumes in the channel, in B2B, generally has been under pressure and that should correlate, as well, but the business continues to be profitable. And the integration plan is progressing well. We felt -- we thought it was important given the power of the CARWAVE platform and the feedback from customers; we wanted to replicate that experience within the BacklotCars market, another part of building out new technology and functionality within the system. So there's been a lot of focus on that. That is now -- that now exists. It's still in a, I call it, an advance beta, but we held our first sale in the month of July. We migrated cars over, we brought over some buyers and sellers and we have an auction to pressure test the system to get customer feedback and so forth. So again, that was positive, that was a key milestone along the way. And I'd say, we're now in the latter stages of that migration and certainly we expect to complete it this year. So I feel good about that. I feel good about getting to one marketplace, getting all our sellers and buyers into one digital venue, leveraging the network effect, so on and so forth. So we're well on track and feel good about that. And, again, feel good about the long-term prospects for the digital dealer-to-dealer marketplace.

[Eric Loughmiller:]

And Peter, if I could add some clarity. Daniel, the combination of our digital -- digital D2D marketplaces would be CARWAVE, BacklotCars and TradeRev, in aggregate, those three businesses are also profitable in aggregate.

[Daniel Imbro:]

Right. That's all I had.

[Peter Kelly:]

Well, you mentioned CARWAVE. I just want to be clear to everybody, also the total -- totality of D2D is profitable in aggregate.

[Daniel Imbro:]

Appreciate all the color and best of luck going forward.

[Peter Kelly:]

Thank you, Dan. So I believe that concludes the questions. So thanks -- thank you Jacob; do we have any more questions in the queue?

[Operator:]

No. No, sir. This concludes our question-and-answer session. I would like to turn the conference back over to Peter Kelly for any closing remarks.

[Peter Kelly:]

Thank you, Jacob. Well, thank you again for your questions and for your interest in KAR Global. I'm encouraged by our second quarter results in light of the current market challenges and I believe that we are executing well against the leaders that we control. To summarize, once again, we completed the transaction and are fully committed to our digital marketplace strategy. We've paid down a meaningful portion of our debt. Continue to generate positive cash flows. We've increased revenue and gross profits, despite weaker seller supply, and despite marketplace conversion. And I believe we have a sound strategy in place to reach our 2022 goals and beyond. As I look beyond 2022, I'm also very encouraged by our longer-term prospects for growth. As we outlined in our Investor Day update in June I believe our growth will be driven by a number of important factors. First, the ongoing secular shift towards digital marketplaces across our entire industry. This will drive increased volume in both the dealer and commercial part of our business. Second, a broader recovery in commercial volumes across our industry. Third, the continued strong performance by businesses like AFC and ADESA Canada where we have differentiated offerings in a strong market position. And finally, our continuous focus on cost efficiency and being an asset-light digital company. Together, I believe these factors will help us navigate any short-term challenges while positioning us for accelerated growth in the future. I look forward to sharing our progress towards these goals on our next call. Thank you everybody and have a great day.

[Operator:]

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