KAR Auction Services Inc

NYSE:KAR

Earnings Call Transcript 2023-Q2

[Operator]

Good morning, and welcome to the OPENLANE Second Quarter 2023 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] 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.

[Mike Eliason, Treasurer and VP, IR]

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?

[Peter Kelly, CEO]

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. And 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 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 Q1 to Q2 volume increase in any year since before the pandemic. We believe that Q2 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 Q2 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 Q2 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 Q2, $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 Q2 of last year. Excluding the one-time benefit, marketplace adjusted EBITDA would have been $24 million. That's a $19 million improvement compared to Q2 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. And that is excluding both the $20 million benefit this quarter and the $11 million one-time charge that was incurred in Q1.

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 Q2.

OPENLANE generated cash flow of $47 million from operating activities in Q2. 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 mass vehicles and all type vehicles in between.

I want to thank our team for the creativity and effort they've put into executing a near flawless and launch. The response from our customers has been very positive, perhaps even more positive than I had expected. And 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. And while still early, we've seen sustained levels of buying and selling with some cohorts increasing purchases over their premigration volumes.

So, 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.

So, 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 in section 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 select the most risk-prone vehicles for an independent review for posting to the marketplace.

The objective here is to continue to increase buyer and set our confidence in the inspection themselves, while also improving our gross margins by lowering arbitration expenses and other direct costs.

And finally, 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. And 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.

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 Q2 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 structure 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 a fragmented sell 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 function 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.

And I'll begin by saying that 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 I've said before, these are necessary ingredients to balancing supply and demand in the used vehicle market.

As new vehicle inventory increases on dealership loss, we are starting to see evidence of increased incentive spending by OEMs. And 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.

As I've said on prior calls, I believe leasing will remain a very important part of the way new vehicles are brought to market in North America. And I think the two trends around leasing originations support this point of view.

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 Q2.

I believe it speaks to the resiliency of our asset model. And 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 but also 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.

I also 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.

So, 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, not -- 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. So, overall, we expect a solid performance from AFC in the second half of this year, although our full year results that 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 the 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.

So, in summary, as I've said on prior calls, 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 risk from our technology and product investments.

And 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.

So, 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?

[Brad Lakhia, EVP and CFO]

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.

And our second quarter and year-to-date results are the best evidence of this reflection. And 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 by 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.

And 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 cost 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 US 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 range -- 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.

[Operator]

Thank you. We will now begin the question-and-answer session. [Operator Instructions]

Today's first question comes from Rajat Gupta with JPMorgan. Please go ahead.

[Rajat Gupta, JPMorgan]

Great. Good morning and thanks for taking the question. Just trying to first one related to the marketplace business. If we look at -- if you look at the second quarter trajectory relative to the first quarter, volumes were up sequentially roughly 5%. But the adjusted EBITDA, excluding the one-timers, was flat to down slightly.

How should we think about that cadence? And the reason I ask that is 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?

Getting any helpful clarity on the second quarter versus the first quarter. Can you maybe help us like understand like how we should think about modeling the EBITDA going forward? Then I have a follow-up.

[Peter Kelly, CEO]

Thanks Rajat. I appreciate that. This is Peter here. Listen, I guess 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.

So, I think we're seeing some of the things actually your question gets to, which is what 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 do we optimize the gross profit structure, direct costs, SG&A, et cetera.

I think the digital business model is inherently more scalable. That's been my experience since I got in this industry with a digital model at OPENLANE. These business are extraordinarily scalable and I'm seeing that in our results.

I'd say one of the differences between Q1 and Q2 is conversion rates were, in general, lower in Q2. That's not unusual. We have -- as we've said on prior calls, the spring market in this industry conversion rates tend to be the strongest in Q1. So, high conversion rates also translate into higher gross profits and overall improvement in results.

But I think notwithstanding that, I think the Q2 results are very strong and give me increased confidence in the scalability of this model. Confidence I already had, but they sort of reinforced that. So -- the other thing I'd say, Rajat, is while we've spoken about our cost efforts, some of those costs will not fully realized and evident until 2024.

So, for example, in the cloud migration of remaining infrastructure to the cloud, that actually cost us additional money in the first half of the year because not only were we maintaining our infrastructure in one location, we had contractors and employees focused on a big migration effort. Now that that's done, those costs can be reduced.

So -- and that's just one example of a number that I could make. So I guess, Rajat, I am confident that in the quarters and years to come, this business will demonstrate excellent scalability.

I think digital business models operate on a more fixed cost kind of basis and that the marginal cost per incremental cars sold is actually relatively small. Now, it varies a little bit depending on if it's a dealer car or commercial car, et cetera, but I'm confident we'll have great scalability here.

[Rajat Gupta, JPMorgan]

Got it. Got it. That's helpful color. And then maybe as a follow-up, just in terms of the price increases or the ARPU trajectory going forward? Particularly as used car prices start to move lower here in the second half, how should we think about the ARPU or the auction ARPU. Any way to think about modeling that, maybe layering in the commercial mix coming in as well.

Do you think the industry can still have the ability to drive fee increases like every year to offset some of just the headline decline in used car prices? How should we be thinking about that going forward?

[Peter Kelly, CEO]

Yes. Some fraction of the ARPU is tied to vehicle values because the higher value of the vehicle, as you know, Rajat, the buy fees are often sort of stair stepped in value bands. So, if used vehicle prices decline, there could be some downward pressure on that. Prices on the sell side of the marketplace are more fixed, less dependent upon vehicle value.

I guess, we're seeing competitors increase their prices in this industry. So, we think we have room if we needed to. I think we're being cautious about that, but we have certainly tried to optimize pricing in various parts of the business over the last 12 months, and that's been reflected in the numbers. I would say they should increase at a minimum at the rate of inflation.

And then Rajat, as you know, there is a mix component to the extent off-lease volumes do come back in considerably greater numbers and sell in that upstream channel, those have a lower ARPU, but obviously a higher gross profit percentage than other types of transactions in our marketplaces.

[Rajat Gupta, JPMorgan]

Got it. So, on a gross profit per unit perspective, like should we expect any meaningful change there with that mix shift? Or is that you think that remains consistent with the lease mix coming in?

[Peter Kelly, CEO]

I've been very pleased with how that metric has trended. I mean we've done a really good job of gross profit per unit. But Rajat, I will say that we do generate gross profits that are not directly tied to transaction volumes.

So as transaction volumes increase, not all those components will increase at the same rate. The number I focus on more candidly, is gross profit as a percent of net revenue in the marketplace. I think that's really sort of insulates the risk -- not the risk, the mix shift.

So, there is a mix aspect to this. But from a management perspective, can we optimize and maximize gross profit as a percent of net revenue. That to me is the key sort of KPI that I look at each month.

[Rajat Gupta, JPMorgan]

Got it.

[Peter Kelly, CEO]

And I think we've been doing a good job with that. Thanks Rajat. Thank you.

[Rajat Gupta, JPMorgan]

Thank you. Thank you.

[Operator]

And our next question today comes from John Murphy of Bank of America. Please go ahead.

[John Murphy, Bank of America]

Good morning guys. Peter, just three quick ones. First, you mentioned the migration of customers to a single platform and you were doing some training for those customers. I'm just curious if you could talk about that process a little bit more?

And if there's any sort of leakage you think as you're kind of transitioning to the single platform or actually you're potentially making some gains of new customers as you consolidate?

[Peter Kelly, CEO]

Great. Well, so I was speaking specifically, John, to our Canadian migration and the launch of OPENLANE Canada which really happened at the very end of the quarter. So, it was the last, I think, two weeks of June, but there obviously was a lot of planning work and execution work done in the earlier part of the quarter.

Listen, I think it went really well. We were delivering a brand-new marketplace in terms of feature and function to market. So we put a lot of effort into training, webinars, all sorts of activities to help our customers sort of understand how the new site works. Obviously, we'll try to make it as simple as we could as well. We migrated the customers in cohorts.

We actually started with the TradeRev dealers first because we felt those were probably the more digitally adept. And then once that was done, we then focused on migrating the ADESA customers. But John, it went really well. No measurable leakage I think that was the phrase you used. Our Canadian roads remain strong throughout, and customers are getting the benefit of all the vehicles in one place.

So, we've had dealers that in the past, just weren't TradeRev buyers and now they're looking at those cars and saying, hey, I can buy that car, and you'll deliver it to me, and that's great. So, we're very excited about that, excited about what it does for market position in that market.

What we planned in the US is a little bit different, John. It's really going to be a rebranding of the backlog cars marketplace to an OPENLANE brand and then the integration of the commercial inventory into that marketplace. So, that actually de-risks our US migration a lot because from a user experience perspective, the thousands of dealers that are logging on to that marketplace every day, the feature function is not going to change.

All that's going to change is got the logo on the top left is going to change, some of the color pallet is going to change. But the technology itself, the business process will the same.

But in addition, they'll now have access to all these what we believe will be a growing volume of off-lease vehicles that are going to start to flow through that marketplace in 2024 and beyond. So, I think that sort of de-risks that one. But obviously, we still have a lot of execution between now and the end of Q4 when we plan to get that done.

[John Murphy, Bank of America]

And that flows to my second question. Your expectation is that volumes are bottoming out here and we'll recover, it sounds like somewhat meaningfully in 2024 and beyond. What are the key channels that you're expecting to recover?

It sounds like repo is actually recovering right now. Is there kind of a tape delay on lease and other dealer lease returns and then ultimately dealer side? I mean, how do you kind of see the progression of this bottoming out and recovering by segment or by channel coming back?

[Peter Kelly, CEO]

Yes, I guess, John, thank you. Specifically, what I feel confident of is the volumes in the second half of this year will be higher than the volumes in the second half of last year. And then as we look to 2024 and 2025, we expect further volume growth perhaps accelerating over time as we get into a sort of 2025, 2026 time frame would be my view. But to go sort of segment by segment.

Let me start with dealer. With more cars on dealers' lots, dealers are more likely to put a car into wholesale than they were, say, a year ago because a year ago, they had empty lots. They get these cars on trade in and they say, you know what, maybe I'll resell this car.

So -- what we're seeing is we're seeing actually growth in the volume being posted by dealers. We're seeing cars posted per dealer starting to increase fairly meaningfully in the second quarter, I'd say. And that's consistent with more new cars on their lot, greater inventory on the lot, et cetera. So, I think we see a positive driver in the D2D space.

But it's -- that segment was never too badly impacted by the compression, but still positive. Repo obviously has been up. Now our business services at the repo segment that benefits us, but we don't sell repos in our marketplaces for the most part because they typically sell in a physical model. Now that may have changed over time. But today, John, in the United States, most people sell it physical. We're seeing more sales rental sellers.

And I spoke at some length about lease. We didn't see an increase in lease returns, if you like, in the second quarter. Some of our customers are telling us that their models show lease volumes increasing later this year and into next year. But what I pointed out is what I thought very positive news in the second quarter was just to see an increase in lease originations.

Lease originations have been down, but we're seeing that start to increase again in a meaningful way. I think that reinforces, John, my view that leasing is going to be an important part of our industry, an important part of the way vehicles are brought to market.

We obviously have a very strong position there. I recognize it's going to take some time for those vehicles to reach maturity but -- and passes quickly. And I'm excited to see leasing on a rebound in the retail environment.

[John Murphy, Bank of America]

And then just one last, how's given the $20 million early termination payment. Can you guys just tell us exactly what that's for in the quarter? And is it kind of one-time? Or is this something should be spread over periods that we shouldn't be backing out? Just want to understand what's going on there?

[Peter Kelly, CEO]

Yes, a little bit nuance on that. John, it's a one-time early termination of a contract associated with 2019 transaction. And over the past number of years, that contract has generated I would say about $5 million a year, all pay the third quarter of the year.

So, that was a fact, and that contract was going to continue through, say, the third quarter of next year. So there's a -- if you like, we're trading a $20 million one-time payment for two $5-ish million payment Q3 of this year, Q3 of next year. That's how I would think about that. Obviously, that was done through mutual agreements and both parties happy with that outcome.

[John Murphy, Bank of America]

Okay, very helpful. Thank you.

[Peter Kelly, CEO]

Thank you, John.

[Operator]

And our next question today comes from Bob Labick with CJS Securities. Please go ahead.

[Bob Labick, CJS Securities]

Good morning and thanks for all the comprehensive answers. I just have a couple of nuance questions here, too. Now obviously, we've made great progress with the platform consolidation, and that's very exciting. But given the kind of weak industry volumes, how are you going to gauge success?

Are there new metrics you can share with us, it's traffic on the new side? Or how are you internally gauging the success of the platform consolidation, given as we say at the bottom end -- the bottom of a cycle.

[Peter Kelly, CEO]

Thank you, Bob. Good question. Obviously, one of the things I like about a digital business, in addition to being very scalable is you get tremendous data because every customer traction leaves a recordable footprint. So, we look at a tremendous amount of data across this company.

I would say the five metrics I look at the most in terms of the marketplace would be volume sold volume posted from that, obviously drive conversion rate, participating sellers, participating buyers and then retention rates of your customer base. So, those are the metrics we look at.

Obviously, our results correlate the closest with volumes sold in any given period of time because that's what drives revenue. But the other ones are all inputs into that. So we look at all of those. Listen, I'm pleased with a lot of the metrics we're seeing.

We're seeing increased customer participation, as I mentioned earlier, we're seeing increased volume of vehicles posted per selling dealer. That's starting to trend up again. Conversion rates have been strong. Used vehicle prices have been under pressure in Q2. They declined pretty much for the entire quarter.

We did see conversion rates drop a bit relative to Q1 but they were quite resilient. I take some comfort from that. And then sort of the retention rates of customers within our platforms is very strong. These are platforms that build a habit with customers who come in daily, weekly, smaller customers might come in monthly.

Sometimes a customer might skip a month, not buy any cars, maybe they've got too much inventory or maybe not sell cars because they've got too little inventory. But typically, they're back a month later. So, there's a lot of good fundamentals in these marketplaces, a great customer and a repeat -- a very repeatable customer interaction, which I think is the strength of the business.

[Bob Labick, CJS Securities]

Okay, great. That's very helpful and I appreciate it. And then just real quick, I think in the auction fee section of the one of the releases. You mentioned a slight increase in auction fees from a smaller mix of lower fee commercial off-premise vehicles. And I think that's probably either grounding dealer buying it or whatnot. Can you just give us a sense of kind of what drives that and how that trend may change over the next several quarters?

[Peter Kelly, CEO]

Yes. Good question, Bob. Listen, I'm very much looking forward to an improvement in off-lease maturity volume because what we've really sort of had to sort of work our way through over the last couple of years is not just reduced volume at the top of the funnel, reduced number of cars sort of flowing in, and that was a substantial reduction, down 50%-plus.

But also, essentially, the transaction is all kind of migrating up into that top of the funnel grounding dealer transactions, which is our lowest revenue transaction in this entire business, right? So, we have volume compression with revenue compression, you multiply those together, and you got severe compression on that business.

And as I look to the future, I see both of those things starting to unwind and reverse. Now, I'm not promising that is going to happen immediately. I think it's going to play out over time. But I'm confident it will happen. And I think that would be a double positive as we see not only volumes increase, but the mixed shift.

And I will say we started to see a mix shift first in Q1 used vehicle prices appreciated right? And it was a little unexpected how strong used vehicle pricing was in Q1. I would say in the last month or two, we're starting to see the mix shift more positively again. It was not material in the second quarter, but we're starting to see a more favorable mix in that upstream channel for us as well, which drives ARPU.

[Bob Labick, CJS Securities]

Super. All right. Thanks very much.

[Operator]

Thank you. And our next question today comes from Bret Jordan at Jefferies. Please go ahead.

[Bret Jordan, Jefferies]

Hey good morning guys.

[Peter Kelly, CEO]

Good morning Bret.

[Bret Jordan, Jefferies]

Could you give us maybe as we look forward two or three years, how you see lease returns, obviously, what's going to get bought out, you can't predict. But I guess, leasing probably troughed in the second quarter of 2020 when dealerships were closed. But how do you sort of see on an annual volume, the cadence of lease returns in 2024, 2025? When is the cyclical growth year?

[Peter Kelly, CEO]

Thanks Bret. If you look at lease originations, the lease origination percentage declined from 2020 to 2022. And what that means is there are fewer off-lease vehicles in those portfolios. And you can, again, think of the lease rule of thumb, three-year maturity. So, leased in 2022, maturing in 2025.

So, that's the very, very top of the funnel. How many vehicles are in the portfolio. And I think what we're going to see there is that number is -- reduces to 2025 and then increases post 2025 would be my view.

The second question, which is probably more important right now is of those leases, what percentage actually get returned. And that's driven by the equity position of the vehicle. So, for the last 18 months, the equity position of off-lease vehicles has been extremely strong, so consumers have been hanging on to them and not returning them.

And then if they return the grounding dealer buy them. So what I -- so I think over the next two years, we're going to see the intersection of two kind of contradictory forces. On the one hand, there's fewer off-lease vehicles at the top of the funnel. But on the other hand, consumers are going to buy a declining percentage of those and an increasing percentage are going to be returned.

And the reason I think that is we're going to see some pressure on used vehicle values, but also the residual values of those leases was written at higher levels because they were sold at higher MSRP.

So, I guess in that, I'm expecting a small increase in lease volumes in the coming two years, but a more favorable mix within our market and an accelerating volume and mix picture kicking in towards the end of 2025 and beyond.

And I guess I'd say, long-term, I believe leasing will be a very important part of the way vehicles are brought to market. I think it will be back in the 3 million to 4 million units a year leased. We'll see high consumer return rates, and we'll have a very, very good business in the off-lease space, I believe.

[Bret Jordan, Jefferies]

Okay. And then a quick question. On the deal of the dealer impairment charge, I think 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 when the business was when IAA spun out and TradeRev was sort of a focus? Or is it really just the lack of dealer consignment cars that's impacting that longer term view?

[Peter Kelly, CEO]

I don't think the size of the market is different on any long-term view. I think in the last couple of years, it's been a little compressed for some of the factors I mentioned. Industry data sources have that dealer to dealer at a low end, $6 million units, but that does not include vehicles that are transacted sort of informally between dealers. So, high-end estimates run 10 or above 10 million units in that market.

So, it's a big segment, a big opportunity for us. I like how we're positioned in the market. I think we're on the right side of a physical to digital secular shift, which I think will be positive long-term for the company.

I can also say that I spoke about our improved EBITDA performance in the first half of this year. Without question, our digital D2D model was a strong contributor to that improvement. And we had our best ever sort of financial performance from that segment in the second quarter.

So, I'm really pleased about that. Seeing strong customer adoption, strong numbers around volumes posted, et cetera, strong conversion rate. So, I kind of look at the goodwill thing is somewhat technical accounting-driven and does not, in any way, impact my view of the long-term opportunity in this space.

[Bret Jordan, Jefferies]

Okay, great. Thank you.

[Peter Kelly, CEO]

I think we have time for one more question, Rocco.

[Operator]

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

[Daniel Imbro, Stephens]

Thanks. Appreciate you guys squeezing me in here at the end. Just a couple of questions. Maybe one, Brad, on the SG&A side. follow-up on Rajat's question earlier. Marketplace SG&A has been pretty consistent kind of low 30% -- but as we add back volume, would you expect to have to add back expenses to handle that volume, Peter said it's scalable. So, should we expect further SG&A leverage into the high 20s? How would you think about SG&A marketplace margin going forward?

[Brad Lakhia, EVP and CFO]

Yes, I think -- thanks for the question. I think the way to think about it is essentially what Peter referred to earlier, I mean, we see the marketplace business as being very scalable, very fixed cost base in terms of its structure. So, in terms of the incremental SG&A dollars that we need to support incremental volume, fairly modest.

[Daniel Imbro, Stephens]

Got it. And then a quick follow-up on AFC. Peter, last few quarters, loan origination outpaced marketplace volume growth. 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? And how do you feel about the 2% charge-offs going forward as you project more used price pressure or maybe more pressure on the independent used dealer out there?

[Peter Kelly, CEO]

Good question. First of all, listen, I think independent dealers are an important part of this retail ecosystem and will be as far as the future as I can see. They serve -- they provide unique offering in the market, and I think there's a strong demand for that offering. So, they'll be in business and we'll be in business to serve them. In the first and second quarter, loan loss ratio was at the high end, the 2% end of our 1% to 1.5% to 2% range.

So, I guess, given that fact, we've just been a little bit more focused on managing risk and running the more conservative business that we've talked about on these calls. Obviously, signing up new customers and generating new loans is important, too. So, we're focused on that. But in this business, it is a balancing act, and we've been -- we've just been focused on making sure we've got a good handle on the risk environment.

We believe we do. I think it was clear in my remarks, we expect solid performance in AFC. But there's no question with the benefit of hindsight last year and then probably the prior year, AFC was a beneficiary of historically low risk loss ratios that we should not expect to recur in the foreseeable future.

[Daniel Imbro, Stephens]

And anything on the loan origination outlook part of that?

[Peter Kelly, CEO]

Well, we expect to continue to grow the business, but -- and we expect AFC to continue to be a contributor, but we expect most of the growth in the pro forma to come from the marketplace side of the business.

Again, we love the AFC business, but we take a conservative view on the market, and we are growing it. We want to keep growing it, but we also want to make sure we have the right sort of portfolio that we like having in this business.

[Daniel Imbro, Stephens]

Great. Appreciate all the color.

[Peter Kelly, CEO]

Thank you.

[Operator]

Thank you. And ladies and gentlemen, this concludes our question-and-answer session. I'd like to turn the conference back over to the management team for any final remarks.

[Peter Kelly, CEO]

Thank you, Rocco. I appreciate that. And to the participants, thank you all for your time today for your questions. Before we close, I I'd like to leave you with more takeaways from the quarter. I believe our Q2 results demonstrate a significant improvement in the business and I believe they provide me and hopefully, all of us with increased confidence in our digital asset-light model as we look to the future.

Again, I'd like to highlight our company has strong cash flow characteristics. It has improved its overall liquidity position in the quarter and now has increased flexibility in terms of capital deployment.

I believe our one brand; one marketplace strategy will increase our differentiation in the marketplace and will also enable us to continue to increase our efficiency and reduce our costs.

Finally, the macro factors that I see point to an improving outlook for commercial off-lease volumes. I believe that the headwinds of the last two years looks set to become tailwinds in the years to come.

So, thank you all for your joining today's call. I look forward to updating you on our progress in our next call three months from now. Thank you very much.

[Operator]

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.