OPENLANE, Inc. (OPLN) Earnings Call Transcript

Okay. I think if you could take your seats, we're probably ready to get going with the next presentation. Very happy to have here with us Eric Loughmiller, Executive Vice President and Chief Financial Officer of KAR Global. Eric, thanks for coming to the conference.

Thank you, Ryan, for having us. We're glad to be here.

Okay. Great. Maybe we can talk about, well, a couple significant transformations of the business. I mean on the one hand, there had already been this increasing digitalization of the business and focus on the D2D app-based business even prior to the sale of the ADESA Physical Auction Business in the U.S. to Carvana. But maybe we can start with that second part because it really was another step change, right, in the transition. So maybe you could talk a little bit about what the experience has been for the Remainco since the time of the sale. I think that prior to your recent earnings call, there have been some speculation that the Remainco could have been somehow hurt by the separation. But you or Peter were of the view that perhaps there were opportunities there to benefit the Remainco as a physical business increasingly transitions to online. So let's just start there with how you think the Remainco has fared subsequent to the sale.

Well, thanks, Ryan. I think it's clear, Remainco is the beneficiary of what we think is a transformation of the industry to a more digitally focused marketplace. However, the transaction created a little bit of stir about who would do business with a retailer who's a competitor of many of the franchise dealers and the like. The good news is it strengthened our relationship with our customers at KAR Global. In the United States, they've seen our commitment to the digital marketplaces. In particular, several of the OEMs that are here talking through your conference are very pleased that we're going to invest in digital marketplaces like their private label sites, whether that be Ford Drive or DealerSource for GM or ultimately, you get the Hyundai Kia's different sites, Toyota, Honda. We manage all these names and the investment in a workflow or a process at end of lease that allows the remarketing of the car seamlessly and without touching it, is very advantageous to them. We've seen conversion rates even with the lack of volume, it doesn't matter. They see the benefits of a 90% conversion in the private label sites, whether that be grounding dealer or sold to a franchise dealer of their brand. So -- well, I don't think you can use today's environment to predict the future entirely. They are clearly going to probably use the digital marketplaces more than they were in the past that setting prices more realistically because it avoids so much cost of moving the car downstream. The problem is we just don't have any cars. I mean you all know what's happening out there. Dealers are trying to circumvent leases by buying them out early, getting the residual value, sharing the equity in the car with the consumer, but taking some of it into their, hopefully, retail profit. But that game is probably nearing an end as prices start to moderate and we're starting to see the beginning of that. The customer reaction has been good. I'm glad we've got the transaction done in 2007. I was part of a team that went out and borrowed $2.8 billion. And as I'm sitting here 15.5 years later, I'm looking at repaying all of that debt and having a balance sheet that's essentially debt-free. For a CFO, that's a pretty good round trip, one you'd like to experience before you end your career, and I probably would have never guessed that, that could happen. We were very comfortable with 3x leverage, and now we're at less than 1x net leverage and paying, as all of you know, redeeming bonds and actually paying the debt down. So I really like where we're positioned. Our customers like that we're less levered. Our customers like that we're focused on digital. They like that we're really looking at one part of the marketplace that might be, I would argue, highest value to their process. And there will be players and we didn't leave them without other options, whether they like that option or not or their franchise dealers like...

I'd like to ask about how your end market exposure and, hence, cyclicality may have changed subsequent to the sales. So I mean putting aside the dealer-to-dealer app-based business, which is, by definition, dealer consignment only, it would seem that your dealers were not transacting through OPENLANE. Really, they were transacting oftentimes through the physical auctions business. Are you now even less exposed to dealer consignment, even more exposed to commercial consignors? And what does that imply for the cyclicality of the business?

Well, Ryan, that's an interesting analysis that I agree with what you said at face value, but then when you dig into it, the physical auction business has far greater exposure to the commercial segment of our marketplace than anybody ever expected. And that's evidenced by the significant and material reduction in profitability before we sold the ADESA U.S. Physical Business to Carvana. Our profits were down from a high of over $300 million of EBITDA down to a net -- pardon me. I may have to get some water here and then -- no, I'll be fine for now. So as you think about it, what happens with the commercial vehicle, it tends to be a higher value car, tends to be attracted to a large part of your buyer base and tends to use a lot of services at the physical location. So while we remain exposed on the off-lease portion of our business in particular, we have reduced our exposure to things like repo trends, off-lease vehicles and abundance that end up at the physical auction. And what we eliminated that probably is most attractive to us, we've eliminated a high fixed cost component of labor that goes with all of those physical sites in the U.S. Now let's be fair, I still own the Canadian business that operates out of physical locations. That's 14 sites. As anybody from Canada who likes to ignore, it's roughly 18% to 20% of the size of the U.S. business, although it's a very strong market for us. I do still have the exposure there. However, that business has moved to a completely digital auction format. We do not run any live physical auctions. They are all done on Simulcast, Simulcast Plus, OPENLANE or TradeRev in Canada. So I do have a little bit less exposure to labor, but I still have some up there. But I think that's the big change. So -- and interestingly enough, where my exposure is in the U.S. is probably more on revenue per unit. Unfortunately, I'm going to get $50 a transaction on probably over 800,000 OPENLANE transactions. At the peak, that was 1.4 million. That 1.4 million was at an average of about $110, $115 per transaction. And that's a business that has no labor, 0 labor for touching the car. So where I'm heard probably more is on revenue and the incremental contribution. But I'm still getting -- I mean we bought OPENLANE in 2011. They were selling 300,000 cars. I'm at the girth of supply here, and I'm going to probably sell close to 800,000 is what I expect for the year on that site. But I never would have thought it would get to the revenue per transaction with those now.

Now as significant as the digital transformation is and with the sale of the ADESA U.S. Physical Business and with the secular growth opportunity in dealer-to-dealer app-based business, all of which I want to spend plenty of time talking about, it seems like a lot of the attention at the moment we were just discussing is really on the near-term volume environment because it is so profound, the shift that we've seen, because of all the distortion that's taking place and has been taking place for the last 24 months in the auto industry. So let's dig into that. I heard you and Peter discussed in the most recent call that perhaps the volume headwinds may be bottoming out at the moment. But let's start with off-lease and then we'll move to repossessions. So starting with off-lease, maybe you can just talk about what you're seeing there over the short term. We have seen a little bit of moderation in used vehicle prices down about 7%, I think, year-to-date, with some calls for more decline. And so first of all, you can talk about what that might mean over the short term. And then also maybe we could talk about the medium term because there has been, obviously, a decline in auto sales. And then there's also been -- which is down about 20% versus 19%, 17% to kind of 13.7%. But then there's also on top of that kind of a decline in the lease penetration rate sort of 33% to kind of 22% or something like that. So what is the -- but even as the 3 years from now, we'll suffer from lower sales and lower lease penetration, still, it should be better than cycling past. I would imagine all these headwinds from residual prices tracking differently. So if you could talk about the trend in off-lease volumes over the short term and then maybe over the medium term.

I think you're going to have to be patient. I think in the short term, off-lease volumes are going to be grounding dealer. Maybe we'll see less disintermediation of the grounding dealer by the likes of CarMax and Carvana that are buying out consumers. Maybe they'll start to slow that down as they start wondering how much they can pay for a car and retail it at a profit. That's the big challenge. And when prices are steadily increasing, you can't make a mistake. You just buy the car, and worst comes to worst, you wait 2 months and it will be worth more, right? That time is over. The problem is the equity versus residual in a lease return right now -- and by the way, we have 4.5 million leases that were written. I've got the chart right here in front of me. 4.5 million leases were written in 2019, 4.394 million in the U.S. They're all coming back. Probably less than 1.3 million of them are going to end up back to the captive finance company. They're getting purchased by the consumer, bought out by dealers. And if they're lucky, they get to the grounding dealer in that, call it, 1 million to 1.5 million range somewhere. I'm going to follow that with years with only 3.6 million, 3.6 million. And this year probably we'll be under 2.5 million we've just written as my guess by the end of the year. So short term, value still have a long way to go before it won't be attractive for third parties to try to buy leases at residual values that were set in 2019, early 2020. Medium term, I'm going to abate one headwind calling residual values, and I'm going to add to it the lack of inputs. I'm going to have a declining lease return number. That's medium term. Long term, I feel very good about the marketplace, whatever long term is. It has pushed it out a little bit. Where will I get back to volumes where we optimize the use. But the good news is, I think we're going to offset some of that with increased conversion rates on the OPENLANE sites. Where we've been at 95%, 90%, 85% conversion of cars that get listed on the site, predominantly taken by grounding dealer. Historically, we might have been between 30% and 45% depending on the market. We're not -- I don't think we're going back there. I think we're going to end up not staying at 85% to 95%, but not going back to 35% to 45%. We're probably going to end up somewhere, I would think, 60% to 70% depending on market conditions. And that means even with fewer inputs, I will get my volume back, I think, on the OPENLANE site a little earlier than we'll see the entire market recover. That would mean downstream to the physical locations. So it remains important. I am less dependent, to your point in the first question, on the off-lease volumes because I don't have that high fixed cost labor component of the physical locations. So I'm a little bit more, shall we say, flexible on profitability at the top of the funnel, as you and I have called it for many years when we introduced the funnel for the off-lease returns. That means selling before the car is touched in the wholesale marketplace from a grounding dealer location. And then I'm going to add to that, something new that may be exciting, I hope. And that's programs like Ford Blue Advantage and GM's CarBravo program. There is the talk about, will they be able to get more consumer interest to compete with the likes of the digital retailers here in the United States for those programs? They're all looking in Europe at an agency model. And by the way, that does not exclude us from the transaction because our expertise is handling transfer of title and cash. So those programs will utilize our OPENLANE platform in order for us to execute the transaction because the consumer under both programs is taking delivery from a local franchise dealer, and that's how they get the asset and transfer everything so they can sell the car into the consumer's hands. So I think our opportunities in the outlet space are great. I think we'll see how behavior changes. I do think of all of the segments of our business, that's the longest pole in the tent, meaning you've got a long way to get to the top here, primarily because of multiple factors. Residual values have to come down, volumes have to recover and behavior has to figure itself. And when I talk long term, near term, I'm talking 1 year, 1.5 years; medium term, 1.5 years to 3%; long term, more than 3, not 10. Do please don't read that into 10. I sure would like to see lease originations with higher interest rates, affordability of vehicles. Everybody can afford a vehicle when interest rates are 0. We have more disposable income in your household than you've ever had because nobody's commuting. Those that are underemployed probably had some type of government subsidy for 1.5 years. We're past those days. Inflation has taken over. High interest rates are back. It will be hard for many consumers to buy a whole car. And you know a lease is a way that you only have to pay for half a car and you get a new one every 3 years. Welcome to America, land of opportunity. That's what the leases do. That will be back, especially in market conditions and economic conditions like we're beginning to experience now.

Some of your comments there about free money coming to an end and it does dovetail a little bit into my next question, which is about the other category of vehicles that is down sharply, which is the repossession vehicles, maybe some better or worse as on the horizon depending on your perspective. They plummeted to all-time lows during the pandemic. First, maybe because of the unprecedented forbearance programs, followed by the unprecedented stimulus programs, followed by the unprecedented inability to spend money on other things, followed by those all '20 followed by in 2021, the chip shortage and the incredible inflation in used vehicle prices, which put everybody into an equity position, right? I mean if you got all this equity in your vehicle, even if you did have a cash crunch, why not just pay it off, sell it, pay off the bank and right, why repossess? So what is the outlook now? We've started to see delinquencies move up a little bit. We're starting to see -- well, the last labor report was red hot again. But the expectation is labor market has been cool. We've had a couple of quarters of contracting GDP. When do you think this turns? How quickly can it come back? Remind us of the materiality to KAR? I think you guys call yourselves the repo king or others call you the repo king within the industry? Do we have a better trend here to look forward to than off-lease volumes?

Well, the repo king is now my nephew instead of my child because Carvana owns the repo king. ADESA U.S. was the repo king. However, I am seeing the benefit in our Canadian business. We actually have very significant share in Canada. And actually, there's an entity up there that processes repos for a lot of the finance sources. They have a different market. Captive finance companies are not permitted to enter into leases for the OEMs up there. They went to private lending, very much like Europe, where it's actually third parties own the leasing companies. And we are already seeing the repo volumes increase in Canada. I suspect that we will in the second half of this year see significant number of [ repos ]. The bottom line is, if they came to you and said, "Listen, you're not making your payment. I'm going to enter into a legal process, cost you money, you're going to have to hire a lawyer. And ultimately, I'm going to enter a judgment against you for any shortfall. Or why don't you just go sell your car because you can pay off the entire loan and I'll waive the fees." That's what's been happening. Delinquencies have been up for over a year because the minute government stimulus stopped, payments slowed in some households, especially in the subprime category. Problem was delinquencies did not lead to default that led to repo. Delinquencies led to what you would call an asset-based lending, a workout situation. We just convinced the borrower to sell the asset and pay you off in full and avoid the bank. Chase Bank is actually part of the lending portfolio. Chase doesn't have to incur the legal cost, but it just is an easier transaction. We are going to very quickly, by the end of this year, I'm predicting that the equity and the value of especially used cars is probably going to be down enough that now all of a sudden, there's going to be shortfalls. That is when the repo king takes over. And it will be -- right now, it's predominantly a physical business. That has to do with some case law around proving as a commercially viable market. It is set up, but we've developed data and information that we collect now across all of our marketplaces where I think we can compete for that business, where historically, the digital D2D space has not been able to participate in many repo transactions, except for credit unions. Credit unions typically do not use leverage for making loans and they typically don't enter judgments. So they have been less concerned about case law. They settle up with their borrowers and just say we made a mistake, get on with your life. So credit unions have used OPENLANE. They've used TradeRev. They've used BacklotCars in the past. But I think there will be opportunity with others, but that is white space for us in the digital marketplaces in the U.S.