OPENLANE, Inc. (OPLN) Earnings Call Transcript & Summary

Hi, everybody. Thanks so much for joining us. Again, Doug Karson here at Bank of America. We're so delighted to have KAR Auction Services with us today. And with us from the company, we have CFO, Eric Loughmiller, and we're going to have about 30 minutes of a fireside chat format. We'll be getting some questions from investors that will be dialing in, but I'm going to be hosting the first few topics. Thank you, Eric, for joining us. We really appreciate it and all your support for all these years.

I wanted to start by talking about the very strong margins the company has boasted over this very challenging environment. If you could talk to us about your margins and maybe we could weave in the [ cost ] of reducing some of the SG&A costs that has been kind of targeted as an opportunity.

Thanks, Doug, and thanks for having us today. And it's nice to come to a leverage conference instead of an equity conference because we can focus on the things that are positive here about our business. First and foremost, while the pandemic created a lot of challenges for us and everyone else, it gave us an opportunity. It accelerated the conversion of what was historically a very physical auction environment, very quickly into a digital transformation where we're selling all of our cars digitally. Now even prior to the pandemic, we were offering all of our cars in a digital format. But a lot of the buyers would come to the auction and try to transact live and in person. That didn't happen in 2020. And so we accelerated the transformation of the business to a digital model. And in doing so, we eliminated about 5,000 direct labor positions throughout the company. We eliminated some SG&A as we were able to get more efficient using the technology. And that's resulted in gross profit per unit increasing to -- most recent quarter was $274 per transaction in the ADESA segment. And we've been able to reduce the SG&A. We took about $150 million of annual labor cost out. About 2/3 of it was direct labor and 1/3 of it was SG&A. And then as Doug mentioned, I don't think we're done. We had an Analyst Day in September. We talked about an opportunity to continue reengineering our processes. While we've taken the format of the auction into a digital front end, we now have to get the back end to follow that. And so we've got some technology enhancements that would allow us to further reduce what I call the administrative cost of processing these transactions. So we look forward to it. In the Analyst Day materials, we've identified, over the next few years, $30 million in reductions in SG&A compared to the current run rate that we think we can achieve, again, through process reengineering.

Right. That's very helpful. Excellent. If we could just talk maybe about the migration we've seen to online transactions versus the standard way we used to do business before. Like how has that migration been?

Again, this is one thing COVID did for us. It accelerated the pace of change to a great extent. And Doug, when I say that, we were closed down. We were not allowed to have buyers in the auction arenas there. It's too close contact. This was, again, over a year ago. And so if you wanted to get access to inventory -- and while things pretty much shut down end of March 1 and April 2020, they quickly went back to where automobile sales really were strong through -- they started picking up in the middle of May and got extremely strong through the summer months, continued strong, had a little weakness in the fourth quarter of '20 and then picked up right where we left off. And now we have a situation where there's no inventory. Dealers are constantly looking for the vehicles that they could put on a used car lot. Well, when we shut down, the only way they could get inventory was to go into digital formats. And the good news is KAR was, in my view, a leader in becoming a digital enterprise. We have committed about 2016 to a digital future. We said our strategy was to lead a transformation of an industry that had been heavily dependent on physical auctions into a digital marketplace format, and this accelerated the pace of change. Now interestingly enough, and this probably applies to a number of businesses, COVID caused this change to really come forward and everything went digital in a matter of weeks in order for the business to get -- to go back. Well, here we are starting to say get past some of that shock of COVID, get back -- while things aren't fully open, it's generally business as usual. It did not accelerate everybody quite as much as we would have liked to. So while we may have taken a 5- to 10-year transformation and moved it into 5 to 10 weeks, we are now learning that not everybody is committed to the digital transformations. We've started running vehicles through the physical lanes in 30 locations in the United States, none in Canada, and that focus has been on lower-value vehicles and lower-value repossession vehicles. To the extent that the sellers prefer to have a car run across the block to demonstrate that the car is operational, we are willing to do that at certain locations with the right mix of vehicles. Interestingly enough, when we run those vehicles, over 60% are still acquired by buyers who are online. They are not in person. So it isn't as if this isn't a digital process. It is. But it appears on certain vehicles, less than $7,000 is what our [ tech ] data says. There is an advantage to have the car running through an auction lane. So again, the digital transformation is real. We think it will continue to be increasingly digital in the wholesale used car auction business, but it's not 100% digital yet.

Right. I'd like to ask a question about CARWAVE and BacklotCars and TradeRev, just a bunch of exciting combinations here. Just if you can kind of talk about some of the rationale behind those.

It's very interesting that in 2011, we acquired OPENLANE and committed to a digital format, feeling like that's how off-lease cars would transact. Then in 2015, we invested in TradeRev. We subsequently acquired 100% of TradeRev. Then in 2020, in the midst of COVID, we added BacklotCars. Those are -- TradeRev and BacklotCars and now CARWAVE are all digital dealer-to-dealer marketplaces. TradeRev was founded in Canada, and we introduced it into the U.S. marketplaces. BacklotCars was founded in Kansas City, had a focus on the central part of the United States, really in Kansas City, and growing outward from there. And CARWAVE was a digital -- can you hear me? CARWAVE was a digital dealer-to-dealer marketplace that started in California and has -- had great success on the West Coast. So what we've done is combine those. We're integrating all 3 in the U.S. onto a single platform. And the goal here is to have the largest buyer and seller base on a single platform in the digital dealer-to-dealer space. The technology is different in each of those but not a differentiator in our view. What we think is having good technology is required and having a strong go-to-market strategy is critical to success. So we see ourselves being a leader in North America in digital dealer-to-dealer transactions. Our goal is to be the leader in the U.S. We're currently #2 and growing at a rapid pace. And not only is this a new way to transact the dealer-to-dealer transaction, but it's also a way to increase the total addressable market in our space. Historically, there have been about 10 million transactions in what we call the formal auction marketplace. We believe there are 20 million to 25 million transactions where cars change hands. In the past, a big portion of those were transacted in informal marketplaces. So what we've done is put a technology solution in place, a very efficient marketplace, the car doesn't need to move, very low cost. And we believe this will expand our addressable market from 10 million to probably in the neighborhood of 15 million, maybe a little bit better, 15 million transactions. And that's really what we're after. Can we grow the addressable marketplace by having this efficient digital marketplace with very low transaction costs around putting that car up for sale and getting it into the hands of another dealer? Again, remind everyone, this -- we are a B2B business. We only operate in the wholesale space. We are not a retail marketplace at all. I'm hearing blank space. Is there a disconnection? [Technical Difficulty]

Doug just got back on, if anyone can hear me.

Okay. Doug, are you back?

Yes. So I'm not sure what happened to my bandwidth, but I am back. I'm sorry about that, and I apologize.

No problem. I hope everyone heard my response to your question.

Yes. I think everyone else was hearing you except me. So I don't know where we stop, but let's -- let me switch into some of the -- maybe you could kind of talk a little bit about the cash flow on the balance sheet, that would be really helpful.

The one thing about our business, and we experienced this back in the Great Recession, as we've renamed it for 2009, our business becomes a very high cash flow conversion enterprise. Ironically, there's low inventory. Cars turn very fast. We have a finance company that does floor plan lending. The day -- average days outstanding are reduced. The collateral values have increased. There's very little bad debt. And in fact, in the third quarter, on our portfolio of loans, recoveries actually exceeded the bad debt expense for the third quarter of 2021. And that's something that just isn't going to happen very often. But it's the type of lending we're doing. With used car values so high, and I'm sure you'll want to get into what's happening there, what that does, it strengthens the transaction, the cash moves quickly, and we are a strong generator of cash. Even in a depressed period of performance where we don't have inventory, it does generate a lot of cash. We have utilized -- in 2020, we raised $550 million in a private investment type transaction, issuing some preferred stock to shore up the balance sheet. As the markets came back to -- we weren't sure what it would be. And in fact, we raised that amount of money. People asked why that amount. We said we thought we had to have enough capital to get through the end of 2021, feeling like COVID could impact us that long. And we said that at the time and people laughed at us because by June, our markets were hot. I mean we set records in the month of June and continued strongly in July 2020, and then we ran out of cars. Basically, the industry recycling inventory that had built up, values were increasing. And as a result, the cash conversion is great. I just don't have enough transactions. But with that said, we've deployed capital by buying BacklotCars. And we've just acquired CARWAVE. That's increased our net leverage temporarily. But we'll continue to have strong cash generation. Our EBITDA will grow because we're lapping those very poor quarters, especially we're now -- we're past Q2 of '20. But Q4 of 2020 was the lowest actual performance, I think, for the company, excluding April, where everything was shut down. So the Q4 will lap after this quarter, and we'll start to be building up the EBITDA. Our cash will be generated. Our net debt will decline. And our target leverage is 3x or less total leverage on a net basis, and we're comfortable we can get there in a relatively short period of time after the acquisition of CARWAVE and the use of cash. We have not used our line, our revolver. For any of these acquisitions, we've used cash on the balance sheet. And we still -- I still am sitting with a little over $200 million of cash on my balance sheet even today. So the balance sheet is in good shape. We have been acquiring back some stock in 2021, not a lot, and that is because I can offset the dilution of the preferred stock issuance from 2020. I've been buying back stock below the [ $17.75 ] conversion price. At this point, after these acquisitions, we've said that will not likely be a priority until we again reduce our net debt down to less than 3x.

Right. Excellent. Can you maybe share a little about the pricing environment you've seen kind of in the industry and how sustainable do you think, like, that is and where it'll kind of be headed?

Well, anyone who has shopped for a new or used car realizes, how can this continue? Used car prices are at all-time highs because new car prices are at all-time highs. I mean I just saw a piece this morning where the average new car price in November is estimated to be $44,000. I mean that's got to be 30% or 40% above the typical average net new car price. And what that does is used car prices have increased, new car prices increase as well. And we have a shortage. If you go out and try to buy a used car, you'll find out their price is extremely high because there's more demand than there is supply. So as I look at that, it's going to change. First thing we have to have is we have to have increased production of new cars. We need more inventory on the lots of the franchise dealers, the new car dealers. When that occurs, you'll start to see them having less used car inventory, which will spread it around through the market. We've started to see, I think, some stabilization, if not moderation, of pricing on the lower end of the used car market. We're not yet seeing on what I call the upper end, that off -- 3-year off-lease car with less than 40,000 miles that has, again, an average wholesale value, $21,000 right now. Just to give you an idea, Doug, of these values. In the third quarter, the average auction price on our OPENLANE platform was $21,500. And a year prior to that $21,500, that was $19,000 roughly. When you go to the digital dealer-to-dealer, we were at $10,700. That's a lower-value car. That was $8,300 a year ago. These are huge increases in used car values at the wholesale market, and that all gets passed on to the consumer in the retail price. As I look at this I'm saying, "it's going to come down. " Once we stabilize -- first, we need production. We need off-lease cars to be -- to have at least equal supply to demand. Right now, there's more demand for those vehicles than there is supply of them. Then that will filter down through all of the used car values. Again, the average cars sold in our auctions is probably more like 7 to 8 years old. It's not the newer vehicle. It will filter down to that level. So as I look at it, I think prices will start to moderate. It might be well into '22 before we see that. But we're starting to see signs. IHS has indicated new car production is picking up, that most plants are back online here in Q4. That will help us, and we'll just need time for that to work its way through the system. I've read where many of the national retailers are down to 20 days sales and inventory. That number needs to get back up in that 40 to 50 to 60 range, and that'll help us. It will take time to get there. But we do see prices moderating throughout '22 into '23 and prices coming down. Probably by '23, I would expect we would start to be seeing more normal conditions on supply and demand, and that would be good for pricing.

Could you talk to us a little bit about like your long-term leverage targets and potentially what type of ratings that you're looking to maintain?

Doug, our target is total leverage of 3x the last senior. We have bonds due in '25 that I'm focused on what will I do with those bonds. The one thing I would tell you, we've not changed our long -- our target for total leverage of 3x or less. However, a digital business model would likely end up with a balance sheet target where you would want less leverage because when you look at technology-oriented business models, marketplace businesses, they typically would have less leverage than that because there's a lot less investment in infrastructure around the physical locations. So I'm not saying we're changing our targets now. But we do recognize, as we more -- move more digital, it might be a leverage profile where we would target less leverage. Now the good news is that I have $950 million in bonds that come due in 2025. And on our Analyst Day, we indicated that between now and the end of 2025, we expect our businesses to generate $1.5 billion of cash from operations. That will be available to support -- looking at our balance sheet and say, what's the right balance sheet next, right leverage amount or the type of business we are operating at that time? To the extent it's more technology oriented, it is possible that we will consider reducing our leverage target from 3x to something less than that. In terms of ratings, our industry being auto related, it's classified by S&P and Moody's in a category -- again, I don't focus as much on that. I mean again, we tend not to be investment grade. And no matter what we do and how well we perform. But they do have a stable to positive outlook on us because of our strong cash generation even through COVID. So we're satisfied with our current ratings. And generally, the price on our debt has been, I would say, even better than our rating would indicate. It might be in the marketplace because of our strong cash generation. So it's not been actually a deterrent in the leverage markets for us to have the ratings that we do have.

A question coming here from the audience. How does the migration to EV and hybrids affect your business?

It's interesting. It doesn't really impact our business. We've been handling Teslas in large quantities for a long period of time. Now more and more coming. We have -- again, our facilities, if they are marshaled on our facilities, we have the ability to charge vehicles very quickly. Again, you can be a super user. So superchargers is not a big deal. They're not a huge capital investment relative to the numbers of vehicles. In fact, it's a very efficient process. We can be charging vehicles 24/7 because -- to be honest, because have so many vehicles come through our properties. But the EV -- the change there is actually, how do you handle the batteries? I mean it has nothing to do with the vehicle itself is, is there going to be a demand for us changing our batteries prior to wholesaling them? At this point, there has not been on any vehicles. And we have to get prepared for that. But at this point, there's been no demand. While we are prepared to respond -- whenever the markets change and the type of work we're doing on the vehicle changes, we'll be ready. We have the space. We have the infrastructure in place. We have the power into the facilities, and it works very well. Again, these are -- we have [ 70 ] locations throughout North America that are predominantly used for marshaling vehicles, doing reconditioning of the vehicle, preparing them for retail sale. And it's quite an important part of our business. So we're prepared to handle the EV, shall we say, transition that will occur over the next decade in our opinion. It also -- EVs have been remarkably resilient on retaining value. Now whether that's because of the likes of Tesla controlling supply and demand a little bit, but the EVs ironically do very well in the digital format. There's greater confidence in an electric vehicle than perhaps an internal combustion engine, knowing it's dependability. Based -- and again, based upon the batteries and the fact that, that's the primary driver. Over time, we'll see if that continues. I don't think there's a long history of EVs to see are there mechanical issues other than the batteries that you have to deal with.

There's a question coming [Audio Gap] expansion in other markets that you're not currently in?

We're in the -- we're focused on the U.S. right now, digital D2D. That is our primary. Canada, we're in a leadership position. And again, it's easy. It operates very similar to the U.S. So North America is getting a lot of attention. We do operate in Europe -- in Continental Europe through ADESA Europe and in the U.K. through ADESA U.K. Those are 100% digital platform businesses. We have no physical auction operations. And at this point in time, I would say we've deprioritized it temporarily because of the focus on winning in the digital B2B space in North America and, in particular, the U.S. But it's an area where we would see ourselves investing in growth over the next 5 years for sure. And again, though, it will be a different type of investment than how we build up the North American business, which started as a roll-up of physical location. Lots of property. Now transforming it into a digital marketplace business. We have started in Europe as a digital marketplace business. We do not focus on physical auctions. It's a very digital enterprise, and it's profitable and growing. Despite the fact that the volumes are down, profitability is growing. The economic model is fantastic in Europe, and we see that as an opportunity to us. However, it's an opportunity that we think that we can take advantage of with cash we generate from the businesses as opposed to needing outside capital as of now.

That makes a lot of sense. Question here. Labor has been pretty tight. Labor cost has gone up. How have you been able to attract talent and retain talent and afford some of the rising prices of labor?

Prior to COVID, we had done a study of the lower end of our labor pool in the auctions and found that we had to increase. We could not continue operating with the minimum wage that was in place and going up from that because we started seeing competition for talent with the likes of Amazon hiring, Walmart. Ironically, those are the types of businesses we were competing with for the talent that comes in to drive vehicles. A lot of people that are at the end of their careers come in and work in our business model driving vehicles. They enjoy it. And so we've seen labor costs come up, but they were coming up unrelated to COVID. Now with COVID, I think we were better prepared because we had raised the [indiscernible] in the field and trying to be responsive to competition. We then eliminated 5,000 positions. Ironically, having less demand for a period of time, it was a good time because it was hard to hire people. Now as we -- one of our initiatives is increasing what we call the retail reconditioning, reconditioning vehicles for the e-retailers so the car can go from our site directly to the consumer's driveway. It doesn't need additional reconditioning by the likes of CarMax, Carvana, Vroom, Shift, all the e-retailers and the franchise dealers. For that, we need to increase our reconditioning team. We need to increase the number of employees. It's a challenging environment right now. But these are jobs that have good, stable hours, especially if you're mechanically inclined, so we feel we can fill all the positions. The wage rates are reasonable relative to the value that we deliver to the customer. So the margins continue to be pretty strong for most -- for all of those services. And so we've been able to respond to it, but it is a challenge that we're dealing with every day. And that challenge is where do you find the talent pool? And I'll be honest, where we're operating tends to be in areas with large commercial properties around it. And we're seeing a lot of competition from the likes of Amazon putting in distribution centers around the areas where we're also -- where we've been operating through, in many cases, 10, 20, 30 years. So a new competition for talent. But I think we're up to it, and we'll be able to get the talent. The labor rates are consistent. Again, it's a high-value service with high productivity. So we can absorb the increased labor cost because we have such high throughput on these sites. It's like a mass production factory. There's no downtime unlike there might be in a service operation of a dealership or something like that. I think we're in a good spot. But we are hiring, especially as it relates to our recon opportunity for the e-retailers.

Eric, that makes a lot of sense. Thank you so much. It is an excellent overview and presentation. Thank you for digging deep into some of those answers. And without further ado, we'll wrap up the fireside chat with KAR Auction. Thank you so much.

And thank you, Doug, and thanks, Bank of America for hosting us.