Openlane Inc (KAR) 2016 Q4 法說會逐字稿

Good day and welcome to the KAR Auction Services Q4 and FY16 earnings conference call. Today's conference is being recorded. At this time, I'd like to turn the conference over to Mike Eliason. Please go ahead.

Thanks, Jessica. Good morning and thank you for joining us today for the KAR Auction Services fourth-quarter 2016 earnings conference call. Today we will discuss the financial performance of KAR Auction Services for the quarter ended December 31, 2016. After concluding our commentary, we will take questions from participants.

Before Jim 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 Provisions of the Private Securities Litigation Reform Act of 1995. Investors are cautioned that such forward-looking statements involve risks and uncertainties that may affect KAR's business, prospects, and results of operations and such risks are fully detailed in our SEC filings.

In providing forward-looking statements, the Company expressly disclaims any obligation to update these statements. Lastly, let me mention that throughout this conference call, we will be referencing both GAAP and non-GAAP financial measures.

Reconciliations of the non-GAAP financial measures to the applicable GAAP financial measure can be found in the press release that we issued yesterday, which is also available in the Investor Relations section of our website. Now, I'd like to turn this call over to KAR Auction Services CEO, Jim Hallett. Jim?

Thank you, Michael. Good morning, ladies and gentlemen and welcome to our call. I'm excited this morning to be with you to share our overview of our performance for 2016, maybe even more excited to share with you what we see in 2017 and going forward.

Want to discuss a capital deployments in 2017 and then, very enthusiastic to introduce a new project to you which relates to our online selling platform that we will be referring to as New Wave, and then longer-term, I want to talk about KAR's performance, our strategic focus and then capital deployment going forward.

With that said, I want to say at the very outset that I'm very enthused, not only about the opportunities that we have in front of us for 2017, but even more so the visibility that we have for the next three years. I believe that we've made the investment and we've truly positioned the Company to take advantage of the market that we see coming at us over the next three years.

And as we complete this call, I'm looking forward to getting on the road with Eric and Michael and spending considerable time with you to share our optimism as we go forward. With that said, let me turn to our fourth quarter, with KAR's consolidated results. I believe they are very much in line with our expectations, but we do recognize the results for the segments were a little choppy.

And as I've discussed many times with you, I believe one of the true values of the KAR combination is what I would refer to as the complementary and diversified nature of our business, where we can have one part of the business perform extremely well when maybe another part of the business is experiencing a little bit more pressure. And that's exactly what we've seen in the fourth quarter.

We saw this play out: IAA had an extremely strong performance which did offset the pressure on earnings at ADESA. I believe the key takeaways for 2016 results are, revenue grew 17%, adjusted EBITDA grew 15% to $748 million, and free cash flow grew 9% to $368 million. I'll talk a little bit more about how we deployed that capital or deployed that free cash in a few minutes.

At ADESA we had a challenging fourth quarter, so let me speak to that. We saw our activity slow in October and early November. Conversion rates dropped at the physical auction despite the shift in the mix to more commercial vehicles, and we saw consignors that have become very price-sensitive during that period of time where conversion rates fell.

ADESA 's performance, I believe, was consistent with the uncertainty in the retail space that was centered around the election. Same-store physical auction volume was flat year over year in the fourth quarter. Dealer consignment volumes, excluding the acquired auctions, was down 7% in the quarter.

For the year, same-store dealer consignment volumes were down 2%, which was very much in line with our expectations. Commercial volumes excluding the acquired auctions was up 6% at physical auction. Average revenue per unit was up at the physical auction, as well.

I believe that the revenue per unit is a reflection of the higher utilization of ancillary and other related services on cars that did not sell in the quarter. As you know, these ancillary services come with lower margins. However, I do believe this sets us up very well for 2017, when I expect these cars to be sold. Our leadership in the private label online auction channel was evident with a 16% increase in volume.

Again, I believe that we are in a great position as I look forward into 2017. We've had more commercial vehicles on the ground at year-end and the mix of vehicles awaiting sale is very good for us. Most of the vehicles that we have on the ground at the end of 2016 are what we refer to as the captive finance vehicles. Whereas if I compare that to year-end 2015, most of those vehicles on the ground were what we refer to as OEM vehicles or factory buybacks.

In the case of these vehicles at year-end 2016, the fleet lease cars, we generally generate more profit and more revenue opportunity on these capital finance cars. So, again, I am very encouraged by the inventory that we had going into 2017.

Overall, I would say that ADESA had a strong 2016, especially they had a strong first half of the year. And then for the year, we were able to improve our adjusted EBITDA margin. We grew our adjusted EBITDA 28%. Again, I believe we are in a great position to deliver even better results as we look at what's going on in the industry and the market in 2017.

Insurance auto auctions had an exceptional fourth quarter. Revenue grew 16% on an 18% increase in volume. Adjusted EBITDA was up 22% and we improved our adjusted EBITDA margin. In contrast to ADESA, insurance auto auctions had a great second half of 2017 after a relatively slow start in the first half.

AFC's performance was very much in line with independent used car dealer retail activity. For the fourth quarter, retail used car sales by independent dealers was relatively flat year over year, and our performance at AFC was consistent with this retail trend. However, our provision for loan losses was increased in the fourth quarter and I will let Eric give you the details on that in a few moments.

But I believe the bottom line is that we're seeing decreasing used car prices and a retail used car market that is starting to level off. This will put some pressure on the independent used car dealer, and we are now anticipating that our loan losses will be 1.75% to 2.25% range in 2017, and this is a modest increase from what I previously shared with you. I believe we have great visibility into 2017 and we expect a very strong year.

We are expecting adjusted EBITDA of $825 million to $850 million in 2017 and free cash flow of $395 million to $420 million. My outlook for 2017 is based on the following -- at whole car auctions, we will see commercial vehicles should increase as lease returns and repossessions are expected to increase over 2016 levels.

Dealer consignment volumes may continue to decline modestly in 2017 as we see the SAAR remaining flat to slightly down. In total, we expect used-car volumes to increase, used car values are expected to decline 3% to 5% as the increase in supply combined with the heavy incentives that are being placed on new car sales will push down used-car prices.

Insurance Auto Auctions is also well positioned. Again, the drivers of this business, we're seeing an increase in miles driven, increase in the complexity of these new vehicles and we are seeing an aging car park that will all contribute to increased total loss rates for the insurance industry. We expect 5% to 7% increases in the industry volumes in 2017, which will drive strong revenue growth.

Our inventory at Insurance Auto Auctions was up 25% over the prior year, again, setting us up for a great start to 2017. Independent used car sales in the US and Canada are expected to level off after seven years of growth. This will result in slower growth at AFC. SG&A growth has been a topic over the last year.

We have been increasing SG& A to support our growth and to meet the growing technology needs of all of our businesses and to staff the strategic initiatives that I believe will be critical to our long-term success. This is what I referred to at the outset of this conversation. I also expect the pace of growth in SG&A to slow compared to what it was in 2016.

We would also expect to complete the integration of the auctions that we acquired in 2016, which will further contribute to improved performance at ADESA. I believe that our capital deployment in 2016 reflects our ability to utilize cash in many different ways to create shareholder value.

We utilized $432 million to acquire businesses. Those were made up of the eight Brasher locations, one location in Flint, Michigan and another location in central Florida. As well, we also acquired an online auction business in the UK.

We paid $157 million in dividends to our shareholders and we repurchased $80 million of stock in the fourth quarter. Although we had utilized a substantial amount of our capital for acquisitions, we felt our stock was undervalued in the fourth quarter and we purchased 1.9 million shares in the open market. The deployment of capital for growth and providing a return to our shareholders remains a top priority at KAR.

Now, I'd like to update you on the strategic project called New Wave, which is our next-generation online solution. Our online selling platforms represent one of the most valuable and differentiating assets with nearly 750,000 vehicles sold upstream in 2016.

To remain at the very forefront of this segment of the business, we are investing $20 million to $25 million over the next three years to redesign and enhance our market leading position. New Wave leverages the latest advances in online and digital technology to deliver a more simplified user experience and enable seamless use across desktop, mobile and tablet devices.

It will also integrate the advanced analytics, pricing and reporting capabilities generated by KAR's data science solutions team and we expect to begin deploying the New Wave solution later this year and the investment is included in our 2017 capital expenditures estimate. As I look beyond today and even beyond 2017, let me provide some insights on KAR's performance, our strategic focus and our capital deployment over the next three years.

First and foremost, our auction businesses are well-positioned for the next three years. Off lease volumes will continue to grow through 2019 and we expect the repossession volumes to grow as well. We would expect the mix of commercial vehicles versus dealer consignment vehicles at physical auctions to move closer to a 60/40 split.

We were 52% commercial and 48% dealer consignment in 2016. This should drive increases in revenue per vehicle sold, and partially offsetting the increase commercial volumes will be a decline in dealer consignment volumes. Our outlook is based on the SAAR remaining at current levels and we are also expecting the recent growth of SG&A to stabilize over the next three years.

We've been adding additional talent and technology to all of our businesses to support our growth and provide the foundation for executing on our strategic initiatives that I spoke to. Now that we've built many of the new capabilities within KAR, the pace of SG&A growth should decline and be below our revenue growth over the next three years. As we look forward, we expect salvage value volumes to grow 5% to 7% per year over the next three years.

Our strategic focus can be described in two categories. First, expand our capabilities for serving our existing customers. We will continue to invest in technologies with programs like New Wave, that I've just described. We will enhance our services around the extensive and unique data that we acquire in all of our businesses and we will identify and develop new and alternative venues to serve our wholesale customers.

We are constantly watching for innovation and new competitors and I believe that the consolidation of the whole car and the salvage wholesale markets into duopolys does invite competition and disruptors. My goal is to make sure that we are providing the services that our customers are demanding, and if our current business model is to be disrupted, we need to be that disruptor.

The second category is international expansion. We've had the opportunity to enter new markets with our people, processes and technologies. I believe that it's always better to enhance an existing business in a new geographic market. I can tell you that we're focused on mature markets with relatively stable economies outside of North America. We expect to acquire businesses that can serve as a platform for introducing our technology and our service offerings and we are not looking for transformational transactions, but transactions that would be more in line with the size of the deals that you've seen us do here in the US.

We do have a number of potential targets identified. In addition to new geographies, we are also planning to enhance our offering in the UK by combining our online capabilities with the TradeRev platform. Our target market is the commercial consignor and we believe that the UK will grow over the next three years.

Now, let me speak to capital deployment. We will generate $395 million to $420 million of free cash flow in 2017 and we expect this to grow each year over the next three years. We are currently allocating 45% to 50% of our free cash to a recurring dividend. Our remaining capital is available for acquisitions or return to shareholders through share repurchases or special dividends.

In addition to the cash generated from our operations, we also have access to the capital markets. Our target senior leverage is three times adjusted EBITDA, and we would expect to use our balance sheet as our leverage falls below three times. Finally, the possibility of a significant reduction in corporate taxes in the United States could be a real positive for KAR.

We currently pay US taxes at the Federal statutory rate and a 1% reduction in the Federal corporate income tax rate would result in a $0.02 per share increase in net income. We would also see a similar reduction in our cash taxes, and this could be an additional source of free cash flow over the next three years.

With that, I will end my comments and I will turn it over to Eric for his commentary and then we will come back for Q&A. Eric?

Thank you, Jim. I would like to start by reviewing our guidance for 2017 in more detail. Jim has updated you on our adjusted EBITDA and free cash flow guidance. We expect our capital expenditures to be approximately $145 million and this includes the capital for New Wave that Jim discussed.

Cash taxes are estimated to be $165 million for 2017. There are two conservative assumptions we have used in computing this cash tax number. First, we are assuming the US Federal income tax rate does not change in 2017 from the current tax rate. As many of you know, we have a relatively high corporate tax rate due to the cash nature of our businesses.

Any reduction in the US corporate tax rate would be a direct savings in cash taxes. I currently estimate that a 1% reduction in the US corporate tax rate would reduce cash taxes by approximately $4 million. The second assumption that is conservative is our anticipated tax deduction for option exercises in 2017. We have approximately 400,000 outstanding options that will expire if not exercised in 2017.

The exercise of these and any other vested stock options outstanding results in a tax deduction for the difference between the fair value on date of exercise and the exercise price. Our cash taxes will be impacted by the timing of these exercises and the related fair value of KAR stock on the date of exercise. Cash interest on corporate debt is estimated to be $120 million in 2017.

We have assumed two interest rate increases in 2017 that will impact adjusted LIBOR. As you can see in our reconciliation of net income to EBITDA, adjusted EBITDA and free cash flow included in our earnings release, we expect total interest expense of approximately $170 million, of which $50 million is interest on the AFC securitization and amortization of debt issuance costs included in our interest expense number.

We expect 2017 net income per share of $1.70 to $1.80 and operating adjusted net income per share of $2.15 to $2.25. The difference between net income per share and operating adjusted net income per share is amortization expense related to acquisitions net of income taxes. We have assumed an effective tax rate of 37% for the year.

Now, turning to our 2016 results, I would like to review an area that I believe has been misunderstood by some investors. In computing operating adjusted net income we are adding back amortization expense related to acquisition accounting for intangible assets established in the opening balance sheet of the acquired entity. We do not adjust for depreciation and amortization expense related to tangible assets or identify technology assets in service.

In 2016, depreciation and amortization expense totaled $240.6 million, of which $97.1 million was amortization expense related to acquisition accounting for intangible assets. These numbers can be seen in the reconciliations of net income to adjusted EBITDA and net income to operating adjusted net income, included in our earnings release.

In discussions with investors, it appears that many have overstated the add back for amortization in computing operating adjusted net income. We also had higher depreciation and amortization expense than we expected in the second half of the year, as more assets were placed in service and the related lives were shorter than our original projections. This lowered operating adjusted net income.

For 2017, we expect total depreciation and amortization of $278 million, of which acquired amortization expense added back to compute operating adjusted net income is $101 million. We have not anticipated any acquisitions in 2017 in determining these estimates. We will adjust our estimates if acquisitions are completed during the year.

Another item of note impacting our 2016 financial statements is the gross up of revenue for purchased vehicles in the ADESA segment. We purchased less than one half of 1% of vehicles sold, primarily to settle arbitration issues where the seller and buyer could not reach agreement on the value when there is a dispute over the disclosures of the condition of the car.

Previously, we had recorded these transactions by netting the cost of the vehicle with the ultimate selling price. Because ADESA had the risk of loss on the vehicles purchased, we have included the sale price of the vehicle in revenue and the purchase price of the vehicle in cost of services. This change in accounting for purchased vehicles was identified and made voluntarily by management.

There is no impact on gross profit, operating profit or net income. Most important, we have excluded the growth selling price from an average revenue per unit at physical auction. Accordingly, our ARPU metric is consistent with all prior calculations. We have disclosed the impact of this reclassification on revenue and cost of services by quarter for 2016 and 2015 in our 10-K that we expect to file this week.

ADESA's fourth quarter performance was highlighted by strong top line growth, but weaker flow-through to adjusted EBITDA than we experienced in the previous three quarters. We had some unique one-time items that were expensed in Q4. We had a customer of Cars Arrive file for bankruptcy with approximately $4 million owed to us.

This represents substantially all of the increase in bad debt expense in Q4 at ADESA. We also had costs incurred related to the acquisition of the Flint auction and increased compensation and technology costs related to our strategic growth initiatives. This made the incremental margins in the fourth quarter for ADESA very messy. It looks as if this messiness is contained in Q4 and I do not expect it to continue in the first quarter of 2017.

Now, let me speak to AFC's loan loss situation in a little more detail. Actual losses incurred in the fourth quarter aggregated $9.4 million. Generally, these losses are due to cars being sold and therefore no longer available as collateral for unpaid loans.

As retail used car sales for independent dealers level off and used vehicle prices decline, it is expected that loan losses increase, especially as you compare this to the last five years of very low loan loss activity. In addition to actual losses incurred, we increased the allowance for loan losses by $2.3 million in Q4.

Approximately half of this increase in the allowance relates to a large balance outstanding with an individual dealer in the southeastern United States. We identified this loss during our routine lot audit process. The account was current at December 31, 2016. But because we identified the loss of collateral, we have recognized a loss for the amount of the loan not protected by the collateral.

As we look into 2017, we are expecting loan losses in the first half of the year to be at the high-end or above our annual loan loss expectations. We expect loan losses as a percent of loans outstanding to be lower in the second half of the year. A number of risk mitigation processes have been instituted at AFC that are helping identify potential loss accounts earlier in the collection cycle. AFC is also focused on growing accounts with lines of credit less than $500,000, as we have seen lower loss rates within this group of customers.

Now, let me speak to capital deployment and our capital structure. In addition to completing a number of acquisitions in 2016, we also repurchased $80 million in KAR stock on the open market in the fourth quarter. We had a limited time with an open window for purchasing stock in the open market in Q4. This limited the total amount of stock purchased. Our net leverage was 3.2 times adjusted EBITDA at December 31, 2016. This net leverage is based on actual adjusted EBITDA and not pro forma results of operations for businesses acquired.

Our target net leverage is three times or less. We regularly analyze the loan markets and our debt instruments. The soft call on our current term loan facilities expire on March 9. We have not considered any potential reduction in interest costs in our 2017 guidance.

In conclusion, 2016 was a good year for KAR and each of its business segments, given the market conditions we faced. We saw a stronger performance at ADESA and AFC in the first half of the year than the second half. In contrast, IAA had a strong finish to the year after a slower first half.

This all adds up to an enterprise that consistently generates cash that can be deployed to enhance shareholder value either by investing in strategic growth or returning capital to shareholders. We have very good visibility for several years and feel it is a great time to invest in KAR.

That concludes my remarks and I will return the call to Jessica to moderate our Q&A session. Thank you.

(Operator Instructions)

Elizabeth Suzuki with BofA Merrill Lynch.

Just a modeling question. And the detailed 2017 outlook you provided is really helpful. I wanted to ask specifically about the DNA assumption, which looks like you've got increasing 15% year over year? Is any one of the three business segments there bearing more of the burden of that increase? Or, is it pretty equal across the board?

Liz, it's typical to our past pattern, technology is probably the biggest driver of that and that's why the shorter lives give you increased depreciation. That is probably a little heavier at ADESA than it is at IAA and AFC. That is typically half or a little more than half of the total CapEx, and the remainder I would spread equally across ADESA -- actually, not equally -- I would do equally to ADESA and IAA with a much smaller portion to AFC as they don't have the physical footprint.

Okay. Great. Looking at IAA, what's the penetration rate with recently acquired dealerships? Is there still some more work that needs to be done in building a financing relationship with those dealers? Or, should we expect that IAA will grow similarly to core organic growth in the future?

Are you saying IAA or AFC, Liz?

Sorry. IAA in terms of relationship with the communities that you've recently built.

The noninsurance customer, right?

Yes.

That's an ongoing process. It's blocking and tackling, as they say. It's one dealer at a time. I think there's a lot of runway for them.

I will point out, though, that there is significant volume coming from the insurance industry which puts our facilities closer to capacity and so you have to slow down a little bit if we don't have room for more cars, at times. I think you'll see the insurance industry actually outgrowing the noninsurance industry over the next couple of years.

Great. Thank you.

Matt Fassler with Goldman Sachs.

My first question relates to New Wave, just kind of a high level question --why now? I know it's always a good time to invest in technology. Also, competitively, within the ecosystem, how do you expect this to change your positioning, if you could say, perhaps, where you think you will be three years from now as this investment is done, versus where you stand today?

Right. We consider our online platform to absolutely be in a leadership position, just to give you a little bit of detail on that. Our online platform provides approximately $80 million in revenue. It's our highest profitability of all of our offerings and I believe that it's our responsibility to enhance that value proposition, provide more flexibility and more services to our customers.

We talk about integration that we can do with our data and analytics, which has become a real major focus of KAR as well as a major focus of our customers. This is what they are asking for.

I think there's an opportunity to not only take care of our existing customers and provide a better experience for them, but I also think there's an opportunity to grow new customers on that platform, as we go forward. Again, really excited about the opportunity that we are going to be able to actually take this to market here in 2017.

Okay. My second question relates to the salvage business. Obviously, the volumes were kind of blowout. If you talk to the ASP, and what the moving pieces were there, particularly as scrap steel prices have shown a bit in declines and have recovered to some degree. Where might the ARPU or the ASP in that business start to happen?

I think, Matt, the salvage business -- I would refer to it as being very, very steady. I think, as you look at scrap prices now, the comps year over year are much more in line. We haven't looked at scrap prices, in terms of our forecasting and our budgeting.

We haven't looked at scrap prices increasing significantly. We've looked at them staying relatively flat with where they are today. If they were to increase, obviously that would be a bonus for our proceeds. Eric?

I would add, Matt, we were down 2% in revenue per unit across the IAA platform on a net revenue basis and that's strictly due to proceeds and that's pretty consistent with the market. Again, we consider it fairly level but it was down compared to a year ago.

Understood. Finally, getting us comfortable with the recovery and loss rates in AFC, as you go through the year, you had some idiosyncratic factors drive it to that 2.6% level. To the extent that you are 2.25% or so and presumably the ASP declines in the market, used car values don't recover, what will enable you to get that number back down again in the second half of the year?

We've done a number of things on loss mitigation, but the most important is these losses are concentrated heavily into the largest accounts, meaning the largest credit lines, Matt. We are very focused on really expanding that lower base, that $500,000 or less dealer. Because, we are finding again, less risk.

Even though it sounds like a riskier proposition, the risk is spread across a larger population of dealers as you have a very small number with over $1 million that are disproportionately affecting the losses here in the near term. The dealers with the larger credits are making the biggest bets. They are also, as we've said before, getting credit from multiple sources, in some cases.

The smaller dealer is less likely to have the credit available for them throughout the marketplace and get overextended at the same level.

Matt, I would just take you back and remind you that AFC still remains a great business. Not only is it a great service to our customers and very complementary to both IAA and ADESA, it has extremely high margins, as you know. Again, I think what we are seeing here, is we are just seeing a few of those independent lower end dealers tail off here as a result of prices that dropped in October and November in the fourth quarter and as volumes dropped it held steady.

I think there's a little bit of a shakeup that's going to take place. I think Eric said in his comments that we expect most of that shakeup to take place in the first half of the year.

As we go forward in the second half of the year, we are pretty good about how we are positioned and as we scrutinize those dealers, we have absolutely scrubbed every dealer and we've scrutinized these dealers and we've scrutinized their lines.

I will say one thing, we've become maybe more focused on their total credit availability, not just from AFC, but what they might have with other entities, as well. That's something we're focused on as we extend credit going forward.

I feel compelled, Eric, to ask you one quick follow-up to something you said. Understanding that your due diligence processes, is getting tighter, wouldn't the larger dealers be somewhat healthier, if you will, generally speaking with their scale? Are they ever a leading indicator of what comes down the pike, or is that not the right way to think about that?

Matt, you're absolutely right. They are a great indicator of the positive but they're equally risky on the negative. It's fewer of them. I will tell you a majority of them are very healthy. They've got consolidation of SG&A and things like that with their larger scale but they also, when they make the bet, it's just riskier.

That's why I highlighted in my commentary that it was actually one dealer was a problem in the fourth quarter. It tends to be one or two, Matt. Where, across the rest of the platform, that risk is spread over 10,000 dealers.

Thank you.

Ryan Brinkman with JPMorgan.

I understand the debt charge-off at AFC, of course that's been part of the story all along. What gives rise to the bad debt expense at ADESA? Is it just the risk from the Cars Arrives business? Is that pretty manageable and unusual and nonrecurring, et cetera? I think that was an important piece, that charge of the pressure on incremental margin in 4Q.

Was there anything else in your operating expenses that was a nonrecurring or semi-nonrecurring nature? Sometimes before you've called out compensation expense or some other factor?

Ryan, I will let Eric take the bad debt and I will just talk about the performance, in general, at ADESA in the fourth quarter. I think, number one is there was no question that we saw a softening in October and November centered around the election and a lot of uncertainty. In fact, December was an excellent month.

December performed extremely strong but couldn't make up for what took place in October and November. Then, what we did see -- we saw a shift in the revenue mix at ADESA during the fourth quarter. A lot more of these commercial vehicles, a lot more of these vehicles that are using the ancillary and related services.

As you know, these ancillary and related services come at reduced margins to what the sale -- what the buy and sell fees are at the auctions. Along with that, we also had the SG& A pressure, where the investments I talked about that really position us for the next couple of years here. The good news coming out of all this, is customers were sensitive to price and resisted price in October and November, started selling in December.

But the inventory that we had on the ground going into 2017 is extremely attractive inventory, it's high dollar cars. It's going to use ancillary services. I think it positions us very well, as I said in my commentary, as we go into the year. So, all in all, I don't look at ADESA in a 90 day period.

We've had quarters like this before. As you look at this business over 12 months, I think ADESA had a very good year. Eric, maybe you can speak to some of the debts -- the debt that you talked about at Cars Arrive and some of the one-time charges?

Ryan, the Cars Arrive -- that's a unique item and not repeatable. It's unusual to have that much outstanding from one customer. It's actually a structured reorganization. We have written off 100% of the balance owed to us, expecting no recovery. If the business continues, we would probably look at that as to how we can continue serving that customer.

That $4 million accounts for almost the entire increase in SG&A related to bad debt at ADESA. We don't have that in any other business and we don't see anything across the spectrum of our customers at ADESA. As you know, generally, we are owed more money than we -- by our customers -- I'm sorry, we collect more of their money than we are owed.

And have the proceeds of the car and most of the part over the business at ADESA. So it's not exposed to the same level as transportation. The other areas where there is one-time items, we had some expenses related to professional fees associated with the Flint acquisition that we've disclosed. Then we have some technology spend that I think is unique.

Now, it will transition off. It's actually related to the integration activities and I'm not adding that back because it's running the businesses while we are getting ready and executing on the integration, especially at Brasher's and Flint. Those will taper off in the second half of next year as we get them on our AMS system. So, those are kind of -- I call them one-time but the biggest was the bad debt.

Thanks both for the excellent color. It looks like online-only auctions at ADESA rose a strong 16% while physical was flat? But, I understand that almost all of the dealer consignment business which is softer is physical, right?

Is it not fair, then, to infer from the fact that fiscal overall was slack, the thesis of off-lease volumes slowing down into lower rungs of the funnel was somehow off track? How did the off-lease at physical and associated ancillary services track relative to your expectations in the quarter?

I think that we did see the drop in dealer consignment that you mentioned, but there were more cars sold at physical auction. If you think about it, I think that we would expect -- I think it was within our expectations.

There were more institutional cars. Institutional cars were up 6% at physical auction, offsetting the 7% decline in dealer consignment, Ryan. That's what Jim's referring to -- more cars sold at physical auction in the quarter. It was on the institutional side.

(multiple speakers) Jim, talked about the early part of the quarter as really what caused it when the consignors didn't like the pricing.

Right. I think I mentioned that a couple of times. As you were in that election time in October and November, customers were just resisting price and we didn't see that start to loosen up until December. I can just expand online a little bit, as we think about it. We've always maintained the position that we don't dictate to our customers where they should sell a vehicle.

We believe the customer should choose where they sell the vehicle and we believe the market will determine what the best channel for the vehicle is. Our responsibility is to provide the best venues, provide the best opportunities in these various channels, to be able to offer the cars. Expand the tools and the things I talked about in data and analytics to help them make better decisions, in terms of where they should sell those vehicles and how they should sell those vehicles.

Again, continue to grow the buyer base online and let the market take over. With that said, with the vehicles that are coming to the top of the funnel, we will sell more vehicles online. As a percentage, I believe that percentage will drop and I am convinced that more vehicles will get to the physical auction where we do get to enhance the cars with those ancillary related services. All in all, I think it --

Just on geography, investors like these multiples that you pay for things like Flint, relative to your Wall Street trading multiple. With Flint behind you, with Pittsburgh organically into Chicago with Brasher's, are you pretty much filled out? Is there anywhere left where you could make a really accretive acquisition? In the past you mentioned [Sonapi] in South Florida? Any room, still, to expand like that?

There is still a handful of what we would call really, really plum auctions, really desirable independents. It's mentioned that some of them are second and third generation. They are at that inflection point of do I stay in or is this the time to exit? We have had conversations with some of those independents and we believe there may be some additional opportunities. But, nothing that we are able to speak to today.

Okay. Thank you.

Gary Prestopino with Barrington Research.

A lot of the questions have been answered in terms of the flow-through of cars dealing with commercial. Jim, based on your experience in the business, when you get into a situation like this where the conversion rates are down, the dealers are not taking the prices that are offered on the cars at the auction -- how long from the beginning of that time period to where that situation actually becomes more clear, or clears and the dealers will start accepting the prices for the cars at auction?

These cars eventually have to sell, right? They can't just keep backing up on the dealers' lots. They can't just keep backing up at inventory on your lots, as well?

Gary, good point. As I like to say, the good news of these vehicles are all on a one-way ticket. They are eventually going to be sold. The commercial consignors are not going to take these cars back out of inventory and transfer them to another location or another channel. Once they've arrived at auction, they will get sold on the commercial side.

With the dealers it's a little bit different, dealer consignment. They will resist price and take the vehicle back and try to retail it or wholesale it or package it or do something different with it. For the most part, I think the market does adjust and it's not like it's going to take them months and months to figure out that the markets changed and I better start accepting today's price sort of thing.

Because this is not going to get better with time. In the case of the last quarter, we saw it last for probably 60 days. October, November it resisted and December, the volumes started to sell. They started to accept price and going into 2017.

One of the other things, Gary, that I would speak to, and it primarily applies to the dealer side -- to the commercial side, and then there's some things we are doing on the dealer side that I will talk about, as well. On the commercial side, our customers are really asking us to help them make better decisions. This is the focus on data and analytics.

We put together a data science team here at KAR in 2016. We continue to add to that team. Really, as we call it, to take all of this data that we have, turn it into actionable intelligence and predictive analytics and allow customers to make better decisions.

I think, as we can provide better analytics to our customers, whether it's selling in the upstream venues, in the closed sale, the online sail, or when it gets to physical, we can help them get more familiar with what that car should be selling for in today's marketplace. So, that is something that's in very high demand and I believe that we are in a position to build those pricing engines and to lead the charge in this area.

The other area that I mentioned to you on the dealer side, we do have some products that we think will help the dealers get more familiar with the pricing in the market and this one product that I would turn to is a product that we call Autoniq. Autoniq really gives you -- I guess -- the aggregation of all the various books and the pricing data that is current in today's marketplace.

It's on your mobile phone, it's an app. It gives you real pricing on the market, recent pricing on the market. It's a subscription business. We continue to grow that business. Dealers continue to be more dependent on that as they are in the lanes making decisions and I think that will help our dealers convert at a high rate, as well.

So, there some things going on here that I believe will shorten that time span from, I resist the price today, how soon do I get comfortable with this is the real price I should be selling the vehicle at. A long windy answer but I hope you get it.

I get it. Lastly on the Cars Arrive loss that you had, was that for physical transportation services? Are there cars involved that were lost in that?

No. That was 100% transportation services, Gary.

Okay. Thanks, Eric.

Ben Bienvenu from Stephens.

On the interest expense piece of the guidance, I'm curious. Does that assume you maintain your leverage target of three times? To what extent can you factor in the magnitude of the rate increases that you are thinking about?

Yes. It actually assumes that we only repay debt as required according to the terms of the agreement, which is a very nominal payment on a quarterly basis, Ben. We actually reduced our leverage through the growth in our adjusted EBITDA.

I would tell you using the current level of debt throughout the year is the best way to go on that. That's how we've looked at it with two LIBOR interest rate increases. And in our materials we disclosed to you, we do have some caps in place so if interest rates were to grow at a faster rate, at least for the near-term, we wouldn't see an impact if we hit up against our cap.

Great. Just to clarify on the cadence of the AFC provisions, you mentioned the first half would be a little bit above average and getting better in the back half? Should we expect the first half to be above the range that you indicated? Then, the back half below, or perhaps toward the higher end of the range but moderating from this higher 4Q level?

Based on the fact that the fourth quarter was above that range for the one quarter of the year, there is a possibility it could be above that range. I can't predict where it will be because it basically involves cars sold out of trust and what activity is occurring, Ben. I think there is exposure to it being above the range in the first half and then falling either to the low end of the range or at the low-end of the range, as you look forward.

Who knows where it will end up. The crystal ball is not clear when you look that far out but that's how we see the pattern as we look at the year.

Great. On the IAA total lost inventory growth, really substantial, up 25%. You called out part of the increase related to cat volume? I'm curious, can you quantify what amount of the 25% increase was related to catastrophic event volume?

I don't have it in front of me but it wasn't significant portion of it.

Okay.

It wouldn't even hardly be meaningful. It's across the board. There's a lot of cars getting totaled right now with all the miles driven.

Okay. Great. One last one for me. Your guidance on share count assumes that the share level stays relatively stable. You've got your three-year, $500 million authorization in place.

Is it reasonable to expect that you will be ratable in that buyback? Or more opportunistic? Is the repurchase of the options exercised you mentioned, reflected in that guidance? How are you posturing there?

I will take a piece of that and I will let Eric add to it. I think the stock repurchase is always an option to us. We've always said that we are going to have 45% to 50% of our free cash and dividends, we're going to continue to look at acquisitions and the one thing that we're not going to do is we are not going to sit on cash.

We're not going to stockpile cash. If we get to a position where we don't have immediate plans for acquisitions, we will look to stock buybacks. I would say that as we look at the first quarter and we are two thirds of the way through the first quarter, the first quarter is the quarter where we have the highest use of cash.

So, it's unlikely that we would think about anything here during the first quarter but it's always an option as we go forward. Eric, do you want to add to that?

No. That covers it very clearly.

Thanks so much.

Bret Jordan with Jefferies.

A question -- not to over flog the ADESA incremental margin. But, it sounded like you are messy on the quarter. Was the flat physical volume ex-acquisitions, the big driver? If we think about going forward, trying to take a look at dealer consignment, it was down 3% or 4% in the prior quarters and down 7% in this quarter?

If we take out that window around the election, were we in the low to mid-single digit range? Going forward, if we stay flat at physical, will the lower SG&A you are forecasting allow positive incremental margins at ADESA?

Brett, you've analyzed it reasonably well. The fourth quarter, seasonally, is always experiencing a lower incremental margin in the core business, because there's a higher mix of ancillary and related services than there is cars sold as result of the end of the year.

In prior years, I will just speak to history -- that has always set us up well as it did last year, for a strong start to the year, because you've got the low margin revenue behind you and you get that high-margin auction revenue when they sell the car. I would tell you, December was very strong. Had very good incremental margins.

Even on a seasonal basis, they probably would have been better. I don't want to get into a month, but it's a little bit unfair because you had the burden of some cost in October and November that contribute to that for the cars that did sell. You know, we saw a little bit of slowing at the end of Q3 and we talked about it then in the ADESA business.

I think it all led up to basically that there is pent-up supply of vehicles that is going to be very good for us as we look into 2017. There are one-time type items in SG& A -- that bad debt from Cars Arrive that I talked about. Also in SG&A is some of the professional fees related to acquisition activity that impacts the incremental margins a little bit.

That stuff will not recur. That's where I countered the messiness doesn't continue into the first quarter.

Okay. You think you'll return to physical volume growth in the first half of 2017?

Yes. That would be fair with our outlook.

One question on the IAA inventory? I think you said the catastrophic didn't play a major role and that inventory build? Are cycle times normalized, now? Is there anything happening from a title transfer with any major insurers that is backing inventory up?

Well, I will say in certain states, there is some pressure on cycle times. It's the volume, it's more the volume and getting through them. But, it's not evident as much because we had such strong volume actually sold, Brett.

So, while the cycle times I think are getting longer with a couple major insurers, not like they did in the past where they became burdensome. There's a lot of cars to process and you can't just sell more cars each week. The demand has to be there. It will take longer to sell the car even if the titles have been processed when you have this much inventory. But it sets us up for a great start to 2017.

Okay. The question was asked earlier, I didn't quite hear. Did you say catastrophic was not a major contributor to the inventory build?

It's not a major component of the inventory. There is some. As you know, a lot of the catastrophic events were earlier in the fall and those cars have been selling through at a rapid -- as fast as they can.

Okay. Thank you.

This does conclude today's question and answer session. Mr. Eliason, I'd like to turn the conference back to you for any additional or closing remarks.

Thank you, Jessica. This is Jim. First and foremost, I want to thank you for being on the call. I think, as I've said, we are in a great position. We feel very, very good about our business. We spoke about the investments that we've made.

We spoke about really having a defined a defined strategy and a real plan in terms of how we're going to execute going forward. I would continue to remind you, not only optimistic about 2017, but really optimistic about 2018 and 2019 as well with the visibility that we have. Again, I know that people are focused on ADESA's fourth quarter.

It's not like it hasn't happened before and I would say not to be so much focused on the quarter but focused on the long-term vision and execution that we have going forward here. I think it's a great business and I can tell you have never been more confident and more excited about the business. I look forward to continuing to show you good results as we go forward here.

Thank you for being on today. We appreciate your interest and we look forward to chatting with you more. As I said, we will be getting on the road and having some more one-on-one discussions. Thank you.

This concludes today's call. Thank you for your participation. You may now disconnect.