10-Q 1 karq3201810-q.htm 10-Q - SEPTEMBER 30, 2018 Document
Use these links to rapidly review the document


 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
ý
 
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2018
OR
o
 
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission File Number: 001-34568
________________________________________________________
kargreenlogonewoct2018.jpg
KAR Auction Services, Inc.
(Exact name of Registrant as specified in its charter)
Delaware
(State or other jurisdiction of
incorporation or
organization)
 
20-8744739
(I.R.S. Employer
Identification No.)
13085 Hamilton Crossing Boulevard
Carmel, Indiana 46032
(Address of principal executive offices, including zip code)
Registrant's telephone number, including area code: (800) 923-3725
________________________________________________________
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ý    No o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ý    No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of "large accelerated filer," "accelerated filer," "smaller reporting company," and "emerging growth company" in Rule 12b-2 of the Exchange Act.
Large accelerated filer ý
 
Accelerated filer o
 
Non-accelerated filer o
 
Smaller reporting company o
 
Emerging growth company o
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o    No ý
As of October 31, 2018, 134,599,244 shares of the registrant's common stock, par value $0.01 per share, were outstanding.
 



KAR Auction Services, Inc.
Table of Contents

 
 
Page
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 


2


PART I
FINANCIAL INFORMATION
Item 1.    Financial Statements
KAR Auction Services, Inc.
Consolidated Statements of Income
(In millions, except per share data)
(Unaudited)
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2018
 
2017
 
2018
 
2017
Operating revenues
 
 
 
 
 
 
 
ADESA Auction Services
$
527.0

 
$
477.1

 
$
1,593.4

 
$
1,464.3

IAA Salvage Services
321.1

 
287.7

 
991.6

 
883.8

AFC
85.4

 
78.2

 
255.6

 
219.5

Total operating revenues
933.5

 
843.0

 
2,840.6

 
2,567.6

Operating expenses
 
 
 
 
 
 
 
Cost of services (exclusive of depreciation and amortization)
533.2

 
479.2

 
1,599.5

 
1,462.1

Selling, general and administrative
186.0

 
155.7

 
556.2

 
467.7

Depreciation and amortization
65.6

 
66.2

 
202.8

 
195.2

Total operating expenses
784.8

 
701.1

 
2,358.5

 
2,125.0

Operating profit
148.7

 
141.9

 
482.1

 
442.6

Interest expense
49.2

 
41.5

 
139.2

 
121.9

Other income, net
(3.1
)
 
(0.1
)
 
(4.5
)
 
(1.7
)
Loss on extinguishment of debt

 

 

 
27.5

Income before income taxes
102.6

 
100.5

 
347.4

 
294.9

Income taxes
25.1

 
37.7

 
86.7

 
105.7

Net income
$
77.5

 
$
62.8

 
$
260.7

 
$
189.2

Net income per share
 
 
 
 
 
 
 
Basic
$
0.58

 
$
0.46

 
$
1.94

 
$
1.38

Diluted
$
0.57

 
$
0.46

 
$
1.92

 
$
1.37

Dividends declared per common share
$
0.35

 
$
0.32

 
$
1.05

 
$
0.96

   










See accompanying condensed notes to consolidated financial statements

3


KAR Auction Services, Inc.
Consolidated Statements of Comprehensive Income
(In millions)
(Unaudited)
 
Three Months Ended September 30,
 
Nine Months Ended
September 30,
 
2018
 
2017
 
2018
 
2017
Net income
$
77.5

 
$
62.8

 
$
260.7

 
$
189.2

Other comprehensive income (loss)
 
 
 
 
 
 
 
Foreign currency translation gain (loss)
6.3

 
12.7

 
(12.0
)
 
26.4

Comprehensive income
$
83.8

 
$
75.5

 
$
248.7

 
$
215.6

   

























See accompanying condensed notes to consolidated financial statements

4


KAR Auction Services, Inc.
Consolidated Balance Sheets
(In millions)
(Unaudited)
 
September 30,
2018
 
December 31,
2017
Assets
 
 
 
Current assets
 
 
 
Cash and cash equivalents
$
455.1

 
$
317.2

Restricted cash
22.6

 
19.4

Trade receivables, net of allowances of $13.0 and $11.2
851.2

 
725.5

Finance receivables, net of allowances of $13.8 and $13.0
1,965.9

 
1,899.6

Other current assets
176.8

 
175.7

Total current assets
3,471.6

 
3,137.4

Other assets
 
 
 
Goodwill
2,209.7

 
2,191.7

Customer relationships, net of accumulated amortization of $861.5 and $805.0
315.6

 
375.6

Other intangible assets, net of accumulated amortization of $383.0 and $338.7
353.6

 
350.6

Other assets
38.1

 
20.8

Total other assets
2,917.0

 
2,938.7

Property and equipment, net of accumulated depreciation of $833.7 and $755.1
912.0

 
908.2

Total assets
$
7,300.6

 
$
6,984.3

   

















See accompanying condensed notes to consolidated financial statements

5


KAR Auction Services, Inc.
Consolidated Balance Sheets
(In millions, except share and per share data)
(Unaudited)
 
September 30,
2018
 
December 31,
2017
Liabilities and Stockholders' Equity
 
 
 
Current liabilities
 
 
 
Accounts payable
$
870.3

 
$
682.7

Accrued employee benefits and compensation expenses
115.0

 
104.4

Accrued interest
21.7

 
7.3

Other accrued expenses
183.4

 
171.5

Income taxes payable
3.4

 
5.8

Dividends payable
47.1

 
47.0

Obligations collateralized by finance receivables
1,366.3

 
1,358.1

Current maturities of long-term debt
17.7

 
12.4

Total current liabilities
2,624.9

 
2,389.2

Non-current liabilities
 
 
 
Long-term debt
2,657.6

 
2,667.7

Deferred income tax liabilities
189.6

 
192.7

Other liabilities
267.0

 
249.8

Total non-current liabilities
3,114.2

 
3,110.2

Commitments and contingencies (Note 8)

 

Stockholders' equity
 
 
 
Preferred stock, $0.01 par value:
 
 
 
Authorized shares: 100,000,000
 

 
 

Issued shares: none

 

Common stock, $0.01 par value:
 
 
 
Authorized shares: 400,000,000
 

 
 

Issued and outstanding shares:
 

 
 

September 30, 2018: 134,599,191
 

 
 

December 31, 2017: 134,315,118
1.3

 
1.3

Additional paid-in capital
1,225.9

 
1,251.8

Retained earnings
371.5

 
257.0

Accumulated other comprehensive loss
(37.2
)
 
(25.2
)
Total stockholders' equity
1,561.5

 
1,484.9

Total liabilities and stockholders' equity
$
7,300.6

 
$
6,984.3








See accompanying condensed notes to consolidated financial statements

6


KAR Auction Services, Inc.
Consolidated Statements of Stockholders' Equity
(In millions)
(Unaudited)
 
Common
Stock
Shares
 
Common
Stock
Amount
 
Additional
Paid-In
Capital
 
Retained Earnings
 
Accumulated
Other
Comprehensive
Loss
 
Total
Balance at December 31, 2017
134.3

 
$
1.3

 
$
1,251.8

 
$
257.0

 
$
(25.2
)
 
$
1,484.9

Cumulative effect adjustment for adoption of ASC Topic 606, net of tax
 
 
 
 
 
 
(3.0
)
 
 
 
(3.0
)
Net income
 

 
 
 
 
 
260.7

 
 
 
260.7

Other comprehensive loss
 

 
 
 
 
 
 
 
(12.0
)
 
(12.0
)
Issuance of common stock under stock plans
1.4

 
 
 
14.2

 
 
 
 
 
14.2

Surrender of RSUs for taxes
(0.2
)
 
 
 
(10.1
)
 
 
 
 
 
(10.1
)
Repurchase and retirement of common stock
(0.9
)
 
 
 
(50.0
)
 
 
 
 
 
(50.0
)
Stock-based compensation expense
 
 
 
 
18.1

 
 
 
 
 
18.1

Dividends earned under stock plans
 
 
 
 
1.9

 
(1.9
)
 
 
 

Cash dividends declared to stockholders ($1.05 per share)
 

 
 
 
 
 
(141.3
)
 
 
 
(141.3
)
Balance at September 30, 2018
134.6

 
$
1.3

 
$
1,225.9

 
$
371.5

 
$
(37.2
)
 
$
1,561.5

   




















See accompanying condensed notes to consolidated financial statements

7


KAR Auction Services, Inc.
Consolidated Statements of Cash Flows
(In millions)
(Unaudited)
 
Nine Months Ended
September 30,
 
2018
 
2017
Operating activities
 
 
 
Net income
$
260.7

 
$
189.2

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
Depreciation and amortization
202.8

 
195.2

Provision for credit losses
27.7

 
30.8

Deferred income taxes
(2.3
)
 
7.9

Amortization of debt issuance costs
8.0

 
7.8

Stock-based compensation
18.1

 
16.8

Gain on disposal of fixed assets
(0.6
)
 
(0.5
)
Loss on extinguishment of debt

 
27.5

Other non-cash, net
(0.7
)
 
7.4

Changes in operating assets and liabilities, net of acquisitions:
 
 
 
Trade receivables and other assets
(144.4
)
 
(91.7
)
Accounts payable and accrued expenses
216.5

 
97.5

Net cash provided by operating activities
585.8

 
487.9

Investing activities
 
 
 
Net increase in finance receivables held for investment
(90.2
)
 
(38.5
)
Acquisition of businesses (net of cash acquired)
(23.3
)
 
(47.0
)
Purchases of property, equipment and computer software
(121.1
)
 
(110.1
)
Advance to equity method investee

 
(5.0
)
Proceeds from the sale of property and equipment
0.5

 
0.3

Net cash used by investing activities
(234.1
)
 
(200.3
)
Financing activities
 
 
 
Net increase in book overdrafts
14.3

 
31.7

Net decrease in borrowings from lines of credit

 
(80.5
)
Net increase (decrease) in obligations collateralized by finance receivables
6.0

 
(33.0
)
Proceeds from long-term debt

 
2,717.0

Payments for debt issuance costs/amendments

 
(22.6
)
Payments on long-term debt
(8.0
)
 
(2,427.9
)
Payments on capital leases
(23.5
)
 
(21.7
)
Payments of contingent consideration and deferred acquisition costs
(7.4
)
 
(7.0
)
Initial net investment for interest rate caps

 
(1.7
)
Issuance of common stock under stock plans
14.2

 
9.8

Tax withholding payments for vested RSUs
(10.1
)
 
(5.7
)
Repurchase of common stock
(50.0
)
 
(100.0
)
Dividends paid to stockholders
(141.2
)
 
(131.5
)
Net cash used by financing activities
(205.7
)
 
(73.1
)
Effect of exchange rate changes on cash
(4.9
)
 
16.5

Net increase in cash, cash equivalents and restricted cash
141.1

 
231.0

Cash, cash equivalents and restricted cash at beginning of period
336.6

 
219.7

Cash, cash equivalents and restricted cash at end of period
$
477.7

 
$
450.7

Cash paid for interest, net of proceeds from interest rate caps
$
120.7

 
$
95.6

Cash paid for taxes, net of refunds
$
96.9

 
$
91.8


See accompanying condensed notes to consolidated financial statements

8


KAR Auction Services, Inc.
Condensed Notes to Consolidated Financial Statements
September 30, 2018 (Unaudited)
Note 1—Basis of Presentation and Nature of Operations
Defined Terms
Unless otherwise indicated or unless the context otherwise requires, the following terms used herein shall have the following meanings:
"we," "us," "our" and "the Company" refer, collectively, to KAR Auction Services, Inc. and all of its subsidiaries;
"ADESA" or "ADESA Auctions" refer, collectively, to ADESA, Inc., a wholly-owned subsidiary of KAR Auction Services, and ADESA, Inc.'s subsidiaries, including Openlane, Inc. (together with Openlane, Inc.'s subsidiaries, "Openlane"), Nth Gen Software Inc. ("TradeRev") and ADESA Remarketing Limited (formerly known as GRS Remarketing Limited ("GRS" or "ADESA Remarketing Limited"));
"AFC" refers, collectively, to Automotive Finance Corporation, a wholly-owned subsidiary of ADESA, and Automotive Finance Corporation's subsidiaries and other related entities, including PWI Holdings, Inc.;
"Credit Agreement" refers to the Amended and Restated Credit Agreement, dated March 11, 2014, as amended on March 9, 2016 and May 31, 2017, among KAR Auction Services, as the borrower, the several banks and other financial institutions or entities from time to time parties thereto and the administrative agent;
"Credit Facility" refers to the seven-year senior secured term loan B-2 facility ("Term Loan B-2"), the seven-year senior secured term loan B-3 facility ("Term Loan B-3"), the senior secured term loan B-4 facility due March 11, 2021 ("Term Loan B-4"), the senior secured term loan B-5 facility due March 9, 2023 ("Term Loan B-5"), the $350 million, senior secured revolving credit facility due March 9, 2021 (the "revolving credit facility"), and the $300 million, five-year senior secured revolving credit facility (the "2016 revolving credit facility"), the terms of which are set forth in the Credit Agreement. Term Loan B-2, Term Loan B-3 and the 2016 revolving credit facility were repaid in May 2017 with proceeds from Term Loan B-4, Term Loan B-5 and the senior notes (defined below);
"IAA" refers, collectively, to Insurance Auto Auctions, Inc., a wholly-owned subsidiary of KAR Auction Services, and Insurance Auto Auctions, Inc.'s subsidiaries and other related entities, including HBC Vehicle Services Limited ("HBC");
"KAR Auction Services" refers to KAR Auction Services, Inc. and not to its subsidiaries; and
"Senior notes" refers to the 5.125% senior notes due 2025 ($950 million aggregate principal outstanding at September 30, 2018).
Business and Nature of Operations
As of September 30, 2018, we have a North American network of 75 ADESA whole car auction sites and 178 IAA salvage vehicle auction sites; in addition, we offer online auctions for both whole car and salvage vehicles. ADESA also includes TradeRev, an online automotive remarketing system where dealers can launch and participate in real-time vehicle auctions at any time and ADESA Remarketing Limited, an online whole car vehicle remarketing business in the United Kingdom. IAA also includes HBC Vehicle Services Limited, which operates from 14 locations in the United Kingdom. Our auctions facilitate the sale of used and salvage vehicles through physical, online or hybrid auctions, which permit Internet buyers to participate in physical auctions. ADESA and IAA are leading, national providers of wholesale and salvage vehicle auctions and related vehicle remarketing services for the automotive industry in North America. ADESA's online service offerings include customized private label solutions powered with software developed by its wholly-owned subsidiary, Openlane, that allow our institutional consignors (automobile manufacturers, captive finance companies and other institutions) to offer vehicles via the Internet prior to arrival at the physical auction. Remarketing services include a variety of activities designed to transfer used and salvage vehicles between sellers and buyers throughout the vehicle life cycle. ADESA and IAA facilitate the exchange of these vehicles through an auction marketplace, which aligns sellers and buyers. As an agent for customers, the Company generally does not take title to or ownership of vehicles sold at the auctions. Generally, fees are earned from the seller and buyer on each successful auction transaction in addition to fees earned for ancillary services.

9

KAR Auction Services, Inc.
Condensed Notes to Consolidated Financial Statements (Continued)
September 30, 2018 (Unaudited)


ADESA has the second largest used vehicle auction network in North America, based upon the number of used vehicles sold through auctions annually, and also provides services such as inbound and outbound transportation logistics, reconditioning, vehicle inspection and certification, titling, administrative and collateral recovery services. ADESA is able to serve the diverse and multi-faceted needs of its customers through the wide range of services offered.
IAA is one of the leading providers of salvage vehicle auctions and related services. The salvage auctions facilitate the remarketing of damaged vehicles that are designated as total losses by insurance companies, recovered stolen vehicles for which an insurance settlement with the vehicle owner has already been made, purchased vehicles and older model vehicles donated to charity or sold by dealers in salvage auctions. The salvage auction business specializes in providing services such as inbound transportation logistics, inspections, evaluations, salvage recovery services, titling and settlement administrative services.
AFC is a leading provider of floorplan financing to independent used vehicle dealers and this financing is provided through 130 locations throughout the United States and Canada as of September 30, 2018. Floorplan financing supports independent used vehicle dealers in North America who purchase vehicles at ADESA, IAA, TradeRev, other used vehicle and salvage auctions and non-auction purchases. In addition to floorplan financing, AFC also provides independent used vehicle dealers with other related services and products, such as vehicle service contracts.
Potential Spin-off of IAA
In February 2018, the Company announced that its board of directors had approved a plan to pursue the separation of its salvage auction business, currently operated by IAA, through a spin-off. The Company also announced that the separation was subject to customary regulatory approvals, the execution of intercompany agreements between the Company and the new salvage auction company, final approval of the board of directors and other customary matters.
The Company expects to complete the spin-off in 2019. The Company may, at any time and for any reason until the proposed transaction is complete, abandon, modify or change the terms of the spin-off. There can be no assurance as to whether or when the spin-off will occur. IAA filed its initial Registration Statement on Form 10 on June 28, 2018 and Amendment No. 1 to its Registration Statement on Form 10 on August 30, 2018.
Basis of Presentation
The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles in the United States of America ("U.S. GAAP") for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and notes required by U.S. GAAP for annual financial statements. Operating results for interim periods are not necessarily indicative of results that may be expected for the year as a whole. In the opinion of management, the consolidated financial statements reflect all adjustments, generally consisting of normal recurring accruals, necessary for a fair statement of our results of operations, cash flows and financial position for the periods presented. These consolidated financial statements and condensed notes to consolidated financial statements are unaudited and should be read in conjunction with the audited consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2017, as filed with the Securities and Exchange Commission on February 21, 2018. The 2017 year-end consolidated balance sheet data included in this Form 10-Q was derived from the audited financial statements referenced above and does not include all disclosures required by U.S. GAAP for annual financial statements.
Use of Estimates
The preparation of the consolidated financial statements in conformity with U.S. GAAP requires management to make estimates based in part on assumptions about current, and for some estimates, future economic and market conditions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the period. Although the current estimates contemplate current conditions and expected future changes, as appropriate, it is reasonably possible that future conditions could differ from these estimates, which could materially affect our results of operations and financial position. Among other effects, such changes could result in future impairments of goodwill, intangible assets and long-lived assets, incremental losses on finance receivables, additional allowances on accounts receivable and deferred tax assets and changes in litigation and other loss contingencies.

10

KAR Auction Services, Inc.
Condensed Notes to Consolidated Financial Statements (Continued)
September 30, 2018 (Unaudited)


Equity Method Investment
Prior to the acquisition of TradeRev in October 2017, the Company accounted for TradeRev as an equity method investment because we had the ability to exercise significant influence over operating and financial policies but did not have a controlling financial interest. The Company’s share in the net losses of TradeRev for the three and nine months ended September 30, 2017, was $1.6 million and $4.3 million, respectively. This amount was recorded to “Other income, net” in the consolidated statements of income.
Revenue Recognition
In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers (Topic 606), which superseded the revenue recognition requirements in ASC 605, Revenue Recognition. The new guidance provides clarification on the recognition of revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. Topic 606 also requires additional disclosures to help financial statement users better understand the nature, amount, timing and uncertainty of revenue that is recognized. In preparation for the adoption of Topic 606, we assessed our contracts with customers, evaluated our revenue streams and compared current accounting practices to those required under the new standard. As a result of these efforts, we identified certain impacts to the presentation and timing of revenue recognition for a contract liability (deferred revenue) related to a material right associated with certain volume-related rebates. We have implemented the appropriate changes to our processes and controls to support recognition and disclosure under Topic 606.
We adopted Topic 606 in the first quarter of 2018 using the modified retrospective transition method and recognized the cumulative effect of initially applying the new standard as a decrease of $3.0 million to the opening balance of retained earningsPrior periods have not been retrospectively adjusted.

There were no material contract assets, contract liabilities or deferred contract costs recorded on the consolidated balance sheet as of September 30, 2018. For each of our primary revenue streams, cash flows are consistent with the timing of revenue recognition.

For the nine months ended September 30, 2018, revenue recognized from performance obligations related to prior periods was not material. Revenue expected to be recognized in any future year related to remaining performance obligations, excluding revenue pertaining to contracts that have an original expected duration of one year or less and contracts where revenue is recognized as invoiced, is not material.
ADESA Auction Services
Revenues and the related costs are recognized when the services are performed. Auction fees from sellers and buyers are recognized upon the sale of the vehicle through the auction process. Most of the vehicles that are sold through auctions are consigned to ADESA by the seller and held at ADESA's facilities or third-party locations. ADESA does not take title to these consigned vehicles and recognizes revenue when a service is performed as requested by the owner of the vehicle. ADESA does not record the gross selling price of the consigned vehicles sold at auction as revenue. Instead, ADESA records only its auction fees as revenue because it does not take title to the consigned vehicles and has no influence on the vehicle auction selling price agreed to by the seller and buyer at the auction. Our buyer fees are typically based on a tiered structure with fees increasing with the sale price of the vehicle, while seller fees are typically fixed. Revenues from reconditioning, logistics, vehicle inspection and certification, titling, evaluation and salvage recovery services are generally recognized when the services are performed. ADESA generally enforces its rights to payment for seller transactions through net settlement provisions following the sale of a vehicle.
IAA Salvage Services
Revenues (including vehicle sales and fee income) are generally recognized at the date the vehicles are sold at auction. Most of the vehicles that are sold through auctions are consigned to IAA by the seller and held at IAA's facilities. IAA does not take title to these consigned vehicles and recognizes revenue when a service is performed as requested by the owner of the vehicle. IAA does not record the gross selling price of the consigned vehicles sold at auction as revenue. IAA seller revenues represent the combination of the inbound tow, processing, storage, titling, enhancing and auctioning of the vehicle and are recognized at the date the vehicles are sold at auction. Related costs are deferred and recognized at the time of sale. Generally, IAA buyer revenue is recognized on the date the vehicles are sold at auction. IAA typically enforces its rights to payment for

11

KAR Auction Services, Inc.
Condensed Notes to Consolidated Financial Statements (Continued)
September 30, 2018 (Unaudited)


seller transactions through net settlement provisions following the sale of a vehicle. Buyer revenue not recognized at the date the vehicles are sold at auction includes annual buyer registration fees, which are recognized on a straight-line basis, and certain buyer-related fees, which are recognized when payment is received.
AFC
AFC's revenue is comprised of interest and fee income, provision for credit losses and other revenues associated with our finance receivables, as well as other service revenue. The following table summarizes the primary components of AFC's revenue:
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
AFC Revenue (in millions)
2018
 
2017
 
2018
 
2017
Interest and fee income
$
80.7

 
$
71.8

 
$
243.1

 
$
213.1

Other revenue
3.4

 
3.0

 
9.6

 
8.9

Provision for credit losses
(7.3
)
 
(5.0
)
 
(22.1
)
 
(27.5
)
Other service revenue
8.6

 
8.4

 
25.0

 
25.0

 
$
85.4

 
$
78.2

 
$
255.6

 
$
219.5

Interest and fee income
Interest on finance receivables is recognized based on the number of days the vehicle remains financed. AFC ceases recognition of interest on finance receivables when the loans become delinquent, which is generally 31 days past due. Dealers are also charged a fee to floorplan a vehicle ("floorplan fee"), to extend the terms of the receivable ("curtailment fee") and a document processing fee. AFC fee income including floorplan and curtailment fees is recognized over the life of the finance receivable.
Other revenue
Other revenue includes lot check fees, filing fees, lien holder payoff services and other related program fees, each of which are charged to and collected from AFC's customers.
Other service revenue
Other service revenue represents the revenue generated by Preferred Warranties, Inc. ("PWI"). PWI receives advance payments for vehicle service contracts and unearned revenue is deferred and recognized over the terms of the contracts utilizing a historical earnings curve. The average term of the contracts originated in 2017 was approximately 1.7 years and PWI had unearned revenue of $34.5 million at September 30, 2018.
New Accounting Standards
In August 2018, the Financial Accounting Standards Board ("FASB") issued ASU 2018-15, Intangibles - Goodwill and Other - Internal-Use Software (Subtopic 350-40): Customer's Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That is a Service Contract, which aligns the requirements for capitalizing implementation costs incurred in a cloud computing arrangement that is a service contract with the requirements for capitalizing implementation costs incurred to develop or obtain internal-use software. The new guidance is effective for annual periods beginning after December 15, 2019, including interim periods within those fiscal years. The Company is currently evaluating the impact the adoption of ASU 2018-15 will have on the consolidated financial statements.

In May 2017, the FASB issued ASU 2017-09, Compensation - Stock Compensation (Topic 718): Scope of Modification Accounting, which clarifies when changes to the terms or conditions of a share-based payment award must be accounted for as modifications. The new guidance is expected to reduce diversity in practice and result in fewer changes to the terms of an award being accounted for as modifications. Changes that do not impact the fair value, vesting conditions or classification of an award will not require modification accounting. The new guidance is effective for annual periods beginning after December 15, 2017, including interim periods within those fiscal years. The Company adopted ASU 2017-09 in the first quarter of 2018 and the adoption did not have a material impact on the consolidated financial statements.

12

KAR Auction Services, Inc.
Condensed Notes to Consolidated Financial Statements (Continued)
September 30, 2018 (Unaudited)



In November 2016, the FASB issued ASU 2016-18, Statement of Cash Flows (Topic 230): Restricted Cash, which addresses diversity in practice that exists in the classification and presentation of changes in restricted cash on the statement of cash flows. The new guidance is effective for annual periods beginning after December 15, 2017, including interim periods within those fiscal years. The Company adopted ASU 2016-18 in the first quarter of 2018 and the adoption resulted in an increase of $0.7 million in net cash used by investing activities for the nine months ended September 30, 2017. The increase related to reclassifying the changes in our restricted cash balance from investing activities to the cash and cash equivalents balances within the consolidated statements of cash flows.

In August 2016, the FASB issued ASU 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments, which provides guidance on the statement of cash flows presentation of certain transactions where diversity in practice exists. The new guidance is effective for annual periods beginning after December 15, 2017, including interim periods within those fiscal years. The Company adopted ASU 2016-15 in the first quarter of 2018 and the adoption did not have a material impact on the consolidated financial statements.

In January 2017, the FASB issued ASU 2017-04, Intangibles-Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment, which simplifies the test for goodwill impairment by eliminating Step 2 (implied fair value measurement). Instead goodwill impairment would be measured as the amount by which a reporting unit's carrying amount exceeds its fair value, not to exceed the carrying amount of goodwill. The new guidance is effective for annual periods beginning after December 15, 2019, including interim periods within those fiscal years. Early adoption is permitted. We do not expect the adoption of ASU 2017-04 will have a material impact on the consolidated financial statements.

In June 2016, the FASB issued ASU 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. The update changes the methodology for measuring credit losses on financial instruments and the timing of when such losses are recorded. The new guidance is effective for annual periods beginning after December 15, 2019, including interim periods within those fiscal years. Early adoption is permitted beginning in annual periods beginning after December 15, 2018, including interim periods within those fiscal years. We do not expect the adoption of ASU 2016-13 will have a material impact on the consolidated financial statements based on the short-term nature of AFC's loans.

In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842), which replaces existing lease guidance. The ASU is intended to provide enhanced transparency and comparability by requiring lessees to record right-of-use assets and corresponding lease liabilities on the balance sheet, with an exception for leases that meet the definition of a short-term lease. The new guidance will continue to classify leases as either finance or operating, with classification affecting the pattern of expense recognition in the statement of income. The new guidance is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Early adoption is permitted and as permitted by ASU 2018-11, Leases (Topic 842): Targeted Improvements, the Company expects to apply the new standard at the adoption date and recognize a cumulative-effect adjustment to the opening balance of retained earnings in the period of adoption. The Company is currently evaluating the impact the adoption of ASU 2016-02 will have on the consolidated financial statements and anticipates that the new guidance will significantly impact its consolidated financial statements, as the Company has a significant number of leases. Our current minimum commitments under non-cancelable operating leases are disclosed in the "Contractual Obligations" section of "Management's Discussion and Analysis of Financial Condition and Results of Operations" in Part II, Item 7 of our Annual Report on Form 10-K for the year ended December 31, 2017 and in Note 13 to the Consolidated Financial Statements of the same report. In addition, our Credit Agreement specifies that the net debt covenant shall continue to be calculated as if the accounting standard had not been adopted and that we could enter into negotiations to amend such provisions in the Credit Agreement so as to equitably reflect such changes with the desired result that the criteria for evaluating our financial condition would be the same after the change as if such change had not been made.


13

KAR Auction Services, Inc.
Condensed Notes to Consolidated Financial Statements (Continued)
September 30, 2018 (Unaudited)


Note 2—Acquisition
On February 1, 2018, the Company completed the acquisition of STRATIM Systems Inc. ("STRATIM"). STRATIM is a mobility and fleet management software company based in San Francisco, California that uses data analytics to help fleet owners manage, maintain and service their fleets. The addition of STRATIM supplements KAR’s broad portfolio of wholesale used vehicle physical, online and digital auction marketplaces and ancillary service providers.

The purchase price of STRATIM, net of cash acquired, was approximately $23.3 million. The purchase price for the acquired business was allocated to acquired assets and liabilities based upon fair values, including $1.8 million to intangible assets, representing the fair value of software of $1.4 million and acquired customer relationships of $0.4 million, which are being amortized over their expected useful lives. The purchased assets included accounts receivable, computer equipment and software. The purchase accounting associated with this acquisition is preliminary, subject to determination of tax attributes and final valuation results. The acquisition resulted in goodwill of $22.0 million. The goodwill is recorded in the ADESA Auctions reportable segment. The financial impact of the acquisition, including pro forma financial results, was immaterial to the Company’s consolidated results for the nine months ended September 30, 2018. Financial results for STRATIM have been included in our consolidated financial statements from the date of acquisition.
Note 3—Stock and Stock-Based Compensation Plans
The KAR Auction Services, Inc. 2009 Omnibus Stock and Incentive Plan ("Omnibus Plan") is intended to provide equity and/or cash-based awards to our executive officers and key employees. Our stock-based compensation expense includes expense associated with KAR Auction Services, Inc. performance-based restricted stock units ("PRSUs"), service-based restricted stock units ("RSUs") and service options. We have classified the KAR Auction Services, Inc. PRSUs, RSUs and service options as equity awards.
The following table summarizes our stock-based compensation expense by type of award (in millions):
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2018
 
2017
 
2018
 
2017
PRSUs
$
3.7

 
$
3.1

 
$
9.3

 
$
8.7

RSUs
2.9

 
2.4

 
8.6

 
6.9

Service options

 
0.3

 
0.2

 
1.2

Total stock-based compensation expense
$
6.6

 
$
5.8

 
$
18.1

 
$
16.8


PRSUs and RSUs
In the first nine months of 2018, we granted a target amount of approximately 0.2 million PRSUs to certain executive officers and management of the Company. The PRSUs vest if and to the extent that the Company's three-year cumulative operating adjusted net income per share attains certain specified goals. In addition, approximately 0.3 million RSUs were granted to certain executive officers and management of the Company. The RSUs are contingent upon continued employment and generally vest in three equal annual installments. The weighted average grant date fair value of the PRSUs and the RSUs was $54.14 per share and $54.23 per share, respectively, which was determined using the closing price of the Company's common stock on the dates of grant.
Share Repurchase Program
In October 2016, the board of directors authorized a repurchase of up to $500 million of the Company’s outstanding common stock, par value $0.01 per share, through October 26, 2019. Repurchases may be made in the open market or through privately negotiated transactions, in accordance with applicable securities laws and regulations, including pursuant to repurchase plans designed to comply with Rule 10b5-1 of the Securities Exchange Act of 1934, as amended. The timing and amount of any repurchases is subject to market and other conditions. During the nine months ended September 30, 2018, we repurchased and retired a total of 932,400 shares of common stock in the open market at a weighted average price of $53.62 per share under the October 2016 authorization. In 2017, we repurchased and retired 3,279,089 shares of common stock in the open market at a weighted average price of $45.74 per share under the October 2016 authorization.

14

KAR Auction Services, Inc.
Condensed Notes to Consolidated Financial Statements (Continued)
September 30, 2018 (Unaudited)


Note 4—Net Income Per Share
The following table sets forth the computation of net income per share (in millions except per share amounts):
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2018
 
2017
 
2018
 
2017
Net income
$
77.5

 
$
62.8

 
$
260.7

 
$
189.2

Weighted average common shares outstanding
134.5

 
136.4

 
134.5

 
136.8

Effect of dilutive stock options and restricted stock awards
1.1

 
1.3

 
1.2

 
1.5

Weighted average common shares outstanding and potential common shares
135.6

 
137.7

 
135.7

 
138.3

Net income per share
 
 
 
 
 
 
 
Basic
$
0.58

 
$
0.46

 
$
1.94

 
$
1.38

Diluted
$
0.57

 
$
0.46

 
$
1.92

 
$
1.37

Basic net income per share was calculated by dividing net income by the weighted average number of outstanding common shares for the period. Diluted net income per share was calculated consistent with basic net income per share including the effect of dilutive unissued common shares related to our stock-based employee compensation program. The effect of stock options and restricted stock on net income per share-diluted is determined through the application of the treasury stock method, whereby net proceeds received by the Company based on assumed exercises are hypothetically used to repurchase our common stock at the average market price during the period. Stock options that would have an anti-dilutive effect on net income per diluted share and PRSUs subject to performance conditions which have not yet been satisfied are excluded from the calculations. No options were excluded from the calculation of diluted net income per share for the three or nine months ended September 30, 2018 and 2017. Approximately 0.6 million and 0.5 million PRSUs were excluded from the calculation of diluted net income per share for the three months ended September 30, 2018 and 2017, respectively, and approximately 0.6 million and 0.5 million PRSUs were excluded from the calculation of diluted net income per share for the nine months ended September 30, 2018 and 2017, respectively. Total options outstanding at September 30, 2018 and 2017 were 1.1 million and 2.0 million, respectively.
Note 5—Finance Receivables and Obligations Collateralized by Finance Receivables
AFC sells the majority of its U.S. dollar denominated finance receivables on a revolving basis and without recourse to a wholly-owned, bankruptcy remote, consolidated, special purpose subsidiary ("AFC Funding Corporation"), established for the purpose of purchasing AFC's finance receivables. A securitization agreement allows for the revolving sale by AFC Funding Corporation to a group of bank purchasers of undivided interests in certain finance receivables subject to committed liquidity. The agreement expires on January 31, 2020. AFC Funding Corporation had committed liquidity of $1.50 billion for U.S. finance receivables at September 30, 2018.
We also have an agreement for the securitization of Automotive Finance Canada Inc.'s ("AFCI") receivables which expires on January 31, 2020. AFCI's committed facility is provided through a third-party conduit (separate from the U.S. facility) and was C$125 million at September 30, 2018. The receivables sold pursuant to both the U.S. and Canadian securitization agreements are accounted for as secured borrowings.

15

KAR Auction Services, Inc.
Condensed Notes to Consolidated Financial Statements (Continued)
September 30, 2018 (Unaudited)


The following tables present quantitative information about delinquencies, credit losses less recoveries ("net credit losses") and components of securitized financial assets and other related assets managed. For purposes of this illustration, delinquent receivables are defined as receivables 31 days or more past due.
 
September 30, 2018
 
Net Credit Losses
Three Months Ended September 30, 2018
 
Net Credit Losses
Nine Months Ended
September 30, 2018
 
Total Amount of:
 
 
(in millions)
Receivables
 
Receivables
Delinquent
 
 
Floorplan receivables
$
1,967.1

 
$
14.7

 
$
7.1

 
$
21.3

Other loans
12.6

 

 

 

Total receivables managed
$
1,979.7

 
$
14.7

 
$
7.1

 
$
21.3


 
December 31, 2017
 
Net Credit Losses
Three Months Ended September 30, 2017
 
Net Credit Losses
Nine Months Ended
September 30, 2017
 
Total Amount of:
 
 
(in millions)
Receivables
 
Receivables
Delinquent
 
 
Floorplan receivables
$
1,901.1

 
$
12.1

 
$
4.7

 
$
26.8

Other loans
11.5

 

 

 

Total receivables managed
$
1,912.6

 
$
12.1

 
$
4.7

 
$
26.8

AFC's allowance for losses was $13.8 million and $13.0 million at September 30, 2018 and December 31, 2017, respectively.
As of September 30, 2018, and December 31, 2017, $1,935.2 million and $1,893.2 million, respectively, of finance receivables and a cash reserve of 1 percent of the obligations collateralized by finance receivables served as security for the obligations collateralized by finance receivables. Obligations collateralized by finance receivables consisted of the following:
 
September 30,
2018
 
December 31,
2017
Obligations collateralized by finance receivables, gross
$
1,374.8

 
$
1,371.4

Unamortized securitization issuance costs
(8.5
)
 
(13.3
)
Obligations collateralized by finance receivables
$
1,366.3

 
$
1,358.1

Proceeds from the revolving sale of receivables to the bank facilities are used to fund new loans to customers. AFC, AFC Funding Corporation and AFCI must maintain certain financial covenants including, among others, limits on the amount of debt AFC and AFCI can incur, minimum levels of tangible net worth, and other covenants tied to the performance of the finance receivables portfolio. The securitization agreements also incorporate the financial covenants of our Credit Facility. At September 30, 2018, we were in compliance with the covenants in the securitization agreements.

16

KAR Auction Services, Inc.
Condensed Notes to Consolidated Financial Statements (Continued)
September 30, 2018 (Unaudited)


Note 6—Long-Term Debt
Long-term debt consisted of the following (in millions):
 
Interest Rate*
 
Maturity
 
September 30,
2018
 
December 31, 2017
Term Loan B-4
Adjusted LIBOR
 
+ 2.25%
 
March 11, 2021
 
$
708.0

 
$
711.3

Term Loan B-5
Adjusted LIBOR
 
+ 2.50%
 
March 9, 2023
 
1,036.9

 
1,041.6

Revolving credit facility
Adjusted LIBOR
 
+ 2.0%
 
March 9, 2021
 

 

Senior notes
 
 
5.125%
 
June 1, 2025
 
950.0

 
950.0

Canadian line of credit
CAD Prime
 
+ 0.50%
 
Repayable upon demand
 

 

Total debt
 
 
 
 
 
 
2,694.9

 
2,702.9

Unamortized debt issuance costs
 
 
 
 
 
(19.6
)
 
(22.8
)
Current portion of long-term debt
 
 
 
 
 
(17.7
)
 
(12.4
)
Long-term debt
 
 
 
 
 
 
$
2,657.6

 
$
2,667.7

*The interest rates presented in the table above represent the rates in place at September 30, 2018.
Credit Facility
On May 31, 2017, we entered into an Incremental Commitment Agreement and Second Amendment (the "Second Amendment") to the Credit Agreement. The Second Amendment provided for, among other things, (i) the refinancing and repricing of the existing tranche B-2 term loans ("Term Loan B-2") remaining after the repayment with new tranche B-4 term loans in an aggregate principal amount of $717 million ("Term Loan B-4"), (ii) the refinancing and repricing of existing tranche B-3 term loans ("Term Loan B-3") remaining after the repayment with new tranche B-5 term loans in an aggregate principal amount of $1.05 billion ("Term Loan B-5") and (iii) a $350 million senior secured revolving credit facility (the "revolving credit facility"). A portion of the proceeds received from the issuance of the senior notes was used to repay a portion of Term Loan B-2 and Term Loan B-3, as well as the outstanding balance on the 2016 revolving credit facility.
The Credit Facility is available for letters of credit, working capital, permitted acquisitions and general corporate purposes. The Company also pays a commitment fee of 30 to 35 basis points, payable quarterly, on the average daily unused amount of the revolving credit facility. The rates on Term Loan B-4 and Term Loan B-5 were 4.69% and 4.94% at September 30, 2018, respectively.
The obligations of the Company under the Credit Facility are guaranteed by certain of our domestic subsidiaries (the "Subsidiary Guarantors") and are secured by substantially all of the assets of the Company and the Subsidiary Guarantors, including but not limited to: (a) pledges of and first priority perfected security interests in 100% of the equity interests of certain of the Company's and the Subsidiary Guarantors' domestic subsidiaries and 65% of the equity interests of certain of the Company's and the Subsidiary Guarantors' first tier foreign subsidiaries and (b) perfected first priority security interests in substantially all other tangible and intangible assets of the Company and each Subsidiary Guarantor, subject to certain exceptions. The Credit Agreement contains affirmative and negative covenants that we believe are usual and customary for a senior secured credit agreement. The negative covenants include, among other things, limitations on asset sales, mergers and acquisitions, indebtedness, liens, dividends, investments and transactions with our affiliates. The Credit Agreement also requires us to maintain a maximum leverage ratio, provided there are revolving loans outstanding. We were in compliance with the covenants in the Credit Agreement at September 30, 2018.
There were no borrowings on the revolving credit facility at September 30, 2018 and December 31, 2017. In addition, we had related outstanding letters of credit in the aggregate amount of $32.4 million and $42.8 million at September 30, 2018 and December 31, 2017, respectively, which reduce the amount available for borrowings under the revolving credit facility.

17

KAR Auction Services, Inc.
Condensed Notes to Consolidated Financial Statements (Continued)
September 30, 2018 (Unaudited)


Fair Value of Debt

As of September 30, 2018, the estimated fair value of our long-term debt amounted to $2,677.6 million. The estimates of fair value were based on broker-dealer quotes for our debt as of September 30, 2018. The estimates presented on long-term financial instruments are not necessarily indicative of the amounts that would be realized in a current market exchange.
Note 7—Derivatives
We are exposed to interest rate risk on our variable rate borrowings. Accordingly, interest rate fluctuations affect the amount of interest expense we are obligated to pay. We use interest rate derivatives with the objective of managing exposure to interest rate movements, thereby reducing the effect of interest rate changes and the effect they could have on future cash flows. Currently, interest rate cap agreements are used to accomplish this objective.
In August 2017, we entered into two interest rate caps with an aggregate notional amount of $800 million to manage our exposure to interest rate movements on our variable rate Credit Facility when three-month LIBOR exceeds 2.0%. The interest rate cap agreements each had an effective date of September 30, 2017 and each matures on September 30, 2019. We paid an aggregate amount of approximately $1.0 million for the caps in August 2017.
In March 2017, we entered into two interest rate caps with an aggregate notional amount of $400 million to manage our exposure to interest rate movements on our variable rate Credit Facility when three-month LIBOR exceeds 2.0%. The interest rate cap agreements each had an effective date of March 31, 2017 and each matures on March 31, 2019. We paid an aggregate amount of approximately $0.7 million for the caps in April 2017.
We are exposed to credit loss in the event of non-performance by the counterparties; however, non-performance is not anticipated. ASC 815, Derivatives and Hedging, requires companies to recognize all derivative instruments as either assets or liabilities at fair value in the balance sheet. The fair values of the interest rate derivatives are based on quoted market prices for similar instruments from commercial banks. The following table presents the fair value of our interest rate derivatives included in the consolidated balance sheets for the periods presented (in millions):
 
 
Asset Derivatives
 
 
September 30, 2018
 
December 31, 2017
Derivatives Not Designated as Hedging Instruments
 
Balance Sheet Location
 
Fair Value
 
Balance Sheet Location
 
Fair Value
2017 Interest rate caps
 
Other assets
 
$
6.9

 
Other assets
 
$
2.6

We have not designated any of the interest rate caps as hedges for accounting purposes. Accordingly, changes in the fair value of the interest rate caps are recognized as "Interest expense" in the consolidated statement of income. The following table presents the effect of the interest rate derivatives on our consolidated statements of income for the periods presented (in millions):
 
 
Location of Gain / (Loss) Recognized in Income on Derivatives
 
Amount of Gain / (Loss)
Recognized in Income on Derivatives
Derivatives Not Designated as Hedging Instruments
 
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
 
2018
 
2017
 
2018
 
2017
2017 Interest rate caps
 
Interest expense
 
$
0.2

 
$
0.1

 
$
6.3

 
$
(0.4
)

18

KAR Auction Services, Inc.
Condensed Notes to Consolidated Financial Statements (Continued)
September 30, 2018 (Unaudited)


Note 8—Commitments and Contingencies
We are involved in litigation and disputes arising in the ordinary course of business, such as actions related to injuries; property damage; handling, storage or disposal of vehicles; environmental laws and regulations; and other litigation incidental to the business such as employment matters and dealer disputes. Management considers the likelihood of loss or the incurrence of a liability, as well as the ability to reasonably estimate the amount of loss, in determining loss contingencies. We accrue an estimated loss contingency when it is probable that a liability has been incurred and the amount of loss (or range of possible losses) can be reasonably estimated. Management regularly evaluates current information available to determine whether accrual amounts should be adjusted. Accruals for contingencies including litigation and environmental matters are included in "Other accrued expenses" at undiscounted amounts and exclude claims for recoveries from insurance or other third parties. These accruals are adjusted periodically as assessment and remediation efforts progress, or as additional technical or legal information becomes available. If the amount of an actual loss is greater than the amount accrued, this could have an adverse impact on our operating results in that period. Such matters are generally not, in the opinion of management, likely to have a material adverse effect on our financial condition, results of operations or cash flows. Legal fees are expensed as incurred. There has been no significant change in the legal and regulatory proceedings which were disclosed in our Annual Report on Form 10-K for the year ended December 31, 2017.
Note 9—Accumulated Other Comprehensive Loss
Accumulated other comprehensive loss consisted of the following (in millions):
 
September 30,
2018
 
December 31, 2017
Foreign currency translation loss
$
(37.3
)
 
$
(25.3
)
Unrealized gain on postretirement benefit obligation, net of tax
0.1

 
0.1

Accumulated other comprehensive loss
$
(37.2
)
 
$
(25.2
)

Note 10—Segment Information
ASC 280, Segment Reporting, requires reporting of segment information that is consistent with the manner in which the chief operating decision maker operates and views the Company. Our operations are grouped into three operating segments: ADESA Auctions, IAA and AFC, which also serve as our reportable business segments. These reportable business segments offer different services and have fundamental differences in their operations.
The holding company is maintained separately from the three reportable segments and includes expenses associated with the corporate offices, such as salaries, benefits and travel costs for the corporate management team, certain human resources, information technology and accounting costs, and certain insurance, treasury, legal and risk management costs. Holding company interest expense includes the interest expense incurred on capital leases and the corporate debt structure. Intercompany charges relate primarily to interest on intercompany debt or receivables and certain administrative costs allocated by the holding company.

19

KAR Auction Services, Inc.
Condensed Notes to Consolidated Financial Statements (Continued)
September 30, 2018 (Unaudited)


Financial information regarding our reportable segments is set forth below for the three months ended September 30, 2018 (in millions):
 
ADESA
Auctions
 
IAA
 
AFC
 
Holding
Company
 
Consolidated
Operating revenues
$
527.0

 
$
321.1

 
$
85.4

 
$

 
$
933.5

Operating expenses
 
 
 
 
 
 
 
 
 
Cost of services (exclusive of depreciation and amortization)
307.8

 
202.5

 
22.9

 

 
533.2

Selling, general and administrative
111.8

 
28.8

 
8.1

 
37.3

 
186.0

Depreciation and amortization          
31.9

 
24.3

 
2.3

 
7.1

 
65.6

Total operating expenses
451.5

 
255.6

 
33.3

 
44.4

 
784.8

Operating profit (loss)
75.5

 
65.5

 
52.1

 
(44.4
)
 
148.7

Interest expense
0.5

 

 
15.0

 
33.7

 
49.2

Other (income) expense, net
(1.9
)
 

 
(0.1
)
 
(1.1
)
 
(3.1
)
Intercompany expense (income)
6.9

 
9.4

 
(0.9
)
 
(15.4
)
 

Income (loss) before income taxes
70.0

 
56.1

 
38.1

 
(61.6
)
 
102.6

Income taxes
19.0

 
14.3

 
9.0

 
(17.2
)
 
25.1

Net income (loss)
$
51.0

 
$
41.8

 
$
29.1

 
$
(44.4
)
 
$
77.5

Total assets
$
3,171.7

 
$
1,435.2

 
$
2,395.5

 
$
298.2

 
$
7,300.6

Financial information regarding our reportable segments is set forth below for the three months ended September 30, 2017 (in millions):
 
ADESA
Auctions
 
IAA
 
AFC
 
Holding
Company
 
Consolidated
Operating revenues
$
477.1

 
$
287.7

 
$
78.2

 
$

 
$
843.0

Operating expenses
 
 
 
 
 
 
 
 
 
Cost of services (exclusive of depreciation and amortization)
272.6

 
184.8

 
21.8

 

 
479.2

Selling, general and administrative
87.6

 
26.5

 
7.2

 
34.4

 
155.7

Depreciation and amortization          
28.5

 
23.1

 
7.9

 
6.7

 
66.2

Total operating expenses
388.7

 
234.4

 
36.9

 
41.1

 
701.1

Operating profit (loss)
88.4

 
53.3

 
41.3

 
(41.1
)
 
141.9

Interest expense
0.2

 

 
11.0

 
30.3

 
41.5

Other (income) expense, net
0.2

 
(0.1
)
 
(0.1
)
 
(0.1
)
 
(0.1
)
Intercompany expense (income)
11.4

 
9.5

 
(1.6
)
 
(19.3
)
 

Income (loss) before income taxes
76.6

 
43.9

 
32.0

 
(52.0
)
 
100.5

Income taxes
29.6

 
15.9

 
11.6

 
(19.4
)
 
37.7

Net income (loss)
$
47.0

 
$
28.0

 
$
20.4

 
$
(32.6
)
 
$
62.8

Total assets
$
3,214.0

 
$
1,396.2

 
$
2,206.2

 
$
89.2

 
$
6,905.6


20

KAR Auction Services, Inc.
Condensed Notes to Consolidated Financial Statements (Continued)
September 30, 2018 (Unaudited)


Financial information regarding our reportable segments is set forth below for the nine months ended September 30, 2018 (in millions):
 
ADESA
Auctions
 
IAA
 
AFC
 
Holding
Company
 
Consolidated
Operating revenues
$
1,593.4

 
$
991.6

 
$
255.6

 
$

 
$
2,840.6

Operating expenses
 
 
 
 
 
 
 
 
 
Cost of services (exclusive of depreciation and amortization)
921.0

 
610.3

 
68.2

 

 
1,599.5

Selling, general and administrative
328.9

 
88.0

 
23.6

 
115.7

 
556.2

Depreciation and amortization          
94.4

 
73.1

 
13.6

 
21.7

 
202.8

Total operating expenses
1,344.3

 
771.4

 
105.4

 
137.4

 
2,358.5

Operating profit (loss)
249.1

 
220.2

 
150.2

 
(137.4
)
 
482.1

Interest expense
1.7

 

 
43.2

 
94.3

 
139.2

Other (income) expense, net
(2.4
)
 
(0.8
)
 
(0.1
)
 
(1.2
)
 
(4.5
)
Intercompany expense (income)
26.6

 
28.3

 
(2.1
)
 
(52.8
)
 

Income (loss) before income taxes
223.2

 
192.7

 
109.2

 
(177.7
)
 
347.4

Income taxes
58.0

 
48.2

 
26.7

 
(46.2
)
 
86.7

Net income (loss)
$
165.2

 
$
144.5

 
$
82.5

 
$
(131.5
)
 
$
260.7

Financial information regarding our reportable segments is set forth below for the nine months ended September 30, 2017 (in millions):
 
ADESA
Auctions
 
IAA
 
AFC
 
Holding
Company
 
Consolidated
Operating revenues
$
1,464.3

 
$
883.8

 
$
219.5

 
$

 
$
2,567.6

Operating expenses
 
 
 
 
 
 
 
 
 
Cost of services (exclusive of depreciation and amortization)
842.2

 
555.4

 
64.5

 

 
1,462.1

Selling, general and administrative
260.1

 
79.9

 
22.4

 
105.3

 
467.7

Depreciation and amortization          
82.5

 
69.2

 
23.5

 
20.0

 
195.2

Total operating expenses
1,184.8

 
704.5

 
110.4

 
125.3

 
2,125.0

Operating profit (loss)
279.5

 
179.3

 
109.1

 
(125.3
)
 
442.6

Interest expense
0.5

 

 
31.8

 
89.6

 
121.9

Other (income) expense, net
(0.1
)
 
(1.0
)
 
(0.1
)
 
(0.5
)
 
(1.7
)
Loss on extinguishment of debt

 

 

 
27.5

 
27.5

Intercompany expense (income)
34.7

 
28.3

 
(20.1
)
 
(42.9
)
 

Income (loss) before income taxes
244.4

 
152.0

 
97.5

 
(199.0
)
 
294.9

Income taxes
92.4

 
54.5

 
35.9

 
(77.1
)
 
105.7

Net income (loss)
$
152.0

 
$
97.5

 
$
61.6

 
$
(121.9
)
 
$
189.2


21

KAR Auction Services, Inc.
Condensed Notes to Consolidated Financial Statements (Continued)
September 30, 2018 (Unaudited)


Geographic Information
Our foreign operations include Canada, Mexico and the U.K. Most of our operations outside the U.S. are in Canada. Information regarding the geographic areas of our operations is set forth below (in millions):
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2018
 
2017
 
2018
 
2017
Operating revenues
 
 
 
 
 
 
 
U.S. 
$
805.9

 
$
729.9

 
$
2,459.0

 
$
2,238.2

Foreign
127.6

 
113.1

 
381.6

 
329.4

 
$
933.5

 
$
843.0

 
$
2,840.6

 
$
2,567.6


22


Item 2.    Management's Discussion and Analysis of Financial Condition and Results of Operations
Forward-Looking Statements
This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 and which are subject to certain risks, trends and uncertainties. In particular, statements made in this report on Form 10-Q that are not historical facts (including, but not limited to, expectations, estimates, assumptions and projections regarding the industry, business, future operating results, potential acquisitions and anticipated cash requirements) may be forward-looking statements. Words such as "should," "may," "will," "anticipates," "expects," "intends," "plans," "believes," "seeks," "estimates" and similar expressions identify forward-looking statements. Such statements, including statements regarding our future growth; the potential spin-off of our salvage auction business; anticipated cost savings, revenue increases, credit losses and capital expenditures; dividend declarations and payments; common stock repurchases; tax rates and assumptions; strategic initiatives, greenfields and acquisitions; our competitive position and retention of customers; and our continued investment in information technology, are not guarantees of future performance and are subject to risks and uncertainties that could cause actual results to differ materially from the results projected, expressed or implied by these forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in the section entitled "Risk Factors" in this Quarterly Report on Form 10-Q and Item 1A "Risk Factors" in our Annual Report on Form 10-K for the year ended December 31, 2017, filed on February 21, 2018. Some of these factors include:
our ability to effectively maintain or update information and technology systems;
our ability to implement and maintain measures to protect against cyber-attacks;
significant current competition and the introduction of new competitors;
competitive pricing pressures;
our ability to successfully implement our business strategies or realize expected cost savings and revenue enhancements;
our ability to meet or exceed customers' expectations, as well as develop and implement information systems responsive to customer needs;
business development activities, including greenfields, acquisitions and integration of acquired businesses;
costs associated with the acquisition of businesses or technologies;
fluctuations in consumer demand for and in the supply of used, leased and salvage vehicles and the resulting impact on auction sales volumes, conversion rates and loan transaction volumes;
any losses of key personnel;
our ability to obtain land or renew/enter into new leases at commercially reasonable rates;
decreases in the number of used vehicles sold at physical auctions;
changes in the market value of vehicles auctioned, including changes in the actual cash value of salvage vehicles;
trends in new and used vehicle sales and incentives, including wholesale used vehicle pricing;
the ability of consumers to lease or finance the purchase of new and/or used vehicles;
the ability to recover or collect from delinquent or bankrupt customers;
economic conditions including fuel prices, commodity prices, foreign exchange rates and interest rate fluctuations;
trends in the vehicle remarketing industry;
trends in the number of commercial vehicles being brought to auction, in particular off-lease volumes;
changes in the volume of vehicle production, including capacity reductions at the major original equipment manufacturers;
laws, regulations and industry standards, including changes in regulations governing the sale of used vehicles, the processing of salvage vehicles and commercial lending activities;
our ability to maintain our brand and protect our intellectual property;

23


the costs of environmental compliance and/or the imposition of liabilities under environmental laws and regulations;
weather, including increased expenses as a result of catastrophic events;
general business conditions;
our substantial amount of debt;
restrictive covenants in our debt agreements;
our assumption of the settlement risk for vehicles sold;
litigation developments;
our self-insurance for certain risks;
interruptions to service from our workforce;
any impairment to our goodwill or other intangible assets;
changes in effective tax rates;
the taxable nature of the potential spin-off of our salvage auction business (as described further below) and our ability to successfully complete the spin-off within the expected time frame or at all;
changes to accounting standards; and
other risks described from time to time in our filings with the SEC.
Many of these risk factors are outside of our control, and as such, they involve risks which are not currently known that could cause actual results to differ materially from those discussed or implied herein. The forward-looking statements in this document are made as of the date on which they are made and we do not undertake to update our forward-looking statements.
Our future growth depends on a variety of factors, including our ability to increase vehicle sold volumes and loan transaction volumes, expand our product and service offerings, including information systems development, acquire and integrate additional business entities, manage expansion, control costs in our operations, introduce fee increases, and retain our executive officers and key employees. We cannot predict whether our growth strategy will be successful. In addition, we cannot predict what portion of overall sales will be conducted through online auctions or other remarketing methods in the future and what impact this may have on our auction business.
Overview
We provide whole car auction services and salvage auction services in North America and the United Kingdom. Our business is divided into three reportable business segments, each of which is an integral part of the vehicle remarketing industry: ADESA Auctions, IAA and AFC.
The ADESA Auctions segment serves a domestic and international customer base through live and online auctions and through 75 whole car auction facilities in North America that are developed and strategically located to draw professional sellers and buyers together and allow the buyers to inspect and compare vehicles remotely or in person. Through ADESA.com, powered by Openlane technology, ADESA offers comprehensive private label remarketing solutions to automobile manufacturers, captive finance companies and other institutions to offer vehicles via the Internet prior to arrival at the physical auction. Vehicles at ADESA's auctions are typically sold by commercial fleet operators, financial institutions, rental car companies, new and used vehicle dealers and vehicle manufacturers and their captive finance companies to franchise and independent used vehicle dealers. ADESA also provides value-added ancillary services including inbound and outbound transportation logistics, reconditioning, vehicle inspection and certification, titling, administrative and collateral recovery services. ADESA also includes TradeRev, an online automotive remarketing system where dealers can launch and participate in real-time vehicle auctions at any time and ADESA Remarketing Limited, an online whole car vehicle remarketing business in the United Kingdom.
The IAA segment serves a domestic and international customer base through live and online auctions and through 178 salvage vehicle auction sites in the United States and Canada at September 30, 2018. IAA also includes HBC, which operates from 14 locations in the United Kingdom. The salvage auctions facilitate the remarketing of damaged vehicles designated as total losses by insurance companies, charity donation vehicles, recovered stolen (or theft) vehicles and low value used vehicles. The salvage auction business specializes in providing services such as inbound transportation, titling, salvage recovery and claims settlement administrative

24


services. Another important component of the IAA service offering is the ability to process large volumes of total loss vehicles in a short period of time following catastrophic events such as hurricanes, tornadoes, floods, hail storms, fires or other natural disasters.
The AFC segment provides short-term, inventory-secured financing, known as floorplan financing, primarily to independent used vehicle dealers. At September 30, 2018, AFC conducted business at 130 locations in the United States and Canada. The Company also sells vehicle service contracts through PWI.
The holding company is maintained separately from the three reportable segments and includes expenses associated with the corporate offices, such as salaries, benefits and travel costs for our management team, certain human resources, information technology and accounting costs, and certain insurance, treasury, legal and risk management costs. Holding company interest expense includes the interest expense incurred on capital leases and the corporate debt structure. Intercompany charges relate primarily to interest on intercompany debt or receivables and certain administrative costs allocated by the holding company.
Potential Spin-off of IAA
In February 2018, the Company announced that its board of directors had approved a plan to pursue the separation of its salvage auction business, currently operated by IAA, through a spin-off. The Company also announced that the separation was subject to customary regulatory approvals, the execution of intercompany agreements between the Company and the new salvage auction company, final approval of the board of directors and other customary matters.
The Company expects to complete the spin-off in 2019. The Company may, at any time and for any reason until the proposed transaction is complete, abandon, modify or change the terms of the spin-off. There can be no assurance as to whether or when the spin-off will occur. IAA filed its initial Registration Statement on Form 10 on June 28, 2018 and Amendment No. 1 to its Registration Statement on Form 10 on August 30, 2018.
Industry Trends
Whole Car
Used vehicles sold in North America through whole car auctions, including online only sales, were approximately 9.9 million, 10.6 million and 11.1 million in 2015, 2016 and 2017, respectively. We expect that used vehicle auction volumes in North America, including online only volumes, will be over 11 million units in 2018, 2019 and 2020. Our estimates are based on information from the Bureau of Economic Analysis, IHS Automotive, Kontos Total Market Estimates, NAAA's annual survey and management estimates.
To provide long-term growth for ADESA, we are incurring costs to launch TradeRev in new U.S. markets. TradeRev incurred operating losses of $14.8 million and $37.3 million for the three and nine months ended September 30, 2018, respectively. The operating losses are attributable to the rollout of TradeRev.
Salvage
Vehicles deemed a total loss by automobile insurance companies represent the largest category of vehicles sold in the salvage vehicle auction industry. Based on data from CCC Information Services, the percentage of claims resulting in total losses was approximately 18% in 2017, 17% in 2016 and 16% in 2015. There is no central reporting system for the salvage vehicle auction industry that tracks the number of salvage vehicle auction volumes in any given year, which makes estimating industry volumes difficult. We believe that salvage auction industry volumes will grow 5% to 7% annually, for the foreseeable future.
Fluctuations in used vehicle and commodity pricing (aluminum, steel, etc.) have an impact on proceeds received in the salvage vehicle auction industry. In times of rising prices, revenue and gross profit are positively impacted. If used vehicle and commodity prices decrease, proceeds, revenue and gross profit at salvage auctions may be negatively impacted, which could adversely affect the level of profitability. During the first nine months of 2018, the price per ton of crushed auto bodies in North America ranged from $194 to $215 and finished September 2018 at $196. For comparison, during 2017, the price per ton of crushed auto bodies in North America ranged from $156 to $188.
Automotive Finance
AFC works with independent used vehicle dealers to improve their results by providing a comprehensive set of business and financial solutions that leverages its local branches, industry experience and scale, as well as KAR affiliations. AFC's North American dealer base was comprised of approximately 15,400 dealers in 2017, and loan transactions, which includes both loans paid off and loans curtailed, were approximately 1,700,000 in 2017.

25


Key challenges for the independent used vehicle dealer include demand for used vehicles, disruptions in pricing of used vehicle inventory, lack of access to consumer financing and increased competition resulting from consolidation in the used vehicle dealer industry. These same challenges, to the extent they occur, could result in a material negative impact on AFC's results of operations. A significant decline in used vehicle sales would result in a decrease in consumer auto loan originations and an increased number of dealers defaulting on their loans. In addition, volatility in wholesale vehicle pricing impacts the value of recovered collateral on defaulted loans and the resulting severity of credit losses at AFC.
Seasonality
The volume of vehicles sold through our auctions generally fluctuates from quarter-to-quarter. This seasonality is caused by several factors including weather, the timing of used vehicles available for sale from selling customers, the availability and quality of salvage vehicles, holidays, and the seasonality of the retail market for used vehicles, which affects the demand side of the auction industry. Used vehicle auction volumes tend to decline during prolonged periods of winter weather conditions. In addition, mild weather conditions and decreases in traffic volume can each lead to a decline in the available supply of salvage vehicles because fewer traffic accidents occur, resulting in fewer damaged vehicles overall. As a result, revenues and operating expenses related to volume will fluctuate accordingly on a quarterly basis. The fourth calendar quarter typically experiences lower used vehicle auction volume as well as additional costs associated with the holidays and winter weather.
Sources of Revenues and Expenses
Our revenue is derived from auction fees and related services associated with our whole car and salvage auctions, and from dealer financing fees, interest income and other service revenue at AFC. Although auction revenues primarily include the auction services and related fees, our related receivables and payables include the gross value of the vehicles sold.
Our operating expenses consist of cost of services, selling, general and administrative and depreciation and amortization. Cost of services is composed of payroll and related costs, subcontract services, the cost of vehicles purchased, supplies, insurance, property taxes, utilities, service contract claims, maintenance and lease expense related to the auction sites and loan offices. Cost of services excludes depreciation and amortization. Selling, general and administrative expenses are composed of payroll and related costs, sales and marketing, information technology services and professional fees.

26


Results of Operations
Overview of Results of KAR Auction Services, Inc. for the Three Months Ended September 30, 2018 and 2017:
 
Three Months Ended
September 30,
(Dollars in millions except per share amounts)
2018
 
2017
Revenues
 
 
 
ADESA
$
527.0

 
$
477.1

IAA
321.1

 
287.7

AFC
85.4

 
78.2

Total revenues
933.5

 
843.0

Cost of services*
533.2

 
479.2

Gross profit*
400.3

 
363.8

Selling, general and administrative
186.0

 
155.7

Depreciation and amortization
65.6

 
66.2

Operating profit
148.7

 
141.9

Interest expense
49.2

 
41.5

Other income, net
(3.1
)
 
(0.1
)
Income before income taxes
102.6

 
100.5

Income taxes
25.1

 
37.7

Net income
$
77.5

 
$
62.8

Net income per share
 
 
 
Basic
$
0.58

 
$
0.46

Diluted
$
0.57

 
$
0.46


* Exclusive of depreciation and amortization
Overview
For the three months ended September 30, 2018, we had revenue of $933.5 million compared with revenue of $843.0 million for the three months ended September 30, 2017, an increase of 11%. Businesses acquired accounted for an increase in revenue of $10.6 million or 1% of revenue. For a further discussion of revenues, gross profit and selling, general and administrative expenses, see the segment results discussions below.
Depreciation and Amortization
Depreciation and amortization decreased $0.6 million, or 1%, to $65.6 million for the three months ended September 30, 2018, compared with $66.2 million for the three months ended September 30, 2017.
Interest Expense
Interest expense increased $7.7 million, or 19%, to $49.2 million for the three months ended September 30, 2018, compared with $41.5 million for the three months ended September 30, 2017. The increase was primarily attributable to an increase in the weighted average interest rate for the three months ended September 30, 2018 compared with the three months ended September 30, 2017 of approximately 0.54%, partially offset by a decrease of approximately $17 million in the average outstanding balance of corporate debt for the same period. In addition, there was an increase in interest expense at AFC of $4.0 million, which resulted from an increase in interest rates and increased borrowings under the U.S. securitization agreement for the three months ended September 30, 2018 as compared with the three months ended September 30, 2017.
Income Taxes
We had an effective tax rate of 24.5% for the three months ended September 30, 2018, compared with an effective tax rate of 37.5% for the three months ended September 30, 2017. Our effective tax rate was lower for the three months ended September 30, 2018 as compared with the three months ended September 30, 2017, primarily as a result of the enactment of the Tax Cuts and Jobs Act of 2017 in the fourth quarter of 2017.

27


Impact of Foreign Currency
For the three months ended September 30, 2018, the strengthening of the U.S. dollar has impacted the reporting of our Canadian operations in U.S. dollars. For the three months ended September 30, 2018, fluctuations in the Canadian exchange rate decreased revenue by $4.6 million, operating profit by $1.7 million, net income by $1.0 million and net income per diluted share by less than $0.01.
ADESA Results
 
Three Months Ended
September 30,
(Dollars in millions, except per vehicle amounts)
2018
 
2017
ADESA revenue
$
527.0

 
$
477.1

Cost of services*
307.8

 
272.6

Gross profit*
219.2

 
204.5

Selling, general and administrative
111.8

 
87.6

Depreciation and amortization
31.9

 
28.5

Operating profit
$
75.5

 
$
88.4

Vehicles sold
876,000

 
788,000

   Physical auction vehicles sold
533,000

 
547,000

   Online only vehicles sold
343,000

 
241,000

   Dealer consignment mix at physical auctions
44
%
 
47
%
   Conversion rate at North American physical auctions
62.9
%
 
61.3
%
Physical auction revenue per vehicle sold, excluding purchased vehicles
$
850

 
$
781

Online only revenue per vehicle sold, excluding ADESA Assurance Program vehicles
$
126

 
$
112


* Exclusive of depreciation and amortization
Revenue
Revenue from ADESA increased $49.9 million, or 10%, to $527.0 million for the three months ended September 30, 2018, compared with $477.1 million for the three months ended September 30, 2017. The increase in revenue was primarily a result of a 11% increase in the number of vehicles sold (7% increase excluding acquisitions), partially offset by a 1% decrease in average revenue per vehicle sold. Businesses acquired in the last 12 months accounted for an increase in revenue of $10.6 million. Revenue decreased $3.1 million due to fluctuations in the Canadian exchange rate.
The increase in vehicles sold was primarily attributable to a 14% increase in institutional volume, including vehicles sold on our online only platform for the three months ended September 30, 2018 compared with the three months ended September 30, 2017. Dealer consignment units sold increased 5% (9% decrease excluding acquisitions) for the three months ended September 30, 2018 compared with the three months ended September 30, 2017. Online sales volume for ADESA represented approximately 54% of the total vehicles sold in the third quarter of 2018, compared with approximately 46% in the third quarter of 2017. "Online sales" includes the following: (i) selling vehicles directly from a dealership or other interim storage location (upstream selling); (ii) online solutions that offer vehicles for sale while in transit to auction locations (midstream selling); (iii) vehicles sold on the TradeRev platform (TradeRev was acquired in the fourth quarter of 2017); (iv) simultaneously broadcasting video and audio of the physical auctions to online bidders (LiveBlock®); and (v) bulletin-board or real-time online auctions (DealerBlock®). Upstream selling, midstream selling and TradeRev sales, which represent online only sales, accounted for approximately 74% of ADESA's online sales volume. ADESA sold approximately 343,000 (including approximately 35,000 from TradeRev compared with pre-acquisition TradeRev volumes of approximately 16,000 in the third quarter of 2017) and 241,000 vehicles through its online only offerings in the third quarter of 2018 and 2017, respectively, of which approximately 156,000 and 120,000 represented vehicle sales to grounding dealers in the third quarter of 2018 and 2017, respectively. For the three months ended September 30, 2018, dealer consignment vehicles represented approximately 44% of used vehicles sold at ADESA physical auction locations, compared with approximately 47% for the three months ended September 30, 2017. Vehicles sold at physical auction locations decreased 3% in the third quarter of 2018, compared with the third quarter of 2017. The used vehicle conversion percentage at North American physical auction locations, calculated as the number of vehicles sold as a percentage of the number of vehicles entered for sale at our ADESA auctions, increased to 62.9% for the three months ended September 30, 2018, compared with 61.3% for the three months ended September 30, 2017.

28


Physical auction revenue per vehicle sold increased $69, or 9%, to $850 for the three months ended September 30, 2018, compared with $781 for the three months ended September 30, 2017. Physical auction revenue per vehicle sold includes revenue from seller and buyer auction fees and ancillary and other related services, which includes non-auction services and excludes the sale of purchased vehicles. The increase in physical auction revenue per vehicle sold was primarily attributable to an increase in lower margin ancillary and other related services revenue and auction fees related to higher average transaction prices, partially offset by a decrease in physical auction revenue per vehicle sold of $6 due to fluctuations in the Canadian exchange rate.
Online only auction revenue per vehicle sold increased $24 to $152 for the three months ended September 30, 2018, compared with $128 for the three months ended September 30, 2017. The increase in online only auction revenue per vehicle sold was attributable to an increase in purchased vehicles associated with the ADESA Assurance Program and the inclusion of TradeRev sales. Excluding vehicles purchased as part of the ADESA Assurance Program, online only revenue per vehicle would have been $126 and $112 for the three months ended September 30, 2018 and 2017, respectively. This $14 increase in online only revenue per vehicle was attributable to increased revenue per vehicle for units sold on the TradeRev platform.
Gross Profit
For the three months ended September 30, 2018, gross profit for ADESA increased $14.7 million, or 7%, to $219.2 million, compared with $204.5 million for the three months ended September 30, 2017. Gross profit for ADESA was 41.6% of revenue for the three months ended September 30, 2018, compared with 42.9% of revenue for the three months ended September 30, 2017. Gross profit as a percentage of revenue decreased for the three months ended September 30, 2018 as compared with the three months ended September 30, 2017 as a result of an increase in lower margin related services, an increase in purchase vehicles primarily related to ADESA Assurance and incentives to promote TradeRev.
Selling, General and Administrative
Selling, general and administrative expenses for the ADESA segment increased $24.2 million, or 28%, to $111.8 million for the three months ended September 30, 2018, compared with $87.6 million for the three months ended September 30, 2017, primarily due to increases in selling, general and administrative expenses associated with acquisitions of $17.9 million, compensation expense of $2.1 million, incentive-based compensation expense of $2.1 million, marketing expense of $1.6 million, information technology costs of $0.6 million and other miscellaneous expenses aggregating $1.6 million, partially offset by a decrease in professional fees of $1.1 million and fluctuations in the Canadian exchange rate of $0.6 million.
IAA Results
 
Three Months Ended
September 30,
(Dollars in millions)
2018
 
2017
IAA revenue
$
321.1

 
$
287.7

Cost of services*
202.5

 
184.8

Gross profit*
118.6

 
102.9

Selling, general and administrative
28.8

 
26.5

Depreciation and amortization
24.3

 
23.1

Operating profit
$
65.5

 
$
53.3

Vehicles sold
597,000

 
562,000


* Exclusive of depreciation and amortization
Revenue
Revenue from IAA increased $33.4 million, or 12%, to $321.1 million for the three months ended September 30, 2018, compared with $287.7 million for the three months ended September 30, 2017. The increase in revenue was a result of an increase in vehicles sold of approximately 6% for the three months ended September 30, 2018. Revenue per vehicle sold increased 5% for the three months ended September 30, 2018 compared with the three months ended September 30, 2017, and included a decrease in revenue of $1.2 million due to fluctuations in the Canadian exchange rate. IAA's North American same-store total loss vehicle inventory decreased approximately 9% (4% increase excluding vehicles from catastrophic weather events in 2018 and 2017) at September 30, 2018, as compared to September 30, 2017. Vehicles sold under purchase agreements were approximately 4% and 5% of total salvage vehicles sold for the three months ended September 30, 2018 and 2017,

29


respectively. North American online sales volumes for IAA for the three months ended September 30, 2018 and 2017 each represented over 60% of the total vehicles sold by IAA.
Gross Profit
For the three months ended September 30, 2018, gross profit at IAA increased to $118.6 million, or 36.9% of revenue, compared with $102.9 million, or 35.8% of revenue, for the three months ended September 30, 2017. The increase in gross profit was mainly attributable to a 12% increase in revenue, partially offset by a 10% increase in cost of services, which included costs associated with purchase contract vehicles and organic volume growth. 
Excluding HBC, IAA's gross profit margin was 37.4% and 36.3% for the three months ended September 30, 2018 and 2017, respectively. For the three months ended September 30, 2018 and 2017, HBC had revenue of approximately $7.1 million and $7.3 million, respectively, and cost of services of approximately $6.0 million and $6.3 million, respectively, as fewer of HBC's vehicles were sold under purchase contracts. The entire selling price of the vehicle is recorded as revenue and cost of services for purchase contracts.
IAA recorded a $1.2 million and $4.3 million gross loss for the three months ended September 30, 2018 and 2017, respectively, related to catastrophic events. Excluding these events, (and HBC as noted above), IAA's gross profit margin was 37.8% and 37.9% for the three months ended September 30, 2018 and 2017, respectively.
Selling, General and Administrative
Selling, general and administrative expenses at IAA increased $2.3 million, or 9%, to $28.8 million for the three months ended September 30, 2018, compared with $26.5 million for the three months ended September 30, 2017. The increase in selling, general and administrative expenses was primarily attributable to increases in non-income based taxes of $0.9 million, compensation expense of $0.8 million, bad debt expense of $0.7 million and incentive-based compensation expense of $0.6 million, partially offset by a decrease in professional fees of $0.7 million.
AFC Results
 
Three Months Ended
September 30,
(Dollars in millions except volumes and per loan amounts)
2018
 
2017
AFC revenue
 
 
 
Interest and fee income
$
80.7

 
$
71.8

Other revenue
3.4

 
3.0

Provision for credit losses
(7.3
)
 
(5.0
)
Other service revenue
8.6

 
8.4

Total AFC revenue
85.4

 
78.2

Cost of services*
22.9

 
21.8

Gross profit*
62.5

 
56.4

Selling, general and administrative
8.1

 
7.2

Depreciation and amortization
2.3

 
7.9

Operating profit
$
52.1

 
$
41.3

Loan transactions
433,000

 
402,000

Revenue per loan transaction, excluding "Other service revenue"
$
177

 
$
174


* Exclusive of depreciation and amortization
Revenue
For the three months ended September 30, 2018, AFC revenue increased $7.2 million, or 9%, to $85.4 million, compared with $78.2 million for the three months ended September 30, 2017. The increase in revenue was the result of a 2% increase in revenue per loan transaction, an 8% increase in loan transactions and a 2% increase in "Other service revenue" generated by PWI. The increase in revenue and revenue per loan transaction included the impact of a decrease in revenue of $0.3 million due to fluctuations in the Canadian exchange rate.

30


Revenue per loan transaction, which includes both loans paid off and loans curtailed, increased $3, or 2%. The increase in provision for credit losses, which is a reduction of revenue, resulted in a decrease in revenue per loan transaction of $4 for the three months ended September 30, 2018. The remaining $7 increase in revenue per loan transaction was primarily the result of an increase in interest yield as a result of prime rate increases, as well as an increase in average loan values and average portfolio duration. Revenue per loan transaction excludes "Other service revenue."
The provision for credit losses increased to 1.5% of the average managed receivables for the three months ended September 30, 2018 from 1.1% for the three months ended September 30, 2017. The provision for credit losses is expected to be under 2%, annually, of the average managed receivables balance. However, the actual losses in any particular quarter could deviate from this range.
Gross Profit
For the three months ended September 30, 2018, gross profit for the AFC segment increased $6.1 million, or 11%, to $62.5 million, or 73.2% of revenue, compared with $56.4 million, or 72.1% of revenue, for the three months ended September 30, 2017, primarily as a result of a 9% increase in revenue, which includes the increased provision for credit losses, partially offset by a 5% increase in cost of services. The increase in cost of services was the result of increases in compensation expense of $0.8 million and other expenses aggregating $0.3 million.
Selling, General and Administrative
Selling, general and administrative expenses at AFC increased $0.9 million, or 13%, to $8.1 million for the three months ended September 30, 2018, compared with $7.2 million for the three months ended September 30, 2017. The increase in selling, general and administrative expenses was primarily attributable to increases in incentive-based compensation expense of $0.4 million, compensation expense of $0.4 million and other miscellaneous expenses aggregating $0.1 million.
Holding Company Results
 
Three Months Ended
September 30,
(Dollars in millions)
2018
 
2017
Selling, general and administrative
$
37.3

 
$
34.4

Depreciation and amortization
7.1

 
6.7

Operating loss
$
(44.4
)
 
$
(41.1
)
Selling, General and Administrative
For the three months ended September 30, 2018, selling, general and administrative expenses at the holding company increased $2.9 million, or 8%, to $37.3 million, compared with $34.4 million for the three months ended September 30, 2017, primarily as a result of increases in professional fees associated with the IAA spin-off of $2.1 million, other professional fees of $1.2 million, information technology costs of $1.1 million and compensation expense of $0.5 million, partially offset by decreases in medical expenses of $1.8 million and other miscellaneous expenses aggregating $0.2 million.

31


Overview of Results of KAR Auction Services, Inc. for the Nine Months Ended September 30, 2018 and 2017:
 
Nine Months Ended
September 30,
(Dollars in millions except per share amounts)
2018
 
2017
Revenues
 
 
 
ADESA
$
1,593.4

 
$
1,464.3

IAA
991.6

 
883.8

AFC
255.6

 
219.5

Total revenues
2,840.6

 
2,567.6

Cost of services*
1,599.5

 
1,462.1

Gross profit*
1,241.1

 
1,105.5

Selling, general and administrative
556.2

 
467.7

Depreciation and amortization
202.8

 
195.2

Operating profit
482.1

 
442.6

Interest expense
139.2

 
121.9

Other income, net
(4.5
)
 
(1.7
)
Loss on extinguishment of debt

 
27.5

Income before income taxes
347.4

 
294.9

Income taxes
86.7

 
105.7

Net income
$
260.7

 
$
189.2

Net income per share
 
 
 
Basic
$
1.94

 
$
1.38

Diluted
$
1.92

 
$
1.37


* Exclusive of depreciation and amortization
Overview
For the nine months ended September 30, 2018, we had revenue of $2,840.6 million compared with revenue of $2,567.6 million for the nine months ended September 30, 2017, an increase of 11%. Businesses acquired accounted for an increase in revenue of $26.3 million or 1% of revenue. For a further discussion of revenues, gross profit and selling, general and administrative expenses, see the segment results discussions below.
Depreciation and Amortization
Depreciation and amortization increased $7.6 million, or 4%, to $202.8 million for the nine months ended September 30, 2018, compared with $195.2 million for the nine months ended September 30, 2017. The increase in depreciation and amortization was primarily the result of certain assets placed in service over the last twelve months and depreciation and amortization for the assets of businesses acquired in 2017 and 2018.
Interest Expense
Interest expense increased $17.3 million, or 14%, to $139.2 million for the nine months ended September 30, 2018, compared with $121.9 million for the nine months ended September 30, 2017. The increase was primarily attributable to an increase of approximately $112 million in the average outstanding balance of corporate debt for the nine months ended September 30, 2018 compared with the nine months ended September 30, 2017, as well as an increase in the weighted average interest rate for the same period of approximately 0.43%. In addition, there was an increase in interest expense at AFC of $11.4 million, which resulted from an increase in interest rates and increased borrowings under the U.S. securitization agreement for the nine months ended September 30, 2018 as compared with the nine months ended September 30, 2017. The increases in interest expense were partially offset by $1.9 million received from the counterparties to the interest rate cap agreements and an increase of $4.3 million in the fair values of our interest rate caps which were recognized as a reduction of interest expense.

32


Loss on Extinguishment of Debt
In May 2017, we amended our Credit Agreement and recorded a $27.5 million pre-tax charge resulting from the write-off of unamortized debt issue costs and debt discounts associated with Term Loan B-2 and Term Loan B-3.
Income Taxes
We had an effective tax rate of 25.0% for the nine months ended September 30, 2018, compared with an effective tax rate of 35.8% for the nine months ended September 30, 2017. Our effective tax rate was lower for the nine months ended September 30, 2018 as compared with the nine months ended September 30, 2017, primarily as a result of the enactment of the Tax Cuts and Jobs Act of 2017 in the fourth quarter of 2017.
Impact of Foreign Currency
The strengthening of the Canadian dollar has impacted the reporting of our Canadian operations in U.S. dollars. For the nine months ended September 30, 2018, fluctuations in the Canadian exchange rate increased revenue by $4.3 million, operating profit by $1.6 million, net income by $0.9 million and net income per diluted share by less than $0.01.
ADESA Results
 
Nine Months Ended
September 30,
(Dollars in millions, except per vehicle amounts)
2018
 
2017
ADESA revenue
$
1,593.4

 
$
1,464.3

Cost of services*
921.0

 
842.2

Gross profit*
672.4

 
622.1

Selling, general and administrative
328.9

 
260.1

Depreciation and amortization
94.4

 
82.5

Operating profit
$
249.1

 
$
279.5

Vehicles sold
2,661,000

 
2,436,000

   Physical auction vehicles sold
1,663,000

 
1,735,000

   Online only vehicles sold
998,000

 
701,000

   Dealer consignment mix at physical auctions
43
%
 
46
%
   Conversion rate at North American physical auctions
62.6
%
 
61.4
%
Physical auction revenue per vehicle sold, excluding purchased vehicles
$
836

 
$
761

Online only revenue per vehicle sold, excluding ADESA Assurance Program vehicles
$
120

 
$
109


* Exclusive of depreciation and amortization
Revenue
Revenue from ADESA increased $129.1 million, or 9%, to $1,593.4 million for the nine months ended September 30, 2018, compared with $1,464.3 million for the nine months ended September 30, 2017. The increase in revenue was primarily a result of a 9% increase in the number of vehicles sold (6% increase excluding acquisitions) and average revenue per vehicle sold was consistent. Businesses acquired in the last 12 months accounted for an increase in revenue of $26.3 million. Revenue increased $3.0 million due to fluctuations in the Canadian exchange rate.
The increase in vehicles sold was primarily attributable to a 14% increase in institutional volume, including vehicles sold on our online only platform and dealer consignment units sold were consistent (11% decrease excluding acquisitions) for the nine months ended September 30, 2018 compared with the nine months ended September 30, 2017. Online sales volume for ADESA represented approximately 54% of the total vehicles sold in the first nine months of 2018, compared with approximately 45% in the first nine months of 2017. "Online sales" includes the following: (i) selling vehicles directly from a dealership or other interim storage location (upstream selling); (ii) online solutions that offer vehicles for sale while in transit to auction locations (midstream selling); (iii) vehicles sold on the TradeRev platform (TradeRev was acquired in the fourth quarter of 2017); (iv) simultaneously broadcasting video and audio of the physical auctions to online bidders (LiveBlock®); and (v) bulletin-board or real-time online auctions (DealerBlock®). Upstream selling, midstream selling and TradeRev sales, which represent online only sales, accounted for approximately 72% of ADESA's online sales volume. ADESA sold approximately

33


998,000 (including approximately 86,000 from 2017 acquisitions) and 701,000 vehicles through its online only offerings in the first nine months of 2018 and 2017, respectively, of which approximately 459,000 and 355,000 represented vehicle sales to grounding dealers in the first nine months of 2018 and 2017, respectively. For the nine months ended September 30, 2018, dealer consignment vehicles represented approximately 43% of used vehicles sold at ADESA physical auction locations, compared with approximately 46% for the nine months ended September 30, 2017. Vehicles sold at physical auction locations decreased 4% in the first nine months of 2018, compared with the first nine months of 2017. The used vehicle conversion percentage at North American physical auction locations, calculated as the number of vehicles sold as a percentage of the number of vehicles entered for sale at our ADESA auctions, increased to 62.6% for the nine months ended September 30, 2018, compared with 61.4% for the nine months ended September 30, 2017.
Physical auction revenue per vehicle sold increased $75, or 10%, to $836 for the nine months ended September 30, 2018, compared with $761 for the nine months ended September 30, 2017. Physical auction revenue per vehicle sold includes revenue from seller and buyer auction fees and ancillary and other related services, which includes non-auction services and excludes the sale of purchased vehicles. The increase in physical auction revenue per vehicle sold was primarily attributable to an increase in lower margin ancillary and other related services revenue and auction fees related to higher average transaction prices and an increase in physical auction revenue per vehicle sold of $2 due to fluctuations in the Canadian exchange rate.
Online only auction revenue per vehicle sold increased $16 to $140 for the nine months ended September 30, 2018, compared with $124 for the nine months ended September 30, 2017. The increase in online only auction revenue per vehicle sold was attributable to an increase in purchased vehicles associated with the ADESA Assurance Program and the inclusion of TradeRev sales. Excluding vehicles purchased as part of the ADESA Assurance Program, online only revenue per vehicle would have been $120 and $109 for the nine months ended September 30, 2018 and 2017, respectively. This $11 increase in online only revenue per vehicle was attributable to increased revenue per vehicle for units sold on the TradeRev platform.
Gross Profit
For the nine months ended September 30, 2018, gross profit for ADESA increased $50.3 million, or 8%, to $672.4 million, compared with $622.1 million for the nine months ended September 30, 2017. Gross profit for ADESA was 42.2% of revenue for the nine months ended September 30, 2018, compared with 42.5% of revenue for the nine months ended September 30, 2017.
Selling, General and Administrative
Selling, general and administrative expenses for the ADESA segment increased $68.8 million, or 26%, to $328.9 million for the nine