CarGurus, Inc. (CARG) Q1 2022 Earnings Report, Transcript and Summary

Greetings, and welcome to the CarGurus Inc. First Quarter 2022 Earnings Results Conference Call. At this time, all participants are in a listen-only mode. [Operator Instructions] As a reminder, this conference is being recorded. And I would now like to turn the conference over to your host, Kirndeep Singh, Vice President of Investor Relations. Please go ahead.

Thank you, operator. Good afternoon. I'm delighted to welcome you to CarGurus' first quarter 2022 earnings call. We will be discussing the results announced in our press release issued today after the market closed and posted on our Investor Relations website. With me on the call today are Jason Trevisan, Chief Executive Officer; Scot Fredo, Chief Financial Officer; Sam Zales, President and Chief Operating Officer; and Bruce Thompson, Founder and Chief Executive Officer of CarOffer. During the call, we will make statements regarding our business that may be considered forward-looking within applicable securities laws, including statements concerning our outlook for the second quarter of 2022. Management's expectations for our future financial and operational performance, our business and growth strategies, our expectations for our CarOffer business and acquisition synergies, the value proposition of our current product offerings and other product opportunities, the impact of the semiconductor chip shortage and other macro-level industry issues and other statements regarding our plans, prospects and expectations. These statements are not promises or guarantees and are subject and uncertainties, which could cause them to differ materially from actual results. Information concerning those risks is available in our earnings press release distributed after market close today and in our most recent reports on Forms 10-K and 10-Q, which along with our other SEC filings can be found on the SEC's website and in the Investor Relations section of our website. We undertake no obligation to update forward-looking statements, except as required by law. Further, during the course of today's call, we will refer to certain non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in our press release issued today as well as in our updated investor presentation, which can be found on the Investor Relations section of our website. With that, I'll now turn it over to Jason.

Thank you very much Kirndeep and thank you to all those joining us today. 2022 is off to a terrific start. While macroeconomic factors continue to challenge automotive industry, CarGurus remains at the forefront of providing innovative solutions to both our dealer partners and consumer audience during these dynamic times. In 2021, we transformed our business by acquiring CarOffer, launching CarGurus Instant Max Cash Offer and accelerating our digital retail capabilities. 2021 was the year of transformation for our business. And 2022 was the year of activation in which we plan to execute on the potential built last year by activating digital deal on our platform, lighting up new geographies for CarGurus Instant Max Cash Offer, adding more dealers on CarOffer's matrix and introducing new bundling options across our different offerings. As we initiate these new aspects of the business, we are also unlocking synergies that are made possible through the combined potential of our foundational listings business with the digital retail and digital wholesale businesses to create an end-to-end transaction enabled marketplace for consumers and dealers alike. For consumers, this means a place to transparently shop, finance, buy and sell from the largest selection of dealers' inventory in the U.S. And for dealers, it means the ability to efficiently source market and sell to the largest and highest intent consumer audience in the U.S. As we continue to make this vision a reality, I'm pleased to share CarGurus achieved exceptional results and exceeded our forecasted revenue guidance for the quarter. Revenues for the quarter from our CarOffer business, inclusive of our dealer-to-dealer business and Instant Max Cash Offer was $267 million, growing 50% quarter-over-quarter and over 1600% year-over-year. The industry's first instant trade platform for vehicle acquisition and disposition continues to garner dealer traction as indicated by the dealer base expanding to 10,850 enrolled dealer rooftops at the end of Q1. The joint CarOffer and CarGurus sales teams added another 1,750 rooftops this past quarter. As we continue to grow the network, we're able to diversify the dealer base, utilizing the matrix and further enhance the types of vehicles transacting on our platform. Gross merchandise sales, or GMS, for our dealer-to-dealer business AND Instant Max Cash Offer was approximately $2 billion declining modestly quarter-over-quarter. Each quarter since the acquisition of CarOffer, we have gained a deeper understanding and appreciation for how fluctuations in wholesale and retail prices affect our dealer partners, as they continue to navigate the ongoing semiconductor chip shortage. Two factors drove relatively more subdued dealer wholesale behavior in Q1. One, dealers witnessed wholesale prices start to retreat throughout Q1; and two, retail consumer demand continued to moderate as a result of historically high prices, rising auto loan rates, inflation and delayed tax refunds. Nonetheless, our dealer-to-dealer business generated $105 million in revenue in the first quarter, growing approximately 12% quarter-over-quarter and over 575% year-over-year. The growth this quarter also included changes in our revenue mix. We saw a slight decline in transactions, but an increase in fee revenue as we increased our buy and sell fees at the beginning of March from $275 to $325, an increase inspection cost to $110 from $90. Additionally, we had an increase in transportation services revenue, which is low margin revenue relative to transactions through the assumption of transportation for a large customer who is experiencing a material backlog of vehicle pickups. In spite of continued unpredictability of the effects of the global pandemic and supply chain issues on the used and new car market, I'm pleased with the impressive growth and adoption of CarOffer to date. There remains a long runway for growth, as we continue to further penetrate the U.S. dealer market and provide them with our unique solution to meet their inventory needs. Furthermore, the profitability of the CarOffer business during its infancy highlights the efficiency of the model. Of the $267 million in CarOffer revenue, our Instant Max Cash Offer business generated approximately $162 million, exceeding the high end of our forecasted guidance for the quarter and growing 92% quarter-over-quarter. In Q1, we expanded our coverage to five additional states, now covering approximately 80% of the U.S. While expansion primarily took place towards the end of the quarter, expansion into new markets accounted for 23% of the quarter-over-quarter growth while growth in existing geographies accounted for 77% of the growth, largely driven by improved consumer conversion. This quarter, transactions more than doubled. Much like the last two quarters, we continue to optimize CarGurus' Instant Max Cash Offer, or Instant Max for short, we have added more self-service options as well as greater automation to further enhance the consumer experience. Our virtual inspection intake pilot allows consumers to set up a video call with a CarOffer specialist to improve our condition assessments. Our online appointment scheduling system allows consumers the flexibility to schedule driveway pickups online and was utilized by 85% of consumers. These enhancements provide users more optionality and convenience to compliment receiving the highest and most competitive offer for thousands of dealers. As we approach national coverage, we will continue to optimize and refine the Instant Max experience for both our consumer and dealer partners. We believe over the long run, we are positioned to capture meaningful market share as CarGurus is the only U.S. marketplace where the largest network of dealers and the largest consumer audience can transact instantly and at scale using our instant trade technology. Turning to our foundational listings business, I'm thrilled to share we exceeded our forecasted marketplace revenue for the quarter. This robust performance was driven by healthy dealer editions and revenue expansion. In the U.S., our listings business had strong paying dealer editions in the quarter, up 359 from Q4, growing dealer counts across all our dealer segments. Net dealer ads this quarter were evenly split between new dealer editions as well as dealers who churned off our platform during the pandemic and the semiconductor chip shortage, and have since rejoined. In addition to improving dealer accounts, we saw growth in quarterly average revenue for subscribing dealer, or QARSD. This quarter, U.S. QARSD grew approximately 5% year-over-year to $5,713. QARSD growth was primarily driven by higher paying dealer additions, greater upsells and increased adoption of RPM and Area Boost. In addition to growing and innovating our listings business, we are also focused on continuously providing exceptional customer service to our dealer partners with a strategic emphasis on retention and growth. This focus has allowed us to grow our dealer base while witnessing materially lower churn in Q1 when compared to historical averages since the beginning of the pandemic and chip shortage. Internationally, we ended Q1 with 6,648 paying dealers, down modestly quarter-over-quarter. We saw QARSD grow by 40% to $1,556 year-over-year as a result of existing dealer revenue expansion and one-time discounts offered to select accounts during the lockdown last year. In Q1, we launched digital display in both the U.K. and Canada also known as RPM in the U.S. The pilot demonstrated that dealers utilizing digital display were able to target low final CarGurus customers who have not only visited their own listings, but viewed similar vehicles from other sellers and drive them back to their own websites. Since launching digital display, we're seeing very strong click-through rates to drive dealer adoption. We're thrilled to see strong receptivity for digital display and are excited for international dealers to leverage the same capabilities that are available to our dealers in the U.S. It is through product innovation and outstanding service that will continue to drive growth in our listings business and provide our dealer base with the highest ROI in their markets. In the spirit of always innovating the core functionality of the listings business, in the fourth quarter we tested and launched new digital retail pilots for deposits and hard-pull financing that allowed consumers even greater flexibility and optionality in completing their purchase. These pilots and existing offerings allow our dealer partners to offer our 31 million unique monthly visitors, a convenient self selective journey, all while providing trust, transparency and the best pricing from the largest selection of inventory in the U.S. Following the success of our pilots, at this year's NADA conference, we shared a preview of our upcoming digital retail offering Digital Deal. Digital Deal is an evolution of our CG convert offering, helping dealers close more business from the 60% of CarGurus' auto shoppers who prefer to do more of the car buying process from home. Our Digital Deal solution provides dealers with high-quality sales opportunities by moving shoppers further down the purchase funnel before a dealership visit, by allowing them to build a near penny perfect deal online, including dealership finance and insurance offerings, and scheduling an appointment to visit the dealership to finalize the sale. If enabled by the dealership, shoppers will also have the option to place a $500 credit card deposit to reserve the vehicle for 72 hours. Digital Deal has been made available to select dealers at NADA and will be available for all dealers to opt into later this month. This new product is designed to help dealers compete with online retailers. It empowers dealers to close more business with less time and effort and Digital Deal leads are two-times more likely to close than traditional leads. Combined with Area Boost, Digital Deal gives dealers the ability to sell online in both their local market and as far outside it as they would like. Not only does Digital Deal provide tremendous value to dealers, but car shopper satisfaction is 2.5 times higher than standard CarGurus leads, creating a mutually beneficial offering for our consumer audience and dealer partners. We're excited to launch Digital Deal later this month. With this launch, we're closer to creating a full end-to-end digital retail solution and providing a unique offering to serve our consumers and dealers who wish to have a digital to in-store experience. We believe our digital retail capabilities will level the playing field for our dealer partners who are unable to provide these solutions to consumers on their own and/or wish to utilize our largest consumer audience to sell additional inventory through the CarGurus' digital retail platform to drive greater profitability. With innovative new solutions like Digital Deal and Instant Max Cash Offer, we've been able to realize the full benefits of the efficiencies and synergies that exist when you create a transaction enabled marketplace. Formerly the main value of each consumer came from their VDP lead submission. However, since expanding our business, we are able to increase the value of our shoppers as they interact with multiple products across our platform and thus, increase our revenue per consumer. This allows us to gain leverage in our marketing spend, as we grow the contribution from a consumer across multiple products. For example, approximately 50% of our Instant Max offer savers view a VDP for a new purchase. These consumers are high intent shoppers at the bottom of our funnel who are interested in both selling their car and purchasing a new one. Increasingly, we are able to target these types of consumers and help them engage with even more of our product offerings. Heightened consumer activity creates leverage with our marketing, allowing us to capture synergies from a transaction enabled marketplace that did not exist previously. Furthermore, as we create a stickier platform that services the full life cycle for dealers as well as consumers, we are able to bundle our offerings to capture additional synergies and revenue. This past quarter, we began two small pilots designed to increase dealer engagement in our full product suite. The first is offering advantaged pricing to non-listing dealers who are utilizing our CarOffer platform, and the second is offering dealers that are on both CarGurus and CarOffer, favorable pricing on their listing subscriptions by meeting monthly CarOffer transaction volume thresholds. Although we are in the early stages of tying our offerings into one cohesive product suite for our dealer partners, bundling incentivizes dealers to utilize more than just one of our many offerings to improve their business. All-in-all, we're thrilled with our first quarter results. We're proud of the growth of our foundational listings business as well as the profitability of CarOffer, both driving incredibly strong top and bottom line results. While the semiconductor chip shortage continues to cause near-term inventory uncertainty and volatility, we continue to deliver tremendous shareholder value, all while pushing forward our vision of creating a full end-to-end transaction enabled marketplace. We're combining our foundational listings business with digital wholesale and digital retail to create the only end-to-end automotive transaction enabled marketplace in the U.S. for consumers to transparently and confidently shop, finance, buy and sell from the largest network of dealers and for dealers to efficiently source, market and sell to the largest and highest intend consumer audience in the U.S. We are focused on increasing optionality and convenience for both dealers and consumers by providing consumers flexibility to complete a sale or purchase in a manner that works best for them and offering dealers more choice to tailor their product suite that best serves their individual business. Each transaction is unique. We are committed to creating solutions that mutually benefit the various needs of consumers and dealers. None of these incredible results or innovative ideas would be possible without each and every one of our team members. So, I'd like to take a moment to express my gratitude and appreciation to our employees globally. After a little over two years, I'm excited to welcome our employees back to the office in June. The pandemic created new challenges and disrupted not only our work lives, but our personal lives as well. Nonetheless, over the past two years, our employees embodied our core values and continue to innovate and drive our vision forward. It's through their commitment and passion that we were able to turn our vision into a reality. Now, I'll turn it over to Scott to discuss our financial results.

Thank you, Jason. I'll provide a detailed overview of our first quarter performance, followed by our guidance for the second quarter of 2022. Total first quarter revenue was $430.6 million, up 151% year-over-year and nearly $21 million ahead of the high-end of our most recent guidance range. Marketplace revenue was $163.3 million for the first quarter, up 2% from the prior quarter and up 5% on from $155.8 million in the prior year. The growth in marketplace revenue was primarily due to the increase in our foundational listings revenue driven mostly by an increase in our paying dealers in the U.S. quarter-over-quarter. Wholesale revenue was $91 million for the first quarter of 2022, up 559% from $13.8 million in the prior year. Compared to the previous quarter, wholesale revenue grew 10% in the first quarter. The increase in wholesale revenue compared to the prior quarter is mostly due to the increase in transportation revenue that Jason mentioned. Lastly, our third and final revenue component, product revenue, was $176.3 million for the first quarter, up 9,896% from $1.8 million in the prior year and up 84% from the previous quarter. The increase in revenue from the prior quarter is primarily due to transaction volume growth associated with Instant Max Cash Offer. I will now discuss our expenses and profitability on a non-GAAP basis, which backs out our stock-based compensation expense, amortization of acquired intangible assets, acquisition related expenses and net income attributable to redeemable non-controlling interest. First quarter non-GAAP gross margin was 44% compared to 59% in the prior quarter and 86% in the year ago quarter. The change in non-GAAP gross margin is primarily due to the growth of Instant Max Cash Offer and its associated costs of acquiring vehicles directly from the consumer. Additionally, the contraction was due to an increase in transportation and arbitration costs associated with the dealer-to-dealer services. Total first quarter non-GAAP operating expenses were $125.2 million, up 27% year-over-year. Non-GAAP sales and marketing expense decreased 3% compared to the previous quarter and increased 28% year-over-year to $83.6 million. Non-GAAP sales and marketing expense represented 19% of revenue, down from 38% of revenue in the year ago period. The slight decrease in non-GAAP sales and marketing expense compared to the previous quarter is primarily due to the efficiencies in our paid traffic acquisition spend as we realized synergies that Jason previously mentioned. However, compared to the year ago quarter and moving forward in 2022, while we would expect these efficiencies to remain, we will have increased expense as we invest to market Instant Max Cash Offer and seek to increase our brand awareness among consumers. Our first quarter non-GAAP product, technology and development expenses grew 25% versus the year ago period to $24.3 million. The increase is primarily due to an increase in employee related costs as a result of a 30% increase in headcount and continued investment in our technology teams to grow our new areas in digital wholesale and digital retail, as well as new features and enhancements to our marketplace subscription products. We generated non-GAAP operating income of $62.2 million, representing a margin of 14% and in the middle of our guidance range. Non-GAAP diluted earnings per share attributable to CarGurus Inc. were $0.36 for the first quarter, $0.03 above the high-end of our guidance range. On a GAAP basis, we generated first quarter gross margin of 42% compared to 86% in the year ago period. The contraction in gross margin is primarily due to the reasons previously discussed, in addition to amortization of acquired intangibles of approximately $5.4 million that were previously reported in operating expenses and are now included within cost of revenue. We incurred total operating expenses of $155.2 million, up roughly 28% year-over-year. The increase in operating expenses was primarily driven by an increase in payroll and employee related benefit expenses, as we increased our headcount supporting our core business over the last year by 13% as well as increased headcount as a result of the CarOffer acquisition. First quarter GAAP operating income increased 3% year-over-year to $26.7 million. First quarter GAAP net income attributable to CarGurus Inc. totaled $19.9 million. And first quarter GAAP net loss attributable to common shareholders totaled $62.1 million, primarily due to the accretion of redeemable non-controlling interest to redemption value of $82 million in the first quarter. We ended the first quarter with $375 million in cash and investments, an increase of $53.1 million from the end of the fourth quarter. The increase was driven by a $40 million decrease in our accounts receivable balance, a $30.1 million increase in accrued expenses offset by $23.6 million in payments made to our third-party processor related to CarOffer. We generated $93.1 million in cash from operations in the first quarter and $89.3 million of non-GAAP free cash flow, which includes capital expenditures and capitalized website development costs of $3.7 million. I'll close my prepared remarks with our outlook for the second quarter of 2022. We expect our second quarter revenue to be in the range of $480 million to $510 million. Similar to previous quarters, we are providing second quarter revenue guidance for Instant Max Cash Offer, which we anticipate to be in the range of $219 million to $239 million. We are estimating non-GAAP operating income in the range of $44 million to $52 million and non-GAAP earnings per share in the range of $0.26 to $0.29. We expect non-GAAP operating income to contract in Q2 compared to Q1, as we increase our marketing spend to drive consumer awareness and continue to invest in technology and building our team to drive long-term growth. With that, we look forward to seeing some of you at our upcoming Investor Day. And now I'll open up the call for Q&A.

Thank you. At this time, we will be conducing our question-and-answer session. [Operator Instructions] Our first question is from the line of John Colantuoni with Jefferies. Please go ahead.

Just looking at CarOffer, it looks like average gross merchandise sales per dealership moderated about 30% sequentially in the first quarter and about double-digits year-on-year. Can you just talk to how this compared to your expectations? And whether any recent moderation in consumer demand for used cars is impacting how dealership's willingness to buy programmatically? And then also, how has engagement -- maybe you could talk about how engagement at CarOffer has trended in recent months? And I have a follow-up.

Sure. Sam, do you want to take a shot at this and if Bruce, you want to add anything?

Happy to start, John. Thanks. Sam Zales, and I'll turn it to Bruce, the expert on this in a minute. You're talking about the sequential fourth quarter to first quarter, and I'd say the industry as a whole was impacted by wholesale pricing. When wholesale pricing drops, that is a volatile time, and it makes dealers cautious about buying and selling. And that's a factor we talked about last -- third quarter of last year. So, those -- that dynamic impacts the business. Second comment is consumer demand, as you just said, is soft right now in the market and that does also impact how dealers think about transactions and how much inventory they need. As you've said it, and we look at second quarter starting to kick-off, that wholesale pricing model changes, wholesale pricing is starting to head up again and that is always good news for confidence in dealers transacting both on the buy and sell side. So that is the impact. As you think about it from a macro perspective, let me turn it to you, Bruce, if you have any more to share on that front.

Yeah. I would just basically reiterate what you're saying, Sam, also that we had incredible December and January. Speaking to your point, I think wholesale prices came down 6.4% since the first of the year. That being said, we have today more programmatic buyers on the system as of today than we've ever had. So, we've seen a rapid expansion of that a ton of momentum going into this quarter. And given the headwinds there and particularly February, our aggressiveness to and Instant Max Cash Offer, I mean we're learning every day. Basically, in about six months or so, setup $1 billion business. And we wanted to get aggressive there, but as we're buying these cars, we're finding out, picking up these cars from consumers, paying these consumers on the spot, we're learning a lot. And really getting that dialed in, feeling very, very good about that as we move into this month and next.

Great. And I wanted to ask one about the marketplace. With dealership seeing a moderation in used car demand, could you see that benefiting CarGurus as dealerships look to boost sales by leveraging more digital advertising. I guess, I'm trying to figure out the counterbalance between dealerships trying to offset a drop in demand and maybe being a little bit more careful about how much inventory that they keep at their dealerships. Maybe you could just talk a little bit about how you see that dynamic impacting CarGurus marketplace business? Thanks.

Sure. Thanks John. This is Jason. Yeah. I mean, I think you've probably heard us talk in the past about how now that we have a broader and more complete platform that covers dealers sourcing, marketing and selling and full life cycle for consumers as well. It does balance our business more. And in a lot of respects, when there are tailwinds in one area, there may be headwinds in another and vice versa. And so, as consumer demand does wane and you've heard us say that, but you've probably seen that in other market data points as well, we do feel that dealers are going to have to market more aggressively and that, that will help our marketplace business, and you started to see some of that momentum already in Q1 as we added hundreds of dealers. As long as inventory does remain constrained, though that is a factor that even if consumer demand goes up -- I'm sorry -- even if consumer demand goes down and dealer marketing has tended to go up, if they don't have a lot of cars on their lot, then they may not be as aggressive as they were say pre-COVID. But we think that the inventory situation while remaining challenged for the foreseeable future is probably improving from where it was. And if consumer demand is less rampant than it was in the end of last year -- second half of last year, then that bodes well for our listings business as well as RPM and some of the digital retail products we're introducing as well.

Appreciate the color.

Thanks for the question.

Thank you. We have next question from the line of Chris Pierce with Needham. Please go ahead.

Hey. How are you doing? I think Bruce sort of hit on it, but I kind of wanted to go deeper. I'm looking at slide 29. Can you just walk me through CarOffer non-GAAP gross profit margin heading lower? And does it relate to Internet cash out where Bruce said you're learning every day? Or I guess what are the inputs? Is there a contra revenue in there? Is CarGurus pricing to be lower from arbitration if you just kind of go deeper on that, I'd appreciate it?

Yeah. Scott, do you want to take a shot at that? You're on mute.

Hey, Chris. How are you doing? It's Scott. So, on slide 29, non-gas -- I'm sorry -- non-GAAP gross profit, that's what you're looking at?

Yeah.

So, I mean, we got a huge benefit from the amortization item, right? So, you can see that on the slide. So that trended very high in Q4 because of that one-time pickup. With regards to overall -- I mean if you look at the GAAP gross profit line, you can see that there's a difference from Q4 to Q1. And that is just a mix issue. Some of the points that were mentioned on the call. We -- there was price volatility. So, we got more aggressive on Instant Max with regards to pricing, and we compress gross margins there a bit. We had more transportation costs associated that carried over from Q4 to Q1. So, we mentioned that on the call. So, all of that led to some compression in gross margin quarter-over-quarter.

Okay. And then bigger picture, kind of what are dealers telling you as we get closer to the ADESA deal sunsetting or closing and kind of how are dealers thinking about their sourcing of in their selling in the wholesale market.

I can take -- this is Bruce. I can tell you from my perspective, I think it benefits us we are already seeing some momentum there. And I think that will keep translating as dealers decide whether or not they're going to participate with the ADESA brick-and-mortar auctions or the cobot brick-and-mortar auctions moving forward, I think it bodes well for dealer to moving forward, for sure.

Okay.

Well, this is Jason. We continue to see a share shift from physical to digital. And that is in the grand scheme of things, still in its early days, but it's a pretty steep transition now, and we think that's going to continue for quite some time. So, there's a lot of share to be gained from that. I think the added element -- added benefit that Bruce was referencing is that we have heard dealers specifically say that they're less inclined to work with a group that's owned by a competitor of theirs than they otherwise might have been.

Thank you.

Thank you. We have next question from the line of Tom White with D.A. Davidson. Please go ahead.

Great. Thanks for taking my question. Maybe just a follow-up on the comments about the sensitivity of volumes in the wholesale dealer-to-dealer business to the wholesale prices. Jason, if you looked out like, I don't know, three or four quarters or whenever we think new inventory is going to come back online in a meaningful way. Do you expect that part of the CarOffer business to be sensitive to that as well? I'm curious whether you guys have given any thought to adding a subscription based element to that business?

Sure. So, I can -- this is Jason. I'll take both of those. On your second question, we have a couple of smaller products that are more subscription in nature in the wholesale arena, but it's not the bulk of the business. And from -- as you know, and from a wholesale sort of pure middle of the fairway D2D perspective, we think the transaction model is much more sensible there. And on your first question, the -- and it's going to be a while for new car production to ramp up and have really meaningful impact in sort of a macro way on used car pricing, but we did see used car pricing at the retail level decline in Q1. And in the wholesale as well as somebody earlier mentioned some of the stats there. It's not so much that there is a decline, per se. It's more that there's uncertainty among dealers in the form of volatility. And so, if dealers had a sense for what they felt was going to be, say, a steady decline in pricing over time, they would still need to source cars, and they would still need to sell cars. It's more when there's uncertainty and concern that they have that there might be sharp changes in the near-term or unexpected changes in the near-term. And we've had such a frothy rising market in wholesale unit prices over the course of the last, call it, two years with two periods where prices flattened and declined. And I think both times it was unexpected. And I think it was that uncertainty and that volatility that drove a little hesitancy among them, sort of skittishness, if you will. But I think most people who look at wholesale unit pricing in general, expect that over the next couple of years, it's going to return to some lower level than where it is right now, and dealers know that they're going to need to source cars during that. So that's how I would characterize the sensitivity. It's more around volatility than it is around whether it's a decline in an increase.

That’s great.

Sorry, go ahead. Go ahead. Even in -- I'll finish, sorry. Even in that -- even in the moments of skittishness, I mean we think that A, a digital model still makes more sense and B, an instant trade platform where you can control your bidding and you're selling in a much more sort of controlled and technical way actually provides comfort in periods of skittishness. You're not as reliant on the outcome of one or one set of auctions.

Got it. That's really helpful. A quick follow-up. I remember last quarter you guys talked about the rental car companies as being an active part of that -- the wholesale dealer-to-dealer business. Can you talk about kind of their level of activity in the second quarter? And just generally, do you view those -- that segment as kind of a durable customer base? Or are they just kind of more opportunistic given that they needed to kind of ramp up their fleets?

This is Bruce. My discussion with the fleet -- basically, we think it is a durable channel for us. And for quarters and quarters to come, if not indefinitely -- as they basically had a migration or shift into buying from the OEMs to nearly new, the channels actually very, very well for them. And we're seeing that in the second quarter as -- obviously, as you see transportation and travel across the country ramp up, it's doing -- we anticipate that will continue for us. And quarter-over-quarter, I think even from the fourth quarter to the first quarter, we were up nearly $100 million. So, we're pleased with the performance in the first quarter. And as Jason indicated, when markets go up and down -- just like the stock market today, when you get a rapid decline, it creates some skittishness, but ultimately, those wave themselves out and you get normalization and stabilization, and we feel very good about where we are today.

Great. Thanks guys.

Thank you. We have next question from the line of Brad Erickson with RBC Capital Markets. Please go ahead.

Hi. Thanks. Just on the margin guidance, you mentioned the sales and marketing expense. Can you just unpack the size of that marketing investment and give us some guardrails as to how to think about how much you intend to spend? And just curious also if there's any contribution there from higher transport reps like there was in Q1, or is that not a factor?

Hey, Brad. It's Scott. I'll take this one. So, there's a couple of pieces there. I'm not going to get too specific on marketing spend, but there's really, I'd say, two underlying elements, something that we've talked about for about a year with regard to needing to spend more on the core business and that started to happen a bit in Q4 and Q1, a bit more than we saw in Q2 and Q3 last year, where we didn't have to spend -- it's been a fraction of what we spent in Q1 of last year. So, we're spending more on the core business to drive traffic to the site, good engagement with consumers on the site and convert those to value leads for the dealers. But what we're also investing more heavily in is marketing Instant Max, and that is sort of the other dimension of marketing that has been minimal spend so far on a relative basis. And that's where we're spending a lot more in Q2 and expect to be on Q2 as well. So, the guidance with regards to earnings really represents an investment in more marketing spend. But also, we are continuing to ramp up the team. We've got a lot of headcount that we're trying to fill across the organization, especially in tech, but really across all teams as well and CarGurus growing their team tremendously. So, it's really people and marketing. It's primarily the investment areas. And then, we're investing a lot in digital retail as well.

Got it. Thanks for that. And then, just on the buy button beyond what you kind of gave in the prepared remarks. Just any updated learnings you can provide there sort of evidence of success and just any update as you continue to pilot that?

Happy to take it, Brad. Thanks. We can't be more excited about the Instant Max Cash Offer product. I think our conversion rates from our site for consumer saving offers conversions from saved offers to transactions are all moving in the right direction, which we're excited about. I'm sorry -- and maybe I'm jumping off of that Instant Max Cash Offer. On the buy button -- sorry, I'm getting too excited about that one. Digital -- so that keeps moving in the right direction. Sorry, Brad. On digital deal, how excited we are for the next phase of that one. As Jason talked about, it's a next expansion of what the convert product is. And what we're adding in capabilities there is an opportunity for dealers to utilize and see the down funnel shopper. We're getting data on the interest of that consumer to purchase and we talked about the close rate on those leads being two times the already terrific close rate we get on our general leads that we get in the business. And that's because we've now added this -- the soft pull financing now to hard pull getting a consumer into the dealer's transaction process. We're fully integrated into the CRM, at the dealership. And that process of starting the shop, finance and buy process for a consumer, we just think is where the industry is going -- 60% of our consumers are interested in doing something digitally. They can do that fully digitally or in-store to test drive that vehicle. We think we have an advantaged product in the marketplace, so excited to launch digital deal. You've heard at NADA. We announced it. We're moving out more formally this quarter, and we're so excited to bring that to market in a much bigger way to get more consumers connected to dealers through a digital purchase.

Got it. Thank you.

Thank you. The next question is from the line of Jed Kelly with Oppenheimer. Please go ahead.

Great. Two, if I may. Just one, can you talk about sort of the catalyst behind some of the price increases for CarOffer and how big of a pricing ramp do you have? And then, just for -- I guess, the product or Instant Max Cash Offer, I mean, how should we think about the gross margin going forward? I mean, do you intend to run that business at breakeven margins to drive consumer engagement? Just how should we view the strategy around the product? Thank you.

I'll take a crack at starting these and others can add. Thanks for the question, Jed. On the price increases at CarOffer, we were and continue to be a price advantaged offer for dealers, we're lower price from just a pure transaction fee basis than most, if not all, of their digital offerings and certainly on the physical side as well, coupled with all of the convenience elements that we add relative to the physical side, which I think if you look at total cost of transaction, we would certainly shine there. And so, we -- between that and dealer satisfaction, we saw an opportunity to increase prices to reflect more of how dealers value it in the market. And is there more in there? I mean, we haven't spoken about that. We just did this one in March, but we feel good about that decision, and we think dealers have been incredibly supportive. And I think as there are a lot of competing alternatives out there that continue to burn capital. They're going to feel more pressure to raise prices, which will only rise the tide in the market for us if we wanted to follow suit. But we're pretty committed to delivering a ton of value to dealers in that respect. On -- actually, before I go to Instant Max, Sam, Bruce, anything or did I cover it?

I think you covered it.

Okay. Great. On Instant Max, Jed, we are -- I mean it is a massive, massive market opportunity. And so, like we've done in other areas of our business and at earlier stages of our business, we're really focused on the unit economics to make sure that we've got them right enough before we really blow it out. And so, we're focused on the gross margin, and that's why we've put in some extra work to show that this quarter, we were at mid -- low to mid single digit gross margin that we were. And some months, we had even higher than that. And other months where it was lower, it was because we were getting more competitive with our offers. And so, we were consciously bringing our spreads down a little bit. We're testing things in these early days where we're -- we tested a sort of a special offer period where we compressed our spreads, again, by design, even more. And we can toggle that up and down. So, in this early stage, we're focused on positive gross margins at the unit level. I don't see a scenario where we take that to negative. And then, it's a matter of when we think we have it right enough how much do we want to invest in marketing to tell the world about this. And we continue to think that from a business model perspective, the fact that we get dealers to offer -- get hundreds or thousands of dealers to offer a bid on a car, that is just a fundamentally better consumer value prop than a consumer having to deal with just one dealer. And we need to tell the world in the market about that better value prop that we have. So, as Scott said, we are going to ramp the marketing for it. We do want to get the word out into the user base. We are seeing sort of cross-pollination between Instant MAX users and those who are shopping and submitting leads and using consumer finance and vice versa. So, we're also seeing the virtuous cycle of it in our platform more generally. So, positive gross margin as far as we can tell or plan to do forever. And -- but we are going to invest more aggressively in marketing because of how great the product is.

And this is Bruce. I would just say these are very, very early days too, right? And we stood up a business that didn't exist here with the company six months ago. And I would tell you, I think we've taken the -- probably grew this buying from consumer business to C2D business quite faster than any other company out there. And we are learning. And as we learn, buying a car from a consumer and buying a car as it decide and seen, we are now just really starting to dial in the algorithms and picking up the car from the consumer and the processes and those type of things. So, I would say that we're going to get better and better at it every month. We're already seeing those improvements and could be more excited about Instant Max Cash Offer.

Thank you.

Thank you. We have next question from the line of Naved Khan with Truist. Please go ahead.

Yeah. Thanks a lot. A couple of questions. Maybe just on the -- on CarOffer. Can you talk about what are you seeing in terms of your older dealer cohorts, dealers who came on board maybe three to four quarters ago. Are you seeing them use the platform more and more to buy cars? Are you seeing them shift share from other channels to CarOffer? Just curious about what the trends in that? And then, on the -- in your prepared commentary, Jason, I think you mentioned some backlog in vehicle pickup. Was that on the IMCO side? Or was that with the car rental companies?

Navid, I can jump in first. It’s Sam Zales, and Jason add more detail or Bruce, if you'd like to. The cohorts are going in the right direction. And I want to be careful about that they're all moving in the right direction. The diversity of dealers getting on the platform and participating in either a buy or a sell fashion and the cohorts themselves moving up into the right is a really great sign for us. But I want to mention that the macro environment that we talked about earlier on the call as it relates to wholesale pricing volatility impacts that in a quarter where we didn't see that it's like the fourth quarter, you saw everything go up into the right. Again, the cohorts going up into the right, but it mutes a little bit when all dealers get skittish. If that's the right word used earlier on the factors of just what's going on in the market. But those cohorts are going in the right direction. They are moving up into the right, and we're proud of that. And we see that expanding as we sign more and more dealers to the platform and initiate their matrices. To your question on transportation, the backlog was -- from the dealer-to-dealer, a large partner there, we took over their transportation for them. That was the one-time change that happened in the first quarter, if that was the question you asked. Bruce, anything -- is that...

I think you're correct. Yes.

Maybe can you explain that a little bit when you said you -- so you did the transportation versus them doing it themselves. Is that the right way to understand it?

Yeah. So, typically, we handle the transportation for all of our clients. We had one large fleet client in particular that handled their own. We sits and they got a bit behind. So, we since took -- taken that transportation on, cleaned up all that. And so that's what you saw there in the first quarter, which is a cleanup of really fourth quarter units.

Got it. So, maybe just on -- maybe just to dig a little bit more into that. So, is that something that might have affected Q1 volumes? Or that wasn't really a factor?

It didn't affect volume so much, but it did -- this is Jason. It did affect the margin profile, because it was sort of disproportionately higher revenue that was transportation related, which, as you know, is lower margin, certainly lower margin than our fee revenue. And this was a unique situation. I mean, we do the transportation in the vast, vast majority of transactions. But in this case, they had historically done it. Dealer experience is really important to us. It's a key focus of ours. And when that became an issue for them, we offered the help to make sure it was a great experience for everyone.

Thank you. We have next question from the line of Marvin Fong with BTIG. Please go ahead.

Great. Thanks for taking my question. Just one for me. I think everything else has been asked. But -- for second quarter, your guidance, just curious on the dealer-to-dealer side for CarOffer, it looks like gross margin was 30% in the first quarter. With the price increases, any thought about what they might be in the second quarter that you're implying in guidance? Should we expect it to be a little bit higher, both in the second quarter and maybe just on a structural basis. Thanks.

So, structurally -- it's Jason. We talked about sort of this one-time event related to transportation. And we talked about some of the dynamics related to arbitration. And then, you're right, it will be a full quarter of fee -- of the new fee structure. And so, for all three of those reasons, if you were to consider on sort of apples-to-apples in terms of transaction volume, yeah, you'd certainly see higher margin in Q2.

Okay. Great. Thanks Jason.

Thank you. We have next question from the line of Doug Arthur with Huber Research. Please go ahead.

I think my question has been answered. I mean, I'm not quite totally understanding why the product gross profit margin went negative, but you've certainly cited a lot of issues. I would assume, over time, the kind of stable to growing margin there is more low to mid single digit over time. Is that still a fair cut out?

Yeah. 100%. And Scott, maybe you can give a little more detail as it relates to Q4 to Q1. But yeah. So, keep in mind, the -- Doug, the product section of the P&L category -- segment of the P&L is not exactly Instant Max Cash Offer. It involves -- it does not involve transportation and inspection related to Instant Max. It does involve D2D arbitration, et cetera. And it's more related to those other things that it was negative. So -- and in fact, if you look in our investor deck, we do a different cut at it. It shows that Instant Max Cash Offer on more of sort of a pure basis, if you will, from a business perspective was 3% non-GAAP gross margin. And we had, like I mentioned a few minutes ago, we had months where it was higher than that. And then, we had months where we consciously brought it down, because we brought down spreads to test competitiveness of our offers. So that's the specifics related to Q1. Longer term, I referenced some of the comments made earlier, too, which is we are getting smarter about our bidding algorithm and pricing. We're always improving our conversion funnel and then the pickup and the land and dealer concept. I mean, those are all things that are still six, eight months since we began them. And so, we have total confidence that the gross margin there has room for upside. And that longer term, it's absolutely mid single digits. And we're even seeing that in periods now, but we're also testing a lot of other things that brought Q1 down to 3%.

Great. That’s really helpful. Thank you.

Sure.

Thank you. We have next question from the line of Alex Potter with Piper Sandler. Please go ahead.

Great. Thanks. Just one for me. It's related to arbitration. You mentioned some arbitration costs had an impact on margins in the quarter as well as well as confidence that, that should improve. If you could just give a little bit more, I guess, qualitative commentary. Are these -- is this an inspection quality issue? And I guess, what levers are you pulling to try to make sure that those inspection reports are more accurate? I don't know, I don't want to put words in your mouth, but anything that you could talk about with regard to arbitration and inspection accuracy would be helpful. Thanks.

Alex, I'll jump in first and turn it to Bruce, who's an expert at this. But from our perspective -- and couldn't be more excited about what the CarOffer business is doing for us. The -- from an arbitration perspective, when prices decline in the market, that's a sign. First of all, I should just say our arbitration numbers are a very, very small percentage of our gross merchandise sales and that's a critical measure of our business. But as prices drop or get fluctuating, as Jason said, a dealer will look at that and say, "Well, I'm going to push back in some cases when the prices are going down on buying a vehicle, but the price continues to drop. We have a no question that asked return policy. We're really defaulting to dealer satisfaction and our approach is to say, let's watch the -- let's broaden our inspection process, and we've done that, adding more inspectors. We talked about adding virtual inspection to our C2D cars as well. That's a huge advantage to our process. And as Bruce keeps saying, we're learning in the process when the price point in the wholesale market is dropping or fluctuating. There are going to be more of those situations that come up. We said that revenue mix went up for us overall. We've looked at that process of inspection and said, let's double down on that. And let's also look at our dealer processes, our dealer results to say if some of them are pushing back on results. We are pushing back on vehicles because the macro environment is lowering prices. We're going to be careful about balancing customer satisfaction with the right kind of business decision. But overall, as I said, the arbitration number is a very, very small percentage of our gross merchandise sales, and we're -- we've made those adjustments as we head into the second quarter to do that. Bruce, anything more you want to add?

Yeah. To your point, I think arbitrations were about 1%, right, of GSM. And you come off a really good December and January. If you're going to get any type of arbitration volume, it's subsequent, right, to February where we did see the drops. We're very disciplined in terms of units that we take. So, we can liquidate those and make sure we're prudent in that regard. But -- we are also adding a lot of other tools that will help us moving forward to mitigate that. But yeah, it was a unique situation, I think, coming off of December and January. And we have a liquidation primarily in February, but we have a good handle on that I think moving forward.

Okay. Understood. Thanks guys.

Thank you. Ladies and gentlemen, we have reached the end of the question-and-answer session. And I would like to turn the call back to Jason Trevisan, CEO, for closing remarks. Over to you, sir.

Thank you very much. So, thanks everyone for tuning in today. Thanks for your questions. We're -- as I said in my prepared remarks, we're really excited about how we performed in Q1, but also about what we have coming up in Q2 and the rest of the year. I think what it shows is that we have really transformed the business to be transaction enabled in all types of transactions on top of our marketplace and that we're now capturing sort of full life cycle needs of both dealers and consumers. And what that does is it opens up new markets for us and allows us to operate a profitable -- a very profitable business to fund all that investment and growth. We're really excited to see all of you in person if you can join us at our Investor Day on May 25 and to dive deeper into our story. And again, thanks very much. Appreciate all the questions. Have a great evening.

Thank you. Ladies and gentlemen, this concludes today's conference. You may disconnect your lines at this time. Thank you for your participation.