AutoNation Inc (AN) 2013 Q2 法說會逐字稿

Thank you for standing by and welcome to AutoNation's second quarter 2013 earnings conference call. At this time all participants are in a listen-only mode. After the presentation, we will conduct a question-and-answer session.

(Operator Instructions)

Today's conference call is being recorded. If you have any objections, you may disconnect at this time. I would now turn the call over to Miss Cheryl Scully, Treasurer and Vice-President of Investor Relations for AutoNation. Ma'am, you may begin.

Good morning, and welcome to AutoNation's second quarter 2013 conference call and web cast. Leading our call today will be Mike Jackson, our Chairman and Chief Executive Officer; Mike Maroone, our President and Chief Operating Officer; Mike Short, our Chief Financial Officer; and Jon Ferrando, our Executive Vice-President, responsible for M&A. Following their remarks, we will open up the call for questions. Robert Quartaro, and I, will also be available by phone following the call to address any additional questions that you may have.

Before we begin, let me read our brief statement regarding forward-looking comments, and the use of non-GAAP financial measures. Certain statements and information on this call will constitute forward-looking statements within the meaning of the Federal Private Securities Litigation Reform Act of 1995. Such forward-looking statements involve risks which may cause the actual results or performance to differ materially from such forward-looking statements. Additional discussions of factors that could cause actual results to differ materially are contained in our press release, issued earlier today and our SEC filings, including our most recent annual report on Form 10-K, and subsequent quarterly reports on Form 10-Q, and current reports on Form 8-K.

Certain non-GAAP financial measures, as defined under SEC rules, will be discussed on this call. Reconciliations are provided in our press release which is available on our website at investors. AutoNation.com. And now, I will turn the call over to AutoNation's Chairman and Chief Executive Officer, Mike Jackson.

Good morning, thank you for joining us. Today, we reported an all-time record quarterly earnings per share from continuing operations of $0.73 in the second quarter, an 11% increase as compared to adjusted EPS of $0.66 for the same period in the prior year. Second quarter 2013 revenue totaled $4.4 billion compared to $3.9 billion in the year ago period, an increase of 13%, driven by stronger performance in all of our business sectors. In the second quarter, AutoNation's new vehicle unit sales increased 11%, and used vehicle unit sales increased 13%. Our coast-to-coast branding rollout unifying over 200 franchises, which began in February, has been completed on time and on budget.

Incremental branding cost was $0.06 in the second quarter, and $0.09 year to date. AutoNation is well positioned to capitalize on the continued auto recovery with an optimal brand and market mix, and a disciplined cost structure. We continue to drive strong results during the multi-year recovery in auto retail. Over the previous 12 months, AutoNation has acquired 10 franchises and has been awarded 4 new franchises by manufacturers. The 2012 annual revenue for the 10 acquired franchises, together with the anticipated annual revenue of the newly awarded franchises once the stores are fully operational, is approximately $1 billion. Now, I will turn the call over to our Chief Financial Officer, Mike Short.

Thank you, Mike. Good morning, ladies and gentlemen. For the second quarter, we reported net income from continuing operations of $90 million, or $0.73 per share, versus adjusted net income of $82 million, or $0.66 per share, during the second quarter of 2012, an 11% improvement on a per share basis. There were no adjustments to net income in the second quarter of 2013. Adjustments to net income in prior periods are included in the reconciliations provided in our press release. The second quarter revenue increased $522 million, or 13% compared to the prior year. Gross profit improved by $68 million or 11%.

SG&A, as a percentage of gross profit, was 71% for the quarter, which represents 121 basis point improvement compared to the year ago period. As part of our AutoNation rebranding initiative, we incurred approximately $11.5 million, or $0.06 per share, of incremental SG&A expense during the second quarter of 2013. Excluding these expenses, our SG&A as a percentage of gross profit, would have been 69.3%. We do not anticipate any additional material rebranding expenses in future periods. Net new vehicle floorplan was a benefit of $10.7 million, an increase of $2.5 million from the second quarter of 2012, primarily due to higher floorplan assistance. Floorplan debt increased approximately $200 million, during the second quarter, to $2.7 billion at quarter end as we increased our inventory levels due to increasing sales volumes.

Non-vehicle interest expense decreased $22 million, compared to the $22.5 million in the second quarter of 2012, due to lower debt balances. At the end of June, we had $400 million of outstanding borrowings under the revolving credit facility, and total non-vehicle debt balance of $1.9 billion. This was a decrease of approximately $21 million compared to March 31, 2013. Provision for income tax in the quarter was $56.5 million or 38.5%. During the second quarter of 2013, we repurchased 65,000 shares for $2.7 million, at an average price of $42.01 per share. AutoNation has $314 million of remaining board authorization for share repurchase. As of July 17, there were approximately 121 million shares outstanding. This does not include the dilutive impact of stock options.

As continued evidence of the strength of our cash flow generation capability, our leverage ratio decreased from 2.6 times at the end of Q1 to 2.5 times at the end of Q2, even after acquiring three stores in the quarter. The leverage ratio was 2.4 times on a net-debt basis, including used floorplan availability, and our covenant limit is 3.75 times. Capital expenditures were $32 million for the quarter. We expect CapEx to be approximately $180 million for the year. Capital expenditures, which include construction in process, are on an accrual basis, excluding operating lease buyouts and related asset sales.

Our quarter-end cash balance was approximately $70 million which, combined with our additional borrowing capacity, resulted in a total liquidity of $864 million at the end of June. Our strong cash flow generation, and best-in-class balance sheet, positioned us to continue to invest in the business and effectively allocate capital to maximize shareholder returns. Now, let me turn you over to our President and Chief Operating Officer, Mike Maroone.

Thanks, Mike, and good morning. In the second quarter, AutoNation delivered a 4.1% operating margin, with solid growth in sales and customer care. We noted continued strong recovery of our important Florida and California markets, where combined, we had a 12% increase in new and used vehicle sales on a same store basis. And in June, we completed the rebranding of over 200 franchises under a unified AutoNation name. As I continue, my comments will be on a same store basis, compared to the period a year ago, unless noted otherwise.

Starting with sales, we are pleased with our overall performance, where on a year-to-date basis and for the quarter, total gross profit for variable operations which combines new vehicle gross, used vehicle gross and finance and insurance gross was up over 7%. And new and used unit volume was also up over 7%. This was driven by continuous improvement in the new vehicle sales pace that also generated more used opportunities. Underneath that, we experienced new vehicle margin compression that was offset by a very strong overall performance in used vehicles, and finance and insurance, both for the quarter and year to date. I will provide more detail as I continue.

Looking at new vehicles in the quarter, new vehicle revenue increased $202 million or 9% to $2.4 billion. A new vehicle sales volume of 71,700 new vehicles. An increase of 4,700 vehicles or 7%. With increases across all three segments. At $33,450 revenue per new vehicle retailed was up $668, with increased average selling prices across all three segments. New vehicle gross profit of $143 million was off 2%, or $2 million in the quarter. And at $1,996 gross profit per new vehicle retailed was off $176, with compression largely in the import segment, primarily attributable to the whipsaw effect of changing stair-step incentive programs, as well as intensely competitive mid-sized cars where there is heavy volume.

Turning to used vehicles, retail used vehicle revenue of $920 million, was up $90 million or 11% in the quarter on 50,400 used vehicles retailed, an increase of 4,100 vehicles or 9% with increases across all three segments. Revenue per used vehicle retailed of $18,250 increased $313. Retail used vehicle gross profit of $81 million was up $6 million, or 8%, in gross profit per used vehicle retailed of $1,606 was off just $18. Relative to inventory, both our new and used vehicle inventory are in good shape. At the end of quarter, new vehicle day supply was 67 days or 64,600 units compared to 60 days and 49,200 units a year ago. And our used vehicle day supply was 30 days, in line with a year ago.

Rounding out the variable side of the business, our finance and insurance team recorded another F&I gross profit per vehicle retailed record of $1,381 in the quarter, an increase in PVR of $99 or 8%. Total F&I gross profit of $169 million, increased $24 million, or 16%, compared to the period a year ago. We attribute ongoing strong performance in F&I to AutoNation's commitment to process, supported by training, and rigorous associate certifications. Next, customer care or parts, service and collision, where we are very pleased with our performance in the quarter, with total customer care margin expanding 50 basis points to a solid 42.6%.

The business continued to grow across the board for customer-pay, warranty, internal wholesale parts and collision for both revenue and gross profit. Overall for the second quarter, customer care revenue increased $36 million, or 6%, to $638 million. And customer care gross profit increased $19 million, or 7%, to $272 million. Continuing the positive trend, customer-pay gross increased 5% in the quarter, making this the 12th consecutive quarter over quarter increase for customer-pay gross. Our customer care team remains focused on operational improvement, margin improvement, and driving sales effectiveness. This coupled with increasing industry units in operation will continue to support solid customer care growth at AutoNation. At June 30, our store portfolio stood at 265 franchises, and 224 stores in 15 states representing 32 manufacturer brands.

In a moment, I will turn the call over to Executive Vice President Jon Ferrando, who will share an update on our corporate development activity. In closing, as I mentioned earlier, we proudly completed the branding of over 200 of our domestic and import franchises in June. As we rolled out the brand, Mike Jackson and I traveled across the country, and were met with an outpouring of enthusiasm from our 21,000 plus associates about uniting under a common brand. I would like to thank all of our associates for their commitment to delivering on our brand promises, and fulfilling our mission of delivering a peerless customer experience, as well as their contributions to delivering another record quarterly EPS. With that, I will turn the call to Jon Ferrando.

Thank you, Mike. During the second quarter of 2013, AutoNation completed the previously announced acquisitions of Don Davis Toyota Scion in Dallas, and SanTan Honda Superstore, and Hyundai of Tempe in Phoenix. These acquisitions align with our strategy of offering our customers all of our core vehicle brands, in our key markets, and they enhance our brand mix in our Dallas and Phoenix markets. The closings were well executed, and the acquisition integrations are on track. The stores are now operating as AutoNation Honda Chandler, AutoNation Hyundai Tempe, and AutoNation Toyota North Arlington.

Also during the second quarter, Mercedes-Benz awarded new franchises to AutoNation in the Atlanta, Georgia and Tampa, Florida markets. We expect to complete the construction and open these premium luxury stores by early 2015. Mercedes-Benz franchises will be excellent additions to our platforms in these markets. Over the last 12 months, AutoNation has completed the acquisition of 10 franchises, and been awarded four new premium luxury franchises by the manufacturers. The 2012 annual revenue for the 10 acquired franchises, together with the expected annual revenue of the newly awarded premium luxury franchises once the new stores are fully operational, is approximately $1 billion.

We continue to actively look for acquisitions and new store opportunities, with a focus on adding new brand representation within our existing markets. We will continue to be selective and prudent with our capital, with a focus on investing to produce strong returns and long-term stock holder value. I will now turn it back to Mike Jackson.

Thank you, John. During the second quarter, we saw continued strength in the auto industry sales as the auto credit environment remains strong, and consumers continue to benefit from the outstanding vehicle quality and selection available today. In addition, our customer care business will benefit as industry units and operation begin to recover in 2013. We are at the beginning of a broad base recovery for the economy in auto retail. As we look at the rest of 2013, we believe that the improvement in new vehicle sales will continue, and continue to expect new vehicle sales to be in the mid-15 unit level. Thank you, and with that, we will be happy to take questions.

(Operator Instructions) James Albertine of Stifel Nicolaus.

Great, thanks for taking my question and good morning. The first thing I wanted to delve into, it seems like you're engineering somewhat of a transition, as it were, from a capital allocation standpoint. Hearing a lot more about M&A, new franchises, awarded points. Can you help us understand how you are think being SG&A? We noticed a little bit more deleverage this quarter than we anticipated. And just want to think through that process over the short, and quite frankly, longer term. Thanks.

This is Mike Jackson.

Our capital allocation strategy has not changed at all in 14 years. It's pretty straight forward. We first look at the opportunities within the existing business, both the needs to maintain the standards and the investment opportunities that are there. And you can see, we have a 14-year track record of investing in the existing business. Then, quite frankly, we look at it on an opportunistic basis, between buying stock, what's available in the marketplace as far as acquisition, and at times, we have even found debt to be the most attractive thing to buy. And, I think if you look at our performance over that, coming up on 14 years in September for me, you can see the discipline that's been applied, and the shareholder value that's been created.

So, depending on what period of time you are in, and what is the balance in the opportunities there you see the behavior. Clearly in '08, '09 and '10, very few acquisitions got done because the gap between what sellers were willing to take and what buyers were willing to pay was too big. So you now have a backlog of the natural arrival in the marketplace each year of deals. So there is a lot of people to talk to, and the gap on price is much closer, so you are able to get to the finish line on more transactions.

So, we are in discussions with a lot of sellers out there. Whether they will result in deals or not, you never know. You have to keep your discipline on the price side, so that remains to be seen. But, looking backwards, we have been in a phase where the opportunity on the acquisition side has been there, and we have acted on that. Going forward, I can tell you the philosophy will be exactly the same. And what actually happens now will depend on how negotiations go, and where the stock goes, the price and other variables.

On the cost side, I think it's important to keep in mind that we have included in our results here, the one time cost of rebranding the Company. We didn't hesitate to make this investment. We think it's a great investment. It's $0.09 so far year to date, $0.06 in the second quarter. You could almost double our growth in earnings per share, if we hadn't rebranded the Company, but we did. And, I think it's the right decision for the long term, and if you look at our leverage ratio without that cost it's below 70%.

But, I'd ask Mr. Short to give more insight on the cost side.

Just to echo what Mike said, in the quarter our headline number was 71%. If you back out the rebranding costs, that takes you down to 69.3%. Which, as I've indicated on previous calls, our intent is to operate below 70%. So, absent those rebranding costs that's where we were. I do think that there were some headwinds we faced in the quarter. Mike called out some of the PVR pressure that we had on our new vehicles. That creates challenges with some of the flow through on the SG&A side.

And, of course, with acquisitions there are always those integration costs that you incur in the first few months of an acquisition, that over the long term pay off in very strong returns. But you do have those start-up costs. So, those were the dynamics that we faced during the quarter. And I think that 69.3% adjusted number is in line with where we want to be, given the acquisitions that we completed during the quarter.

Great answer, guys. Thanks for all of the detail, and good luck in the next quarter.

Thank you, Jaime, for the interest.

Rick Nelson of Stephens.

I wanted to ask you about market share on the new cars side. That 7% unit growth, how do you think that compared to the overall industry? And how you ferret where the strength was by brand or weakness, and geographically, as well?

Rick, it's Mike Maroone. I think from a share perspective, I think we competed strongly. The numbers reported for retail vary tremendously, but I think we are very satisfied with 7%, especially in the midst of rebranding 200 franchises. I think that in terms of who is strong, who is weak, I think we were very strong with Ford on a unit basis. So we had great growth with Chrysler on a unit basis, with Nissan, with BMW. We are very satisfied with our performance across all three segments.

Good to hear. I'd like to ask on the F&I side, too, if you have seen any changes in pricing there as a result of the CFPB, some of their comments.

My position remains the same, that indirect lending, as it's called, has tremendous added value for all the constituencies, the customer most importantly. The lender. And we get an appropriate origination fee. We are able to provide a very competitive rate to the customer, often much better than what they can get in the marketplace. And, we are able to originate loans for the finance institution at a cost lower than what they could do directly. So, when you have a situation like that, it's very sustainable. I would say that even the regulators acknowledge that there is tremendous added value from dealers in indirect lending, and that they are due an appropriate compensation for that.

I would say their focus is on, of course, disparate impact and a broad range. I think for the big public companies which have had caps in place, and procedures in place for a decade, it's not much of an issue. And if lenders were to transition to some sort of flat fee, I don't think for the big public companies that it would be much of an issue. However, if you are a retailer where your model is dependent upon a wide range of mark ups, then you're going to struggle with the transition. I don't think it's an issue for us from everything I've heard.

So, you don't see any effects as of yet? That $13.75 a unit thing, quite strong.

Yes, but you have to look at how we do it. We do it with excellent penetration to begin with. Mr. Maroone, I think it's 70% to 75% of the units we sell?

That's correct.

70% to 75% of the units we sell we arrange the financing for. That's almost $9 billion worth of loans we originated, for instance, in 2012. Our average margin on that is about 120 basis points, which seems to me quite reasonably for all of the value that we just delivered. And, by the way, there is no discussion with the banks, and the regulators that that is an unreasonable compensation for what we generate. And the number you referred to, is only for one-third of that is for the financing. The other two thirds is for products that we generate, and, Mike, you can call out a list of the type of products that consumers buy from us.

What's interesting to note, of course, is that we only show you the commissions on that, the revenue does not go through on our books. So, it shows as 100% margin. But that's because we don't recognize the revenue, because we are acting as an agent to originate those products. But they're high added value for the consumer. We have very narrow reasonable margins on it, so when you have high added value for the consumer, and reasonable margins, it's sustainable. So, Mike, why don't you talk about some of the products that we sell?

Well, Rick, as you know, the primary product that we focus on is vehicle service contracts, and we think it provides excellent value to the customer. It also drives more business into our service departments, and allows us to focus on retaining customers in both sales and service. The other product we feature is prepaid maintenance. And, to give you an idea how the industry looks at that, more and more manufacturers are now including that with the vehicle. And we are very happy to see that, Toyota being the leader along with premium luxury BMW, VW, and most recently General Motors is introducing it.

So, those are the products that we focus on. There's other products like gap insurance, and others that have a lesser impact. But as Mike said 65% of our F&I revenue comes from those value-added products, our compensation plans are heavily skewed to promote those products. And we are very confident that we can sustain this level of performance or even get better.

Rick, there can be, in principle, a debate about the disparate impact, whether it's applied to housing, autos, other things, and whether that's an appropriate regulatory step or not. I think someone other than us will discuss that. Certainly, for large companies, and large financial institutions that have had caps in place for decades, the differences are so narrow and so tight, that I really don't see an issue there. And if there is a transition to a different compensation system, I think it will be manageable for us.

Great to hear it. Thanks a lot for the color, and good luck.

John Murphy of Merrill Lynch.

Good morning, guys. Just a first question on SG&A, just to follow up, I just want to make sure we get this straight, because I think we didn't comprehend this as well as we should have in our estimates for the second quarter. There is fully no more expense that is coming through in the second half of the year for rebranding, and it would be safe to assume that your SG&A to gross could operate at a similar level to what the adjusted number would have been in the second quarter, meaning in the 69% to 70% range? Is that a fair statement?

Yes. John, you are absolutely correct, and maybe we didn't make it clear enough going into it, that there was a surge of costs and spending around the rebranding that would be fully expensed and fully completed by the end of the second quarter. So, it's not even, like I say, it was front loaded. It was all expensed in that period of time, and all completed in that period of time. and will not -- this $0.09 that I'm calling out, will not recur in the second half of the year, let alone talking about next year. It will not recur starting in the third quarter. So, maybe we could have been clearer on that going in, and I had a sense that, maybe, there was some confusion around that, and that's why I want to be so explicit today.

The ongoing number is what matters more, so now that we understand that, I think everybody should understand it now. That's very helpful. Second question. Obviously, you guys should be trusted on allocating capital, given your track record, whether it's making acquisitions or buying back shares. So, that's easy to understand why you are making that shift. But, I'm just trying to understand, as you look at making these acquisitions, or ramping up acquisitions and then getting these add points, has anything changed in the relationship with the auto makers that's making that avenue of capital allocation more attractive than it may have been historically?

I don't think the critical path for us has ever been approval with the manufacturers. We have an outstanding relationship with each and every manufacturer today. That's not to say that if I went back to '05, '06, '07 that we didn't have a different view about inventory than where the industry was, and where it was going, that was rather contentious. But I think everybody -- every manufacturer acknowledges today that our point of view was correct, and the industry is in a better place today. And so, we are really back to a sense of partnership, which is selling cars, and taking care of customers.

And certainly the manufacturers have seen the advantages of the large publicly traded groups in that, when it comes to time to step up to meet standards on facilities we can do it across the entire enterprise in a very professional way. And then when it comes to investing strategically long term where we think customers will be, we have the scale and the ability to do it. So, there is a great sense of partnership.

So, that is not the critical path, I would say it's absolutely price. And, that may sound simple, price, but I think to lose sight of price around acquisitions vis-a-vis what you can do on share repurchase, is a critical mistake in capital allocation, and you can't fall in love passionately with one or the other. It's got to be a cold calculation looking at where you can get the best return. And that's why I said to the point that even at times we looked at, and said, we can buy our debt at a discount. That's the best place for our capital.

So the only thing that's etched in stone for us is that we will invest in the existing Business. There will be capital needs and capital opportunity in our existing Business every year, and every year that comes first. And then we look at it opportunistically from there. And, if you look just at share repurchase, well the point of share repurchase is, A, not only why you are improving the operating of the Business, is to reduce the share count. So, we were very disciplined not to give out shares on acquisition, not to give out options like confetti that you then have to take your capital and buy them all back just to get back to where you were.

So, I think our track record of creating value is strong. So that philosophy remains the same going forward. We recognize, or acknowledge, we are in serious discussions with a lot of sellers. But, I could easily be sitting here a quarter from now and not have a single deal to talk about, because if we don't come to agreement on price, we're not going to do the deal.

Very refreshing. Last question on the Customer Care business, we are starting to see a good acceleration there in the same store sales comps. Bit. I'm just curious if you think we are really just at the early stages of this recovery of UIOs in the zero to five-year old or zero to six-year old range that are your sweet spot. Cause it seems like there might be some more to come, but we are already seeing some really good benefit. So, just trying to understand what inning you think we are in that surge of those vehicles?

For units in operation for customer care, we are in the first inning. And the only thing we have to debate is whether it's the top of the first or the bottom of the first. That's how early we are in units and operation recovery for automotive. It's a mathematical calculation that we could literally tell you for which brand on which day the bottom point is, and when it turns and moves in the right direction.

So, we have made a significant investment in customer care, both from the point of view that we think we can genuinely attract more business through convenience, value and security, our propositions to the consumer. At the same time anticipating the turn, which is this year, means it can be a very rewarding period for customer care.

Mr. Maroone, what would you like to add?

Well, just that two years ago Mike Jackson challenged our team to refocus more effort, more resources on customer care. We brought in a new leader, a very skilled gentleman out of Mercedes, Alan McLaren. He has rebuilt the team, adding talent from Pep Boys, and from inside the industry. So, we've added talent. We've added analytic capability, and we are now at the stage of making a greater investment in customer-facing technology. The idea being to speed up the transaction, to provide more accurate information to customers, to have a clearer line of communication between the technician, the adviser and the customer. And we are at 9 stores into our rollout of that, and pilot, and it's impressive.

And I think that commitment is timely. You had asked the question on the UIO, that the increase in the UIO of that 0 to 5 year population only increased by 1% from the first quarter to the second quarter. And it's still below where the UIO was a year ago. So, I will call it the top of the first inning, to use Mike Jackson's terms, but we are very optimist about the opportunity. We have really focused on speeding up the transaction on express service, on tires, extending hours, and most importantly, putting more talent in the space. So it's a real bright spot for our Business.

That's great. Thank you very much.

Simeon Gutman of Credit Suisse.

Thanks, good morning.

So, Mike, AutoNation has been pretty transparent on its thoughts regarding the stair-steps. And, so I mention it as a reason this quarter that the gross profit was hurt a little. Can you characterize the environment there, meaning are manufacturers leaning toward stair-steps even more than versus a year ago, whatever time frame? And then the other comment that was made regarding some of the competition, some the mid-size imports, is that more a dealer to dealer combat in local markets, or is that coming vis-a-vis manufacturer price decreases, and that's not being passed through in the same way that it was to the dealer before? Thanks.

So, on the epic struggle on stair-steps, we have one break through to report, and that's Nissan. And Nissan was very aggressive on stair-steps for a very long time, and I think to the point where the brand was hurt, in the sense that they were selling the deal more than they were selling a very fine product. And over time that erodes your position. And when you paint yourself in a corner like that, it's not so easy to get out of. But there is new determination at Nissan, a real commitment to get it right. If I look at their actually changing the transaction prices, changing the MSRPs, and adjusting their incentives to a more tactical basis rather than a strategic basis, is a bold step. It will take some time to fully get through it, but I think they should be applauded and admired for what they have done.

So that's a break through. We will see where it leads. We have other companies that firmly believe stair-steps are where to be. And so the struggle goes on. On your second point, I would say stair-steps unleash whipsaw competition at the retail level, where you have basically told the customer, unless the customer shops exhaustively to find out where the greatest stair-step is hidden, that the customer is a fool. So, you put the customer into the marketplace knowing the customer has to go five, six, seven places to find the weenie, where it's been hidden. And, it's not very customer friendly. That's one of the reasons, it's certainly out of step with today's customer. But, if you tell a customer that's what you have to do to get the price, the customer will do it.

So, it unleashes a vicious competition at retail. And even when stair-step programs, and the customer is still trained to do that, so you have a hangover effect that takes quite some time to clear. So, the white hot spot on this whole issue right now is Japanese mid-sized sedans, which is a big part of our Business, and also sub-compact sedans, that's where you really see it. And we applaud the step of Nissan and hope that the level of stair-steps mitigates in the future.

The only thing I'd like to add to it is you've gotta take your hat off to the domestics who now have introduced products, and the Korean, that really give the Japanese imports a run for their money. The Fusion is just hot, hot, hot. The Sonata has been very effective. Chevy is retooling the Malibu. I just think the competition is really intense. The segment is very large. And Mike has already called out all of the challenges of the stair-step programs.

We see, in a high level, the gross profit per unit over time has given back some. So, do you think that this period was unusual in that we could see a bounce back? Or is that memory that Mike Jackson mentioned, is that going to take some time to wean the customer off of?

Our philosophy is the diversified approach. And nobody knows the answer for sure. But the challenge to us, as a management team, is always to find a way to rebalance it. So, when I look at it, when I look at our variable result per vehicle retailed, if I take it all in, all units, new, used, finance, insurance, products, we actually had an increase despite the challenge in front end growth profits on absolute new car. So, we always have ways to try to balance. We've successfully done it here. I think we will successfully do it in the future. In the mean time, we are doing everything possible to stabilize new car front end grosses, and look for opportunities to improve them. But, I can't guarantee you that will happen.

Okay, and just a follow up on the parts and service side. So, the incoming wave of younger cars we are seeing, I think that is a bit easier and more clear cut, given the manufacturer warranty, et cetera, and the dealers typically retain a higher percentage in that bucket. But, my question is on the older vehicle, the older vintages that you are servicing, which I think your business did a great job during the downturn. But, can you talk about now the retention of the older age groups? What's the experience been over the past year or so, and then anything in particular that you are focused on because I think those cars are chunkier from a spending perspective?

It depends upon your definition of old? What are you calling out as old?

Really like 6 to 10 to 12 years tops. But 6 to 10 years roughly.

6 to 10 years is a very small part of our Business. I would say -- Mike what would you say?

It's about 30%. And obviously, you have got a very complex product that's not easy to be serviced. The mechanical break down aspect of it is not easy for your independents to handle it. I think our retention activities that we have undergone in customer care, our communication, our marketing efforts, really applies to both segments. So, I think we can deal with whatever headwind there is there, with this very rapid growth in UIO we are going to experience.

Rod Lache of Deutsche Banc.

Good morning. This is Dan Galves standing in for Rod Lache of Deutsche Bank.

I have a couple of questions. First one on the combination of new growth plus F&I. What's your view of how that would be impacted as interest rates goes higher? I think the benchmark rates for auto loans were up maybe 20, 30 basis points in the quarter. Did you see any impact in the quarter? And what's your view if interest rates continue to rise back towards historical levels?

This is Mike Jackson. Obviously, automotive retail, very much, is in the short end of the yield curve, both for funding our inventory, and what instruments the financial institutions use to fund auto loans. So, we are not really impacted by 10, 20, 30 year rates. And, I expect it to be quite some time until short term rates begin to move. And if they do move, it's unequivocal that it will be because you have an economy that's dramatically strengthening.

So, if you said, Mike, what's your choice, a weak recovery with low rates or a strong economy with normalized rates, I would take the second. I think it's a better place to be. So, also for our customers, 100 basis points on an average car loan is $15 a month. So it's manageable. But I think -- and we did not see rates move in the quarter on lending. You mentioned 20, 30 basis points, we didn't see any movement in the quarter. So, I think it's -- A, I think it's quite some time until you see material movement on rates on the short end of the curve. And when it does move, it will be because it's unequivocally, indisputably a strong economy.

Okay. I appreciate that. I was actually talking about the benchmark, like the three year swap rates that were up 30 (multiple speakers), just so you know. And the second question has to do with customer care. Really, two parts. Someone brought up the 6 to 10 year age group. It looks like that units in operation in that group will fall pretty significantly over the next couple of years. If that's 30% of your business, how does the UIO decline combined with increasing complexity, which probably helps you quite a bit, what do you see of the impact on that 30% of your business? And if you have any sense of where your capacity utilization is on service base currently, I would appreciate any color on that too, thanks.

On the capacity issue, we have continued to renovate facilities and add capacity. I think we've got the capacity to handle that business. The 30% that we quoted is of the Customer-pay and Warranty business, not of the total business. And I think given our retention efforts, we are well equipped to grow our market share in that segment.

Okay, thanks very much.

Addy Oberoi of Goldman Sachs.

Great, thanks a lot. I have another question on the Customer-pay business. Obviously, a great performance in the quarter from a comp standpoint. But correct me if my understanding is wrong here, but I don't think a big part of that was driven by the increase in UIO. So, can you just please elaborate what were the key drivers? Was it more internal, or what led to that strong performance in the segment?

Customer-pay business is about 42% of overall of our Customer Care business, and we have put an incremental marketing spend. We are going to spend about 30% more in marketing this year. We have done some very good work with our analytics group on pricing, and begun to put the tools in place to allow our stores to focus on the pricing. And I think overall, we are just trying to compete in all segments of that Customer-pay business. Both with a very robust tire program, that's now in its second year, a real focus on express service, and really modernizing our whole communication and service. So, there is a lot of focus, a lot of effort, a lot of talent there to drive that Customer-pay business in advance of the UIO.

That's very helpful, guys, and just a follow up on that. If the mix of tire sales in the overall P&S segment is going to grow, typically our understanding is that the margins in the tire segment are lower than your average margin in the overall segment. So, could it pressure margins in the near term, do you think?

I don't think it's that big of a piece today. But we have really worked hard on the margins in our Tire business, and our Tire business gross margin is up about 20%. But, I think we want to compete in all segments of the Service business, and whether it's express tires, low margin, high margin we want to serve the customer, and be a full service provider. So, we are willing to compete, and I don't think it's going to impact our overall margins. Our margins in the quarter were expanded 50 basis points, in spite of a growing Tire business.

Great. Very helpful. Thanks a lot, guys.

Yejay Ying of Morgan Stanley.

Good morning, everyone. I wanted to follow up again on the interest rate environment question, but maybe more on how it pertains to your own capital structure. How do you see this environment impacting your floorplan/slash corporate debt over the coming quarters? Are there any hedges in place or is this just not a concern at this point?

Yejay, it's Mike Short. We don't have any hedges in place. Our corporate debt structure is about 50% fixed, 50% variable, well, a little bit more fixed, maybe 55%, 45%. And, we are happy with that structure as Mike talked about the duration of the majority of our capital structure is fairly short term. So we like operating on the short end of the yield curve, and don't see a reason to want to hedge that. If there is a movement in the yield curve we see that more at the long run of the curve, so we aren't overly concerned about it. And, on the floorplan side it's entirely variable. But, as Mike pointed out earlier, to the extent that we see rates going up that might drive those short term rates higher, that's going to be coincident with an improving overall economic environment, which we are happy to operate in that setting.

Right. That makes sense. Could you give a bit more color on your used inventory as well? So, maybe a break down. How is the late model used supply looking versus the older earlier models, and are you starting to see improvements in off-lease supply?

It's Mike Maroone. We have definitely seen some improvements in supply. It's still not where we would like it to be, but there is a very robust CPO business. CPO increased 17% for us in the quarter. It's about 30% of our Used business, and we are seeing more availability there. So, even in the last two quarters, we have seen some dramatic shifts in product. We have also tried to add capabilities, both buying vehicles on-line, putting together centralized buying teams, and doing some other out of the box things to increase our used vehicle availability. We are really pleased with our Used business. And to get 9% volume growth on a same store basis is a good step for us. We are hoping there is even more there.

Okay. One final question, if I could sneak it in, more house keeping. With regards to the F&I growth, F&I per vehicle that you guys saw, could you break out what the contribution was from the financing side and what the contribution was from insurance?

We break it out really from a product versus rate. The rate contributes about 35%, products contribute 65%.

Right. I meant more of how much did the rates grow? Of that 7% year-on-year growth, what was be the rate side of it, and maybe what was the product side of it?

There is stronger growth on the product side than there was on the rate side. I don't have it at the tip of my fingers. I'm sure we can get that to you.

Okay, great. Thanks so much, guys.

Irena Hodakowski of Keybanc.

Good morning. I wanted to follow up on SG&A expense. Excluding the $11.5 million in costs on the rebranding efforts, your gross profit throughput rate was only 35%, potentially below the three-year average that you've put out there. And you mentioned integration start-up costs, which impacted the second quarter as well. Where are you in that process? Should we be expecting a normalized run rate going forward, or perhaps another quarter of slightly elevated expenses?

Irena, I pointed out two things in addition to the rebranding costs. One is that the front end gross margin compression that Mike discussed earlier, and then, secondly, acquisition and integration costs. Those typically come in over the first couple of quarters following an acquisition as you get systems aligned and people in place. So, that's a couple a quarter time period over the first few quarters following the acquisition.

Thank you for that clarification. And then my last question is on the used vehicle side. The volume is very, very strong and you are really delivering on a process to improve the used vehicle sales there. Very encouraging. And I wanted to ask you on the gross profits per unit. If pulled back slightly on a year-over-year basis, and what we are picking up in the industry and talking to other dealers, majority are reporting a increase on a year-over-year basis. Can you detail what is happening in your specific operations?

We are down $18 on a $1,600 base year-over-year, so it's less than 1%. If I look inside the segments we grew margins in domestic and import. There was a little more pressure in premium luxury, as it's quite a competitive market. There was some shortages in some new products that are caused by upcoming product launches. And so that off-lease premium luxury car was in a lot of demand. But, all in all, I think that there was a solid job done in used to drive the volume, and the gross, at that level.

So, more or less a result of perhaps driving volume, really improving volume there, and will stabilize going forward?

We would like to stabilize or even get better going forward. Again, two of the three segments grew, one put a little pressure. But all in all, our total gross, combining everything, is up 8% on the used side on 9% volume. So pretty comparable.

Well, thank you guys very much. Very well done. Thank you.

Thank you everyone for joining us today.

This will conclude today's conference. All parties may disconnect at this time.