Lithia Motors Inc (LAD) 2020 Q2 法說會逐字稿

Greetings. Good morning, and welcome to Lithia Motors Second Quarter 2020 Conference Call. (Operator Instructions)

I would now like to turn the call over to Eric Pitt, Vice President of Investor Relations and Treasurer. Please begin.

Thank you, and welcome to the Lithia Motors Second Quarter 2020 Earnings Call. Presenting today are Bryan DeBoer, President and CEO; Chris Holzshu, Executive Vice President and COO; and Tina Miller, Senior Vice President and CFO.

Today's discussions may include statements about future events, financial projections and expectations about the company's products, markets and growth. Such statements are forward-looking and subject to risks and uncertainties that could cause actual results to differ materially from the statements made. We disclose those risks and uncertainties we deem to be material in our filings with the Securities and Exchange Commission. We urge you to carefully consider these disclosures and not to place undue reliance on forward-looking statements. We undertake no duty to update any forward-looking statements, which are made as of the date of this release. Our results discussed today include references to non-GAAP financial measures. Please refer to the text of today's press release for a reconciliation to comparable GAAP measures. We have also posted an updated investor presentation on our website lithiainvestorrelations.com, highlighting our second quarter results.

With that, I would like to turn the call over to Bryan DeBoer, President and CEO.

Thank you, Eric. Good morning, and welcome, everyone. To begin, and as our local communities around the country continue to reopen and adjust, our priority remains to ensure the health and well-being of our team members, customers and communities. We would like to thank our team members for their strength, adaptability and courage they have demonstrated navigating the impacts of this pandemic.

Earlier today, we reported the highest adjusted second quarter earnings in company history at $3.72 per share, a 26% increase over last year. These results were driven by strong sequential improvements throughout the quarter in all business lines culminating with used vehicle sales increasing 23% and returning to the year-over-year growth levels experienced pre-COVID-19. Our rapid growth continues to be powered by people and innovation, and our teams remain committed to safely meeting customers' needs, through the entire ownership life cycle while elevating the experience through affordability, transparency and convenience.

Our omnichannel strategy led us to another quarter of record earnings, and a step closer to our recently shared 5-year plan to eclipse $50 billion of revenue and $50 of earnings per share.

During the quarter, we experienced one of the lowest monthly new vehicle SAARs in history and not only maintain profitability, but achieve the strongest net income levels in our history for both May and June, with net income increasing 44% and 97%, respectively, over the prior year. As noted in our interim quarterly updates, the sequential improvements we recognized throughout the quarter concluded in June with total revenues decreasing 2% and total gross profit increasing 15% for the month. Our declines in revenue were offset by significant improvements in margins that Chris will speak to in just a few minutes.

While we focus on executing each day, we are guided by our long-term vision and will now discuss the details of our 5-year plan and the introduction of our new national digital home channel and brands.

We are in an exciting time as we embark on our 5-year plan to expand our presence in the over $2 trillion market of automotive products and services. Our strategy focuses on the most expansive addressable market of any retailer in the automotive space. This plan was designed to address both the full vehicle ownership life cycle and all levels of affordability. It includes new and certified vehicle sales from 30 manufacturers, a full spectrum of noncertified used cars and the high-margin aftermarket businesses, including service, body and parts. Our history of exponential growth within the industry, coupled with our team's ability to execute has positioned us with a self-generating cash engine, producing over $0.5 billion annually to pragmatically and profitably disrupt this industry. Our strategy for disruption begins by combining our proprietary technology with the scale of our people, inventory and network to modernize the industry. As we continue to develop and bring to market our digital home solutions in the second half of the year, our teams are ready to serve not only our traditional customers, but also incremental e-commerce customers through our new national brand. The past few years of research and development on our new revenue channel and the recent acceleration of consumer demand for in-home solutions has culminated with this brand launch. Our new national brand name expresses the qualities and services that will be delivered through each of our digital home solutions.

With much anticipation, we are excited to announce our new national brand name Driveway as the guiding light for our all-new experiences and relationships.

As the foundation of our e-commerce digital home solutions, Driveway is designed to reach consumers thirsting for transparent, empowered, flexible and simple buying and servicing experiences. Driveway pricing is completely negotiation-free, providing shopping experiences across our new vehicle, certified vehicle, used vehicle and service body and parts revenue streams. Driveway is home-enabled with the ability to deliver anywhere in the country through our coast-to-coast national logistics network with a free home pickup and delivery for customers. This brand will include our own inventory of over 55,000 vehicles, providing consumers selection in addition to leveraging 2,000 of our existing employees, as customer-facing valets and behind-the-scene specialists to fulfill the Driveway experience. Our 190 existing locations will retain their local brands while a few future locations may carry the Driveway name or utilize Driveway and their branding messages.

Over time, we expect marketing efforts from our local brands to also support the Driveway national brand through the My Driveway portal, a customer experience hub. The My Driveway portal will allow our 5 million paying customers from our local brands as well as new Driveway brand customers to shop, sell and service and manage their vehicles. Simply put, in a single location, a customer can manage their vehicle ownership life cycle from the vehicle information and maintenance history to F&I product subscriptions.

Now I would like to walk through each of the consumer interaction points and revenue-generation opportunities within this e-commerce strategy. Let's begin with our in-home Driveway service experience that will launch later this quarter here in the Northwest. This experience will allow consumers to schedule service work with free home pickup and delivery, including loaner vehicles within a predefined geo-fenced area. This service is a key differentiator in our model as it allows for over 10x the brand impressions compared to digital experiences that only sell a customer vehicle once every 5 to 6 years. This revenue stream will include premium-level pricing, and allow the consumers to subscribe the services for the lifetime that they own their vehicle.

The next consumer interaction point is our used vehicle revenue stream, which has 2 components: inventory procurement and vehicle sales. The inventory procurement component expands our 5 channels of procurement and is key to generating incremental vehicle sales through our e-commerce platform. Our procurement technology, which was deployed in the third quarter of 2019 included the key components of geo-fencing, workflow management and scheduling that are the engines for the other home digital solutions. This selling experience and structure of the impending other components can be seen live today on Driveway.com.

The used vehicle sales experience is also coming to market in the fourth quarter and will be a one-price digitally-enabled experience that will include immediate financing and a massive selections of vehicles that can be delivered anywhere in the country. Our selection will include the entire spectrum of used vehicles, from certified vehicles to 20-year-old value autos. All vehicles will include a 7-day return policy and other brand guarantees to reassure consumers of their purchase and include home delivery fulfilled by our existing logistics network.

Lastly, our new vehicle revenue stream will launch early next year as we continue to perfect the digital integration of manufacturer rebates, leasing options and other variables unique to new vehicles. All of our business lines offered through Driveway will leverage our virtual centers of excellence, or VCEs, to provide a helping hand behind the scenes for buyers that need support along the way. Our VCEs include finance and sales managers to assist in financing the more complex transactions, used vehicle specialists to value the few one-off vehicles that our AI is unable to value and service advisers to offer customers support on pricing for the more complex repairs generated from upsell opportunities for their service work.

Though not assumed in our model, which can be found on Page 11 of our updated investor presentation. We believe that there is opportunity for margin expansion and considerable SG&A reduction as we further leverage our extremely profitable network. With that, we look forward to sharing further details on Driveway over the coming months as each component becomes a reality. The foundation to our omnichannel plan is the growth and expansion of our physical network. Having the ability for consumers to conveniently access all of our businesses is a competitive advantage to ensuring a highly profitable digital experience across the United States.

Our customers' proximity to our physical network is a key element to our design. This enables us to supply convenient and affordable touchpoint throughout the ownership life cycle, especially related to our highest margin service and associated parts solutions, increasing our physical network to approximately 400 locations in 6 regions gives us the ability to reach over 90% of U.S. consumers in 2 hours or less. As such, our top priority for allocating capital will continue to be accretively expanding our network by acquiring strong new locations. With less than 1% of the $2 trillion market, our physical network will be leveraged through Driveway and continuing to grow our core business, allowing consumers to create the experience that they desire.

The opportunities for consolidation within our industry remain plentiful, and our pipeline for acquisitions remain full. Our plan models acquiring approximately $4 billion in revenues annually over the next 5 years. This highly fragmented market has allowed us to consistently invest in increasing the reach and density of our physical network by acquiring strong assets. For more than a decade, we have successfully purchased and integrated acquisitions that have yielded an after-tax return of over 25% annually.

After a strong sequential recovery throughout the second quarter, we renegotiated and restarted acquisitions in the latter half of the year. We have completed 3 acquisitions thus far: Smolich Chrysler Dodge Jeep Ram and Nissan in Bend, Oregon; and Ladin Subaru in Thousand Oaks, California. These locations increased our revenues by $160 million annually, while further improving density within our Northwest and Southwest regions, including the addition of 2 Lexus stores acquired earlier this year, this brings our total network expansion to $320 million thus far in 2020. With more than $1 billion in cash and available credit, on finance real estate that can add an additional $250 million in liquidity, over $500 million in EBITDA production annually and an adjusted leverage ratio below 2x, we are poised for accelerated growth. Assuming an average equity investment of approximately 20% of revenues, our available liquidity and annual free cash flows could add another $7 billion in revenue or more than 50% growth.

In just a few minutes, Tina will discuss additional avenues of liquidity and to expand our robust and disciplined capital strategy to support our strategic goals.

Despite reporting our highest adjusted earnings in company history, we're just getting started. Our company and all of our team members live our mission of growth powered by people and the corresponding value to improve constantly. As such, we remain humble and never quite satisfied as we are tenaciously committed to improve, grow and find new opportunities.

To summarize, our diversified high-growth business strategy is highly complex and has been built despite the considerable barriers to entry in new vehicles, making it difficult, if not impossible, to replicate. Our industry remains ripe for considerable consolidation and is thirsting for modernization. Our growing network composed of our people, inventory and physical network, combined with our Driveway digital home solutions, completes our unique omnichannel strategy. The advantages of a responsive and adaptable team with a multi-decade track record of executing together is the driving force behind our ability to outperform and compete in any environment. This strategy positions us to continue to lead our industry's transformation and progress towards making our 5-year plan of $50 billion in revenue and $50 EPS a reality.

With that, I'd like to turn the call over to Chris.

Thank you, Bryan. I want to start by recognizing our operational leaders who have lived our mission of growth powered by people and focusing on what they can control and identifying the levers that allowed them to persevere through these unprecedented times. Our team's ability to be agile and nimble led us to solutions that continue to meet our customer needs safely and conveniently, resulting in one of the most profitable quarters in the company's history.

With that, I'd like to discuss our same-store quarterly results. For the 3 months ended June 30, 2020, total same-store sales were down 18%, led by a 24% decrease in new vehicle sales, a 1% increase in used vehicle sales, a 7% decrease in F&I revenue and 21% decrease in service body and parts revenues.

As previously reported, results improved throughout the quarter, with total same-store sales improving for June to a decrease of only 6% compared to the prior year.

The new vehicle business line was down 24% for the entire quarter, but improved to a decrease of 13% for the month of June. For the quarter, our average selling price increased 5% and unit sales decreased 27%. Gross profit per unit increased to $2,625 compared to $2,095 last year, a $530 increase or 25%.

Total new vehicle gross profit per unit, including F&I, was $4,291, an increase of $685 per unit or 19%. At approximately $4,300 of gross profit per unit, new vehicles remain highly profitable with a 10.5% margin, similar selling cost per unit as used vehicle and inventory carrying costs that are subsidized by our manufacture partners.

Our OEMs have reopened their factories and adjusted plans to avoid any significant disruption in the availability of new vehicle inventory. As of right now, our stores are positioned with the inventory necessary to meet the increased demand that we were seeing throughout the network.

For used vehicles, we saw a 22% increase in revenues for June and a 1% increase for the quarter. Gross profit per unit for the quarter was $2,243, an increase of 2% or $48 over last year. Total used vehicle gross profit per unit, including F&I, was $3,774, an increase of $185 or 5%.

Our strategy of selling deep into the used vehicle age spectrum through our high-margin core value and value auto vehicles provided us with inventory that have valuations resistant to short-term market fluctuations. In addition, our ability to procure the right scarce vehicles through the 5 different channels is the catalyst for the future success and growth of Driveway.

Additionally, in weaker economic times, these already scarce vehicles are in high demand, as consumers move to less expensive monthly payments and more affordable product options.

New and used vehicle sales are supported by our experienced finance specialists that help match the complexity of a consumer's financial position with the lending options at over 150 financial institutions. In the quarter, our finance and insurance business line showed massive improvement, averaging $1,590 per retail unit compared to $1,454, an increase of $136 per unit over the prior year as consumers continue to take advantage of the product offerings available that protect their mobility investment as well as the record incentives from our OEM partners and historical low interest rates offer.

Overall, new and used vehicle sales create incremental profit opportunities through the resale of additional trading vehicles, greater manufacturer incentives, F&I sales and future service and parts work. We continue to monitor this through the growth of our gross profit per unit, which was $4,030 this quarter, an increase of $412 per unit or 11% over last year. As a result of the accelerated demand seen in the second half of the quarter, total gross profit per unit improved to $4,418 for June.

In addition, our stores remain focused on the highest margin business lines, our service body and parts, which decreased 21% over the prior year, but down only 4% in June. Our service body and parts business capture over 5 million paying consumers and brand impressions annually, generating over 50% margin, and this remains a huge competitive advantage at Lithia. The increasing demand from consumers asking our stores to offer home solutions has shifted the mindset of our teams and has accelerated the ability to leverage our digital home solutions.

Combined with online vehicle sales, used vehicle inventory purchases and at-home service solutions, the Driveway launch positions our company to leverage our growing network, which has the largest reach in the industry. Our facilities, inventory and people are ready to deliver online, in-dealership and in-home solutions to nontraditional auto consumers that we previously may have not have appealed to. Store leaders continue to take prudent and decisive cost savings measures in personnel and advertising expenses, which comprise approximately 75% of our SG&A. These actions led to significant sequential improvements throughout the quarter. Same-store adjusted SG&A to gross profit was down to 64.8% in the quarter, an improvement of 480 basis points over the prior year. To reinforce the SG&A opportunities we have ahead, for the month of June, our company SG&A to gross profit improved at 57.4%, while our high-performance stores consistently maintained SG&A to gross profit metrics at these levels. Significant leverage in the cost structure is attainable as we maintain discipline and look to our e-commerce and digital home solutions to provide incremental sales with lower delivery costs.

In summary, our teams continue to adapt and operate in ways that best match each of their local markets and meet the needs of our evolving consumers wherever, whenever and however they desire. With the information provided by our data science, our teams are nimble and responsible to the changing environment. We are innovating and improving the consumer experience through our incremental and pragmatic modernization and are poised for the growth in the back half of the year.

Our team's ability to achieve high performance in any environment continues to be the foundation as we remain focused on our longer-term goals.

With that, I'd like to turn the call over to Tina.

Thank you, Chris. For the quarter, we generated free cash flows of $96 million. As a result, we ended the quarter with over $750 million in cash and available credit. Earlier this month, we completed an over $250 million syndicated real estate credit facility, bringing our total current cash and available credit to over $1 billion. As of June 30, we had $2.9 billion outstanding in debt, of which $1.5 billion was floor plan, used vehicle and service loaner financing. A unique aspect of debt in our industry is the financing of vehicle inventory with floor plan debt. This financing is integral to our operations and collateralized by these assets. The industry treats the associated interest expense as an operating expense and EBITDA and excludes this debt from balance sheet leverage calculations. Unadjusted, our total debt-to-EBITDA is overstated at 5.3x. Adjusted to treat these items as an operating expense, our net debt to adjusted EBITDA is 1.8x.

Additionally, this week, we filed an equity shelf registration statement, allowing us to issue equity periodically at opportunistic points through various avenues such as an at-the-market equity program or follow-on equity offering. This will allow us to expand liquidity options within our capital structure and ensure we have the necessary firepower to accelerate and execute our growth plan in any environment. In line with our overall capital discipline, our intent is to issue equity if and when our share price meets our internal hurdle rates and deploy the proceeds quickly to expand our network in an accretive way.

Any offer we make under the registration statement will be pursuant to a prospectus supplement filed with the SEC containing more details at the time of any offering. Our capital allocation priorities, which support a diversified high-growth strategy remain unchanged. We target 65% investment in acquisitions, 25% internal investment, including capital expenditures, modernization and diversification and 10% in shareholder return in the form of dividends and share repurchases. Earlier this morning, we announced a 3% increase in our dividend to $0.31 per share.

As Bryan and Chris mentioned earlier, we are well positioned for continued growth throughout the second half of 2020. We have over $1 billion in available liquidity to deploy in acquisitions that meet our strategic objectives and internal hurdle rates.

Additionally, in the upcoming year, we plan to pragmatically invest in modernizing the consumer experience through Driveway, and building the teams needed to support our growth.

Fundamentally, the diversity in our revenue streams, growth plans, variable cost structure and continued consumer innovation, allow us to be responsive to any economic environment and position us well as we continue to drive toward our aspirational 5-year goal of $15 billion in revenue and $50 of earnings per share.

This concludes our prepared remarks. We would now like to open the call to questions. Operator?

(Operator Instructions) And our first question is coming from the line of Rick Nelson with Stephens.

So omnichannel is going to be a big driver to achieving these long-term goals. Bryan, if you could provide more details around omnichannel, the major differentiators you see from other franchise dealers and as well as the online-only platforms.

Sure, Rick, that would be great. It's exciting. You were one of the few people that had figured out the Driveway name even before today. So congratulations on that as well. That was kind of needs that people we were able to find that URL over the last couple of months.

I think the biggest delineation between Lithia Motors is that we look at the omnichannel strategy to be able to attract consumers by how they look at their financing, okay? And I think we built a model that offers products that touch all levels of financing spectrum as well as the associated vehicle inventory to match that as well as the entire life cycle of the consumer, meaning that our ability to provide brand impressions to consumers on a semiannual or annual basis through their service body and parts, is our foundation of how we grew as an organization. I mean Lithia Motors grew out of a small town in Southern Oregon, began in 1946, and it was all about the loyalty and the relationship with the customer. So as we designed our product. It was all about being a -- being able to attract consumers at all levels of the marketplace early in they're buying cycles to be able to have them for the 50 years that they -- or 60 years that they drive vehicles.

Great. So acquisitions, obviously, that's a big part of a long-term growth story. Are you still looking for underperformers? And can you describe the current environment for acquisitions you have in the pipeline? Any color around that would be great.

Sure. Sure, Rick. I would say, absolutely, that value-based acquisition strategy is fundamental to who we are. I will say that we are looking in Regions 4 and 6, which is the lower Midwest as well as the Southeast for business partners and people that have great consumer relationships. And in those instances, we do typically have to pay a little bit of a premium to be able to get those much like the Williams acquisitions in Tampa Bay. But the fundamentals of our value-based strategy are still there.

When we think about $4 billion in acquisition revenue annually, it's very difficult to be able to buy that much value-based strategy. So we had to expand and open up those expectations to be able to buy higher performance as well. To be able to achieve that targeted $4 billion.

I would also say that the acquisition pipeline, we announced, what, about 60 days ago now that we had 14 acquisitions under contract. We've since announced 3 of those. So we still have 11 that we'll be closing in the coming months. And we look forward to them joining our team and expanding our network. The pipeline is still continuing to build on top of that. We have somewhere between $10 million and $15 billion of revenues that are under negotiations or in discussions, okay? And it's really a matter of time and price as to whether or not we're able to accommodate the needs of those sellers and find the right fit for our network development as an organization.

Just to circle back on Driveway.com. The URL is there. What is the timing to put inventory on the website and start transacting business? And is that going to be done gradually with all your dealers? Or is it all at once?

So that's a great question. So we plan on going live with the used vehicle revenue generation stream in Q4. And that should include a good portion of our inventory. We have about 25,000 used vehicles in stock. Our data science is showing that the current pricing that we have on our inventory that 88% of those vehicles will fit the Driveway model, meaning that they will sell and clear within 38 days at the price that our current stores have those listed at, where we're really expanding our reach as we go about that. We do plan on rolling our strategy out market by market, and we've modeled into what, Page 11 of our new investor deck, that the rollout plans are a 3-year strategy across the country, depending on how big or what that network looks like.

Our next question is from the line of Armintas Sinkevicius with Morgan Stanley.

Great. Congrats on the quarter and the announcement with some great detail here. A question around the core growth. You mentioned a 10% CAGR here. If I look at the same-store sales over the last several years, 6% in 2019, 1% 2018, 2% in 2017. Can you provide us with the moving parts to get to that 10% CAGR for the core business?

Sure, Armintas. So our model is actually at 9%, just under. We rounded it up. So we looked at what you looked at and believe that our 2020 trend rate was pushing over 10% in regards to where we were at. We also are finding that best practices within our traditional core network is starting to gain momentum, and I'm sure Chris can share some of that information in the following questions. But we are seeing that best practices in behavioral shift within our traditional network is creating greater customer attraction through more transparent and simple experiences within the traditional channel as well. We thought it was still fairly conservative, being that's what our run rate has really averaged to be able to model that in, and it's something that we're pretty confident that we're going to be able to achieve. We also believe that we can achieve 65% SG&A gross profit within the traditional channel. And if -- for those that are new to the company, we were achieving that pre-growth. So about 50% of our business we've acquired over the last 5 to 7 years. And as most of you know that the acquisitions are of lower-performing high SG&A of around 85%, and it usually takes 5 years for those parts of the network to season. So we, at steady state, we really believe that a 65% SG&A is achievable.

For the month of June, I believe we were at 57%, which is where our benchmark top stores really perform at and maybe provide the guiding light for us to be able to continue to find leverage within our cost structure as well.

Okay. Great. And then on the Driveway side, the $9 billion by year 5, can you walk us through some of the key drivers to getting to that $9 billion?

Sure. So I would say the fundamental opportunity is the ability to procure inventory. And our company has shown the ability to procure inventory, not only from trade, which about 50% of our vehicles come from trade, and they generate approximately $1,200 higher front-end gross margin than vehicles purchased at auctions. We also get that new vehicle trade. So we believe the competitive advantage in terms of cost can help us grow that portion of the business. We also modeled in an additional $1,000 per unit on top of the $300 traditional that we spend on marketing dollars. That, combined with the SEO and SEM through the My Driveway portal, we believe gives us a massive cost advantage against competitors in regards to going to market. So if we need to buy market we have not only the $1,300 to be able to drive national branding or local branding. But we also have a lower cost to market for consumers to be able to compete in price as well as the 4 other business lines that create massive margins to be able to fight in the battleground of used vehicles, which we really believe that's where any battles are going to be fought because there really is no barriers to entry to use vehicles, whereas new vehicles and certified used vehicles, service body and parts where we play has massive barriers to entries because you have to buy a franchise.

So we like how we built the model, and we believe that our ability to grow is really based off that ability to compete and procure inventory.

Your next question is from the line of Ryan Sigdahl with Craig-Hallum Capital.

Congrats on the strong profitability. And also appreciate the additional detail on Driveway and the medium-term targets, et cetera. First, I want to start just on Slide 11, you layout kind of the targets for Driveway. It implies lower EBITDA margin, but better net margin 5 years out. Can you walk through the puts and takes of profitability in the core legacy dealership business versus online?

Sure, Ryan. I can give you a little bit of color on that. So within the Driveway channel, we believe that SG&A can get below 60%. I think we were at, what, 57%, 58%, P&L in our model, okay?

The key driver in differentiation is in the core model. We -- our primary cost in SG&A is personnel costs at about $1,600 a unit. And within the Driveway channel, we really have that going down to about $1,000 a unit or about a $600 savings. That is the primary cost difference within the model, okay?

We will have to ramp up an Internet sales center, which we've had in Medford for the last 10 years or so. But that team will ramp up on a negotiation-free basis as well. So that is part of the replacement of some of the personnel costs. We also have the VTEs or the virtual centers of excellence in those 3 disciplines, that takes some cost, so we'll be paying our personnel in the field for the expertise, plus paying the expertise -- the nonexperiential knowledge in those valets or that lower cost functions that's customer-facing to be able to achieve that leverage in those synergies within those channels. That's really the biggest difference on how we've thought about the logic, and then there's some nuances in marketing a little bit. And obviously, in terms of facility costs, we're only utilizing -- if you extrapolate out 24 hours of availability in your shop space or your service department, we're currently utilizing about 25% of our capacity within our network. We're utilizing about 50% of our capacity in terms of storage for vehicle sales, okay? And if you comp that against some of the competitors, our actual physical network costs are running at about the same price per dollar of revenue than what our competitors are. But if you look at it on dollars per growth, our cost for our network is much lower than the independent used car retailers.

Good. Helpful. And then as it relates to Driveway and then Shift is coming public via SPAC merger. I guess, anything you can share on what your plans are for your, both financial investments there? And then any current and future operational partnerships going forward?

Sure. So Driveway is entirely separate from Shift. Shift is a wonderful little company that we share best practices with. We share a portion of our network within on the I-5 corridor. And we look to continue with that partnership. We love what they've done, and they've taught us a lot about what consumers are demanding and how to look at it in a more pure sense.

I think it was 3 years ago, we began to reinvent ourselves and think about how we could be more things to more people. And began to talk about that strategy of going to market wherever, whenever and however our consumers desire. And I think Shift was a big part of us understanding that purity of what consumers are looking for and that modernization wasn't occurring at a faster rate as we really needed it to internally. And I think we'll continue to be able to share those best practices and the execution of both organizations.

Great. One more for me, and then I'll turn it over. So very tight supply of new used vehicles going on right now. How do you feel about your current inventory levels by category? I know you talked a lot about kind of trade-ins and kind of how you procure, but how do you feel about your inventory today?

Ryan, this is Chris. Right now, I think from an inventory perspective on new, we feel like we do have some pockets of inventory that are very tight. We have certain inventory that we have plenty of. And I think as you look at the production that's coming down the pipeline with manufacturers that are really trying to keep up with the demand that we're seeing based on the shutdowns that they had due to COVID. We feel like we'll have more normalized new car inventories in kind of August, September timeline, but for the most part, we have the inventory that we need to meet consumer demand. On the used car side, with the increases that we've seen, right now, I guess we'd say we could never have enough inventory because with the demand that we're seeing right now in our model, especially in that core and value auto product, which it's difficult to procure. We're really working to make sure that we backfill the improvements that we're seeing, especially in June with our new car -- used car sales up 19% and make sure that we have plenty of used vehicles moving past August because we are right now positioned well for July, and we're seeing great trends in used car sales in July.

Next question is from the line of Rajat Gupta with JPMorgan.

Congrats on the quarter and the launch. Just had a couple of follow-ups from the previous questions. You gave us the economics of Driveway going forward and what the SG&A profile might look like. But just on the advertising side, I mean, you're roughly at $250 per unit, steady state. You talked about $300 for Driveway. I mean you have these online digital peers spending upwards of $1,000, $1,500 per unit. And how do investors get comfortable that you will need to spend that much higher or your advertising expense might not need to move higher here in order to get that kind of growth because the $9 billion in 5 years just seem pretty aggressive from a CAGR perspective. So just curious as to like how you manage that spending. And I have a follow-up.

Sure, Rajat. That's a great question. So we might have got our wires cross just a little bit. So we spent $300 in traditional advertising in our core business. We've throttled in our model, the ability to add another $1,000 per unit or $1,300 a unit to be able to compete head-to-head with whoever we need to. That is in the model. Okay. So remember that. The other thing to remember is our 5 million impressions that we currently have with our service, body and parts customers annually. We believe that the efficiency of our marketing because of the ad core that we built, which is basically a way to move us up page on search through impressions, which impressions are built off of the time people spend on your website. So the My Driveway portal will reside under the core traditional 190 local brands as our customer portal. So the scheduling of appointments and service body and parts the payments of service body and parts, they're looking at your vehicle and the history of your maintenance, the payoff of your vehicles when you look to trade it. Our ability to communicate directly with the consumers is going to be done through that portal, which is all going to reside under Driveway.com, okay?

So we believe that the efficiencies of our $1,300 may have a 2 to 3 magnitude improvement over what the efficiencies of other retailers may be. Because their impressions are really only relative to those shopping or those ended up buying. And if you think about when consumers buy, it's not very often, okay? And I think it's a key nuance on making sure that when you build a model, you have to be able to pay for things that yield returns in perpetuity rather than just buy a market.

Got it. That's helpful. And just in terms of the expenses or you've taken with regard to building out the platform, just the IT infrastructure and related to that. Is most of that behind you? Or I mean, how do we expect that to lever up here through this ramp-up phase?

Sure, Rajat. So being a traditional retailer moving into a new channel of digital. We didn't really understand the ideas of capitalization of R&D and those type of things until a few months ago. So about 60% of our costs before we get to an iterative state on our digital solutions is already spent going forward throughout the rest of 2020 as we finish out the MVP products of each of those different components. We will be capitalizing a fairly good portion of it, but you won't see impact in terms of SG&A because the organization is growing at a fast enough rate and maintains cost control through our operational savvy to be able to ensure that this is not a cash burn or cash drain going forward.

Got it. That's helpful. And will we be getting like quarterly updates on revenue, profit from Driveway going forward? Or is this more -- I mean, I'm just curious, like is this going to be a different segment? Or like is it going to be intertwined with the overall company? Like how are you going to give us like details here going forward?

It's a great question, Rajat. And I would say this. At some point, we may break out the individual revenues of Driveway. But at this stage, we really look at the 22% used car lift that we had pre-COVID and the 23% post-COVID now as seeing the improvements that are coming through sharing of best practices as well as digital home solutions. So it's hard to really delineate at this stage, but we're going to do our best to transparently be able to portray what's occurring within both channels, okay? And we'll work on that in the coming quarters to be able to share that. We would also share this with you. In terms of new vehicle margins as well, it's important to remember that though automotive new vehicle retailers show a 5% to 6% margin on very high dollar revenue products. We also make another 4.5% in F&I. So our actual margins on new vehicles are 10.5%, including F&I, and the only way you get the F&I is to sell the vehicle. So for us, as we think about modeling or we think about the strategy, there is a nuance that new cars have to grow as well because it is the catalyst to be able to drive all the downstream business of trade-in certified service body and parts. So remember that as you think about the strategy.

We also produce almost 16.5%, a little more than a 16.5% margins in used cars when we include our F&I on those products as well because the cars that Lithia motors procure and the model that we've built for the last 25 years, it's all about 0 to 20-year-old vehicles that are hyper scarce. It's not cars that new entrants into the space or digital retailers that are looking to grow revenues can afford to get because they're highly competitive. You have to get those to the downstream. You have to have technicians and so on and so on to be able to do that. Just a little bit more color as to how you think about the aggregated model, Rajat. But we understand, and we will continue to try to provide you insights as to how much each of the 3 channels of core network growth and Driveway are producing over the long haul.

Got it. Sorry. I just had one last follow-up. You gave some color on the inventory situation and just how July was tracking. Any quantification of like how the volumes have looked like here for used and new and just spot and service activity into the first 3 weeks here?

Sure, Rajat. I know it's a really -- it's a tough environment. There's no question, and we had shared that we were really noticing that there was a direct tie in with the shelter-at-home orders. And then we noticed after that, that it was not just shelter at home, but it was severity of outbreak, where we are seeing a little bit more severity across the country where it's broad spread. However, we are seeing similar trends in July to what we saw in June, okay?

I would also note that in service, we were down 2% in June. Keep in mind that we did have 2 extra days. So as you're doing your modeling on service, we had 2 extra days in June, which you can probably kick back another 8% or so into that service. So we were really down, probably 10% on a year-over-year monthly basis.

The next question comes from the line of Bret Jordan with Jefferies.

Could you talk a little bit about the AI strategy on used sourcing, I guess, sort of, are you buying all of your used inventory with a system as opposed to the used manager at the dealership? And maybe what you're seeing from a conversion rate, how many of your offers are being accepted by the seller?

So -- sure. So let me start by saying we believe that used car procurement starts with heavy lifting, okay, that it's not something that you're going to be able to perfect in AI. We procure about 8% of our product from the channel of direct from consumer, okay? Because we're so far upstream, we can procure more inventory by being more aggressive in terms of our valuations on trade-ins, and that is our primary focus. Now in terms of our AI, we are seeing good adhesion. So when we make offers on vehicles, we're seeing about a 50% take rate, okay? Once they get that offer, and they can -- we can do that directly in their home or they bring it into our fulfillment network to be able to procure that. We are only spending about $30,000 in the Pittsburgh market to be able to procure this $15,000 -- sorry, $15,000 a month to be able to procure those. So we're spending about $300 a car to be able to procure. So that gets ramped up about 3 weeks ago as we launched the Driveway brand in Pittsburgh, which will be one of our 2 or 3 launch markets, okay? And if -- for those that have followed us, the Pittsburgh market and barrel.com has been the shelter that we've been building that proprietary procurement technology, okay? So the early stages are good. We are able to buy vehicles at a slight premium to what we're taking them in on trade for. But we are able to procure more vehicles through that channel. I believe we move from 6% to 7% or 8%, it's still minimal. Remember, 50% of our vehicles come off-trade. But as we begin to push those same-store growth rates up, we'll have to be able to procure more through either AI or networking with Manheim or ADESA to be able to track those vehicles or going directly to the rental agencies, which is an easy way to procure as well.

Okay. And I guess, I think you said 80% of your current inventory will be posted on Driveway when that is live? Or are you going to -- in all of your physical product on that? Or will it always be a subset?

So 88% of our vehicles we're intending to show on Driveway, okay? We also are a company that believes in growth powered by people and making decisions closest to the customer. And Chris and our group leaders have spent a considerable amount of time prepping the stores for the behavioral shift of their people, not being involved with the sale other than as the valet, which is the lower experienced personnel that really just follows the word tracking that's provided on the workflow management systems, okay? So it is a little bit different for them, but we believe that we'll have an 80% to 90% take rate on the stores because they do also have to commit to a 7-day return policy. They have to commit to certain certification levels of 140-point inspections. They also need to commit to certain warranty guidelines, plus they need to be part of the Driveway network to be able to be last mile in terms of the logistics of their valets, so they have to train valets to be able to do that. But we're way down the road on that. And we're really pleased that the behavioral shift pre-COVID, we thought, might take us 2 to 3 years, and there is why we had a 3-year rollout built into our model. But with COVID coming into play, the behavioral shift in our stores and that belief by store personnel that consumers are demanding something that is more convenient and more transparent is creating incremental growth in used cars even within our traditional network, even pre-full rollout, okay? So we are seeing some nice lift in that environment.

Okay. Great. And then one housekeeping question. You talked about cost reductions during a pandemic and some that would be permanent. Is your SG&A experience on the recovery consistent with what you were seeing earlier as far as ability to keep costs out as volumes come back?

Yes, this is Chris. I mean I think the whole SG&A improvement that we saw in the quarter, culminating with a 57% SG&A to gross in June, as we talked about, is really a testament to the variable cost structure that we have in our stores. And then as our empowered GMs in every single market based on what's happening with them, based on market demand, are really working to maximize revenue and grow, so move as much volume as they can and obviously, minimize the cost. So I think the level step that we saw as a result of some significant changes that we put in place as a result of the massive drop in volume going into March and April. It is sustainable, and we are seeing that as of June 30, we're about 20% down in overall headcount still from where we were in March. And you're seeing a 6% drop in revenue. So our stores are well aware that their largest SG&A item is personnel. The next one is advertising. So managing those 2 levers as we move into a recovery and start to see new vehicles come back online, parts and service come back online and continue to maintain the benefits that we have with our used car volumes right now is critical. And as we move forward to target an SG&A to gross percentage close to 65%, which we've talked about for years, I think it seems a lot more attainable in the near term than maybe it did last year when we talked about it.

Our next question is from the line of John Murphy with Bank of America.

Just a first question on Driveway. And I'm just curious, what the automaker response has been. Because, I mean, in some ways, I mean, this makes -- it seems to make a lot of sense and seems to be a great driver of growth. But it could be interpreted as sort of running into franchise law sort of hurdles or potentially even the framework agreement hurdles on the new vehicle side. Obviously, that wouldn't be the case necessarily for used or parts and service. But just curious, if there's any kind of response, either positively or negatively from your automaker partners?

John, this is Bryan, again. I think our plans consider our framework agreements and the magnitude of those. We have no intent to step over the national brand or world brands of our manufacturer partners, that is number one. It is key why the 190 currently local brands exist and will continue to exist. We do intend to use the My Driveway portal as a way to communicate with our consumers, okay? We're fortunate that 70% of our manufacturers also allow the utilization of a national brand within our branding or our naming of our dealerships. We don't have intent to change all the names of our stores. We don't believe that, that's crucial because ultimately, the relationships that we have locally with our consumers is what drives the success of those stores, okay? So we do think that there could be 1 or 2 of each brand or possibly someday, 1 in each of the 6 regions that could also distribute new vehicles within those brands that accept it, okay? Only 30% of our manufacturers have issues regarding the use of national brands. And at some point, even those manufacturers have relaxed those standards in the event that your network is built out.

Okay. Also keep in mind in terms of the 6 business lines, new vehicles is only 1 component. We currently also sell certified vehicles as well as the service business, which is the top of that repair chain, which allows us to capture the maintenance business for the life of ownership of that customer, okay, which are crucial elements that are usually not as big of issues with manufacturers. But we will obviously respect that while we still continue to build strength within those manufacturer brands because ultimately, it is about loyalty and retention within those partnerships with our brands. And we're pretty good at adding that value. And I think most of our manufacturers really look at Lithia Motors as a company that's added value for them as well, okay, so everything that we plan on doing will add value to the partnership and not just be for adding value to Driveway or Lithia.

Yes. I mean, I guess their minds sort of bent a little bit in the last downturn with the allowance of that national branding by all the mass market, not Lex guys. So it just sounds like their minds are bending a little bit more here because you're representing the brands well and servicing the customers well. So I'm just curious if they have responded and said, "Hey, listen, this is a great idea. We appreciate the partnership or not yet." I'm just curious if there hasn't been any OEM response specifically on these efforts yet that you've heard?

Right. John, so we have heard from one of the 3 brand that does not allow national branding, and they've been very accommodating regarding using a slogan or a Driveway experience under the name or in your marketing to be able to still push that in-home experience, which is the most important part that we're really trying to accomplish is to be able to go head-to-head with entrants that are providing in-home solutions, whether it's a direct-to-consumer new vehicle manufacturer or new entrants into the used car space. I would also say this, manufacturers are pretty comfortable that our inventories today reside on CarGurus, cars.com and TrueCar, okay? So that's already something that's out there. So their perception of it could be more around the idea that they're getting more exposure for their brands. And we imagine that marketing is pretty expansive and it's how big a reach can you get, and this is just one channel to be able to expand the reach of that inventory.

Yes. Okay. That's helpful. And then just on the equity shop that Tina discussed. I'm just curious how much of that could be used to fund M&A and keep owners of may be large or even smaller groups involved on the equity side and participation like deals used to get done in the past. I mean I think there's a little bit less of that now, but it sounds like that may come back into [vogues], which what you're working on. So I mean, you're selling the dealership, but still participating in potential upside. Could these -- could that equity shelf kind of indicate that we're looking at that and it might not just be just to rate capital and pay somebody in cash, but actually to pay some groups inequity?

John, this is Tina. For us, the equity shelf was just a good move to be able to have that opportunistic avenue out there for us as we think about how we want to execute on this growth plan and how we want to expand the business. We wanted to keep the optionality out there. And from our perspective, we're looking at all of the different internal hurdle rates as we look at it, and we will continue to be disciplined. It is tied to how we continue to grow the business and want it to be an accretive source of capital for us to continue to grow.

But that equity issuance, Tina, would be specific to a transaction? Or would that just be to build? And not just -- I don't mean to say it that way, but would that be to just raise cash, to have a war chest to go out and make acquisitions? Is this very -- with these deals being exactly or issuances being very specific to an actual deal?

I think follow our overall capital policy, right? I mean, if you think about where we spend most of our capital to deploy, it is on acquisitions, and we have to keep that balanced.

Okay. And then just lastly on the front-end grosses, they were over $4,000 in the quarter, which is really great. And I think you mentioned in June, they were over $4,400, which was quite fantastic. I'm just curious, what levels you think are sustainable on those front-end grosses going forward? Because I think in the second quarter last year, it was $3,600, which is very good, too. But over $4,400 in June is fantastic. I mean how much of that is sustainable? And how much of that can you -- do you think you can control?

Yes. John, this is Chris. I think when we look at what's going on in the market right now, we're seeing like record incentives coming in from the OEMs, which obviously help us for down payment with consumers and structure, the right deal for customers. You're seeing historic interest rates. You're seeing the cash position of consumers higher than it's ever been. A lot of folks that were planning to do big vacations this summer are deferring those vacations, which is giving them capital to put down into what we're seeing in some of the demand that we're seeing in new and used cars. Credit availability has never been higher. Our banks that went through the last recession, understand that the risk of default on auto loans is very low. And so I think all of those things have been really a catalyst for us to be able to -- with lighter supply, keep our margins high. I'd like to say that we'll keep it as long as we can. And if the market stays strong, that's possible. But I think some of this is outside of our control, and we're going to do what we can to hold the line on margins as long as possible.

Okay. I'm sorry. And one last one speaking on the used side. The strength in used vehicle demand has been phenomenal, it's driven pricing up. It's driving volume up. I'm just curious who you're seeing there? Is it sort of through the income spectrum or if there's anything sort of unique to the time and place that we're in right now? I'm just trying to understand the sustainability there and just how broad-based, I mean, we hear anecdotes of $10,000 or less vehicles being incredibly strong because we're trying to get off public transportation, but then limited supply of new vehicles. So just trying to understand that dynamic of that what appears to be very strong used vehicle demand across the spectrum, if you're seeing anything unique that explains this and how sustainable you think it will be?

Yes, John, it's Chris again. I mean when you look at the quarter, our value auto sales were down about 6%. Our core product was up 5%, and our CPO units were actually down 12%. And so I think the demand that we're seeing is really in that core product, which we talked about for quite some time, is the most difficult to go out and buy. But we've had a heavy focus way prior to COVID on getting our stores empowered to run out and use the 5 channels, now 6 channels to procure more used cars and try to mirror more of the national used to new ratio of 2.3:1 when we're sitting at 1:1 today. So I think if we can keep procuring vehicles, finding new channels to acquire more used cars, outside of just typical trades on new and the used cars that we sell, we think we can continue to generate a flywheel in used cars that's going to continue to grow for quite some time, as indicated in some of the models that we laid out in the investor presentation.

Our final question on the line of David Whiston with Morningstar.

First, on the quarter, is it fair to say the big SG&A improvement was primarily due to less headcount?

Yes, David, Chris. We saw in the quarter, a 20% reduction in our personnel cost. But we actually saw a 40% reduction in our ad spend as well. So I'd say, those 2 things that have typically been the main drivers of SG&A kind of work hand-in-hand to bring down our SG&A to growth. And much of that, we hope, is sustainable into the third quarter.

Okay. And in terms of this hyper-growth plan laid out, your net debt to adjusted EBITDA is quite low. Where are you comfortable taking that for the right deal?

David, this is Bryan. So we actually look at it. So remember, in the core, we're only talking about high single-digit growth, which is where we've been. In terms of network development, the purchasing of acquisitions, that's a lot of the lift of where it comes from, which is something that we've done in the past. And then when you move to the Driveway channel, it's about procurement and really a growth rate similar to what new entrants into the used car space of experience, but we also have new vehicle revenues that can be pushed through the Driveway channel as well as service and parts business. So I think as you think about that, that's a lot of the SG&A improvements are going to come from top line improvement. So we are looking at a 57% SG&A in the Driveway channel and 65% in the core as well as the network growth channel.

Okay. And on the, I think, the slide say, $3 billion to $5 billion of acquired revenue annually, and then when you talked about $4 billion on the call today, that's a huge number from what you guys have done even with DCH. I mean is this coming more just from a huge quantity of deals relative to the past or also some much bigger targets? Because it just it doesn't seem there's that many large -- really large groups out there, but you know the market way better than I do.

David, I see what you're asking. So let me jump back real quick and clarify, you were asking about leverage, not in terms of expenses, in terms of balance sheet. So our model is -- shows leverage between low 2s to as high as 3.0, and we hit that in year 3. It assumes the capital need for about $900 million in terms of equity at some point when it's constructive and it matches acquisitions. So that is how we built that, and that keeps our leverage intact. Everything else is from free cash flow generation within the model, which is massive as we begin to build that momentum. In terms of size of acquisitions, this will be a combination of staple diet or value type investing, which now most of the organization, and there's probably 20 to 30 people, whether it's general managers, group leaders or corporate staff that are working around that level of acquisitions. So that is always there. We have midsized groups between $500 million and $1 billion in size. And those things over $1 billion in size, it's really a matter of our ability to constructively aggregate and find partners that believe in our strategy. And believe in the network development and the ability to leverage the Driveway brand name across the United States or possibly even someday in the future moving into other English-speaking countries.

At this time, I'll turn the floor back to Bryan DeBoer for closing remarks.

Thank you, David. Hey, thank you, everyone, for joining us today. We hope each and every one of you remain safe, and we look forward to updating you again on our third quarter results in October and sharing other incremental information as we continue to roll out our strategies, our Driveway strategies over the rest of this year.

Thank you. This will conclude today's conference. You can disconnect your lines at this time. Thank you for your participation.