Lithia Motors Inc (LAD) 2006 Q2 法說會逐字稿

Good afternoon, my name is Henry and I'll be your conference facilitator today. At this time, I'd like to welcome everyone to the Lithia Motors second quarter 2006 conference call. (Operator Instructions) After the speakers' remarks, there will be a question and answer period. (Operator Instructions) It is now my pleasure to turn the floor over your host, the Director of Investor Relations, Mr. Dan Retzlaff. Sir, you may begin your conference.

Thank you, Henry, and good morning to everyone. And good afternoon to those of you on the east coast. To begin, the Company wants you to know that this conference call includes forward-looking statements. These statements are necessarily subject to risk and uncertainty and actual results could differ materially due to certain risk factors. These risk factors are included in our second quarter earnings press release, and in the Company's filings with the SEC.

Now, I'd like to thank you for joining us for our second quarter 2006 earnings conference call. I have with me today Sid DeBoer, the Chairman and CEO of Lithia; Dick Heimann, our President of Corporate Affairs; Bryan DeBoer, our President and Chief Operating Officer; and Jeff DeBoer, our Chief Financial Officer. At the end of their remarks, we'll open the call to questions. And now it is my pleasure to turn the call over to Lithia's Chairman and CEO, Sid DeBoer.

Thank you, Dan. Good morning, everyone. Thanks for joining us today. In the second quarter, as you saw, total sales increased 13% and total gross profit increased 13%. Same-store sales and gross profits were up across all business lines except the new vehicle business, where same-store sales were up and gross profits were down slightly. Lithia's second quarter results can be characterized by three months that were just fair. We missed having one big month like we normally have in each quarter. Normally we have that one strong standout month within the quarter. June was the month we would hope that would have happened. June had a tougher comparison, though, with June of last year, which was a very strong month.

You may recall that in June of 2005, employee pricing programs were just gaining steam, and we had a weaker incentive environment in June of this year, so that helps explain some of that. As a matter of fact, according to Auto Data, overall industry incentive expenditure per unit in the second quarter of this year was down about 13% year against year, with GM spending down 28%, Ford down 7, and Chrysler spending about the same as their prior year. Chrysler did have confusion that year at month-end, relative to employee pricing not being in effect but being publicly known.

Our strategy to aggressively pursue market share, that began in the first quarter of the year, continued throughout this second quarter. This resulted in an increase in new vehicle same-store sales of 6.6%, on top of a 4.8% increase in same-store sales last year in this quarter. I want to point out that selling volume and driving same-store sales growth is a critical element in our long-term plan, as it definitely improves our relationships with our manufacturer partners, and ultimately insures our ability to purchase stores over time. New vehicle same-store unit sales for the quarter increased by 10%. This is well above the industry total decline of 5% for the quarter. Retail sales were really down even more for the industry, since the minus 5% decline includes increased fleet sales. Lithia's domestic same-store unit sales increased 6% while the industry recorded a decline of 12.5%.

Our import same-store unit sales increased 19.1% compared to an industry increase of only 5%. The difference in the new vehicle same-store sales increase of 6.6%, and the same-store unit increase of 10.1%, is due to an $887 decrease in the same-store average price per unit for the quarter. This is due to a shift in mix to less expensive vehicles. Demand drives gross margins, not just the price of the vehicle. Since lower priced vehicles tend to be more in demand now, we're still able to get good gross margins out of those sales. Because of a shift in demand towards cars and more fuel-efficient vehicles, we did see those higher gross margins in those vehicles, than we did for trucks and SUVs in this quarter.

For the second quarter, net income from continuing operation was 11.7 million. And earnings per share from continuing operations were point - were $0.55. This includes the effect of accounting for equity-based compensation under FAS 123R, which had the effect of decreasing reported earnings by $0.03. Comparable earnings with last year would have been around $0.58. As mentioned in our press release, our earnings did not quite keep pace with our sales and gross profit growth in the quarter, due to some unusual expenses and also because we sacrificed new car margins in order to gain sales volume and market share. And that was in the face of a difficult sales environment affected by both higher fuel prices and higher interest rates. Jeff will discuss these unusual items in more detail later in the call.

For the quarter, total used vehicle same-store sales increased 9% and same-store units increased by 5.3%. That's for our used car business. Average same-store retail prices increased by $450. Retail margins were 10 basis points below last year, and gross profit per unit increased by $81. Total, same-store used vehicle gross profit for the quarter increased by 7.5%. In the past, we have seen when we shift the focus in our stores towards more new vehicle sales, it has hurt our used unit numbers. This quarter, we were able to sell more used units and boost our average used vehicle gross profit per unit for the quarter, even in the face of increasing new vehicle sales. On a combined basis, new and used vehicle same-store sales for the quarter increased 7.4%, and units increased 7.6%. Combined, new and used vehicle same-store gross profit increased 2.5%.

Related finance and insurance same-store sales increased 14.3% as a result of the large unit increases for new and used vehicles in the quarter. Our service and parts business performed really very well this quarter with same-store sales increasing 7.5%. This was on top of a 1.4% growth last year in this quarter. Same-store warranty sales in the second quarter were up 3.8%. Interestingly, domestic brand warranty work declined by 1.5%, while import warranty work increased by over 15% for the quarter. Lithia's ongoing focus and success in selling our lifetime oil program, coupled with our ongoing service initiatives, continues to pay benefits in same-store sales increases. In addition, the large number of new units we sold in the first and second quarters of the year should continue to benefit our service and parts business longer term. Same-store gross profit in the parts and service business grew 9.2% for the quarter. Finally, same-store sales were up 7.6% and total same-store gross profit for the Company was up 6.8% for the quarter.

For the second quarter of 2006, Lithia has increased its dividend by 17% to $0.14 per share, as we announced earlier. I think that pays out on August 4. We have doubled our dividend in the last three years. We initiated, actually, the first one in the public sector in auto retail to initiate a dividend of $0.07 per share in the second quarter of '03, and raised that to $0.08 second quarter of '04, and then $0.12 in the second quarter of last year. This continues to be a good means for Lithia to return capital to shareholders. We also believe it increases our exposure to a broader shareholder base who can only buy stocks that do have dividends. I would now turn things over to Mr. Dick Heimann, our President of Corporate Affairs, who will comment further on our sales, brand mix and inventory positions. Dick?

Thank you, Sid. Good day, everyone. And let me thank you again for all the support that you give our Company. Let me start out by commending the Lithia operational leaders and team members for the exceptional job they did in pushing same-store sales and increasing units in operation in what was a weak sales environment. I'm confident that we will see the benefit in more units in operation, in our parts and service business in the years to come, and also in returning customers to our stores when they are ready to purchase their next vehicle. A customer that we can service today greatly increases our chance of being able to service that customer in the future.

We currently have operations, it's hard to believe, in 13 states already. Our same-store sales broken down by state now stands at Oregon with 17%, Texas and California both with 15%, Washington, 13, Idaho and Alaska with 8%, Colorado, 7, Montana, 6, Nevada, 5, Nebraska, 3, South Dakota, 2, and New Mexico with 1%. Now let me list the states in order of increased same-store sales performance. New Mexico, Texas and Idaho performed best, followed by Montana, Washington, Oregon, California, South Dakota, Nevada, Colorado, Alaska, and finally, Nebraska. The states of New Mexico, Texas, Idaho, Montana, Washington, and Oregon all experienced nice double-digit gains in same-store sales. California, Nevada and Alaska performed well even though they were faced with difficult positive comparisons in the second quarter of last year.

Our new vehicle mix by manufacturer as a percentage of total new vehicle units for the quarter was 40% Chrysler Dodge Jeep; 19% GM Saturn; 12 for Toyota Scion; 7, Ford Lincoln Mercury; 5% each for Honda and Hyundai; 3% each, Nissan and Subaru; 2% BMW; 1% Volkswagen Audi; leaving approximately 3% for all the other brands for a total of 25 different brands. We have continued to see a noticeable shift in unit sales from truck and SUVs to the smaller SUVs and sedans. 58% were truck/SUVs versus 67% last year, a substantial change due to higher gasoline price and shifting consumer tastes. On a dollar sales basis, 66% were truck/SUV versus 71% last year in the second quarter.

Now, let's shift to an inventory discussion. You may recall, then, the first quarter, we received additional incentives from our largest manufacturer partner for taking and selling extra vehicles. Throughout the the first quarter through Company-wide promotional initiatives, we were able to reduce our excess inventories to normal levels. We took advantage of these same programs again in the second quarter, with the knowledge that any excess inventories can be sold in our strongest third quarter selling period. Our new vehicle inventory day supply was 10 days below year-end 2005 levels and 21 days above average levels for the end of June. We have started off the third quarter with a strong July, and we will be working to sell down our new vehicle inventory to normalized levels by the end of the year.

We believe that we are at the correct inventory levels with used vehicles, and with good quality used vehicles, that should benefit our used vehicle business throughout the the rest of the summer. Used vehicle inventories at the end of June were three days above our average levels for the first time of the year, but six days below where we were last year at the end of June. As in the second quarter, we plan on being more aggressive in used vehicle business and are going to push the used vehicle sales even more in the third quarter. Pricing continued to stay firm in the second quarter, as demonstrated by a $584 increase in used retail prices, and an increase in gross profit per retail unit of $81.

Lithia continues to generate industry-leading finance insurance income. Our F&I per vehicle for the second quarter was $1088, a full $50 increase over the same period last year. We had penetration rates for the financing of new and used vehicles of 78%, service contracts of 42%, and our lifetime oil product of 39% in the second quarter, about the same as last year. Now, it's my pleasure to have you hear the numbers from Jeff DeBoer, our CFO. He'll provide with you some more details on the financial results.

Thank you, Dick. I'll start with the revenue numbers. For the second quarter, total revenues increased 13%. About 50% of this increase was from acquisitions in the prior year, and 50% was due to same-store sales increases. Gross profit also increased by 13%, operating income increased 6%, and pretax earnings from continuing operations declined by 7%, because of the items mentioned previously by Sid. We posted record first-quarter sales of 846 million.

New vehicle sales increased 13%, total used vehicle sales increased 15%, finance and insurance was up 21% and service, body and parts increased 14%. New vehicle sales comprised approximately 58% of total sales. Used vehicles were 27%, parts and service, 10%, and finance and insurance, roughly 4%, all approximately the same as last year. The contribution to gross profit by business line this quarter was 25% new versus 27% last year, 22% used versus 22% last year, 30% service and parts versus 29% last year, and 23% F&I as compared to 21% last year. The decline in new vehicle margins, tire service parts, service and parts margins, and higher F&I, are apparent in these mix of numbers for this quarter.

I'll now go over the gross margins by business line. Gross margins for new vehicles in the second quarter were 7.3%, a 60 basis-point decline over the second quarter of last year. As Sid mentioned, we decided to go after volume in the quarter and as a result, the margins pulled back a bit. Our historical average gross margin for this business line in the second quarter is 8.4%. Year-to-date, new vehicle margins were 7.6%, a 40 basis point decline over last year. The used retail vehicle second quarter gross margin was 15.8%, 10 basis points lower than last year. Our historical average gross margin for this business line in the second quarter is 14%. So we are still tracking at very high levels. Year-to-date, used retail gross margins were 15.6%, a 10 basis point decline over last year.

The used, the wholesale used vehicle business continues to do well. In the second quarter, Lithia had a wholesale used margin of 2.8% versus 3.9% last year, and gross profit per unit was $168 versus $234 per unit in the second quarter of 2005, and pricing has declined $43 per unit. We have now seen three full years of wholesale gross profit gains in a business that traditionally is not profitable. Year-to-date, wholesale margins are down 20 basis points to 3.9%. Gross profit per unit has declined $6 to 241, and pricing has increased $202. The parts and service gross margin for the second quarter was 50.3% as compared to 49.3% in the same period of last year, a full 100 basis point increase. Our historical average gross margin in the service and parts business is 47.3%, so we are still well above historical levels.

This is the highest parts and service gross margin achieved by the Company since becoming a public Company in late 1996. We saw gains in both the parts and service margins for the quarter. Year-to-date, parts and service gross margins are up 60 basis points to 49.6%. Again, a record level for the Company. For the quarter, our total gross margin for all businesses combined, increased by 10 basis points to 17.0%, mostly as a result of the gains in the parts and service business. SG&A as a percentage of gross profit went up by 130 basis points for the quarter to 74.6%. Approximately 60 basis points, or nearly half of the increase, is due to the increased compensation expense resulting from the implementation of FASB 123R.

Additionally this was up against an improvement, or reduction, of course, of 340 basis points in the prior year on solid same-store sales increases, and still marks an improvement of 210 basis points on a two-year basis. We can also see how the mix shift to lower margin new vehicle sales affected our SG&A leverage. While 60 basis points of the increase in SG&A as a percentage of gross was due to the option-related expense last year, that were new this year, the other increases were due to higher investments and personnel, systems and training for our centralized efforts in future projects. We will continue to experience these costs through the rest of the year and they should start to anniversary themselves in the first quarter of next year.

In addition, as these initiatives take hold, we will start to realize the intended cost reductions. The next four largest cost items, sales compensation, rent, advertising and payroll taxes, were all flat or down as a percentage of gross profit year-over-year. So we are doing a good job of holding the line on costs at the stores, while selling many more new vehicles. As a result of the higher SG&A in the quarter, our operating margin of 3.8% was 30 basis points less than the second quarter of last year. This is still 20 basis points above our 3.6% average for the second quarter of the year.

I'll now discuss the debt and capital side of the business. For the quarter, the total of flooring and other interest expense as a percentage of revenue was 1.5% as compared to 1.2% last year. The increase is due to both higher inventory and higher interest rates in the period. We have substantially minimized the impact of higher fixed rates by fixing a significant amount of our flooring debt with interest rate [swap]. We have outstanding 175 million in low fixed rate interest swaps, with an average remaining term of 2 to 3 years. Due to the unusual flatness of the yield curve, we were able to recently secure a 10-year fixed interest rate swap for $25 million, at the same rate as a 5-year swap would have cost. This swap replaces one of a similar size that had expired recently.

We continue with with our disciplined hedging strategy, including all fixed-rate debt obligation and hedges. Approximately 37% of our total debt had fixed rates at the end of June. This compares to 41% last year. The decline is due to the greater amount of inventory that we had in flooring related to that inventory at the end June of this year, plus additional total flooring that we have taken on from acquisitions over the past year. For the quarter, we had an increase in flooring and other interest expense of approximately $3.5 million. Approximately half of the increase was due to higher rates and half was due to higher volume. Including the swap, our average interest rate increased by 70 basis points year-over-year to 5.5%. On average, market rates went up nearly 200 basis points. So our 70 basis point increase is a result of our hedging strategies.

Finally, earnings per share from continuing operations, excluding the effect of the accounting change, were $0.58 compared to $0.62 in the same period last year. This is a decline of just over 6%, as the bottom line numbers were impacted by a number of items. These items include hailstorms at three of our stores -- at stores in three of our markets; a higher tax rate due to a change in accounting estimates; a deferral of some manufacture incentives to the third quarter; and higher interest expense corresponding to increased inventories and higher rates. This quarter and in the first half of the year, we have also had a duplication of costs related to various long-term operational initiatives which Bryan will discuss later in the call. These costs were apparent in higher SG&A expense, as mentioned before. We do expect that these initiatives will benefit the Company long -- will benefit the Company's long-term performance, and more than offset the current added short-term expense. Many of these items will not carry through to the third quarter. However, we do expect the higher SG&A plus the option and interest expense to be factors throughout the the rest of the year.

Now looking at the balance sheet, we have nearly 23 million in cash, plus 53 million in contracts in transit, for a total cash of $76 million at the end of the quarter. Our long-term debt, excluding used vehicle flooring, is largely composed of debt from the convertible offering, real estate and equipment financing, and totaled $311 million of total debt. The breakdown of of this 311 million is: 169 million in real estate mortgages; 50 million in equipment debt; 85 million from the convert; and approximately 7 million of other debt. Our long-term debt to total cap ratio, excluding real estate, is 23%, so we still have a very unlevered balance sheet. Our good will as a percentage of total assets is now only 16%. This is down from 19% as we continue to execute our acquisitions strategy at very good valuation.

Shareholders' equity rose by 5% to 483 million from 460 million at the end of 2005. Lithia's book value per basic share, unadjusted for real estate value, is now $24.80. Our price to book ratio, as of the close of the market yesterday, was 1.1 time. Looking at free cash flow, net income from continuing operations plus depreciation and amortization for the first half of the year was $30.6 million, and non financiable CapEx was $9 million, dividends paid were $4.7 million, so we had a free cash flow of approximately $16.9 million in the first half, which was largely used for acquisitions. Our total non financiable CapEx expectations for the full year is expected to be between 25 and $30 million. As a final note, the higher tax rate is related to a change in estimation of tax reserves for the year, in the second quarter. Looking at the full year, we expect the rate to be more normal and stable at 39, between 39 and 39.5%.

Now to our guidance. For the full-year 2006, our guidance has been lowered to $2.20 to $2.28. In particular, we have noticed that analysts' projections for the third quarter are overly optimistic. We have very difficult comparisons in the third quarter of this year, as we face record high operating margins and strong same-store sales growth concurrent with a very strong incentive environment in the third quarter of last year. The full-year 2006 guidance is on a continuing operations basis. It assumes a steady pace of acquisitions and dispositions, and includes the effect of FASB 123R, expensing for stock options and our employee stock purchase plan that took effect starting in the first quarter of the year.

If you adjust everything, our new guidance is roughly the same as our earnings per last year, so we're basically saying that we can make the same EPS as we did last year, in a much more difficult year. In addition, in our model we've included 50 basis points of additional interest rate hikes over the next two quarters, which is more than we had originally forecasted. That concludes the financial summary. I'll now turn things over to Bryan for the operational side.

Thank you, Jeff. And thank you to everyone listening in this morning. I'd like to first update you again on our acquisitions so far in the year. In early April, we added Lithia Dodge of Fresno with annualized revenues of approximately $50 million. Along with this acquisition, we were also awarded two additional Chrysler Dodge Jeep open points in and around the Fresno market. Once the addition of these two open points are completed over the next few years, Lithia will be the exclusive Dodge dealer in Fresno, as well as the two closest surrounding markets. Pretty exciting for us.

Additionally in May, we acquired Lithia Chrysler Dodge Jeep in Twin Falls, Idaho, and in June, two more stores, Lithia Dodge Jeep in Bryan, Texas, and Lithia Chrysler Dodge Jeep of La Crosse in Wisconsin, which actually is our first store now east of the Mississippi, despite the fact that it's only about 300 yards from the river. Anyway, it's kind of exciting for us that we'll be able to leverage and build some synergies from. Combined, we have closed on approximately $160 million in annualized revenue so far this year. Most importantly, however, is that we have a number of good acquisitions in the pipeline for the rest of the year, and we are still on track to hit our annual acquisition targets.

Now, I would like to provide an update on our current operational initiatives that Jeff mentioned earlier. As we have discussed previously, our new industry-leading customer centric sales processes are really taking hold. The key of this new process is that our showrooms will have interactive personal computers available for our customers and our sales personnel. Our initial rollout in all of our California stores during May and June of this year are yielding exciting feedback from our customers and our employees, who feel very empowered and truly appreciate the time savings and simplifications that are coming from this system. Remember, also, this is a deployment method for our LSMS systems, which is our follow-up systems, as well as it simplified our forms and made a lot of the forms electronic.

We're also continuing our work on centralizing many operational functions at support services here in Medford. New and used vehicle inventory control, Internet lead follow-up, service and sales follow-up, and certain back office functions are being redeveloped to improve performance, gain productivity and efficiency. As with most of these initiatives, our objectives are to free up our store personnel so that they can spend more time on the retail push and on growing a quality team of employees. Despite our used vehicle sales continual strength during 2006 and 2007, our used vehicle model is receiving an entire face lift. Currently, our certified used vehicle sales are up 60% for the first 6 months of the year. This is obviously late-model used vehicles. Our silver plan sales year-to-date are up 19%, which are the higher mileage vehicles over 75,000-miles. So as you can see, we're covering the broad spectrum of the used car business well and growing in all areas.

The following used vehicle initiatives have and will be successful at enhancing sales and are the reason our profit margins and volume in used vehicles continue to remain high. The initial rollouts of our assured used program in the Tri-Cities, Abilene and Reno markets, are going well and generating good results. We have established strong marketing initiatives to promote the assured use program in these markets the rest of the year. If you are new to the call, and the Lithia story, I'd like to take a few moments and update you on what this program is all about, because this is a key focal point for Lithia in the future. Lithia assured used vehicles will be sold at what we term low haggle pricing, very similar to our promo price model for a new vehicles which many of you are familiar with.

The assured vehicle program is designed to ease the customers' used vehicle transactions, while offering unprecedented peace of mind to used vehicle purchasers. In designing this unique program, Lithia has partnered with a nationally recognized used vehicle evaluation company, and our own IT department, in order to develop pricing models. Assured prices reflect current market values with the -- without the typical dealer markup that is allowed for negotiations. In other words, a Lithia customer is immediately given a competitive price without requiring the frustrating hassles of negotiations by other competitors.

Lithia is also providing a 60-day, 3,000-mile, if it breaks we'll fix it at no cost, limited warranty on all used vehicles. The warranty is also supported by a rigorous 160 point inspection, extensive detailing and reconditioning, and a vehicle history report on every vehicle. In addition, the assured program allows all customers, and I repeat, all customers, to return the vehicle within 3 days or 500-miles of that purchase. Unlike other return programs, which may require a trade-out to another vehicle or possibly even being charged for this benefit, the assured program at Lithia allows customers to exit the deal and receive their trade-in back, all at no cost to the customer and no questions asked. And this is working very effectively in our stores.

As a follow-up, we have rolled out the used vehicle first look technology to approximately 65 of our stores, and the rest should be completed by early October. This tool assists our procurement specialists and stores to secure additional high demand used vehicles to increase sales. Our first independent used car outlet will be operating in stride by the middle of next year. We have developed industry-leading, customer-focused processes, intelligent customer-centric IT systems, an intelligent used vehicle procurement and inventory management system, and most importantly, leveraging Lithia's common language approach to operations and processes.

This model will greatly enhance our growth opportunities and will be in addition to our current projections under the existing new car franchise model. We are carrying additional compensation and SG&A expenses related to this initiative, and the other core operation initiatives that I have talked about as well. We do, however, believe that these investments are necessary in order to develop a superior operating model and a strong and competitive Company for our future. As I mentioned earlier, we are excited about each of these initiatives and will continue to execute and implement them throughout the the year. We expect to see solid traction from these investments beginning in 2007 and beyond. Now I'd like to turn things back over to Sid for some closing comments. Sid?

Thanks Bryan, Dick, and Jeff. And hopefully you all have a pretty good understanding of what took place in the quarter. There are a couple of points I think we may have missed in the conversation so far. As you all may have noticed, there is no more discontinued offs. We have disposed of the two stores that we had in discontinued ops at the start of the year, and we haven't assigned any others to that section at this time. And also, for July's business, just so you know, you saw that General Motors was down 18, Ford down 32, Chrysler down 34, Toyota up 16, Nissan down 16, and Honda up 8. For us, we were down less than one-half of those declines in our July performance in our stores. So we've got good indications that we're really holding up well in the face of these declines that some of our manufacturers are experiencing. Incentives should be hot in August and we are well prepared to sell a lot of cars in August.

In closing also, I'd like to talk about the last few years, we've made a lot of progress in developing and proving our operating model. It's really quite unbelievable how well the Company has done in those areas and we continue to invest there. The benefits have been apparent not only over the last few years but in the last two quarters, as demonstrated by our ability to produce strong same-store sales in gross profit growth. We have now reached another phase where we are building additional groundwork in preparing to launch ourselves even further towards the superior operating model, as we make ongoing investments as new initiatives, as Bryan has explained, and introducing a new stand-alone used car vehicle operation as well.

We ask our investors for some short-term patience here, as we wait for the long-term benefits of some of these investments. Our acquisition strategy will continue to focus on regional markets, and also don't forget that we are attacking import and luxury brands in metro markets, and still part of our core strategy. Our sales strategy of taking market share and selling more volume will continue to support this acquisition strategy and gain support from our manufacturers as we go forward. In the coming years, our operating model will continue to drive these same-store sales increases. We'll get cost savings throughout the the organization. The value from these new acquisitions should begin to play in. We are seeing a good start, as I said earlier, in July, and we are looking forward to the second half of the year. And for now, that concludes the presentation and we'll open the floor for questions and thank you all again for joining us and being part of the Lithia group.

(Operator Instructions) Your first question is coming from Rick Nelson of Stephens. Please go ahead.

Thank you and good afternoon.

Hello, Rick.

Can you provide a little more color on the inventory position, maybe as it relates to your bigger brands like Chrysler and GM?

Did we have those numbers, Rick, in terms of the day supply change, we're up about 20 days over what we were last June at this time. But down from the day supply level we had at year end. So we've reincreased some of that. A lot of that has to do with the buildout in the manufacturing processes which normally increase this time of year. Chrysler is still the heaviest. And we're really taking a bet on some volume increases in our GM stores, too. So we have got pretty good inventories there. And believe it or not, our Ford stores are actually doing real well as well. So, those three brands, we're not that concerned over. And there is some increase in Toyota store inventories as well. They're not creeping up by any means, but they've got issues with Sequoias, and full-size Tundra pickups. I just noticed their incentives for the next quarter, for this August, have increased quite a bit. So they're all going for it in this month of August.

Are are the employee pricing programs, are they having any impact on sales?

Well, you know, our promo pricing strategy fits right into the employee pricing. So we're probably getting more benefit out of that than Chrysler has as a whole. Their ads for that failed to get the message across about employee pricing. And they have two new ads that start in August, and hopefully they'll be stronger about the benefits of employee pricing. They should get a better uptick out of that in August. That's our hope. I'm on their national dealer council and we hammered them about the Dr. Z ads, are great for product and building image for the manufacturer, but just mentioning employee pricing at the end of the ad didn't do anything to explain the huge benefits of employee pricing. It means that people don't have to haggle for a good deal on an automobile. And that they're going to be able to buy a car way less than MSRP without any kind of a fight on the showroom floor. They don't tell that in the message. Last year, we had the momentum of GM explaining that really well throughout June. And so it caught on quicker. But I do believe Chrysler's got the message about that and hopefully the new ads will help increase the response from customers in terms of employee pricing.

Are there industry factors that are helping the used car business right now? Everybody seems to be reporting good numbers in used cars. I'm wondering if that is sustainable and just what the drivers are.

I think it's pretty sustainable Rick. I think we've had our fall off in that split between new and used, relative to the impact of incentives, has certainly softened. It's kind of solidified where it's at. We do see pretty strong auction prices for the late model used cars, surprisingly. I get a weekly report from our people that are in the field on that, and that continues to demonstrate a lot of demand. We're being very careful on inventories there and keeping those on a very low turn rate, and don't want to be caught with the normal seasonable downturn in values that happens in late September and October on those models. So we're pretty good at managing that. But I think overall, everyone is learning how to be better at used, and certainly we're the leader in that, and we continue to demonstrate growth there.

And can you tell us a little bit more about this used car format that you have in mind, then what sort of personnel and costs you're incurring today to launch that?

Rick, I've probably said all I can about it. We're not trying to explain it completely yet. Obviously, we're hinting at the reality that it exists, and we are hinting at the reality that it's costing us something to invest in that. We're trying to hold to that to a minimum, obviously, but it will accelerate as time goes on, and hopefully we'll also get income and generate profits at the same time. So, the impact is pretty well in those forecasts that we put forward, and probably had some impact on our estimates for this year now. Because we know it's a reality and we're accelerating that as much as we can. We're trying to find a balance between hitting current earnings and investing in the future. And to balance, obviously, but it's critical to the success of our Company. We are so excited about that used car opportunity, and we know that we're the Company that can execute that, at least at the level of CarMax, and maybe even exceed some of their performances over time, because of our strict operating model and the ability to integrate our new car operations and the back end of our business in supporting both of these unique retailing outlets.

How would it be different than a CarMax store?

There will be a larger reach into the lower end of the market. And we'll have a broader range of opportunities for people to finance vehicles.

Through third parties?

Yes, always.

Yes.

Maybe not always. We're certainly steady in that initiative as well, but it's 3 or 4 years away if we ever do start anything there.

And '07, how many stores are you talking about?

On the used car side, it's a test store, Rick.

Just 1, Rick.

Just the one will be open for sure.

Thank you.

Yep.

Thanks, Rick.

Thank you. Your next question is coming from Matt Nemer of Thomas Weisel Partners. Please go ahead.

Matt, you there?

May have lost him.

Can you hear me? Sorry about that.

Go ahead, Matt.

First question is regarding the strategy to drive market share. I understand the long-term benefits to units in operation and the OEM relationships. But it seems like the DCX inventory situation is getting worse, and I'm wondering, how many quarters of excess inventory would you be willing to carry?

It's not really quarters. It might be a month right now of excess inventory. And that's all we'd be willing to carry. It's enough. And I don't believe it's getting worse at all. I honestly feel like July has been a big help that regard. We've certainly dropped our days supply. And I don't see it as an issue. We took them at the right time of year, Matt, and we'll manage that going into the fall. And they also to have to do something to either cut production or get units out the door.

Matt, also, we've obviously locked down our purchasing fairly well and plan on controlling that well into the third quarter, which is normally, that's pretty typical that time of year, as well as we're driving the sales on those over age vehicles and that excess of vehicles through our campaigns, through targeted campaigns in our stores through LSMS, that we've discussed. And that's really a lot of the reasons how we've gotten same-store sales increases, large same-sales increases in comparison to the market. And we'll continue to do that and we're actually adding some staff to drive that even more.

I think those two things you mentioned to start with, the reality of those manufacturers buying into our story, as opposed to other publics, and granting us the right to grow and buy stores aggressively over time, and that hitting big sales volume at all of our stores and demonstrating our ability to do that, and particularly our ability to take stores that are doing half of what they should do, and double them over a 3-year period is huge, Matt. And I mean that's the core underlying reason, because we're restricted, and can be by manufacturers' ability to prove us. And we don't want them just to have to drag their feet into it. We want them aggressively asking us to go buy stores, and we're getting that from two or three of them, and we want it from all of them.

Yeah, no, I understand that. And not to beat a dead horse, but do you think that you would be able to run a little bit leaner than you are, given the fact that you are buying average or underperformers? So in theory, even if -- is it possible you can run leaner and they still want you to buy your stores?

Absolutely. The inventory levels have nothing to do with wanting to buy stores. But the inventory levels do have something to do, when they put an extra 1000 bucks a car on selling them, for you to take them, it's a good business case to take them. And that's the only basis we've increased inventories on. And we've also increased inventories where we know we can increase volumes specifically, like on Chevy Cobalts. We bought a bunch of extra Cobalts, and we're selling them in volume in both Idaho and Fresno, and several of our good-size Chevy stores are doing very well with that. And those are marketing strategies that require a step forward in inventory and then you get increased volumes. And then your day supply falls in line based on the increased turn rates. So, a lot of that's strategic at the same time. But we would never take those units from Chrysler unless they didn't pay us to take them.

Okay. And then, actually kind of on the same topic, on the deferral of OEM incentives, can you quantify how big that was, and it sounds like it hits primarily in the third quarter?

It's about $0.03. It came out of the second quarter and it should all reappear in the third quarter.

Third and fourth.

Maybe a little in the fourth, but most of them will go out.

Okay. And then another question on the investments in long-term initiatives. Can you quantify how much of that is the centralization effort versus other long-term projects, including the used car store initiative?

We don't have that exact number, but I would say it's about 70% the current Lithia initiatives and maybe 30% on the L2 initiatives.

Got it.

We have double expenses on some of those initiatives now

And that's primarily bringing in accounting and payroll, et cetera, in house? Into Medford?

Payroll is already in. Accounting, the payable function and the receivable function are in process.

Okay. What other specific processes are duplicative right now? What's being brought into Medford?

There are certain call centers that are duplicated and then we're boning up in staff for human development as well, which is some of the initiatives we've talked about in prior calls.

The office centralization for accounts receivable, accounts payable. I guess he touched on that.

We try to find everything we can that doesn't touch the customer at the store level, to do in a centralized manner. The used vehicle appraisal center here in Medford, we're spending quite a bit of money on the software and the time integrating that, although that will take a while before it's centralized.

Got it, okay. Thanks very much.

You bet, Matt.

Thank you. Your next question is coming from Scott Stember of Sidoti & Co. Please go ahead.

Good afternoon.

Hello, Scott.

Hi, Scott.

Could you talk about some of these other items, like the hailstorm, damage from that? How much in earnings was that in the quarter?

It was just over a penny a share.

It's mostly insured, but there's a deductible per car and it can add up.

So it's not huge, obviously.

Okay, and just going back to the stand-alone stores, which you were talking about before, I missed some of your comments before. When would you expect to have your first store up and running, for that to be up and running, where? Which market?

Next year; it's probably a time that we'll schedule a visit so people can come see it.

All right. Most of my other questions have been answered. Thank you.

You bet. Nice to hear you, Scott.

Thank you. Your next question is coming from Jonathan Steinmetz of Morgan Stanley. Please go ahead.

Hi, Jonathan.

Hello, can you hear me?

We can hear you, go right ahead.

Okay. Just on this, I'm sorry if you covered this, I was jumping between calls. But on the incentive change, which I assume relates to the Chrysler side, was there any change in the accounting on that, or is it just that you've got some stuff sitting in inventory that they paid you to take, and then it rolls through the P&L in the third and fourth?

It's the latter. The incentive program changed, and we had to account for it according to the new incentive program.

They still based it on what we sold, but since we had to take cars to qualify, they rolled some of that incentive we earned by selling cars into the third quarter, or moved it forward. Chrysler has assured us they're going to never do that again. But whether that will hold water or not, I don't know. Where they pay us something in order to qualify, you have to take cars. I think that's gone. Joe [Eberhart] personally assured our national dealer council that he would never do that again, so we'll see. If it never happens again, that all rolls back in.

Okay. And weren't they doing it that way in the first quarter of this year? I'm just trying to figure out what sequentially would have changed on that.

Basically we sold enough cars, so most of them had gone out of inventory by the time the quarter was over in the first quarter, and second quarter, it came later.

Okay, all right. I got it. All right. And are you able to quantify the amounts of the used car initiative, in terms of just in isolation, as to what that would have boosted the SG&A by?

We're not giving that out yet. It's probably 70% of our expenses, probably for these initiatives internally, and there's an additional probably around 30% that's being spent on L2.

Okay. Thank you very much.

Thank you. Your next question is coming from Rich Kwas of Wachovia Securities.

Hi, good morning out there.

Hello, Rich.

Just want to ask on a change of guidance here. You're about $0.11 short relative to the consensus, and then there's another $0.15 here to be had. Is that mostly coming out of Q3 and then less in Q4? Or how should we think about that?

That's what we were hinting at.

Yes, the comparisons are more difficult in Q3. In Q4, the comparisons are actually relatively easy. So that is correct. More in the third quarter.

Okay.

We're almost tempted to actually give guidance for the two quarters. But we went away from quarterly guidance, so just trying to hint at it enough so you guys can get halfway close.

And as I indicated, if you adjust for the option expense, our new guidance is about the same as we did last year. So we're basically saying we're going to earn as much as we did last year, which was a very solid year for us, even though this year is much weaker, much less incentives, so we really feel it's actually a pretty good year for us.

And then Sid, when you talk about August being hot, I mean, what are the automakers, what's GM and Chrysler going to do to generate interest here? Because obviously, the employee pricing program may be the marketing snafu, but it didn't have the legs that it did last year. And GM is backing away from incentives. What do you think is going to happen in August that's really going to help move the needle here?

Well, I think the numbers get bigger. I just saw the Ford incentives. Did you see them?

Well, they're going to do more regional.

It was quite a bit of money on there, there's 5, $6000 on some of those F-series pickups. And because they've got -- they had the biggest decline in truck sales of anybody. And we've got good inventories of the right stuff. Their heavy-duty stuff seems to be what's slowed down. The light duty isn't quite as bad. But I just think that that war starts, and I'm not sure how long it is before GM blinks. They had a fairly good quarter relative to the others, but I'm sure that they didn't have the big July as much as they did a big June last year. So even though they're down 18%, there's still a fairly small sales volume. So I just can't imagine them -- once they know they're not getting those seven orders, that's when they respond. And they're not getting those seven orders. Dealers are not ordering cars.

All right. So you're backing away a little bit on '07 here, is that right?

Well, yes. We've got -- we're ordering Calibers because we can sell all those we can get in the Chrysler line. We're ordering some strategic vehicles that we've got marketing strategies planned for, like the Cobalt in the Chevrolet line and the new Silverado truck. And we'll still take all the Tahoes, they're still not sitting that badly, the new models. But there's some stuff that we've got to really back away from, unless they can come up with some way to clear inventories we've got. And even then, we'll probably be real cautious about restocking there.

And one point, Rich, Sid touched a little bit on it earlier in the call, is our actual percent margins on cars is actually higher than trucks and SUVs right now, because of the strong demand for cars. So that's not a negative mix shift. People probably don't realize that for an auto dealer in this environment. It's an important point, actually.

Where cars are in short supply, we make better gross, obviously. And you take hotter new products in the car lines, particularly when it backs up, we could sell Priuses at 3 or 4,000 over MSRP. We don't as a Company, but there's still huge waiting lists for those kinds of cars.

But that also implies your SG&A leverage is not as great.

Right.

They're lower priced, so correct.

Yes, that's what happened last quarter.

And so in fact, if that could continue here, assuming this mix shift is -- continues with more cars and trucks.

We expect it to continue. And that's the reason for the lower end of guidance.

Okay, great. Thank you.

Thanks, Rich.

Thank you. Your next question is coming from Kelly Dougherty from Calyon Securities. Please go ahead.

All right, thanks.

Hello, Kelly.

Hi, how are you?

Real good, thanks.

It seems that is one of the rationales behind your push on the new vehicle volume is to drive future service business. But anecdotally, it seems that buyers of domestic vehicles are somewhat less likely than import buyers to return to the dealership for service. I was just wondering if you guys had any anecdotal or any kind of evidence that your consumers are more likely than the average domestic consumer to return to the dealership.

Our statistics show the return rates are very equal, particularly as you're a good promoter of service sales through our lifetime oil program. So we don't see a material difference between those numbers. Historically, Japanese meant largely cars had less defects, so people that ran stores, in order to have any service business, had to be good at selling customer pay labor. And they didn't, couldn't rely on warranty sales to support those operations. But today, I don't believe that's the case, even in most good run dealerships. Everyone is focused on increasing customer pay, and it only is a matter of time before most domestic owners come back in the same amounts that import motors, I mean, owners will. It's just a matter of effort and focus inside the store, in marketing and in selling at the service drive.

Another important point there, Kelly, is in the smaller markets, we're the only dealership for these brands. There's no other dealer for this brand, plus there's not the national service companies in the small markets. There was not really a good option for them, so the retention rates are higher in smaller markets, I believe.

Okay, so as long as Auto Zone stays out of your market, seems like that you guys are good.

And that ain't going to change overnight.

Okay.

I mean, I really think with our selling model and the lifetime oil change, I mean our issue still is just capacity to handle oil changes in a quick way. We're upping the quick lube bays at all our stores, on ongoing it's a lot of the cost of some of the reconstruction in the stores, to get that so that people can come in and get out of there in 30 minutes. Because even if they've paid for it in advance, which they have, they won't come back if we can't take care of them quickly. And we want them back, because then we have the opportunity to sell them all the additional services they need.

Okay, great. And you guys are still committed to increasing shifts and things like that, rather than adding service bays?

Absolutely.

Okay. Just a quick question on the employee discounts from last summer. I was wondering if you could give me a little bit more detail on how things looked at your GM dealerships on the new vehicle side in June, if you saw any kind of material effect from the comps associated with the strong month they had. And if you expected to see anything similar at the Ford and Chrysler dealerships in July or August.

One of the dynamics related to that employee pricing was that the most popular shorter demand, shorter supply vehicles went out first on that, so you got a big ramp-up when GM had it in June last year. They got ahead of everybody and they took big share. And it really worked, and it continued in July. Less so for them, but more so as the other manufacturers leapt in for them. Because, our -- like for instance, heavy-duty diesel trucks at the Dodge stores were really in kind of short supply when that thing kicked off. And those were the first vehicles that customers could come in and get a far better price than they were being offered before that came out. So you got some cherry picking. Late in the employee pricing program, in late August, a lot of the really good stuff was gone. We were actually short of inventory. That is not taking place yet at our Chrysler stores. We still have a good supply of everything. And they've included the 300 in that and they didn't last year, and that full-sized rear-wheel drive vehicle, which has still got good demand.

So, I think we'll continue to see some impact. We're lacking the consensus of everyone running the same type of ad, and we didn't have that good, strong General Motors ad that they developed last year running for the Chrysler employee pricing. If you remember, they talked, they had employees on there talking about you get to buy for what I pay. And it was just -- it was really warm and fuzzy and people understood it. I don't think Chrysler has done a good job of getting that message out. But it's harder, too, when there's only one of you playing that game.

Okay. I appreciate that. Thanks.

You bet. Thanks, Kelly.

Thank you. Your next question is coming from Jim Larkins of Wasatch. Please go ahead.

Hello, Sid. I wondered if you could just give a little bit more color on how we should think about terminal operating margins and operating leverage. The investments that you're making, were you required to make these investments regardless of what was going to be happening with the new used initiatives? I mean, did you hit sort of a capacity at your existing call centers and processing centers? Can you just kind of give us some color there? And going forward, looking out at kind of a 3 to 5 year model, are you going to be able to move much above that 4% operating margin rate?

Jim, this is Bryan. Our operating margins and the reason for doing those things is two-fold. It's obviously cost savings in the short long-term, year, two years out. But more importantly, it's the effectiveness of those jobs that we can perform them in a better way, and more professional way.

And in terms of the margin, the future, we do have stores way above 5%. And that's certainly achievable. But again, as you remember, we're continuing to buy stores and mix those in. And then, you've got these initiatives that are costing us, obviously, some margin. So those investments, if we stop making them, we could certainly grow our earnings per share on a short-term basis. But it's not the best thing for the Company long-term. As a long-term investor, as you are, and I know you're familiar with those projects that we're working on, I don't want to promise that we're going to be at 5% some day, but we sure hope to be.

Well, the only way we could is by doing these projects, Jim. That's the important point. These projects allow us to get to a 5% margin.

We don't know how low the gross margin might go, but we know that if we can increase the volume out of the same amount of expense, that we can get to a higher return on sales.

That's very helpful. Thank you for the comments.

You bet, Jim.

Thanks, Jim.

Thank you. Your next question is coming from Matthew Fassler of Goldman Sachs. Please go ahead.

Thanks a lot. Good afternoon. A couple of questions. I'd like to circle back on the decision to take on some more inventory. If you could just sort of bottom line the financial impact of that decision, both on the quarter and then on the year, to the extent that you get any pay back from the OEMs over the course of the next quarter or two.

I think your best way to look at that is the increased flooring cost is really the only real cost you could assign to that. And it's -- what, how much did it amount to? We're about -- we have about $256 million more in flooring than we had last year. And you can do the math on that. That's additional cost. And that -- couple the -- remember, the inventory increase is two of them. There's one that we took because we got more incentive money, and some of that now has been delayed into another quarter in the future. Second part of it is strategically buying vehicles in volume and marketing them in volume and new ways, and we're doing that with more and more manufacturers. We call it loop internally, Lithia unadvertised price, what's the e for?

Event.

Event. And we work them weekly now in the stores, and it's huge. We've actually lowered advertising expense and we're able to push these vehicles out. They're a little lower margin, but we manage to sell a lot more, and that really gets us on first base with some of our manufacturer partners, and we're going to continue to expand that. And those are strategically taking place, and that's some of the inventory increase.

I'm just wondering, looking at the new car gross margin decline, some of that seems, I know some of that's mix driven, some of it seems as if once you take on this inventory, there's obviously urgency to move it. I wonder if there's a financial point beyond which you're reluctant to continue to build inventory essentially, that to work with the OEMs.

We will not build inventory just to work with an OEM. It's always a business case that it makes more money for us and increases sales. That's the only reason we increase inventories. And we still feel that's the only thing we've done.

Fair enough. And then just a second question, on the -- some of the projects, the long-term projects that you've discussed in depth on the call, is it fair to say that the timing or the urgency that you assigned to them, or the costs that you expected for them, changed perhaps between last quarter and this? And if that's so, which are the ones that essentially either got more expensive or became higher priority for you, such as the spending, is growing a bit from what you might have originally expected?

None of that's really happening. I mean, we are talking about that so people are aware that we're carrying expense there, because we do tend to run a little higher on expense than we would without those things. But the real issue of this quarter was that we didn't get as much volume in one month that we needed to get past these smaller, this $0.11 that we didn't make. Because it's huge. If can you get an extra 3 or $4 million worth of net out of a month, I mean, we didn't have one of those big months. We had three fair months. So that's really the reason. Our inventory position would even be better if that had happened. We had hoped it would happen in June. Didn't. So we might have two boomers in the third quarter. We just don't know. We're going to be conservative and base what's happened in the last - you know, our future projections on what happened in this quarter.

Got you. Understood, thank you.

And that's kind of where we're at. Because if we had a great big August and September, we didn't have a very good September last year. That could make a bigger quarter than what you guys might have predicted. But reality is, we think you're aggressive on the third quarter because it's a hell of a comp last year. We had a big, big July and a big August, and a fair September. So this year we had fair April, fair May, fair June. We've got a pretty good July behind us. But we don't have a boom one yet. So if August booms, it's going to help. But I think our forecasts are right on target. They're really safe. They're doable and I don't -- hopefully no one's too aggressive on those at this point, there's no reason to be.

Understood. Thank you.

Thank you. Your final question is coming from Richard [Kine] of Kensington Management Group. Please go ahead.

Hi, Dick.

Hi there, how is everybody out there?

Well, we're real good. We would sure like to have had a little better news, but basically I think the story makes sense.

I have a couple of questions. Number one is, Sid, last time you had mentioned that the both cars -- not cars, trucks and SUVs were holding up pretty well in your markets, and now you've mentioned that they're not. Has this been a sudden turndown, or what? Could you sort of go into that a little bit?

Every quarter we've given data that was down 500, 600 basis points, a mix [shift]. We've given that data very clearly every quarter for the last three or four quarters, actually. So it's not a sudden thing, no.

But Dick, it's not extreme, either. There's still demand and I think that's how I answered your question when you asked it before. It's nothing we need to panic about, it's a gradual shift. And then you're -- we're improving margins dramatically on those vehicles that are in demand, because there's a lot of demand for some of the more fuel-efficient vehicles. So it shifts it. We just got to get better at selling those now, and shrink our inventories over time in those vehicles that aren't as in high a demand. We're still getting pretty good demand on light duty truck. That's not died by any means. Most of the die off is in the heavy duty.

Okay. Here's what I've been meaning to ask you for a long time, I really haven't gotten around to it. If you took a used vehicle, and let's say your average price is $16,000 right now, and you take a wholesale vehicle and that's $6000. So there's a $10,000 difference. Now, you mentioned that there's a $2500 gross profit on that. So does it -- so we're really talking about like 3700 between the cost and the -- and what you're getting for it, what you're getting for a used vehicle and what you're -- and the profit. So is that all reconditioned? Why is there such a big difference between used, a used vehicle and a wholesale vehicle? And I'm sure you're going to say number one, that the wholesale vehicle is not our best vehicle, or we would be selling it as a retail vehicle.

A wholesale vehicle, we're basically selling it for our cost, Dick. And it's just our management of the disposal that's given us a small profit. Because there's a cost that you establish when you trade for a car or buy a car. And so when you don't sell it or you don't want it, then you wholesale it back to someone else and let them sell it. So there's never going to be a lot of margin in the wholesale side. Ideally, you don't want any. You just want to manage that so you don't lose money. But we've been doing a little better than that, because some of the systems we developed have actually found ways to get more out of those cars than we anticipated. So, that's become a small sub-business.

But, our real focus is trying to get so we can retail more of those older cars and have to wholesale less of them. Because then we can make our higher margin on them, and there's quite a bit more margin in a $6000 car. If we can make $2000 on it, that's 33%. It's a hell of a lot better margin. So that's why we mention this silver used car in our press -- in our conference call here. Bryan talked about those sales being up 19%. That's those cars over 75,000 miles. We think we can do a lot more with those over time. We used to and we still do in Medford, in our mature stores. But some of the newer stores, they just never got accustomed to really marketing and selling those. We'll continue to work on that.

Okay. But if you took a whole, take a new vehicle, one could say hey, I make X amount on a new vehicle, but when I take the trade-in, I could increase the profit on the trade-in or --

In theory, yeah.

It's a big part of being a new car dealer, you're right onto something there. Every time we can trade for something that sells well, it's one we don't have to buy, and it might be one we can't buy somewhere. So it's an advantage, certainly. Which is one of the things we look at, it's one of the reasons we price a lot of these new cars real aggressively now, to get a lot more better trade-ins, and we've got a pot lot full of them right now, which is great. Because this is some of the best used car selling season coming up.

Okay. I thank you.

You bet, Dick. Nice to hear you.

Thanks, Dick.

Thank you. There are no more questions. I will now turn the floor over back to your hosts for any closing comments.

Okay. Thanks a million, everyone, again for listening. And keep watching. We're in progress, and have patience. We're going to do just fine. Thanks for calling, for listening in.

This concludes today's Lithia Motors conference call.