Lithia Motors Inc (LAD) 2014 Q2 法說會逐字稿

Greetings and welcome to the Lithia Motors Incorporated second-quarter 2014 earnings conference call.

(Operator Instructions)

As a reminder this conference is being recorded. I would like to turn the conference over to your host today, Mr. John North. Thank you, sir. You may begin.

Thanks and good morning. Welcome to Lithia Motor's second-quarter 2014 earnings conference call. Before we begin, the Company wants you to know that this conference call includes forward-looking statements. Forward-looking statements are not guarantees of future performance and our actual results of operations, financial conditions and liquidity, and development of the industries in which we operate may differ materially from those made in or suggested by forward-looking statements in this call.

Examples of forward-looking statements include statements regarding expected operating results; projections for our third and fourth quarter performance; expected increases in our annual revenues related to acquisitions; our belief that the DCH Auto Group transaction will close in the fourth quarter; and anticipated available liquidity, free cash flow, and leverage after the transaction. We urge you to carefully consider this information and not place undo reliance on forward-looking statements. We undertake no duty to update our forward-looking statements, including our earnings outlook, which are made as of the date of this release.

During the call we may discuss certain non-GAAP items such as adjusted net income and diluted earnings per share from continued operations, adjusted SG&A as a percentage of revenues and gross profit and adjusted pretax margin. Non-GAAP measures do not have definitions under GAAP and may be defined differently, and not comparable to, similarly titled measures used by other companies. We caution you not to place undo reliance on such non-GAAP measures, but also to consider them with the most directly comparable GAAP measures. We believe the non-GAAP financial measures we present improve the transparency of our disclosures, provide a meaningful presentation of our results from core business operations because they exclude items not related to core business operations, and improve the period-to-period comparability of our results from core business operations.

These presentations should not be considered alternative to GAAP measures. A full reconciliation of these non-GAAP items is provided in the financial tables of today's press release. We have also posted an updated investor presentation on our website, lithiainvestorrelations.com, highlighting our second-quarter results. On the call today are Bryan DeBoer, President and CEO; Chris Holzshu, Senior Vice President and CFO; and Sid DeBoer, Executive Chairman.

At the end of our prepared remarks, we will open the call to questions. I am also available in my office after the call for any follow-up questions that you may have. With that, I will turn the call over to Bryan.

Good morning, everyone, and thank you for joining us.

Today we reported second-quarter adjusted net income from continuing operations of $35.2 million, compared to $27.4 million a year ago. We earned $1.34 per share in the first quarter, compared to $1.05 per share last year, or an increase of 28%. Our revenue exceeded $1.2 billion in the second quarter, a 21% increase over the prior year. From this point forward, all comparisons will be on a same-store basis.

For the first time in our Company's history, this quarter we saw double-digit increases in all four business lines. Total sales increased 11% and the SAAR accelerated throughout the quarter, reaching the level of $16.9 million in June, the highest level since July 2006. In the quarter, new vehicle revenues increased 12%. Our new vehicle average selling price increased 3%. Unit sales increased 9%, which was above the national average of 7%. Domestic unit sales increased 7%, compared to 6% nationally. Import sales increased 10%, compared to 7% nationally, and luxury unit sales were up 11%, in line with the national average.

Retail used vehicle revenues increased 11% in the quarter. Our retail used vehicle average selling price increased 6%. We retailed 5% more units over the prior year, resulting in our used-to-new ratio of 0.8 to 1. Our performance improved in all three used vehicle categories in the second quarter. On a unit basis, certified pre-own grew 11%; core product, or vehicles three to seven years old, increased 3%; and finally, value autos, or vehicles 80,000 miles or greater, increased 4%.

An increasing supply of late model vehicles caused our certified pre-owned segment to grow more quickly than the other categories, resulting in revenue outpacing unit growth. We sold a monthly average of 55 used vehicles per store, up from 51 units in the second quarter of 2013 and 43 units in the second quarter of 2012. Going forward, we will continue to focus our efforts to procure core product and gain ground on our 75 units per store used vehicles sales initiative. Our F&I per vehicle was $1,206 compared to $1,102 last year, or an increase of $104 per vehicle. Of the vehicles we sold in the quarter, we arranged financing on 73%, sold a service contract on 44%, and sold a life time oil product on 38%.

Our penetration rates in the service contracts and lifetime oil sales increased 140 and 40 basis points, respectively. Our service, body and parts revenue increased a record 10% over the second quarter of 2013. This was on top of last year's 7% increase over the second quarter of 2012. Customer pay work increased 10%, which is the 20th consecutive quarter of improvement. Warranty sales increased 15% which is the seventh consecutive quarter of improvement. Wholesale parts increased 8% and body shop increased 10%.

Gross profit for new vehicle retailed was $2,269 compared to $2,278 in the second quarter of 2013, or a decrease of $9 per unit. Gross profit per used vehicle retailed was $27.88 compared to $27.65 in the second quarter of 2013, or an increase of $23 per unit. In the second quarter, the blended overall gross profit per unit was $37.49 compared to $36.25 last year, or an increase of $124.

As we have previously discussed, our store personnel monitor overall gross profit per retail vehicle sale to evaluate their performance. While there has been a shift in the allocation of gross profit by business line within the vehicle sales, the overall result increases operating profits.

Our total gross margin was 15.7%, down slightly compared to 15.9% in the same period last year. Increases in vehicle sales continued to outpace our growth in service, body and parts and this mix shift explains the decline in overall margin. As of June 30th, new vehicle inventories were at $741 million, or a day supply of 71 days, a decrease of five days over a year ago. Used vehicle inventories were at $204 million, or a day supply of 60 days, an increase of 9 days from a year ago.

I would like to provide an update on the acquisition climate and current conditions within the marketplace. We continue to seek exclusive domestic and import franchises in mid-size rural markets and exclusive luxury franchises in metropolitan markets. During the quarter, we acquired Access Ford in Corpus Christi and expanded our operations in Portland, Oregon market with the acquisition of Vic Alphonso Cadillac and Braley Graham Buick GMC. Including these transactions, we have acquired or opened eight stores with estimated annual revenues of $290 million in 2014.

Additionally, in June we announced the combination of Lithia and DCH Auto Group Inc., one of the 10 largest dealer groups in the country. The 27 stores in their network are located in New Jersey, New York and Southern California. They are predominantly import brands, with 82% of their sales in Honda, Acura and Toyota, Lexus, and will generate approximately $2.3 billion in annual revenue.

Since the date of the announcement, our teams have been working diligently together to learn more about each other and solidify our plan to combine our organizations later this year. We believe the addition of Shau-wai Lam and George Liang and their seasoned team of leaders will create a powerful alliance for the future.

This team allows a second growth strategy for Lithia, unlocking stores in metropolitan markets across the United States. The end result more than doubles the number of acquisition candidates available to the combined organization. Chris will have a further update on our combined outlook in a few minutes, but we are pleased with the progress we have made and still anticipate a closing in the fourth quarter of this year.

Additionally, our core Lithia operational team continues to focus on seeking opportunities that fit within our exclusive market strategy. Our appetite for additional acquisition remains steady and we will continue on the path while maintaining our discipline on our return thresholds and strategic objectives.

With that, I will turn the call over to Chris, our CFO.

Thank you, Bryan.

As we previously discussed, we grew overall same sales 11% in the quarter. We continue to focus on increasing overall gross profit in order to leverage our cost structure. As a result, our second-quarter adjusted SG&A as a percentage of gross profit dropped 80 basis points to a record 65.2%. This improvement was primarily related to leverage in advertising expense of 70 basis points and rent and facility costs of 50 basis points.

Through-put as a percentage of each additional gross profit dollar over the prior year we retain after selling costs, and adjusted to reflect same store comparisons, was 51%. We continue to target incremental through-put of 50% in the future.

At the end of the quarter, we had $28 million in cash and $84 million available on our credit facilities. Currently $216 million of our operating real estate is unfinanced. These assets could provide up to an additional $162 million of available liquidity in 60 to 90 days. This brings our total liquidity to $274 million, and we remain comfortable with our overall level of available credit. At June 30, excluding new vehicle floor plan financing, we had $268 million in debt, of which $167 million is mortgage financing, $96 million is used vehicle financing, with the balance on a revolver.

We have no mortgages maturing until 2016. We have no high yield bonds or convertible notes outstanding. We were in compliance with the debt covenance at the end of the quarter.

Our free cash flow, as outlined in our investor presentation, was $18 million for the second quarter of 2014. Capital expenditures, which reduced this free capital figure, were $23 million for the quarter. Over the past 30 days, we have been in discussions with many of our lender partners to expand our credit facility and to obtain mortgage financing in order to position us for the integration with DCH later this year. We anticipate funding the transaction through the expansion of Lithia's existing credit facility by $600 million and by obtaining incremental mortgage financing of approximately $200 million.

As we contemplate a combined organization, we estimate our 2014 full CapEx will be $110 million. This budget is based on $30 million in lease buyouts, $30 million in new or remodeled facilities as a result of prior acquisitions, $9 million for open points granted by the manufacturer and $41 million related to facility improvements, maintenance CapEx and other business development opportunities. Based on the DCH integration, our combined CapEx estimates and full-year guidance, our 2014 free cash flow is estimated to be $97 million.

After financing the DCH combination, our year end leverage ratio will be 1.8 times net debt-to-EBITDA, excluding floor plan debt. This higher leverage ratio increasing interest on our line of credit, which is variable and adjusts monthly. Therefore we expect modestly higher interest expense in 2015 and beyond.

Our capital strategy is unchanged as we maintain a balanced approach to acquisitions, internal investment, dividends, and share repurchases. In the quarter we repurchased 30,000 shares, bringing the year-to-date repurchases to 45,000 shares at a weighted average price of $72 per share. This modest repurchase program is intended to off set dilutive effect of employee stock grants and our current authorization of 1.7 million shares remains in place for opportunistic repurchase if available. However, we will continue to maintain our strict ROE thresholds required before we commit to deploy capital in any avenue.

We have been closely monitoring the availability of credit within our customer base, as we believe it is one of the main drivers in continued recover in SAAR. Of the vehicles we financed in the second quarter, 12% were to sub-prime customers, and increase of 90 basis points over the second quarter of 2013.

Despite this improvement, this is still below the national average penetration for sub-prime at 20%. More importantly, the percentage of sub-prime customers that were able to obtain financing increased 220 basis points from the second quarter of last year to 17% of the customers who completed a credit application. While this rate improved year over year, a 17% approval rate still means 8 out of 10 sub-prime customers were declined credit.

We continue to carefully monitor registration levels in our markets to gauge our process in the economic recovery. While overall our markets are equal with 2006, and our western markets registration levels remained 7% below 2006 through April of 2014, the most recent data available. We believe this indicates market expansion that will come to fruition over the next few years as credit availability returns and unemployment levels decline.

We have updated our guidance for 2014 and project earnings of $1.36 to $1.38 per share for the third quarter of 2014. Additionally, we have provided guidance of the fourth quarter to $1.10 to $1.12 for Lithia, $0.13 to $0.14 per share for DCH and $1.23 to $1.26 per share for the combined organization, assuming an October 1 integration with DCH. As contemplated, this would increase full-year earnings to a range of $4.95 to $5 per share for 2014.

For additional assumptions and the additional color promised on last month's DCH call, I would refer you to today's press release at Lithiainvestorrelations.com. This concludes our prepared remarks. We would now like to open the call to questions. Operator?

(Operator Instructions)

Our first question comes from Steve Dyer with Craig-Hallum. Please proceed with your question.

Nice quarter.

Morning, Steve.

You guys put up such a comprehensive packet of slides that it takes away a lot of the easy ones, so thank you for that.

One question that I do have is SG&A to gross keeps working down to levels that seem hard to believe three or four years ago. After you make the DCH acquisition, would you expect those to pop back up a bit until you get the through-put there to where you want it?

Yes, Steve. This is Chris. Yes, definitely.

When you look at the opportunities that we see with the combined organization with DCH, leverage, continued leverage, is one of those things that we anticipate we're going to be working on with them. And so, as we look to Q4, and 2015, we believe that SG&A is going to go up, but our goal is to work together to leverage those expenses back down and get back to something that we're comfortable and used to longer term.

Okay. Great. And then just another quick one for me, as it relates to your used inventory. Are you happy with where that is sitting? Are you having success sort of procuring the used trade now that some of the late model kind of lease returns are starting to come back? How do you feel about that piece of the business?

Steve, this is Bryan.

I think we're up about eight days, nine days or something in relationship to where we were last year. We're comfortable with where we're at.

What is really happening is it's much easier to procure those certified and late model vehicles, and a lot of our stores, it is the path of least resistance to find those cars. We do believe that there is some training and some opportunities in really staying focused on that core product.

If you remember that core product is that 3 to 8 year-old vehicle. If you look at the bucket of the 3 to 8 year-old vehicles, or that six years of vehicle, about half of those years are sub-14 million SAAR years. They are difficult cars to find. It's something that we have known. But also now with an increasing SAAR in current vintages, it is easier to find those cars when people are trading them in and they take dollars.

So it's quite a balance to be able to keep our teams and our general manager are pretty attentive on helping their used car people and managers divest those cars that are late model and continue to try to find those core products. I think as we move forward, we will be dropping off a 10.8 million SAAR and a, what, a 12.2 SAAR, something like that, that are really those eight- and seven-year-old vehicles right now. That should help things and keep our focus back on core product and driving toward that 75 units.

Got you. Okay. Last one for me. As you look forward to additional acquisition opportunities, how would you anticipate funding those?

I think you've got a little bit left on your revolver. I think you could probably do more there. Would you do mortgages? Or just kind of general framework as to how you would think about that.

Yes, Steve. This is Chris.

As we laid out in our prepared remarks, we expect to expand our facility to $1.6 billion and, you know, take on about $200 million in mortgage financing. At the completion of that, we should have between $200 million to $250 million in liquidity, which would give us plenty of dry powder to continue to execute on acquisitions as they come up.

Okay. Sounds good. Thanks, guys.

Thanks, Steve.

Our next question comes from Gary Balter with Credit Suisse.

Andrew on for Gary. Congrats on the strong quarter.

Thanks, Andrew.

Of course. One quick question.

You guys are running so strong right now. When you evaluated the DCH Auto transaction, how did you weigh the strong opportunities ahead from the acquisition against the possibility that the company -- that this company with an entirely different operating strategy could distract you somewhat from the underlying strength you are currently seeing?

Andrew, this is Bryan.

I think as we began to meet the management team of DCH, it became pretty apparent that they run their operation and are very solid in how they do that. Their culture was very similar to ours.

So we didn't really look at it as a distraction; rather, an ability to challenge each other to do better. I think when we look at the DCH organization, we really rely that Shau-wai, who will be invited on to our Board of Directors, George and TY are really who his two field generals are, have good grasp of that organization. I think the ability to bring them in and integrate is less risk when you have the ability and a strong trust to challenge each other. I think the goals that we have established for each other are reasonable.

Understood. Congrats and good luck in Q3.

Our next question comes from Rick Nelson with Stephens Incorporated. Please proceed with your question.

Thinking about the DCH acquisition and building out our models to next year, how should we think about the SG&A to gross at DCH as it relates to Lithia?

Yes, Rick. This is Chris.

You know, what we tried to do with the guidance that we gave out in Q4 was lay out what we're comfortable kind of showing as a combined integration of the Lithia and DCH team. What we did, I think we gave some color on what we expected DCH to look like on a full-year basis down to the EPS contribution. And while we're not calling out specifics related to, EBITDA or op margin or SG&A, you can see the opportunity and the difference between the Lithia and the DCH team.

I'll tell you that there's several things that we're considering as we bring these companies together. One being a metro strategy, which typically brings in a lower net margin, as well as the time it's going to take for integration. And so as we think about the things that we have gone through with Lithia over the years and the improvements we have found, as we apply those to the DCH organization and work with their team, we know there's opportunity there and work towards it.

It's not something that is going to happen in a quarter or in a year. It's going to be something that's transformational that takes 3 to 5 years to fully integrate.

Thanks for that color. Also as a follow-up, I was looking at your updated PowerPoint on page 18 where you talk about the integration results for the 2010 acquisitions and the 2011 acquisitions. Just how pretty meaningful margin expansion for those stores acquired in 2010. Still meaningful for the 2011 group but below the 2010 acquisitions.

If you could comment there on what the operating margin for the 2011 lags on the 2010 and Lithia's own operating margin.

Rick, this is Bryan.

I think any time you have an acquisition, there's integration differences. There's people changes that come and it appears that 2011 is just a little slower than what it was.

It could be franchise mix to some extent of what we purchased. But we don't foresee any serious issues there and believe that it's just opportunity that's still sitting there.

Rick, the one thing that I will say is that every single one of the acquisitions that we've done are at or exceeding our initial hurdle rates that we set when we set our capital deployment up on that acquisition. Overall, we feel very good about the acquisitions that we purchased since 2010 and we know that, yes, there's a few opportunities in certain stores but we're exceeding the hurdle rates that we laid out in front of us back then.

Great. Thanks a lot, and good luck.

Thanks, Rick.

Our next question comes from Scott Stember with Sidoti & Company.

Good morning.

Hey, Scott.

Can you maybe talk about brand mix or how the brands performed on the new side within the quarter? You already gave out by luxury, domestic and foreign imports. Just talk about maybe by brand specific?

Hi, Scott. They're scrambling.

Scott, we're just pulling the notes that we have. Revenue for domestics were up 13%.

Right.

Imports were up 10%. Luxury was up 12% as we laid out in the call. Maybe (multiple speakers) be more specific on any individual franchise.

If there was any brand that stood out, good or negative.

Yes. I mean, we had several brands that were up double digits. Chrysler, GM our strong domestic franchises continue to be above double-digit growth.

Subaru was up 38% -- sorry, Hyundai was up 38%. Subaru was up 18%. There's some highlights there. Kia was up substantially, but remember it's actually only one store in here.

Okay.

So there were some hot spots. But like Chris said, Chrysler, General Motors both double digits, Ford double digits.

Okay. Got you.

And on the used gross margin down 80 basis points the second quarter to 90 in the second half of the year, is that simply a mix shift towards the CPOs away from the growth that you had saw the last couple of years in the value side?

This is Bryan.

Good work, Scott. You got it exactly. The RSPs are up a little bit and it's primarily the certified cars and they bring about the same amount of gross per deal, and obviously at a higher cost.

Okay. And on the customer pay side, on the parts and service customer pay, it continues to go up. Is this just further evidence of the benefit of increased UIOs? Is there anything else to it? Is there anything that you're doing at the store level that is helping that along?

This is Bryan again. I would say there is definitely a tail wind when it comes to UIO.

Remember we've also installed our idea of commodity sales where we're more of that one-stop shopping experience. We're seeing the benefits of that, and obviously they're outpacing a little bit so we really believe that our markets may perform a little differently. We're able to capture that warranty work at a little higher retention rate and we really believe that can continue because, just like I discussed in UIO, if you look at our core product, it's that 3 to 8 year-old vehicle.

That's kind of the heart of our off-warranty business and in our service departments as well. We still have three of those six years that are below a 14 million SAAR. As that continues to grow, it's imperative that our teams are open eared when our customers are coming in and trying to meet all of the needs that they really desire.

Got you. Last question. Can you talk about what you guys have seen in July so far at the store level?

We're on track, Scott.

Okay. That's all I have. Thank you.

Thanks.

Our next question comes from John Murphy with Bank of America. Please proceed with your question.

Good morning, guys.

Just a question on [MA] financing. The one piece of currency that you have not mentioned as a potential source to do deals is your stock. I'm just curious if you have considered that in DCH acquisition? And also pretty importantly, there's one of your public peers is trading at a pretty extreme discount to you that seems like they need so help executing, and your stock for their stock would be a very accretive deal.

I'm just curious if you thought about that as a currency or even thought about more, bigger, larger acquisitions out there?

This is Chris.

We definitely continue to look at optimizing the capital structure that we have and leveraging our ability one, to take on debt, and two, to leverage our stock. The other access that we have not tapped was the bond and debt markets. We continue to look at our capital structure.

Our goal is to maximize our borrowings, obviously at the lowest possible cost, and right now we feel comfortable that -- for the acquisitions we're doing, expanding our facility, continuing to take on -- or use the free cash flow that we're generating in excess of $100 million a year is what is prudent. But if and when a larger acquisition comes to market, we understand that we have currency with the stock that we have and we will use it when the time is right.

And assuming financing is really not that big a hurdle because it doesn't seem like that's a hurdle right now, operationally, in execution and swallowing another large acquisition maybe of the size of DCH or maybe something even a bit bigger, do you think you have the team in place that can handle that, or is that something that might -- you might have to hit pause on doing something that large again because there's a lot of integrations going on with DCH already?

John, this is Bryan.

Albeit that we believe that we have a good humble yet competent team, I think that it's fair to say that we have some work in front of us. We need to focus on the DCH program.

But we also never rule out other opportunities, and I think if it's a larger type of transaction, I think we will cross that bridge when we come to it. And I think in Q1, Q2 we can probably give you more color as the DCH and the Lithia teams begin to grow together.

Okay. Then just on parts and service, you're having great same-store sales comps there which are, I'm sure, a focus of yours. But it also seems like we're finally seeing a benefit of the consolidation in the Chrysler GM dealership -- GM and Ford dealerships and you're seeing more UIOs come through your smaller base of dealerships.

Have you done any studies or could you illustrate to us the benefit that you're getting from a lot of those store closures, particularly on parts and service and ultimately on the new vehicle sales in the future?

John, this is Bryan.

I don't know that we're seeing benefits of store closures. A lot of the store closures occurred in metropolitan areas. Remember, we're single-point market so there may have been a franchise or two.

The benefit that we're seeing is really the growing UIO base and in our ability to attract through better customer service by providing a lower cost product and a quicker time of -- in our dealerships. I think outside of that, we need to just keep our head down and stay focused on that and we will be capturing a lot of that UIO that's -- really, the bulk of it is still not even been tapped.

Okay. And then on the online investment that a lot of your peers are making, or investment online, potentially taking the consumer through the full transaction through an online process. There are some companies that seem like they're almost betting the farm, literally, on that investment. Yet you guys really aren't highlighting that as a big drag on investment and that's sort of a huge focus.

Is that the kind of thing you're working on in the background and you feel like you can do on an ongoing basis and don't need to run a big tear-up like your competitors are? I'm just kind of curious how you're thinking about that.

I think you've got it. Remember, we're an entrepreneurial-based model.

We really are focused on allowing our stores to make those decisions and test those within individual markets. What we will find is that each of them are growing at a fast rate and they're able to meet the needs of -- in home with our stores, much like our Reno Subaru store. It probably has an 800 to 1,000 mile radius of who they touch. They do those type of things online and in the dealership.

And I think anything to help speed up the customer process is beneficial. But we are an entrepreneurial-based model. We do focus on some of those things at corporate but we really believe that that innovation and that change starts at the ground level with the demand coming straight from our consumers.

Lastly on sub-prime, you guys cited that you were at 12% of your sales were sub-prime. Is that new and used? And also the figure that you quoted of 20% of all vehicles sales being sub prime, was that new and used? Because my understanding is that new is significantly higher -- I mean lower than that and used is a bit higher than that.

Yes, John. This is Chris. And it is new and used on both.

Okay. Do you have a figure for just new vehicle sales roughly?

No. We don't break that out separately, no.

Okay. Thank you very much.

It is lower, though, John. You are right.

Our next question comes from Bret Jordan with BB&T Capital Markets. Please proceed with your question.

Good morning. A couple quick questions.

One of them, I guess, we look at parts and service and it being higher than peers and higher than expected. Are you getting much attachment from the recall that you're bringing cars in for the ignition switch and selling a brake job? Is there some near-term correlation to what has been historic high recall?

Absolutely there is attachment, especially when it comes to the older product like the General Motors product that is as old as seven, eight years old. We are seeing in Chrysler about a 40% increase in our warranty business. General Motors was 34.3%. Toyota and Ford and some of those were even pretty high. That ability to upsell and hopefully --

The big thing is can you do it in an expedient matter. They're so used to it. They haven't been in the dealership in 5 to 7 years, sitting around for two, three, four hours and these are 0.2, 0.3, 0.4 flat rate hours and it's a very quick service and now we have to show that we can do that.

We are getting some attachment. Another point to make, our 10.4% S&P same-store sales growth also does not include used vehicle recon.

Okay. And then a question on the finance side -- or I guess the transaction side. Do you have a feeling for lease penetration relative to your new unit volumes in the quarter? I guess how you stack up relative to industry average, it seems like maybe your regional and product mix might underindex the leasing. Is that -- is there upside (multiple speakers).

Yes, this is Bryan again.

So you just touched on one of the big opportunities our Company has, much like our 75 unit per store in used. We only lease at 6% to 7% of our new car population.

This is something that we really believe that the DCH organization and their team can help teach us, because they lease in the high 30s and low 40 percentile in their stores. So this is an opportunity for Lithia and it may be additional volume that has been uncaptured because of our, to some extent, ineffectiveness when it comes to leasing.

Okay. Great. Thank you.

Thanks, Brett.

Our next question comes from James Albertine with Stifel Nicolaus. Please proceed with your question.

Thanks and good morning. First, I apologize if there's a bad connection here. I'm just going to ask my questions real quickly if I can in the event that I maybe lose you by accident.

On parts and service, really want to touch on a few things, gross margins, as well what we're hearing across the sector it seems with respect to capacity constraints. First on gross margin, how should we think about -- and understanding if we don't have internal recon flow through your P&S business. How should we think about it for the back half of this year based on the recall work you're seeing, the [UIO] influx that you're seeing and so on and so forth?

And separately, capacity constraints, I would imagine that's the biggest SG&A item for your parts and service business. Given that a lot of dealers are looking for more technicians, are there implications to your SG&A to gross or your through-put in general that we need to consider for the back half? Thanks so much.

Okay. Jamie, that's a lot of questions. We will try to answer all of those together here.

So the first one, related to parts and service gross margin, we did guide the full year. I think one of the sensitivities that we run into with guidance on parts and service is warranty comes second to customer pay and the gross margin contribution. So if warranty is outpacing customer pay, there's a slight headwind there as far as gross margins are concerned. Both of those threw up 10% and 15% respectively in the quarter, far out pace whole sale parts in the body shop business. So I'll answer that question.

And then the second question related to SG&A? You know, when you look at sales versus parts and service, the parts and service business generates about a 60% through-put versus sales, which is just slightly below 50%.

So obviously there is a benefit for through-put there in the service department. And yes, we do have a lot of initiatives right now to find techs. Our tech count is up about 11% year over year. That's an opportunity for us. But I think ultimately if we can get techs in the shops generating that CP and warranty work, that's a tail wind that we're going to have.

As far as capacity, Bryan, do you want to take that? Or Sid?

No, it's just -- this is Sid. Hi.

When you think about the tech pool out there, it's huge. And if we can have a better place to work with more opportunity, with a good stable plan for health and benefits, which Lithia has, I think we can access that pool that is out there without really growing our own techs. So I think we can solve the tech shortage better than some others, maybe. That's one advantage of our size and our credit, our reputation as a great employer.

It's the same thing with general managers, it's the same thing with salespeople. If we can have a better place to work, we can grow.

Because there's a huge pool of people out there in the private -- we're still as a group, what, 10% of sales of public companies. And we probably are a better place to work. So that can really be a tail wind for us. So that's kind of the view on that.

Jamie, did we answer your capacity question? Do you want me to give color on that.

I think additional color is always welcome. Thank you so much.

In terms of capacity -- this is Bryan, by the way. We currently utilize about 55% to 60% of our existing shop space with our current business. That's also without expanding our hours. Okay?

So we have lots of head room for growth when it comes to our facility. The exciting thing is DCH also has spent considerable dollars over the last couple of years expanding their facilities, so they actually have head space as well to be able to handle that incoming UIOs that we're all so anxious to be able to bring into our dealerships.

Thanks for the comprehensive answer and good luck in the back half of this year.

Thanks, Jamie.

Our next question comes from Ravi Shanker with Morgan Stanley. Please proceed with your question.

Good morning, guys. A question on F&I per unit.

You guys are one of the few dealers, one of the only dealers [that we have seen] so far to report improving sequential F&I per unit. It went up a nice chunk. How much of that has to do with some of the initiatives you've put in place with pricing and where do you think that can go in the next few quarters?

Ravi, this is Chris.

You know, specifically on how much we relate it to pricing, we had a price increase. We didn't disclose what that was on our fixed price F&I products. Unlike most dealers, we don't negotiate on the price of our F&I products. We actually negotiate term and deductible. So yes, there's a benefit there. I don't think it covered the difference between what we saw last year.

What we really noticed was the penetration, both for service contracts, lifetime oil and our GAP products are improving. Service products were up, what was it, 120 basis points and lifetime oil was up 130 basis points. Those products are great not just for generating F& I profits, but also for retention back into the service drives. We think those products have been key to us and have allowed us to see the last two quarters some really strong parts and service comps.

Where can it go? When you compare us to our public peer group, we know we're on the bottom end of that. We make about $300 less in a used vehicle F&I business than we do in new vehicle F&I business. Our used-to-new ratio, which is somewhat stronger affects that, but there is definitely opportunity there.

Like everything that we do, we have a list of 20, 25 stores that we're focused in on that have opportunity and we're working to improve overall F&I PVR in those stores that will bring up the $1,200 hopefully to $1,250 and $1,300 and it's something we're actively working on.

Understood. A couple of questions on DCH. How do we think of the seasonality of the business compared to yours given the different geographic and brand mix?

Hey, Ravi. This is Bryan.

So remember some of it is in the northeast, which is pretty seasonal. And there's obviously LA, which is not quite so seasonal. I think if you compared it to how Lithia is, it appears very similar to how we respond to the seasons quarterly.

Okay. I will probably follow up with John on that, too. One just more question on DCH.

This is obviously one of the biggest deals the industry has seen in a long time. Have you seen this kind of open the doors, if you will, either for other dealers to try -- other privates to try to sell or some of the publics try to respond to your action by doing something similar?

Ravi, this is Bryan again.

I don't know what the appetite is and I don't know what the mentality is of all dealers across the country. We have been in discussions with other dealer groups, and it's a matter of whether it's the right timing for their succession planning or for their, to some extent, for their pocket book. I think what it may show is that the ability to do this is out there. I think that's fair to say.

And it may spark some interest in other groups to look at exit strategies, or in this case, look at partnership type of strategies. And I think when you look at Lithia and you look at the ability for us to allow dealerships and groups to operate as entrepreneurs as they always have, we believe it's a pretty important part of the acquisition formula as to who are the suitors that they choose.

Great.

(Multiple speakers) Ravi, our entrepreneurial focus at the store level, store by store, really allows something like this, maybe better than somebody who is trying to control everything that happens at a store.

Understood. Yes. We certainly think that's one of the best qualities of Lithia. I certainly believe that.

Great, Ravi. Thanks.

Thanks, guys. Bye.

(Operator Instructions)

Our next question comes from Brett Hoselton from KeyBanc. Please proceed with your question.

Good morning, gentlemen.

Hey, Brett.

I kind of wanted to talk about debt capacity and M&A for a bit. If I understand you correctly, you're saying we have got, give or take, around $274 million of available capacity at this point in time.

If I take the DCH acquisition, if it met your return on equity criteria, you have a couple different ideas in there. You have one, this 20% idea and then you've got the 75% to 100% return over five years. If I just take the 20% idea, I take $0.70 accretion, I get $19 million in after tax on your current share account.

20% return on equity suggests that you're paying $93 million in equity, let's just, say net versus price. I'm kind of guessing that number is probably low. I'm thinking you're probably paying more than that, net.

But then I look at the $274 million capacity. I knock off $100 million for net purchase price. It gives me $174 million left of capacity.

Can you kind of talk -- I ran through a lot of numbers there. I know you know them pretty well, Chris. Can you talk through where I might be overly optimistic, less optimistic, where I'm wrong, what adjustments I want to make to get that math?

I think you did run through a lot of numbers there and I know that you have done a lot on this model. And I think when we get into the detail of this, maybe we take some of these off line.

I will say that what we have laid out as far as guidance is no different than the guidance we lay out for our Company. We look at current trends and look at current trends that we're seeing and we roll those forward into our forecast. And, yes, there's upside there.

We're working diligently with George and his team to identify where that upside is and where the markets may improve and the things we can leverage together to generate a five-year return that meets our hurdle rates. And yes, we paid more than $93 million, obviously, for the DCH group.

I think that's probably loosely what we're going to share. John might be able to provide you a little more color, you know, on the specifics related to the guidance that we laid out. But at this point in time, our goal is to continue to work to integrate with DCH, focus on the transaction and then, over time, provide more color longer term.

I guess what I'm kind of driving at is not necessarily how much money you're going to make at DCH or how accretive it is and so forth. I guess what I'm asking is if I've got $274 million capacity after the DCH acquisition, give or take, roughly how much do I have left. I'm thinking if you paid in the, I'm guessing, $150 million for DCH net, that leaves you with, give or take, $150 million of additional capacity left, net of the DCH acquisition. Am I even in the park, or am I way off?

Brett, I think what we have been able to share is that after the DCH acquisition, we will have about $200 million of availability. If you go back to our standards formulas on how we purchase, it's usually 10% to 20% of revenue, which gives us the ability to purchase, what, $2 billion to $3 billion dollars in revenue? Sorry, $1 billion to $2 billion in revenue. Freudian slip. (laughter)

There is still headroom, even after DCH. We believe there will be opportunities maintaining the strict disciplines in ROE thresholds that we have established over the last half a decade or so.

We do have capacity -- this is Sid -- to do sub debt as well. It's not been ever tapped in the last 15 years, 10 years with us. It's always out there.

It also sounds like, based on your answer to an earlier question, that you might be willing to tap the equity markets as well, if the right opportunity came along. Is that a fair statement?

That's fair, Brett. At some point we would do that if the timing was right.

As I look at the list of dealers out there, based on what I can see, for example, Automotive News, there's probably another, I don't know, I think I counted 30 or 40 dealers that do $1 billion dollars in sales. There's clearly not an infinite amount, but there's a lot.

So generally speaking, what do you think the possibility of doing another large acquisition might be? Is there anybody out there that you're talking to that has $1 billion dollars in sales, or is it just like -- look, the DCH was really unique. I kind of don't think that's likely to happen here in the future.

Brett, this is Bryan.

If you recall, we looked at a number of different groups. It is unique that the management teams of both organizations, being that we have known each other in different parts for a number of years and the way that we were able to quickly be able to get on the same page in terms of what are we trying to accomplish? How do we go to market? What are we expecting with our consumers? How do we grow our internal employees and teams?

It was pretty natural. And I don't think that any of the discussions we have had with other groups were quite as natural as that. I think that's why it so clearly made it that the DCH team will meet the Lithia metropolitan strategy. I think if we look past that, what we really look to is how is DCH's ability to possibly integrate a group of metropolitan stores?

We have a good grasp for Lithia, in terms of who are the groups that are in those exclusive type of markets, of which there are only 10 or 11 in the country. There's a pretty limited number of groups, but we believe we have a good pulse on those. We believe that there is still opportunity to do other deals like that. But I think for the time being, the fit with DCH is just so nice that it will be hard to look at other ones.

Excellent. Well done in the quarter, guys.

Thanks, Brett.

Thanks, Brett.

Our next question comes from David Whiston with Morningstar. Please proceed with your question.

Thanks, good morning. First, for Chris on the debt-to-EBITDA ratio. Should we assume -- I believe at you DCH press release you talked about 2.5. Should we assume that's a ceiling and you would not want to go above that?

I don't know if that's a ceiling. It depends on what the acquisition market looks like and what else is going on in the business. I would call out that, that 2.5 times does not include any integration of the EBITDA from the DCH group.

So as we stated on the prepared remarks, if you include what our expectations are on a EBITDA basis for 2015, we believe that number is somewhere at 1.8 times. We're very comfortable there and we have plenty of room and capacity to continue to take on debt to take on more deals or other expansion as it comes up.

Okay. Thanks. That's helpful.

And then on -- for future acquisitions, on the brand side between domestic and import premium luxury, is there any one of those three segments you want to skew towards more going forward?

David, this is Bryan. I think when we look forward, the DCH transaction balances our portfolio nicely. We will have three major brands, Honda, Toyota, and Chrysler, with about 25%, 21% and 18% of our mix, respectively.

I think going forward, it gives us the ability to put everyone on a balanced scorecard to some extent and not have any real attraction to anyone. But more the attraction to what we believe their 5 year and 10 year ROE and returns are, which allows us to be a little bit more open minded and a little more strong in terms of different areas such as a Chrysler or a General Motors that we really were pretty heavily weighed in previous to the DCH transaction.

Okay. And I want to go back to the earlier question on leasing. DCH is in the high 30%s, but they have a lot of luxury customers, too. So it's probably not realistic to assume that Lithia can get up in the high 30%s, right?

David, this is Bryan again.

Remember, 82% of their business is Honda, Toyota. However there is Lexus and Acura in that. But the majority is Honda, Toyota which is mainstream franchises much like us.

Now, it is fair to say that the domestics do not have a strong leasing presence, even in metropolitan areas. It's unrealistic to say that we're going to get 35% or 38%. I think it is realistic to say that there is an opportunity in the 20 percentile range and some of our stores in these type of markets, even in domestic stores, are able to accomplish those numbers.

I think it's a matter of teams understanding that all consumers are different, that all consumers financial needs and trading patterns are different, and that we need to provide different alternatives to each and every customer. I think you nailed it pretty good. It is probably not going to be 35%, but it can be somewhere north of 6% to 7%.

Okay. And just one more.

I believe in May, you sold Mercedes Benz of Wilsonville. I was surprised you would want to move away from the Mercedes franchise. Is there something very specific to that store that prompted the sale?

Good question, David. That was agreed to when we purchased the Rasmusson deal in 2010. And when we added the point in Beaverton, Mercedes requested that we didn't control the entire market and that we had a competitor and we had the right to choose one of the three stores to divest, and we chose to divest Wilsonville.

Thanks, guys.

There are no further questions in queue at this time. I would like to turn the call back over to management for closing comments.

Thanks for joining us today. We look forward to giving you updates again in October.

Thank you. This does conclude today's teleconference. You may disconnect your lines at this time and thank you for your participation.