Penske Automotive Group Inc (PAG) 2003 Q2 法說會逐字稿

Good morning, and welcome to the United Auto Group second quarter 2003 earnings conference call. A press release which details United Auto's second quarter results was released this morning and is posted on the company's website which can be viewed at www.United Auto.com. This call is being recorded. If you have any objections, please disconnect at this time. I would now like to introduce Anthony Pordon, United Auto's Vice President of Investor Relations. Sir, please go ahead at this time.

Thank you, Stacy. Good morning, everyone. Welcome to the United Auto Group's second quarter 2003 conference call.

Joining us today are Roger Penske, Chairman, Jim Davidson, Executive Vice President Finance, and Bob O'Shaunessy, Controller.

Before we begin this morning I would like to remind you that statements made in this conference call may include forward-looking statements regarding UAG's future reportable sales and earnings growth potential. We caution you that these statements are only predictions, which are subject to risks and uncertainties, including those relating to general economic conditions, interest rate fluctuations, changes in consumer spending and other factors over which management has no control.

Our actual results may vary materially. These forward-looking statements should be evaluated together with additional information about United Auto, which is contained in UAG's filings with the Securities and Exchange Commission, including our annual report on Form 10-K.

During this call we may also be discussing certain non-GAAP financial information such as adjusted EBITDA that we believe provides useful measurement of our business. You can find a reconciliation of these amounts to get metrics in today's press release posted under the Investor Relations section of our website at www.United Auto.com.

I would now like to turn the call over to United Auto's Chairman, Roger Penske.

Thank you, Tony, and good morning everyone.

The second quarter was another outstanding quarter for UAG with record revenues and earnings per share and outstanding same store metrics. During the quarter our company delivered earnings per share of 58 cents, our best second quarter results since the Penske investment.

During the second quarter, we sold almost 69,000 new and used units, up 15.5%. Our revenues increased 18.7% to $2.2 billion and we continued to grow same store revenues.

In fact, during the second quarter, new revenue grew at 9%, used retail revenue grew at 16.9, our F&I revenue grew at 18.6, service and parts at 9.3. Our total retail revenue was up 11%. That relates to our total retail gross profit that was up 10.9.

All areas of our operations had same store retail unit sales and retail revenue growth, including our U.K. operations, which are included as part of our same store metrics for the first time. Retail revenue in the U.S. was up 10.1, and internationally, it was up 15.6 for a total of 11.0.

We continued to increase units and operations, and we believe this strategy will continue to drive the growth of our higher margin service and parts operation. I think our brand mix, as I said before, is a key differentiator for UAG.

In the second quarter '03, our domestic revenue was 23%, our foreign and luxury was 77, and taking out luxury by itself it was 44%. Our revenue broken down between U.S. and international, the U.S. was 82%, international was 18% of total revenue, which is in line with our long-term expectations and plans to be between 20 and 25%.

You can refer to the selected data sheet contained in our press release for detailed information on our brand mix. Our [INAUDIBLE] Lexus brand was the top at 22%.

Foreign and luxury nameplates continued to perform well in the U.S. market. Imports gained 1.4 market share points during the first six months.

Looking at the most notable elements of the U.S. market share change during this period we would include Honda and Acura, Toyota, Lexus, BMW, and Mercedes.

Just to make a point clear to the folks on the phone, these four brands represent approximately 55% of our business in the U.S. In fact, if we go back and take a look at our business compared to these key OEM's that have had market share increases for the first six months, Honda, Acura were up 14%, the OEM is up 12.5.

We're up 2.7 for Toyota, Lexus, the OEM is up 2.8. At BMW, we're off the charts, we're up 41.2, and BMW as the OEM is up 1.6. On the Mercedes-Benz side, same story, UAG up 6.1, the factory is up 2.9.

Now let me comment on a number of key initiatives we continue to focus on as we manage our business. Specifically, inventory levels and days supply.

We continue to manage our inventories, and our inventory levels have actually declined on a same store basis since the end of the first quarter. On a new basis we're at 56 days versus 59 at the end of Q1, and on used we're at 31 versus 33 at the end of Q1.

Moving on to wholesale losses. Taking advantage of our scale in certain markets, we've implemented closed-bid auctions in several of our UAG areas.

As a result, we've seen a significant improvement in our wholesale results. In fact, during the second quarter, our loss per unit was only $9, and that was on over 17,000 units, compared to $71 loss per unit in the first quarter and $51 loss per unit in the second quarter of '02.

Let me move on to more detail on our second quarter results. Our new retail revenues increased 17.5% to $1.3 billion, and our same store sales grew at 9%. In the U.S., our 9.3 same store new retail revenue growth is impressive when viewed against the 0.6% decline in new retail sales in the quarter ended June 30th for all markets.

Just to give you an idea what the incentive pace was during the quarter, the average domestic incentive was $3737, and the foreign incentive was $1311 per unit. The same store growth was driven by a 13.4% increase in foreign nameplates, our foreign nameplates, offset by a 2.3% decline in domestic nameplates.

This tremendous growth rate of our foreign nameplates further demonstrates the strength of our brand mix.

The second quarter, new unit sales were up 12.2% to almost 45,000, and same stores were up 4.9%.

On the used side we had a great quarter. Our revenues increased 25.6% to $487 million, and our same store increased 16.9%. On a unit basis, our sales were up 22.4 to just under 24,000 units.

During the second quarter we saw renewed strength in our used car market, represented by same store unit sales growth in all of our geographic regions. We attribute a portion of this same store growth to our focus on the sale of certified pre-owned vehicles as well as our stringent management of our used-car inventories.

And if I go back and just give you some metrics on certified used vehicle volumes on a year-to-date versus versus first six months last year, we're up 66% at BMW, 46% at Audi, 22% at Honda, 21.8% at Acura and 7.7% at Mercedes, just to give you a few of the metrics.

As of June 30th we had a 31-day supplied of used vehicles on hand and that was 2 less days than we had on hand at the end of the first quarter.

Our finance insurance business increased 21.5% in the quarter, and our same store revenue increased 18.6. Our average gross per transaction in finance was $786 versus 747 in the same period in '02. Breaking it down, new was $808 per transactions, used was 744.

Our combined finance lease penetration in the U.S. was 75% during the second quarter, 58% of which was with our OEM captive partners. Our leases represented in the quarter 24% of new vehicle financed lease transactions.

Our extended warranty penetration was 36%, 34% new and 42% used.

On the service and parts area, our revenue increased 19.3% to $230 million, and again our same store increase was 9.3%.

Our body shop revenue increased 27%, and our same store body shop increased 21.3. We're operating 21 body shops nationwide at this point.

To make our point, our service, parts, body shop performance can be attributed to our capacity expansion program, and I think on our emphasis on putting units in operation. The company expects this strategy will continue to generate same store growth.

Moving on to gross profit, it was up 18.8% to $320 million, and our gross margin was consistent with Q2 '02 at 14.2%. Same store retail gross profit increased 10.9% to $27.9 million, an 11% increased in related same store retail revenue.

On the SG&A front we had good news. Our total revenues, our SG&A was 11.1% of total revenues compared to 11.7% in the first quarter of '03. Our SG&A increased $44 million versus Q2 '02. Approximately $22 million of this was related to our acquisitions.

Interest expense for the quarter was $10.9 million, up $900,000 versus Q2 '02. This increase in interest expense in the current quarter is primarily attributable to borrowings in connection with the April acquisition of Inskip and other working capital advances.

Our weighted average borrowing rate was down slightly compared to last year. Our floor plan interest expenses in the quarter was $11.7 million versus 8.5 in '02.

The increase in expense in the current year is due to the increase in the outstanding floor plan debt and also the impact of our swaps. In fact, the company incurred $1.7 million in incremental interest costs this year as a result of our swaps.

Just to give you an update on floor plan credits, we had 8.6 in the second quarter '03 versus 8.4 a year ago, and we recorded these as a reduction of cost to sale.

Our tax rate for the quarter was 39.5%.

Moving on to the balance sheet our total inventories at end of June were $1.1 billion which includes $37 million related to the acquisition of Inskip in Warrick, Rhode Island during the second quarter. On a same store vehicle inventories compared to March 31st are down $13 million, or 1.4%.

We've been able to effectively manage our inventory levels despite a significant increase in industrywide supply. In fact, the U.S. days supply of vehicles is 64 days as of July 1st, 2003, versus 60 days as of January 1st, '03. Our new vehicle supply is 56 days.

Our days supply of inventories are improving despite the deterioration in most industry averages. In fact, in the past we've measured turns in day's supply on a trailing 12-month basis. Today to better align ourselves with the industry we'll provide our metrics based on a trailing 30-day basis.

New, we have 56 days, as I mentioned, used 31, parts 53. And if I go back to the end of the year and take December, we were at 57 on new, 36 on used, and 59 on parts. So we've made great progress you know, during the six months.

Let me quickly cover capital expenditures. Major dealership projects continue in the U.S. including our San Diego, Tysons Corner, Virginia, Turnersville, which is the Philadelphia metro.

We also several significant capital projects underway in the U.K., including our new Mercedes-Benz facility in Milton Keens and our would class BMW facility being built in Nottingham England.

Year to date CAPEX was $84 million compared to 42 in 2002. Our full year 2003 CAPEX is expected to be between 140 and $150 million gross and approximately $80 million net on a net basis.

It's interesting to note as we seek financing for all of our capital projects we're finding attractive lease rates both overseas and in the U.S. which are allowing us to lock in favorable rates over the long term.

I would like to continue to emphasize that the facilities work we are doing has allowed us to expand our industry-leading same store comps. And leaves us sufficient capacity to continue that growth I think into the foreseeable future. As we go forward, I know all retail locations will be required to conform to OEM standards.

Looking at our debt position at the end of June, our total long-term debt was $758 million. Breaking this down we have $300 million of 10-year senior subordinated debt outstanding, $420 million remain under our U.S. credit agreement, and $28 million under our U.K.credit agreement and $6 million of acquisition related debt.

We have $311 million available under our U.S. credit line as of the end of quarter. Our debt to capital ratio was 51% versus 50 at the end of the first quarter. In addition to our long-term debt we have approximately $1 billion of floor plan notes payable.

Of our $1.8 billion of total debt, approximately 48%, or $850 million is fixed, with a weighted average of 6.1%, and an average term of 6.1 years.

Let me take a minute, before I close, and just give you an update on our U.K. operations. Looking at the market in the second quarter in the U.K., it was up 1.5%, and essentially flat if you look over the first six months. This compares favorably to the market in western Europe which has declined 2.6% this year.

In the second quarter, retail revenues are up 25.9% versus last year. On a same store basis, retail revenues were up 15.3% over last year. In the U.S. our same store retail revenues were up 10.1%.

Components of the same store retail revenue increase you might want to note in the U.K. our new up 6%, used up 25, F&I up 46, and the important service and parts are up 20. We know that our business has really benefited as the OEM's re-engineer their markets under the new block exemption results.

Since our investment in Sintner in March of '02, we've been successful in adding 14 new franchises with an estimated annualized revenue of $250 million. Total consideration for these franchises, which would include working capital and goodwill, is approximately $16 million U.S. dollars.

If we look at these businesses on a mature basis and say they would earn 3%, this would calculate to a multiple of less than 3, which would include goodwill and working capital, which is certainly much better than we have here in the states. Just to give you an idea of the franchises that we've added, five Mercedes, four Toyota, two Lexus, two Premier Auto Group, and one Porsche.

With the additions of these, we are the largest Mercedes-Benz, BMW, and Chrysler Jeep dealer in the U.K. We're also the second largest retailer of PAG brands.

Before I open up and call for questions, I would just like to quickly address the adjustments to reverse improperly recorded revenue noted in our press release this morning.

During an internal audit in June of this year we identified $3.1 million of overstated revenues in our Arkansas dealerships during the 23-month period prior to March 31st, 2003. Based on a thorough review by management and our external auditors, under the direction of our audit committee, we determined the overstatement was immaterial to the company's financial statements.

As a result, as you saw this morning, we recorded a $3.1 million reduction to revenue during the second quarter, which resulted in a $1.9 million, or 5 cents per share reduction of reported net income. The individual response for this overstatement is no longer employed by the company.

In summary, you can see from the results we released this morning UAG had an excellent second quarter despite the impact of the above mentioned overstatement. All of our business continued to perform well as we grow our base of units and operation, we continue to add service capacity and strive to exceed expectations at every level.

As noted in our press release we reiterate our earnings projection for the year between $1.96 and $2.06, excluding the accounting change, and with third quarter earnings guidance of 58 to 62 cents per share. At this time I'd like to open it up for questions, and thanks for joining us this morning.

Thank you. Ladies and gentlemen, if you wish to ask a question, please press the star, then 1 on your touch-tone phone. You will hear a tone indicating that you have been placed in queue. You may remove yourself from the kau at any time by pressing the pound key. Once again, if you wish to ask a question please star 1. Our first question is Rick Nelson with Stevens, Inc.

Roger, can you provide a little more color on sitner aid its performance in the quarter versus the prior year period?

Well, basically, when you look at s tirkz tner, we've really had the opportunity to take on the same metrics that we've done over here. We're looking at inventory, we've put in a more robust finance and insurance process with a leader in that business. Our new units were up, you know, almost 2%, and used were up almost 15. And I think that, again, units in operation continue to grow the back end. We've had significant training in our sales areas. We have a CRM program, which is outstanding. In fact, we're trying -- looking at trying to replicate that over here. But basically, a number of acquisitions that have been made prior to our ownership really have made traction, and I think the good news is with the market in Mercedes being re-engineered, meaning there are now 34 dealer operators rather than 113, I think we have a much better chance to manage the individual marketers that we have under that brand. Also, we've had the luxury of picking up four Toyota businesses, which have given us a new opportunity in that high-volume brand, and certainly the Lexus brand is growing in the U.K..

Okay. And would you just maybe talk a little bit about the certified pre-owned programs? Obviously, that's becoming a big thing that's helping some of you guys with the used business. Just talk about what percentage of your used sales now are certified, pre-owned, and maybe talk about in previous quarters just to see a trend line there.

I can't give you the specific percentage, but I can tell you that it's a real focus. And a number of our brands, we're in the top three or four in certified pre-owned across the country as they rank us in the top 50 or 100. But it's the focus, because what happens is under a certified pre-owned, you get an extended warranty which is similar to the new vehicle warranty, and you also have the benefit of better finance rates.

So what's happening is, there's a real push, we would call it full circle, to get the OEM dealer to take back these vehicles that might come off lease and then turn them one more time and not have to have them go to the auctions, which only has a tendency to depress, you know, wholesale prices. So I think every manufacturer is on that program, and even on BMW, have a full circle program where anything that's on a lease, we take back at the dealership. So, you know, that's part of their MO from the standpoint of having the franchise.

So, you know, I'd love to talk to you about it maybe off-line and could give you more specific detail. I don't have the numbers here with me this morning on how many more we did this year than last, but, you know, we're up significantly the numbers that I had given you, you know, during the call, again, just to refresh your memory, BMW, we're up 66% over last year, and Audi we're up 46, just to give you two metrics.

And these are two manufacturers that are stressing, and we do get the benefit of the OEM captive finance company.

No, that's good enough. And maybe just, last question, just talk about Chauncy and maybe some of the newer project that are going up, any metrics that you can give us to show how the returns are coming in.

Let me say that we moved our Porsche business from McDowell Road out to Chauncy and we moved to number two in the country. I think we did 76 new Porsche in June, and we've averaged 65 over the last two months, it's been outstanding.

Our BMW business is up 40% on a same store business, and a lot has to do with our business at Chauncy. We're number one with VW in that market, that was a Greenfield site. And, you know, we've seen a great traction.

The other area that's really been strong is San Diego. We've doubled our Mercedes retail business in that market and have really had great traction with Lexus, Toyota and BMW. So those projects where we have the scale continue to prove that our mission is on track.

All right. And just also, I know this question comes up a lot, as far as the bottom line returns. At what point would you say, or just a general time line, would be a point where we could start expecting to see some positive returns from an overall capital deployment standpoint? Let's just say from maybe Chauncy alone?

Well, I think you're already seeing the fact that our same store sales are up. And this is not driven just by new and used, it's driven by our parts and service. And to me, we've gotten the scale now and I think we've put, our SG&A was at 11.1 this quarter, which I think shows that as we get the volume, we're pretty much stabilizing in SG&A, and that's going to drive some better bottom-line metrics. I'm looking also to see that happen. But, you know, our amortization, if you look at it, it's up I think about $5 million or up to $8 million for the quarter, and that relates to a lot of these capital expenditures.

But those are things I mentioned earlier in the call that we have to make because the manufacturers have it as part of your franchise requirement that you'll meet these standards. And I think that units in operation, strong parts and service, in fact, if you take just one metric alone, Audi in north Scottsdale is doubled our Audi business in the marketplace where we have the two locations, we've doubled our service revenue.

Good enough. Thanks a lot.

Thank you. We have a question from the line of David Siino with Gabelli and Company. Please go ahead.

David, good morning.

Good morning. Do you have an overall number year-over-year on Chauncy?

Year-over-year, I don't have it, but if you want to talk with Tony later, maybe we can get that out to everybody, because remember, we have some stores that were new franchises, like many Lincoln Mercury and Volkswagen, then we have other stores that we moved, Porsche, BMW, and Acura. So it's somewhat of a mixed bag.

Okay. And I just -- I'm just trying to understand the, looks like you had strong revenue per unit comps in both new and used but the gross margin as a percent of sales was weaker a little bit. Was that just negative mix or what was that?

I think that, you know, basically when we looked at the mix, probably contributed to that. I can't give that to you specifically.

Okay. And I guess --.

David, we'll follow up with you on that.

No problem. And I guess, lastly, could you just talk about what your advertising expense in the quarter, what the trends are there, year-over-year?

Our advertising trends are up, both in new and used and that's our net spend. That's after any credits that we would get from the OEM's. We think that now that we've got scale, we're able to, you know, impact the market with more spend on advertising, which we, were up about 5%, both new and used, during the quarter.

Great. That's what I was looking for. Thank you.

Thank you. We have a question from the line of Nate Hudson with Banc of America Securities. Please go ahead.

Good morning. Couple of specific questions. First, on the $3.1 million reversal, how was that reflected on the income statement? Was that strictly a reversal of revenue, or does that flow through costs of goods sold or SG&A?

Just a reduction in revenue.

Secondly, what was the impact of currency in the quarter, in terms of how much has it increased revenues, and specifically on the same store number you gave for Sytner, the plus 15%. Is that a constant currency number or was that helped by the strong pound?

Revenue was up $40 million based on currency in the U.K. if you looked at the U.K. numbers.

Okay. And then, last question, just an update on where you stand on acquisitions. What are you seeing out there for the rest of the year? Should we look for some more deals?

Of course, Inskip is roughly 300, 350 annualized, which we did earlier in the year. We'll be closing two BMW businesses in the U.K., based on re-engineering, we're selling one and picking up two in Q3.

And we have two Mercedes businesses which are under contract, which we expect to close on October 1st in the U.K. That will give us the whole market area around Milton Kings, North Hampton, Kettering area, for the U.K. So those are ones that we know we'll close. There are a couple of others which we're working on, but I'm not ready to disclose those at the moment. So I would see moderate activity between now and the end of the year.

All right. Thanks very much.

Sure.

Thank you. We have the question from the line of Adrian Dale with CIBC World Markets. Please go ahead.

I just have a few things. First of all, in terms of that overstatement, in saying it's immaterial, would you say that definitely means there's no impact on EBITDA?

There's no impact. Just a $3.1 million that was reduced, the revenue, so that would have been reduced EBITDA, by $3 million if it went all the way down.

All right. And then your same store acquisition target for '03, I think you had originally said that it was 300 to $600 million of revenue for the year. Is that still the same?

Yeah, I would say that we're in that range. You know, obviously, you don't get it all in the first month, so, I think if we get the $600 million, you'd probably be in the four to five hundred net if you looked at it on an annualized basis. We're well in line with what we had indicated at the beginning of the year.

And what was your rent expense for the second quarter?

Rent expense. I don't have that here, but I will call -- I'll have one of the people call you back.

Okay. Great. And then, just lastly, it looks like your debt level is increasing pretty steadily. Do you have any kind of an upper limit that you're going to try to stay below in terms of, you know, acquisitions going forward, maybe trying to use more stock rather than cash in terms of the acquisitions in order to keep that debt level down going forward?

Well, we have not, I think, gotten off our plan, which says that we'll be around 50% debt to capital. You know, we're carrying probably 30 to $40 million right now in real estate, either land or buildings, which will ultimately, you know, we would do a sell/lease back on, remember we're at $82 million and we expect to be at 80 on a net basis by the end of the year.

But, we certainly are cognizant of our debt level but feel that we're in good shape. I know if you picked up the comment where we have half of our debt is fixed with a 6.1% interest rate, with a term of 6.1 years, so, you know, we think that we're staying on our plan.

Okay. Great. Thank you.

Surely. Thank you.

Thank you. We have a question from the line of Domenic Martilotti with Bear Stearns. Please go ahead.

Domenic, good morning.

Good morning. Just want to touch on that Arkansas overstatement.

Sure.

If I understand this correctly is that you're basically not restating previous quarters because it is relatively immaterial and you're just taking an adjustment to net income and just the second quarter?

That's correct. We reviewed this with the audit committee. We reviewed it with the outside auditors, and based on SAB 99 analysis was deemed to be immaterial.

Okay. So from -- this is up from previous quarter, this was not occurring in the second quarter, so ultimately your income is higher in the second quarter, and this wasn't --.

It would have been 5 cents more per quarter, or $1.9 million after taxes

Just the second quarter.

That's correct.

And also looking at your gross margin it is down. I think you talked about the mix before. But are you seeing more pressure in local markets than just the competition amongst local dealers and trying to close sales?

You know, I'm not as concerned about the local dealers. I think that, you know, we're setting, you know, targets for sales units, and we have our inventory, so I would say that when you looked at our gross profit per transaction, we were basically up about $60 on new and down slightly on used, but, you know, that's probably because we had a lower cost of sale on our used. So, you know, per transaction, you know, it's really up.

Okay. And, lastly, just --

That information, by the way, is available, if you've got the full press release. We break out, you know, gross profit per transaction and our margin was down 2/10's versus the Q1.

Okay. Lastly, could you give a little more color on the closed-bid auctions that you're now doing for your wholesale?

Yeah. What we've decided to do, rather than sell to individual wholesalers, or even incur the expense to take vehicles to the auctions, which basically you have the registration fee, you have the transportation, you have the cleanup, et cetera, et cetera, what we're doing on a weekly basis in some of our larger markets, we'll set up 50 to 100 cars which we'll prepare and put them in an auction area at one of the dealerships, we'll notify all the wholesalers and dealers in that particular market that these cars are available. They will come in in the morning, they'll register, they'll look at the cars, and on a sealed bid they'll give us their prices.

And it's amazing what we've been able to do. In fact, the areas that have been most successful are running a wholesale profit. And this has been quite good because the buyers know where the cars are coming from, they know that it's coming out of our organization. If there's a problem with the car they buy, they bring the car back, and we give them their money back. So it's been quite powerful.

Is it largely because you have to get scale on a market to do something like that?

That's right. You can take a Phoenix market, you can take a Tulsa market, you can take an Indianapolis or Cleveland market and San Diego, and these work very well. I think the ability to do this across the country, you know, it takes time. People have their old ways, as you well know, and what we're trying to do is have a paradigm shift here to a different process.

What would you say your sell-through rate is on those closed-bid actions?

I think we're selling 90%. I know that it's way, way north of 70.

Okay. Thank you.

Thank you. We have a question from the line of Gerry Marks with Raymond James.

Good morning, Jerry.

Forgot to take it off mute. Good morning, Roger.

Good morning.

Net margin. Even if I kind of add back the $1.9 million associated with this change that or adjustment that you're doing it seemed to decline by about 7 basis points from the prior quarter. How come, with earnings growing, that your margins seem to be declining?

Well, I think one of the areas that you've got to look at, you know is our interest cost. You know, we had some swap costs during the quarter that we didn't have in the past, and those probably have affected our net line.

Okay. And with this adjustment that you've had to do, what policies and procedures have you put in place to try to make sure that this doesn't happen again?

Well, you know, obviously you know, as you look at things like this, you really have to look, you know, at our control systems. We're revising our policies and procedures, which basically will strengthen the segregation of duties. And then we made changes to our controls, which should prevent these types of activities occurring.

But I want to say that, you know, it's difficult, you know, to detect fraud. Our systems are basically to recognize GAAP in the accounting procedures, you know, within the company.

I think our internal control environment probably is pretty good, because, you know, our people found this, and this was in a large accounting office that had ten dealerships, and they were testing one dealership through a proper process and picked up a small irregularity, and then from that they moved forward and were able to detect this situation.

Interestingly enough, we have support in many cases from outside auditors who come in and do some testing for us also, and this office had been tested a year ago, maybe not this particular dealership where we found this problem, but, you know, this is something that, you know, we need to look at in the future.

You know, we're going to continue to do additional checking of our procedures. We went around and looked at other large offices after this to be sure that we didn't have the same irregularity happening. And I would say there's going to be continued work in process as we upgrade our systems, not just in Arkansas, but as we look at our systems throughout the company.

I mean, I would have to say this is a wake-up call, but, on the other hand, people are operating outside the realm of good business, you know, it's sometimes going to be hard to detect them on the spot.

Well, we appreciate you discovering it, at least.

Well, I think that bodes well for our people in that we do have a process. This was kind of a tough call to have this morning to have to bring this, you know, to the surface, but, you know, under the current environment, you know, we did everything we could. I'd say our audit committee, they even had outside counsel look over their shoulders to be sure that we had all the information, and this thing, the case was closed. So we will certainly, you know, look at our systems and our controls as we go forward.

Okay. Final question. Your new vehicle gross margins, a lot of your competitors ordered to kind of keep manufacturer relation and grow same store sales above industry averages have been putting some pressure on their new vehicle margins. You guys haven't seemed to have done that, at least to the degree where a lot are going down to maybe close to 7%. Is there some difference in terms of the accounting, or is that just maybe the brand mix, or, why do you think that is?

It's the mix all the way. Remember, when you look at it, in 77% of our business last month, the majority of that had no trunk money and no issue from a standpoint of deteriorating margins. And I think that that's the real reason. Our luxury brand, you know, had very -- or probably very little support during the quarter.

Okay. Thanks.

All right, Gerry. Thanks.

Thank you. We have the question from the line of Michael Milman with Milman Research. Please go ahead.

Good morning. Thank you. I just have two questions. One, maybe you can talk a little bit about what you think about the elasticity in the business is. In other words, you said that incentives were 37, I think, in the quarter, less on the --

Yeah, they're about 14 on the imports.

And if it becomes 4,000 or goes down to 3,000, does this have a big impact, or do these incentives tend to switch buyers from used to new? Some thoughts on that. Secondly, specifically, when you sold your ISC, you said that you were going to put it into stock. Have you done that?

Yes, I did. We spent $20 million to buy shares from JP Morgan. That answers that question.

Let me go back to the elasticity of the market. You know, there's a couple of dynamics that take place here when we talk about incentives. I think that, number one, the incentive drive is certainly being led by the Big Three, and to maintain market share. Because if you look at, over the last four years, they've had about an 8 to 10% market share decrease, and again, they've got certain fixed costs in their factories, which is, rather than have the people in jobs bank and pay them anyhow, they're better to take these dollars and try to grow their units in operation. So I think you're going to see that continue.

The one thing that hurts used with these incentives is that as you put incentives on the new vehicle it drives the residual values of the previous years down, and that really is a real detriment on the domestic side because, as you see little or no incentives on the foreign nameplates, those residuals continue to climb, so you have an imbalance there. So I think that this market share deterioration is going to have to be looked at by the domestic OEM's in order to try to not have their residuals go down.

The market is still 16 million units. And I guess when I listen to the OEM's I think it's going to be a 19 million unit market with all of the increases in new models, but basically, you know, what's happening, the market is being conditioned to deals. And I don't see them really backing off as long as the cash flow is available from the OEM's, and I don't see the market going down to 14 or 15 million. I think we've got a stable market.

And if you look at it over the last three or four years there's nothing wrong with a 16 million market. And the used, because used prices now, from a wholesale perspective, are strengthening, that seems to me to bode well that the business maybe is recovering overall, because as used car strengthen, that's going to help the residual values and should create more new vehicle sales.

More sales or just better prices?

Well, maybe better margin for the dealer, but I haven't seen that, you know, based on the statistics that have been available here in the second quarter, because what you've seen, if you read automotive news, all of the manufacturers have increased their prices 200, 300, 400, but yet they're giving it right back in incentives. That's done fairly quietly. They advertise like hell, you know, the cash available but they don't say too much about the increase in prices.

Okay. Thank you.

Sure.

Thank you. We have a question from the line of Peter Cirus with Gorilla Capital Management. Please go ahead.

First, I want to say that I was responsible for the -- some of the sales increase. I actually bought a car from you this quarter. So --

I hope it was a high margin deal.

No, no, it was definitely a high margin deal. It was a Toyota.

Okay.

The, a Land Cruiser even. As I went around and looked at your various dealers, looked at Chauncy Ranch, which, incidentally, is the best looking retail operation I've ever seen, but anyway, you're putting a lot of capital into -- it looks to me like you're putting a lot of capital into making your dealers have nicer physical plants than the competition. Let me ask first, is that a reasonable assumption?

I would say that, you know, we are trying to be best in class in the markets where we represent the brands. Also, what you don't see is -- maybe haven't seen, that we go into the back shops, we're air conditioning our shops for our mechanics, we're providing break rooms for our people, because, you know, the working environment today, if it's better than the competition, will reduce turnover, and if you look at our turnover metrics in comparison to the marketplace, we're running somewhere around 42 to 43%, and I think the industry is 80 or 90.

I actually did go into the back room, I even saw the Zamboni's at work at Chauncy Ranch. But my question is this. As you sell more new cars and invest in the sort of much nicer dealers, it seems to me that there's a back-end payback with higher rates of service over the long term. Is that a reasonable assumption? And if it is, then what does it say about your sort of continuing earnings model?

Well, number one, we can demonstrate to you every single location that we've added service capacity or enhanced the atmosphere, our service and parts gross is up.

Number two is, that these investments, you know, are for 30 years. And if we can provide a better service environment and better service to our customer, the repeat referral business is going to drive us. Longo, which a Penske Auto Group company run by my son Greg, you know, that business doesn't spend the most advertising in L.A. but they have the best repeat referral business.

And I think that these type of investments, and I've said it once, and I'll say it again, and I think our comps are validating that, this should drive service retention. And this is the highest margin business we have.

So does that mean that strong sales now should lead to better -- I'm not -- to a better stream of earnings over the next, say, five years or -- I'm not saying compared to what the analysts have, I'm not asking you to make projections, but I'm saying somehow the sales that are coming now, given the emphasis on sort of creating strong service, a strong service component, should give you a recurring revenue stream that doesn't appear in the current earnings?

That's our models. You know, units in operation, taking good care of those customers is going to drive parts and service margins, which should drive our overall bottom line. You're absolutely right.

Okay. Thanks.

We have a question from the line of David Siino with Gabelli and Company. Please go ahead.

Just a quick follow-up and sorry if you said this already. The $1.7 million in incremental expense from swaps, that was for quarter or for the year-to-date?

For the quarter.

Thank you. Thank you. Once again if you wish to ask a question, please press star 1 at this time.

And we have a follow-up from the line of Michael Milman. Please go ahead.

Michael, go ahead.

Maybe you gave this. Can you talk a little bit about following on that last series of questions, what your penetration is for parts and service and maybe you can give us some detail as to how that may differ between where you put in capital and where you haven't, and maybe also suggest how it differs by foreign luxury and domestic?

Well, I would say this, that if you looked at the service departments on the domestics, their mix of warranty versus customer labor has always been higher on the warranty side. So that's been coming down, so you're seeing some softening of the overall service business in domestics because of quality.

On the import side, most of the luxury brands, and I'm talking about BMW, I'm talking about Mercedes and Audi, they're underbayed from a standpoint across the country. They have not kept up with the number of service bays required to meet the service customer. In fact, our Audi store in Washington has a ten-day wait, and we're in the process today of adding about 15 more bays.

We did that in BMW, in Chauncy Ranch and our service business is up about 40%. So again, I think that there's a definite correlation between service bays and growing that business. And also what we're doing, too, where we don't have the ability to expand the real estate, we're going to Saturdays and even Sundays and having night service.

Can you give us some metrics so that over time we can follow the progress?

I'm not sure I can give you anything meaningful here but I will be glad to have either Jim Davidson or Tony follow-up with you and try to give you something that's meaningful.

Great. Thank you.

Thank you. And at this time there are no further questions. Please continue.

Okay. Thank you very much, and appreciate you being on our call this morning. Thank you.

Thank you. Ladies and gentlemen, that does conclude our conference for today. Thank you for your participation and for using AT&T executive teleconference. You may now disconnect.