Sonic Automotive Inc (SAH) 2004 Q2 法說會逐字稿

Good afternoon, ladies and gentlemen and welcome to the Sonic Automotive second quarter earnings conference call. All lines have been placed on mute to revent any background noise. After the speaker's remarks there will be a question-and-answer period. If you would like to ask a question during that time, simply press star then the number 1 on your telephone keypad.

If you would like to withdraw your question, press star then the number 2. Should anyone need assistance at any time during this conference, please press star then 0 and an operator will assist you. As a reminder, ladies and gentlemen, this call is being recorded today, July 27, 2004. At this time, I would like to refer to the Safe Harbor statement under the Private Securities Litigation Reform Act of 1995.

During this conference call, management may discuss financial projections, information or expectations about the company's products or markets or otherwise make statements about the future. Such statements are forward-looking and are subject to a number of risks and uncertainties that could cause actual results to differ materially from the statements made. These risks and uncertainties are detailed in the Company's filings with the Securities & Exchange Commission. Thank you.

I would now like to introduce Mr. Jeff Rachor, President and Chief Operating Officer of Sonic Automotive. Mr. Rocher, you may begin the conference.

Good morning, ladies and gentlemen. Welcome to Sonic Automotive's second quarter 2004 earnings call. Joining me today is the Company's Executive Vice President and Chief Financial Officer, Mr. Lee Wyatt. I will begin the call by reviewing overall second quarter performance, industry trends, and an update on strategy. Then I will turn the call over to Mr. Wyatt to cover our financial information in more detail.

The company's revised strategy that was communicated on our fourth quarter earnings call earlier this year was successfully executed for the second consecutive quarter. This execution yielded a second quarter earnings per share of 73 cents from continuing operations, up from 68 cents in the second quarter of 2003 despite a more challenging industry environment. Through the first two quarters of 2004, total earnings per share were $1.25 versus $1.14 in 2003 from continuing operations.

At this time, I wish to reaffirm our full year 2004 guidance of $2.65 to $2.80 per share from continuing operations. based on a 16.5 million unit [SAR]. Total company SG&A, as a percentage of gross profit, was 76.5% for the quarter, beating our previously communicated target of 77%, and down from 77.4% in the second quarter of 2003. We have now closed on all previously announced acquisitions and have no additional acquisition closings planned for the remainder of 2004.

During the second quarter, we closed wave one of the previously announced Houston Luxury Platform. This group of dealerships included Momentum Jaguar, Porsche, Audi, Volkswagen, Land Rover, and Advantage Porsche, Audi and Nissan. I'm pleased to report a smooth integration of these dealerships with 100% of local dealership level management retained.

Earlier this month, we closed wave two of the Houston acquisition, welcoming Momentum BMW and BMW West to the Sonic family of dealerships. Once again, the integration process is shaping up nicely as local dealership management has been retained. The pro forma revenue run rate of the combined Houston acquisition is approximately 600 million annually, bringing our total revenue run rate for completed 2004 acquisitions to approximately 700 million annually.

While no acquisition activity is scheduled to close for the remainder of the year, we are continuing to refine our acquisition process to maintain strategic discipline to focus on premium and Asian import brands to drive higher margin revenue. We remain committed to a manageable growth rate of no more than 10% of revenue for 2005.

It is important to note that Sonic Automotive second quarter performance confirms the validity and continued execution of our revised strategy to slow our acquisition pace to allow the Company to focus on our core operations. In early 2004, management identified some key operating objectives to hold ourselves accountable, including improved new vehicle margins and better accountable including improved new vehicle margins and better control of SG&A.

Sonic Automotive has now delivered on these objectives for two consecutive quarters. This modified profitability model proved timely, dampening the effects of additional volume pressures from a difficult industry environment. By now, the capital markets are well aware of the challenging market dynamics the industry faced in the second quarter. A volatile new vehicle market was led by a 15.4 million unit SAR in June , the lowest since August 1998.

The preowned market continued to enjoy a strong wholesale pricing market as a result of a short supply of off-lease and fleet vehicles. Hence, the retail used car arena was further pressured by huge, new vehicle incentives, making the price payment differential unattractive to the used car buyer.

Now, I would like to review same store performance by segment. New vehicle revenue was down 5.4% versus Q2 of 2003. However, new vehicle gross margin increased to 7.4%, versus 7.1% in the second quarter of '03. In addition to the difficult industry phenomena, internal factors that contributed to our new car trend included a conscious decision to prioritize margin and variable expense control over absolute volume.

In addition, you will remember that last year we were executing a strategy that centered on new vehicle volume and taking market share creating tough comps, especially in many of our import stores. Weather in some key markets such as Texas, which represents over 22% of total revenues, also impacted volume.

Finally, we had the many new dealer operators and regional vice presidents that are continuing to season in their new roles. Used vehicle same store sales were down 12.5% versus Q2 of 2003. Used vehicle gross margin held up, increasing to 10.5% versus 10.4% in the second quarter of 2003. Our certified, preowned initiative has become an imbedded practice in the organization and despite a short supply of certifiable vehicles, CPO made up 31% of Sonic's total used vehicle volume versus 27% in the second quarter of 2003.

We continue to develop the lower cost of sale business segment, supported by strong, sub-prime lending relationships, but have not fully achieved our goals in this phase due to difficulty sourcing inventory. We continue to believe that manufactured, certified preowned and the lower-end segment represent the greatest growth potential for our used car business.

After eleven quarters of strong, compounded, same-store sales improvement, fixed operations revenue was virtually flat for the quarter. The company's service revenue increased 1.2% versus Q2 of 2003. Service gross margin was 68.9% versus 69.3% in 2003. But service customer pace sales increased 2% versus second quarter of '03, while warranty sales increased 4.2% versus Q2 of '03. Internal and sublet were down slightly as a result of vehicle sales volume.

Total same-store parts sales were down 1.9% versus Q2 2003, while parts gross margin was up 53 basis points to 33.2% versus the same quarter a year ago. Customer pay and warranty experienced increases of 2.6 and 6.3%, respectively, versus the second quarter of 2003, with declines coming from internal and concentrated wholesale operations.

Due to our commitment to manufacture certified preowned programs, increased extended service contract sales, and standard service drive processes, I am pleased to report an all-time record fixed absorption of 82.4%. In addition, our facility investment program will continue to add service capacity to accommodate anticipated demand.

We are in the process of adding 139 productive service stalls this year with an additional 255 in the planning stages for future development. Finally, Sonic Automotive continues to differentiate ourselves as an industry leader in customer satisfaction, cultivating owner retention and strong manufacturer support. During the quarter, our strongest performing regions were Alabama, Tennessee, Georgia, the Carolinas, the Midwest, the mid-Atlantic, and Northern California. Our weaker regions were Texas, Oklahoma, Denver, Florida, and Southern California.

In terms of total revenue, our strongest brands were General Motors at 25.7% of revenue, BMW at 12.3%, Honda at 12.2%, Toyota at 10.7%, and Ford at 10%. The luxury and premium import brands continue to outperform Sonic Automotive. At the end of June , total new vehicle inventory was at a 60-day supply. We are comfortable at these levels, which are still far below the industry average.

At these inventory levels we feel we are well-positioned to take advantage of the strong selling months ahead, and have consciously managed a discipline buildup of inventory to avoid the shortages that hurt performance a year ago. We are working collaboratively with our manufacture partners on new car inventory planning to achieve our mutual goal of optimizing inventory turn. Used car inventories are at 41-day supply, a tick high based on a weak June, but we will quickly manage those to historical standards.

In closing, I wish to review Sonic Automotive's progress in executing the strategic shift communicated earlier this year. One, we have slowed the acquisition pace to allow focus on improving core operations. While we are encouraged with the results so far, there is much work ahead. Two, we have closed the previously announced acquisition of the Momentum Group in Houston. Three, we have upgraded and stabilized key management; this is on-going. Four, we have improved operating performance from our discontinued operations. Five, we beat our SG&A target of 77% through consistent control of variable expenses and are comfortable with our targets for the remainder of the year. Six, we remain committed to reducing our net debt-to-total-capital ratio to 40% as a long-term target.

Sonic Automotive management will continue the disciplined execution of our strategy to the remainder of 2004 while enhancing revenue growth through the on-going development of key personnel and the implementation of standardized processes. On July 15th, we paid our fourth consecutive dividend of 10 cents per share. As a result of our annual review of the dividend rate, I am pleased to confirm Sonic Automotive's quarterly dividend increase to 12 cents, payable on October 15th.

We continue to believe that Sonic's dividend program brings value to both the company and our shareholders. Finally, I would like to close my comments by expressing my appreciation to Sonic Automotive's 11,500 associates for their dedication and extra effort in executing our strategy during a difficult business cycle.

At this time, I will turn the call over to Mr. Lee Wyatt to review the second quarter financial information in greater detail. Lee?

Thank you, Jeff. Earnings per share from continuing operations in the second quarter of 2004 were 73 cents, an increase of 5 cents compared to 68 cents in the second quarter of last year. Earnings per share from discontinued operations in the second quarter was a loss of 3 cents compared to break-even in the second quarter of last year. Net earnings per share was 70 cents in the second quarter of this year, compared to 68 cents last year. Earnings per share from continuing operations for the first six months of 2004 was $1.25, an increase of 11 cents compared to $1.14 last year.

Earnings per share from discontinued operations for the first six months of 2004 was a loss of 3 cents, compared to a loss of 4 cents last year. Net earnings per share was $1.23 in the first six months of 2004 compared to 96 cents last year. Net earnings per share in the first quarter of last year included a one-time charge of 14 cents for the adoption of EITF 0216, related to the accounting for vender rebates and incentives.

In reviewing the second quarter in more detail, revenues grew $53.9 million, or 3 %; new vehicle revenue grew 2.3%; used vehicle revenue grew 2.5%; parts, service, and collision revenue grew 8.9%; F&I revenue declined 5.6%. The overall gross margin rate for the second quarter was 15.5%, a 30 basis point increase from 15.2% last year. New vehicle gross margin was 7.5%, a 40 basis point increase over last year. Used vehicle retail gross margin was 10.3%, the same rate as last year.

The parts, service, and collision gross margin rate continued to grow as it increased 50 basis points from last year to 48.8% . On our fourth quarter 2003 conference call, we established the following targets for SG&A in 2004 as percent of gross profit, as a means to hold ourselves accountable for addressing controllable expenses. Those targets were: the first quarter of 2004, 80%; the second quarter, 77%; the third quarter, 77%; the fourth quarter, 78%, and for the entire year of 2005, 76.5%.

In the first quarter, we met our target of 80% and reduced the rate 110 basis points from 2003. In the second quarter our SG&A rate was 76.5%. We performed better than our target of 77% and reduced the rate 90 basis points from 2003. The SG&A improvement is primarily the result of controlling our spending on advertising and selling expenses. The reduced spending rate for these expenses saved approximately $5 million for the quarter over last year.

In addition, we are realizing the benefits of head count reductions completed last year. We're focused on achieving the SG&A rate targets for third and fourth quarter based on continuation of these initiatives. Diluted share count for the second quarter was 42.6 million shares. Discount was 486,000 shares above the second quarter of 2003 and resulted in one cent lower earnings this quarter.

During the second quarter, we paid $10.9 million to purchase 475,000 shares at an average price of $22.93. Through July 21, we have paid $5.2 million to purchase an additional 265,000 shares at an average price of $19.79. The board of directors has recently authorized an additional $20 million for share repurchases. At July 21, $33 million was available under our share repurchase authorization.

Our net debt-to-total-capital ratio is 49.3% for the second quarter. This rate reflects the April acquisition of the Houston franchises. Purchase of the Houston BMW dealerships was completed in July . Since no other acquisitions are planned for the remainder of 2004, the net debt-to-total-debt ratio will be lowered by year end.

Non-forplanned interest expense decreased by $900,000 in the second quarter compared to 2003, reflecting the benefits of previous refinancing activities. Including floor plant debt, approximately 56% of the company's debt is fixed. Our earnings guidance assumes a total 75 basis point increase in LIBOR in the last half of 2004. An additional 100 basis point increase rate in LIBOR rate would increase earnings by approximately two cents per quarter.

Availability under the revolving credit facility was 196 million at quarter end. Based on selling days, day supply of new vehicle inventory was 60 days, used vehicles was 41 days, and parts was 35 days. On a continuing operations basis and excluding one time items, LTM interest coverage was 5.8 times, long-term debt to EBITDA was 3.3 times, and return on equity was 14.8%.

Gross capital expenditures for the second quarter were $24 million. We anticipate that over 60% will be recovered through sell lease-back transactions. Capital expenditures for the year are expected to be approximately $80 million on a gross basis and $30 million on a net basis. In addition, we continued to meet all covenants under our revolving credit facility.

Our annual guidance is unchanged at $2.65 to $2.80. Key assumptions in our guidance include SAR continuing around 16.5 million units, continued execution of our SG&A targets, and continuation of performance of acquired dealerships. Please note that the third quarter of 2003 included a charge of 23 cents for refinancing senior subordinated notes. and the fourth quarter included five cents. primarily for general liability insurance reserves.

Fifteen dealerships were included in discontinued operations on January 1. We've sold three dealerships, and two others are in the final stages of a decision. Four dealerships currently have strong prospects. We have managed -- we have maintained a measured pace of disposition because improving operating performance should result in higher proceeds when sold. We continue to estimate overall proceeds from the discontinued ops group in though range of $20 million.

At this time we will take questions.

[Operator instructions.] We'll pause for just a moment to compile the Q&A roster. Your first question comes from the line of [Rick Nelson with Stevens.]

Thanks. Good morning, guys.

Good morning, Rick.

Question that relates to the full year guidance. It incorporates a pretty good acceleration in EPS. I'm wondering what the drivers are there. Is it all internal initiatives, expenses et cetera, or does it assume any improvement in the operating environment?

Rick, this is Lee Wyatt. The guidance as stated does not include significant improvement in the operating environment that we're in. It anticipates a fairly similar environment to the second quarter.

The real improvements are coming from, as I noted in my comments, the one-time items that were included in the third and fourth quarter of last year, as well as continued SG&A improvement and the the benefits of the acquisitions that we've made in the second quarter and in July . Those would be the primary elements.

Thanks. Jeff, one dealer said last week in their conference call that they saw a notable pickup in July sales. Are you seeing that?

We definitely see improvement in the sales environment over June . But it's too early to determine how July will look compared to a year ago, Rick.

Okay. And then a question on the balance sheet. The debt ratio was flat at 49%. Do you still target 45% debt-to-cap at year end? And also, a question cash, I see the cash balance is zero. What is happening there?

This is Lee again, Rick. The cash balance is zero because we've made a change in our covenant requirements that eliminates the need to have cash on the balance sheet beginning in the second quarter, so we no longer have to move cash up on top of the balance sheet. We'll just leave it in to pay down debt, so that's just a cosmetic change more than anything, based on a covenant change.

Secondly, in terms of targeting 45% net debt-to-total-capital ratio for the year, that has been our target. We made the decision in the acquisition of the Houston stores to make that a full cash purchase. Originally, we had negotiated that a piece of that would be paid through issuing stock, and we made the decision that given the pricing on our stock, that we'd be better off paying cash, so we did that.

The result will be that we may not reach 45%. It may add, you know, we say, and I think in our press release, 45 to 49 %. But long term we are committed to 40% and we thought it was a good investment to use cash versus stock on the total Houston acquisition.

Okay. Very good. Thank you.

Thank you, Rick.

Your next question comes from the line of [Adrienne Dale] with CIBC World Markets.

Hi. Thank you. First, I was just wondering, I think you had said that the certified preowned vehicles were in short supply. I was just wondering if you can explain why that is given the current state of the used vehicle market?

The biggest driver of availability of certified preowned is the pipeline of off-lease vehicles and the manufacturer-sponsored auctions, et cetera. And because of a decline in leasing over the last several years, the current cycle has a shortage in many brands, in terms of vehicles that fit the certifiable criteria coming off lease.

Okay. Great. And then could you also discuss the type of investment involved in adding service stalls?

Of course, most of that service capacity will be added in one of two forms. First, either through green field facilities where we've decided to relocate a dealership and invest in a new, exclusive, full-service dealership facility, or in some select situations where we have a footprint that enables us to just add on, or renovate, existing facilities and add capacity.

Right. But in terms of the dollar investment?

Our capital expenditures for the year, basically, are on a gross basis $80 million and that's any increase in number of stalls are included in that. We have a very high return on those commitments because that is very much guaranteed income whenever we make those kind of investments, so that's in our total capital expenditure budget.

Great. And then finally, can you just tell me what your rent expense was for the quarter?

One moment. Twenty million.

Great. Thanks so much.

Your next question comes from the line of Jeff Black with Lehman Brothers.

Yeah, good morning. Good quarter. I've got a couple questions on the expenses and the used environment. And relative to used, how is the incentive, how are the incentive programs playing out in July in new? Have you seen a significant ramp up in the new area, and how, alternatively, is that impacting used car demand as you see it thus far?

Yeah. This is Jeff Rachor. I'll be glad to take that question. Incentives are up significantly in the month of July. In fact, some of the domestic manufacturers have increased incentive levels as much as 35% from the June period. And whenever there is a very aggressive incentive environment, and some of the financing subsidies that the manufacturers have offered to support new vehicle volume, that puts pressure on used car retailing.

Combine that with a higher wholesale index for used cars and the pricing and payment transaction differential is not as compelling, oftentimes choosing -- a used car buyer then choosing a new car because the payments are more affordable as a result of those incentives and/or financing subsidies.

So the strong incentive environment, coupled with the strong wholesale pricing index that we continued to see in the second quarter and the acceleration of incentives in the third quarter in my view, will continue to put some pressure on the late-model used car business.

You know we're -- we saw a little bit of weakness in June in auction prices. But given the levels of inventory out there -- you are 41 days, I think Auto Nation's at 42 or something in used -- do you see prices in July at the wholesale side showing any weakness thus far?

Well, the Mannheim index was down just a couple of ticks, about .8% month-over-month from June into May, but that still is up significantly from a year ago. The only pressure that we're seeing in the wholesale arena is on large sport utilities and trucks,

and that is driven by the psychological phenomena of fuel prices. And also, that is where the most aggressive, new vehicle incentives are in the new vehicle market.

Okay. Great. And I just have a quick follow-up on expenses. You know, you said you controlled advertising and selling to get the upside in the second quarter.

Can you just give us a sense of what we should look at to suggest that, you know, the changes that you are implementing are permanent and can be continued, not only for the rest of this year but into next?

Yeah. I'll start with that question and then Lee can certainly chime in. We have now executed our strategy, which has been supported by more disciplined processes surrounding both our advertising spend as well as the control of variable personnel expense. And that came in the form of implementing a number of standardized pay-plan frameworks in stores that had out-of-line conditions.

And I think when you see that we've now been able to manage those processes consistently over a six month period, that we now have a platform to move forward and manage those expenses with discipline over forward the longer haul. And as we've already expressed in our opening comments, we're comfortable with the SG&A targets that we've communicated for the third and fourth quarter.

And as we move into '05, we've communicated a longer term target and at this juncture, we believe our processes are sound and that we've developed consistency that can achieve those targets on an on-going basis.

Hey Jeff, this is Lee. I would just add one other comment. If you look at the historic SG&A rates, the historic advertising rates for example, what we're doing right now is just returning to those more traditional rates and really, just eliminating what we would call some excess spending from the prior years. So we're pretty comfortable those are sustainable rates.

Great. Thank you very much. Good luck, guys.

Your next question comes from the line of [Peter Cirrus with Gorilla Capital.]

Hi. Peter Cirrus. I'm not going to yell you at guys today.

Hello Peter. Well, we're grateful for that.

Two quarters in a row, Peter, that's good! [Laughter]

I know. I may lose my reputation for being a bad guy. I have a question. If you guys plan -- if the world stayed flat with the way it is now, and let's say 16 million and a half SAR for the next five years, and you guys said you were not going to make any acquisitions. I'm trying to understand how the business -- the economics of the business itself.

What kind of precash flow would you generate? And if you took that money and have you looked at this? If you took the money you would generate and say, kept your debt to equity ratio the same, in other words kept buying back stock with the free cash flow, what kind of earnings growth could you generate just from basically, internal growth? In a flat car market.

Well Peter this is Lee. Again, our guidance is based on kind of continuing the second quarter environment, which was not a robust environment, obviously.

So our motto right now, being driven by more expense savings, controlling cost, and managing margins, bodes well in a tougher environment, in terms of a revenue environment.

I guess the question I'm asking, Lee, is a little different. If I take the consensus, 2.65 to 2.80, and I assume that you are not -- and I assume you don't make acquisitions and I assume that cost controls continue, blah blah blah, you guys generate a lot of free cash flow. At these kind of prices if I could keep buying stock back, it looks to me like you could generate 15% a year earnings growth in an -- if the environment was flat for the foreseeable future.

What I am trying to understand is, is the bare case on the stock. Because would I be reasonable to assume that you guys, you know, say 10 to 15% earnings growth without acquisitions, if you could use your capital buy back stock?

Yes.

And you know I guess -- because, I mean -- I mean it was certainly a crappy quarter in terms of sales, but yet the earnings look fine. So what I'm trying to understand -- I guess I am trying to understand how, what the people who've seen the $19 stock are saying, and the $20 stock.

But is there -- if -- have you looked at what the earnings would be say, four, five years out if you did nothing -- if you made no acquisitions but just kept controlling cost and kept using the capital buy back stock?

We do not have a number to give you today, but I would say this. We think that a balanced combination of share repurchase and acquisitions is a way that -- in an environment of continuing to build management processes and management controls around SG&A will give us the optimal benefit in terms of earnings per share and our shareholders.

But we can follow up offline if you would like for us to do some of that type of modeling. But we think a balanced approach with controllable acquisition pace on acquisitions that are within our brand strategy, we think that combination optimizes what we can return to the shareholders.

Okay. Well, if you have time later -- you know, no rush on it today, I would appreciate that.

I'd be happy to do it.

Thanks, Lee.

Thank you, Peter.

Thanks, Jeff.

Your next question comes from the line of Charles Gromm with J.P Morgan.

Hi, Charles.

Good morning. How's it going guys? As part of your conversion to 100% standard pay plans, I was wondering if you could comment on what percentage of your sales force is being converted and more forward-looking, where you expect to be at the end of the third quarter and fourth quarter?

If you go back to what we communicated earlier in the year, we wanted to prioritize the rollout of that standardized pay plan framework. And we really focused in the first quarter on the stores that had the most out-of-line conditions. And I would call that, kind of 25% of our stores.

In the second quarter, we were able to follow through on the implementation, and probably an additional 25% of our stores; however, there are certain positions where we have now implemented standardized pay plan framework 100 %.

Those positions would be general managers, F I managers, and our standardized salesperson framework has been implemented in 3/4 of our store at this juncture and was a leading contributor to the better control of SG&A and the reduction of selling expense year-over-year.

Okay. Have you seen an increase in turnover rates as a result of the transition?

We did see some concentrated turnover during the rollout and execution. It was in line with our expectations and is already beginning to stabilize.

And we expect through the remainder of the year that we can reduce turnover from historical levels, now that we have the more management-intensive part of that implementation program behind us.

Okay. Then kind of second, related question. How sustainable is the 7.5% gross profit margin you threw out for the quarter? Could you elaborate a little bit more detail on how you were able to drive the 40 basis point decrease year-over-year?

Sure. We really made a conscious decision that we did not want to sacrifice gross margin the way that we had a year ago to pursue volume and what was really an irrational profit model. We achieved that, one, through just giving that direction to our dealerships, but also a leading contributor to the improvement in gross margin can be attributed to the standardized pay plan implementation.

With the new program and 100% variability, we're really partnering with all of the stake holders who are now participating with 100% commission on the additional gross profit that we generate. And those were big drivers. In terms of our outlook going forward, we do think that recent trends indicate a fiercely competitive new vehicle market.

I think that is confirmed by the high level of incentive spending that you saw the manufacturers bring back in July . So we do think there could be some new vehicle margin compression, but we're comfortable that we will not return to the low, new vehicle margins that we experienced a year ago in the 6.8% range. So again ,we're going to try to hold margin, but we aren't going to do it at the expense of continued declines in market share.

It is a competitive environment and we are convinced we can continue to hold an improved margin rate from a year ago, but do see some risk in maintaining the very impressive 7.5% margins that we delivered in the second quarter.

A follow-up to that, Lee. If your same-store sells for the quarter were flat instead of down 5%, where do you think a ballpark gross profit margin would have been?

Well I think there are a couple things that contributed to that sales decline and part of it was a market phenomena. So even had we sacrificed margin, I don't know that the market conditions existed to have positive, year-over-year same-store sales. But with that I'll turn it over to Lee to give you his viewpoint.

If you think about last year, the second and third quarter where we were aggressive in driving new vehicle sales, our rates were in the 6.8 to 6.9%. So I would say that given flat sales, we would be somewhere between last year and this year in terms of those rates.

Okay. Great. Thanks a lot.

Your next question comes from the line of Gerry Marks with Raymond James.

Hello, Jerry.

Good morning. Most of my questions have been answered. Last year in the third quarter, you guys had a problem with having too many '04s versus '03s. Can you comment on how your mix of inventories look between your '04s and '05s right now?

Yes. As I stated in the opening comments, our inventory is much higher than it was a year ago but still far below industry averages. And part of that was a conscious strategy to have a disciplined build up of '04s so that we weren't caught in a situation where we didn't have a competitive inventory during the changeover cycle that occurs in the third and fourth quarter.

So we feel very good about where our inventories are at this time, and most of that inventory buildup is in brands where we had shortages a year ago and where the manufacturers are typically the most aggressive with year-end incentives.

Okay. And you've kind of talked about the standardization of your pay plans. From the best I could tell, it sounds like about 50 % of your stores on the lower level, and then everywhere with your general managers and F&I managers.

Can you tell us, specifically, what those standard pay plans comprise of for the general managers and F&I managers?

Well, I can give you the kind of conceptual components that support our compensation philosophy. The first one is total variability. So we have no fixed cost component of their pay plan and they're all paid per performance, but it's important to stress that our objective was not to cut individual employee compensation, only to more closely align their compensation with productivity and performance. So it's tied to specific performance metrics that they have influence over.

Obviously, our general managers are most heavily compensated off their P&L that they're responsible for, so that would be a component for them. In F&I, it's all driven by gross profit per unit and each of our pay plans also include a meaningful component tied to customer satisfaction. So again, it usually includes two or three variables. There's usually a volume element, a profit margin element, and a customer satisfaction element.

But again, the real philosophy is to achieve variability, to reward our high-performing producers, and to get the benefit of that variability when we have a seasonal or industry cycle.

Okay. So, Jeff, if I understand this right, in the past what you may have had is one store manager making 20% of the profits of the store -- or maybe that's high, but just for an example purpose -- and now they're making 25%?

No. In the past our managers had a component of their compensation tied to a base salary, and we have virtually eliminated the majority those situations. So we achieve a higher level of variability. And again the -- let me stress one thing -- the real benefit that you're seeing in our SG&A numbers is not from the general manager conversions.

In fact, really, their transition was less of a dramatic change. The real benefit that you are seeing in our variable comp is in more what I would call dealership level management and rank-and-file positions. Service advisors, sales people, desk managers, used car managers, general sales managers, service managers, parts counter people, et cetera.

Okay. So they're maybe where the salesperson was getting a different percentage of growth --

In some stores we might have had a guaranteed salary for one of those positions, while other stores had a combination of salary and commission.

Okay. Last question. In your 10-K, you indicated that in July you do our FAS-142 goodwill test with no announcement to date, does that mean you completed it and there's no assessment negative or positive there?

Yeah, Gerry, this is Lee. That's an annual test that we do, basically, at year end. So it's not a quarterly test as such.

But in your 10-K you indicated that you do that test in July.

It's actually a year-end test. You'd only do a quarterly test if there was some reason that would indicate that you need do. We had no reason to indicate that we needed to do it on a quarterly basis, but it, primarily, is an annual test based on year-end results.

Oh. Okay. So it would be something that would be addressed in next year's 10-K then?

Yes sir.

Okay. Thanks.

Your next question comes from the line of Scott Stember with Sidoti & Company.

Good afternoon.

Hello, Scott.

Could you talk about the warranty work. You indicated that warranty work was actually up. Can you talk about the mix of foreign versus domestic? Thanks.

Yes, I can, and warranty work was up modestly. Warranty work is declining in our domestic stores, overall, but it is up significantly in both our luxury and import brands.

Okay. Is there any more particular trend that you see there, brand wise?

There's a couple of things brand wise. Obviously, from time to time, manufacturers have different recall campaigns. And so those contribute to some level of volatility within the brand family. For instance, our warranty work at Honda was up because they had a transmission recall, which is unusual for them.

At Volvo, our warranty work is up significantly because they've made the decision to include scheduled maintenance and treat it as a warranty reimbursement to their dealers; those would be a couple of examples. But again, the trend year-over-year, there's a couple of brands that had big recalls last year, such as Cadillac. And this year they don't have that same campaign so we have some modest declines in our Cadillac warranty work, as an example.

But in terms of just overall brand trends, domestic warranty is down and luxury import and import is up. And we think over the longer term, with our current brand mix and the acquisition strategy that will support our brand priorities, that we'll continue to benefit from consistent warranty sales in those import brands.

Okay. And could you just talk a little bit about the F&I, maybe on a per-vehicle basis, this year versus last year?

I sure can. When you remove fleet -- which is really the right way to look at it, it's the way that most of the consolidators in the sector report it -- we were only down $2 per retail unit year-over-year. So again, when you remove fleet, we were down $2 per unit; essentially flat year over year.

We think we've bottomed in F&I. We are continuing to focus on 100% menu selling and a value-oriented product offering, with full disclosure to our consumers. F&I was always a strength for Sonic. You'll remember that we were very proactive and took a leadership role in self-imposing rate caps and profit caps as a result of some of the controversy surrounding consumer F&I stories.

And we, again, feel that we've stabilized the F&I performance and hope to be able to make modest improvement going forward.

All right that's all I have. Thanks.

Your next question comes from the line of Adam Kimora with Intrust Capital.

Hello, Adam.

Hi guys. Good quarter. Quick question on taxes. Can you just help us understand a little bit how much they may have affected the comps in the quarter? And then, you know, as I guess it's dried out a little bit down there, have we seen a rebound?

Well, we have seen a rebound in July . Obviously, we don't have the benefit of a full month in July, but we have seen a rebound in sales versus the June period. Remember, Texas is 22% of our revenue and that has been an underperforming market for the industry for some time. I think some of our peers have announced a difficult environment in Texas as well, so when you add some extreme weather conditions, which we think affected about 20 days during the quarter, the performance pressures were compounded.

But with the recent acquisition and a smooth integration there and the favorable brand mix of that acquisition, as well as the strong, incentive position that many manufacturers have taken that impacts our brand portfolio in Texas, we are encouraged by the reversal in trend that we see in July .

Okay. Thanks.

As reminder if you would like to ask a question simply do so by pressing star then the number 1 on your telephone keypad.

We have time for one more call.

Thank you sir. Your final question comes from the line of Nate Hudson with Banc of America.

Hey. Good morning.

Good morning, Nate.

Just wondering, could you give a little bitter sense of how much of the same-store sales decline on the new side was the result of market share losses, versus just the general market decline, or are some of these regional issues?

Well, it was a combination. Certainly, as others have reported, the industry environment was difficult. But I think I acknowledged in my opening comments that there were some internal factors that made the declines that we reported more severe than just what I would consider a market phenomena.

However, we believe that many of those internal factors are temporary. As I noted, when you go back to last year and the second and third quarter, we had communicated a strategy to take a very aggressive posture to drive volume and take market share to perform in the eyes of some of our manufacturer partners and to drive the creation of additional units in operation to support our long-term, fixed operation strategy.

And accordingly, we outperformed the industry in a number of our brands, particularly our import brands and Cadillac. So we're up against some very difficult comps. Those comps will continue through the third quarter and start to ease somewhat in the fourth quarter and obviously beyond.

And one of on the other big factors contributing to our volume pressures in the quarter was, as you know, we experienced some turnover in an effort to upgrade management and regional managers across the company. And it's just logical that those individuals, while we believe are bringing tremendous talent to the table, are going to require a period of time for orientation and seasoning in their new roles, and that's particularly true at the dealership level.

We look for them to continue to grow into those positions and as a result, we'll improve the stability over the third quarter and feel confident that as we head into the end of the year and the first part of '05 that that internal factor will no longer exist.

Okay. And then just one other detail. With you discontinued operations, approximately what is the revenue base of that business at this point?

It's about 5-6 % of our revenue in general, but it's obviously not included in the revenue that we reported. It's reported as a net number, but it's 5-6%of revenue, generally.

Okay. Thanks very much.

At this time, we've reached the end of the allotted times for questions and answers. Back over to you, Mr. Rachor.

Well thank you very much. We just certainly want to take this opportunity to thank all of the participants today and obviously, if anyone has any follow-up calls, Lee and myself will be available through the remainder of the afternoon. Have a great day, folks. Thank you for your participation in the Sonic Automotive second quarter earnings conference call. This concludes today's conference call. You may now all disconnect.