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Edited Transcript of LAD earnings conference call or presentation 24-Jul-19 2:00pm GMT

Q2 2019 Lithia Motors Inc Earnings Call

Medford Jul 26, 2019 (Thomson StreetEvents) -- Edited Transcript of Lithia Motors Inc earnings conference call or presentation Wednesday, July 24, 2019 at 2:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Bryan B. DeBoer

Lithia Motors, Inc. - CEO, President & Director

* Christopher S. Holzshu

Lithia Motors, Inc. - Executive VP & Secretary

* Eric Pitt

Lithia Motors, Inc. - VP of IR & Treasurer

* Tina Miller

Lithia Motors, Inc. - Senior VP & CFO

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Conference Call Participants

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* Armintas Sinkevicius

Morgan Stanley, Research Division - Associate

* Bret David Jordan

Jefferies LLC, Research Division - Equity Analyst

* Christopher James Bottiglieri

Wolfe Research, LLC - Research Analyst

* David Whiston

Morningstar Inc., Research Division - Strategist

* Derek J. Glynn

Consumer Edge Research, LLC - Analyst

* Michael Patrick Ward

Seaport Global Securities LLC, Research Division - MD

* Nels Richard Nelson

Stephens Inc., Research Division - MD

* Rajat Gupta

JP Morgan Chase & Co, Research Division - Research Analyst

* Steven Lee Dyer

Craig-Hallum Capital Group LLC, Research Division - Managing Partner & Senior Research Analyst

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Presentation

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Operator [1]

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Good morning and welcome to Lithia Motors Second Quarter 2019 Conference Call. (Operator Instructions) I would now like to turn the conference over to your host, Eric Pitt, Vice President of Investor Relations and Treasurer. Please begin.

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Eric Pitt, Lithia Motors, Inc. - VP of IR & Treasurer [2]

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Thank you, and welcome to the Lithia Motors Second Quarter 2019 Earnings Call. Presenting today are Bryan DeBoer, President and CEO; Chris Holzshu, Executive Vice President; and Tina Miller, Senior Vice President and CFO.

Today's discussions may include statements about future events, including financial projections and expectations about the company's products, markets and growth. Such statements are forward looking and subject to risks and uncertainties that could cause actual results to differ materially from the statements made. We disclose those risks and uncertainties we deem to be material in our filings with the Securities and Exchange Commission. We urge you to carefully consider these disclosures and not to place undue reliance on forward-looking statements. We undertake no duty to update any forward-looking statements, which are made as of the date of this release.

Our results today include references to non-GAAP financial measures. Please refer to the text of today's press release for a reconciliation to comparable GAAP measures. We have also posted an updated investor presentation on our website, lithiainvestorrelations.com, highlighting our second quarter results.

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

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Bryan B. DeBoer, Lithia Motors, Inc. - CEO, President & Director [3]

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Good morning, and thank you for joining us. Earlier today, we reported the highest adjusted second quarter earnings in company history at $2.95 per share, a 17% increase over last year. Our earnings were driven by record revenues of $3.2 billion for the quarter, with same-store sales revenue growth in all business lines. As a growth company powered by people and innovation, we purchase and build strong businesses that have yet to realize their potential. We achieve operational excellence by focusing our teams on convenient and transparent customer experiences and utilizing proprietary performance management systems to increase market share and profitability. This combination of operational excellence and value-based growth enables our strategy to generate significant cash flows while also maintaining low leverage.

We recently promoted Tina Miller to Senior Vice President and Chief Financial Officer, and George Hines to Senior Vice President and Chief Innovation and Technology Officer. Their dynamic leadership, acute understanding of our model and impact with our operational teams has positioned them to continue to accelerate our performance. We welcome them both to our senior leadership team and look forward to their continued growth and contributions.

Our operational results from this point forward will be on a same-store basis. During the quarter, we grew revenue 6% and total gross profit 9%. New vehicle revenues were up slightly, and our highest margin business lines were all up double digits with used vehicle revenues growing 12%, F&I revenue up 14%, and service, body and parts revenues increasing 10%. These lines accounted for approximately 42% of our revenues and 80% of our gross profit. From core and value auto used vehicles to lifetime oil contracts and one-stop service offerings, our operating model is specifically built to touch the entire life cycle of vehicle ownership and all consumer types.

We generate income from 6 distinct businesses: New vehicle sales, used vehicle sales, finance and insurance, and service, body and parts. This diversification creates strength in our revenue and profit streams and combined with our growth strategy results in a unique opportunity unlike most other competitive models. We generate more than $250 million in free cash flows annually, allowing us to expand our network, invest in innovation and adjacencies and deliver shareholder value. Our physical network enables us to supply convenient touchpoints throughout the customers' ownership experience and drive our higher margin used, F&I, service and parts business lines. This network also provides an infrastructure to deliver our digital solutions to further expand our reach.

We target investing 2/3 of our capital into expanding our physical network through acquiring strong assets at a targeted average equity investment of 15% of anticipated revenues. Our current available liquidity is over $500 million. Combined with $250 million in annual free cash flows, we could add more than $5 billion in revenues or 40% growth. To further illustrate the benefits of our model, if we chose not to add any incremental leverage and just utilize free cash flows for acquisitions, we could add $1.4 billion in revenues and grow approximately 12% annually.

The acquisition market continues to be robust as we have purchased over $320 million in annual revenue so far this year, expanding our national reach to 82%. In the second quarter, we purchased Hamilton Honda in Hamilton Township, New Jersey; Freedom Ford in Morgantown, West Virginia, a new state for us; and Jaguar Land Rover in Mission Viejo, California. We are excited to welcome these new teams to the Lithia family, and we look forward to becoming a top performer with our new manufacture partners, Jaguar and Land Rover.

We continue to optimize our nationwide network. During the quarter, we divested 2 smaller locations, totaling 12 in the past year. As a reminder, all of these stores originally were acquired as part of a previous group acquisition or as open points. As one of the top 3 largest auto groups in the United States, retailing more than 335,000 vehicles annually, offering the second largest owned inventory marketplace online and servicing more than 3.5 million vehicles a year, opportunity to grow still remains. Our industry is highly fragmented with the top 10 dealership groups controlling less than 8% of the U.S. new vehicle market and no single company controlling more than 2% of the used vehicle market. Combined, the addressable new and used vehicle market is over $1 trillion annually, of which we represent 1.2%. Over the coming quarters, we look forward to continuing to expand our nationwide footprint through our disciplined acquisition strategy that historically has achieved an 80% success rate of exceeding our after-tax ROE targets.

New digital technology has enabled us to further activate our physical network and capture additional earnings. We seek to provide customers a seamless, blended online and physical retail experience with broad selection and access to specialized expertise and knowledge. Our ability to retail a full age range of used vehicles is a hallmark of our growth. Sourcing of the right used vehicle drives this business line. Our operational leaders have taken us to 1:1 used to new ratio. Technology now also supports our procurement decisions by guiding us to more of the right vehicles. This combination of aptitude and technology will help us drive towards the national used to new ratio of 2.3:1.

Our finance and insurance profits continue to grow, but opportunities to increase vehicle volume and F&I per unit remain plentiful. To illustrate further, almost half of our consumers have a credit rating of 700 or below and 71% of our consumers with trade-ins have negative equity. The majority of our customers need specialists who can help obtain a financing structure that balances their credit rating, desired vehicle purchase, potential negative equity and an affordable monthly payment.

Alongside this expertise, digital solutions are creating a convenient, transparent environment for those customers that have the financial strength to transact and complete financing online. These specialists, along with digital flexibility, allows us to maximize the full economic benefit of this channel while also selling a greater number of vehicles throughout the entire credit and vehicle age spectrum. This combination will continue to grow profits and expand the reach of our network.

Our partnership with Shift continues to mature. We learn from their digital solutions that are simplifying the car purchasing and selling experiences. Our team provides industry knowledge to Shift as we continue to create synergies. Thus far, we are sharing data, technologies, our physical network and vendor lender relationships. This strategic partnership supports one aspect of our evolution as Shift inspires us to think differently as a retailer.

In closing, we like to reflect on the diversification and value each of our 6 business lines creates relative to other companies that only have 1 or 2 of these components. Then, add the industry consolidation opportunity, our proven growth, existing network potential, combine this with our ability to generate significant cash flows and the differences in value creation and profitability become apparent. We have included further details on Page 16 of our online investor presentation.

We look forward to continuing to drive operational excellence, further the reach of our network and expand our customer offerings with innovative solutions. Combined, this unique strategy springboards us towards a much more meaningful share of the $1 trillion new and used vehicle market and achievement of our $15 EPS milestone and beyond.

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

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Christopher S. Holzshu, Lithia Motors, Inc. - Executive VP & Secretary [4]

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Thank you, Bryan. Lithia's mission of Growth Powered by People is the foundation of our high-performance culture. Our team members embrace our customer-focused environment and promote our value to continuously improve. Our results are driven by our operating model, which combines acquiring, integrating and growing our stores. This model utilizes our store performance scorecard, or SPS, to align our core values with the key metrics that drive our short and long-term success. Whether a recent acquisition or a seasoned store that has been with us since inception, our 15,000 team members leverage this information to find ways to improve the customer experience and improve operations at each location. Additionally, we standardize our noncustomer facing processes, removing the need for store personnel to manage administrative aspects of the business so they can stay focused on creating customers for life.

Turning to same-store results. In the quarter, total sales increased 6% and total gross profit grew by 9%, reflecting strong performance in used vehicles, F&I and service, body and parts. As Bryan mentioned earlier, our operating model is built upon 6 independent business lines that drive our overall performance and the following is additional detail on each of these lines.

The new business line, which is the top of funnel in automotive retail, grew slightly. Our average selling price increased 5% and unit sales decreased 5% in line with retail SAAR. Gross profit per unit was $2,087 compared to $2,068 last year, an increase of $19. Our stores remain nimble in their volume and growth strategies and adapt to local and regional market condition.

Retail used vehicle revenues increased 12%, unit sales increased 12%, while average selling prices remained flat. Used retail gross profit per unit was $2,179 compared to $2,247 last year, a decrease of 3%.

Our used vehicle sales mix in the quarter was 24% certified, 54% core, or vehicles 3 to 7 years old, and 22% value auto, or vehicles with over 80,000 miles. Both core and value auto continue to see unit growth in the mid-teens. We remain focused on procurement of these units and the opportunity to sell more of these vehicles at most of our rooftops.

Our investment in different innovation channels help store leaders leverage technology to procure and sell more used vehicles overall. Most recently, we have incorporated additional online functionality for used vehicles in certain markets that add customer-directed monthly financing and payment options, instant price quotes on trade-ins and negotiation-free finance and insurance products offering. These changes mark our stores continued progress in creating a blended online and physical retail experience. With the additional information customers provide, our financing specialists gain insights faster that help guide customers through a personalized solution that meets their specific needs and personal budget. As a result, we continue to target selling at least 85 units per location per month. In the second quarter of 2019, we reached 72 used units per store per month, an increase of 7% over the prior year.

F&I per vehicle remained strong for the quarter at $1,451 compared to $1,304, an increase of $147 per unit. Overall growth in F&I was due to higher penetration rates and per unit profitability in nearly all of our product offerings. Of the vehicles we sold in the quarter, we arranged financing on 74%, sold a service contracts on 48%, and sold a lifetime oil product on 22%. As Bryan mentioned, we continue to capture the additional earnings potential in F&I by leveraging our F&I specialists to provide the right products to consumers while leveraging relationships with current F&I partners. As 71% of our consumers with trade-ins have negative equity averaging $5,100, our experienced associates have tremendous opportunity to help customers meet their buying needs and accelerate our sales growth.

New and used vehicles sales create incremental profit opportunities to the resale of additional trade-in vehicles, greater manufacturer incentives, F&I sales and future parts and service work. One measure of this is through the growth of our total gross profit per unit, which was $3,602 this quarter or an increase of $129 per unit over 2018.

We continue to exert growth in our highest margin line of business, service, body and parts. As onboard technology in vehicles becomes increasingly complex, the need for our skilled certified technicians will continue to drive demands in service. In addition, as the car park continues to grow with an average age of almost 12 years, more vehicles are staying on the road longer creating more recurring repair and maintenance opportunities. Our service, body and parts revenue increased 10% over the prior year. Customer pay work, which represents over half of our fixed operations revenue stream, increased 8%. Warranty increased 19%, and wholesale parts grew 4% and our body shops increased 7%.

Same-store adjusted SG&A to gross profit was 69.9%, an improvement of 110 basis points compared to the second quarter of last year. As we work to integrate the $7 billion in acquisitions completed over the last 5 years, we target an SG&A to gross profit metric in the mid- to high 60% range. Our teams have made progress on cost savings efforts and continue to focus on personnel, advertising and facility costs, which make up over 85% of SG&A. Lithia's unique operating model leverages our employees to make decisions closest to our customers, allowing us to react quickly to market dynamics and still leverage our scale. Our employees are taking the steps necessary to exceed their annual plan, capture store potential and carry the trends of the first half of the year into the rest of 2019 and beyond.

Before I turn it over to Tina, I wanted to say congratulations on your promotion. Working with you over the past 14 years, it's been great to see you embrace our operational mission and watch you live our value of Growth Powered by People. We look forward to your continued leadership and many more years of success together.

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Tina Miller, Lithia Motors, Inc. - Senior VP & CFO [5]

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Thank you, Chris. We have a great company, and I'm fortunate to have a strong talented team in accounting, tax, finance and SG&A. It is an honor to work with each of them and to support and partner with our operational teams.

As of June 30, we had approximately $263 million in cash and available credit. Unfinanced real estate could quickly provide us with an additional $247 million for an estimated total liquidity of approximately $510 million. We generated free cash flows of $80 million for the quarter and $141 million for the first half of the year. We define free cash flow as adjusted EBITDA plus stock-based compensation, less interest, income taxes, dividends and capital expenditures paid in cash.

Our capital deployment strategy is a catalyst to support our growth. We target 65% investment in acquisitions, 25% investment in capital expenditures, innovation and diversification and 10% in shareholder return in the form of dividends and share repurchases. Earlier this morning, we announced a dividend of $0.30 per share related to our second quarter results. Additionally, we have approximately $234 million in remaining availability under our existing share repurchase authorization.

A unique aspect of debt in our industry is the financing of vehicle inventory floor plan debt. Vehicle financing is integral to our operations and collateralized by these assets. Because of this nature, the industry treats the associated interest expense as an operating expense in EBITDA and excludes this debt from the balance sheet leverage calculation. As of June 30, we have $2.4 billion outstanding as floor plans and used vehicle financing. Unadjusted, our total debt to EBITDA is overstated at 6.2x. Adjusted to treat these items as operating expense, our net debt to adjusted EBITDA is 2.1x, at the low end of our targeted range of 2 to 3x.

Our adjusted tax rate was 27.6%, up 130 basis points compared to 2018, primarily driven by changes enacted in certain states late last year.

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

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question comes from Rick Nelson with Stephens.

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Nels Richard Nelson, Stephens Inc., Research Division - MD [2]

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Congrats on a great quarter.

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Bryan B. DeBoer, Lithia Motors, Inc. - CEO, President & Director [3]

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Thanks, Rick.

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Nels Richard Nelson, Stephens Inc., Research Division - MD [4]

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Can you just discuss the acquisition environment? How the pipeline looks today? Are you seeing more opportunities in Lithia type markets or the metro areas?

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Bryan B. DeBoer, Lithia Motors, Inc. - CEO, President & Director [5]

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Thanks, Rick. This is Bryan. We're seeing good activity in all parts of the markets. We've done $320 million thus far, and we have a fair amount of other things in the pipeline. I would say it's typical to where it was 3 or 4 years ago. There are a fair amount of larger deals as well. It's just a matter that the pricing on them sometimes is a little bit outside of our pretty tight ROE expectations. So we sit a little bit and watch those.

We also, as we start to think about our footprint as a nation, the Southeast is starting to come into focus a little bit better, and we have a number of things in that area that hopefully will come to be in the next number of quarters or year.

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Nels Richard Nelson, Stephens Inc., Research Division - MD [6]

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Great. Also I'd like to ask you about the SG&A. We saw nice narrowing this quarter at 70.1%. If you could talk about the drivers there and the outlook as we push forward for SG&A?

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Christopher S. Holzshu, Lithia Motors, Inc. - Executive VP & Secretary [7]

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This is Chris. As Bryan mentioned, we purchased $320 million in revs in the last year, but over the last 5 years we've purchased over $7 billion in revenues. And typically, those stores that we're bringing on our team are strong assets, but are underperforming and running at SG&A levels as high as 90% or more. And so what we continue to do is optimize top line growth for those stores, generate as much growth as we can and then leverage expenses. And so through the 3 core areas, really personnel, advertising and other incremental costs there, we continue to drive our SG&A down to that mid-60% range that we're focused on.

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Nels Richard Nelson, Stephens Inc., Research Division - MD [8]

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Okay. Great. Finally, if I could ask you on the technology front, if you could update us on Shift, how you're planning or using or planning to use their technology in your dealerships? And Baierl, if there is an update there, what's your learning from a digital standpoint?

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Bryan B. DeBoer, Lithia Motors, Inc. - CEO, President & Director [9]

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This is Bryan, again. The Shift partnership is going really well. We sure learned a lot from, I would say, a clear perspective of our consumers and how to go-to-market with them. We have expanded the partnership in a pretty big way. If you remember we announced the data sharing back in May. We now have 3 locations that we're collaborating, either with purchasing vehicles and selling the vehicles that they purchase for us in California. And then one in Oregon, and then in many of those cases, we're doing reconditioning as well as storing their facilities, and we see that continuing to grow as their growth plans continue to grow.

I think it's important to note that their strategy is an independent channel for us. It's their strategy doing that. Whereas our strategy is developing on its own, and as we look at the Pittsburgh market in baierl.com, as you asked about, we're showing pretty good signs of success in the digital space there. And we can elaborate a little bit more on that as we get into the used vehicles and the new vehicle sales.

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Operator [10]

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Our next question comes from Armintas Sinkevicius with Morgan Stanley.

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Armintas Sinkevicius, Morgan Stanley, Research Division - Associate [11]

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When I look at the strength in same-store used car sales running in the low teens, and you've talked about the opportunity around procurement of vehicles, but then I see GPUs coming in a little bit lower versus at least consensus expectations. Maybe you could help me bridge the delta on the strong same-store sales growth with an emphasis on procurement versus a touch softer on the GPU side.

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Bryan B. DeBoer, Lithia Motors, Inc. - CEO, President & Director [12]

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Sure, this is Bryan. I think to begin with, it's important to always recognize that we base our expense and cost structure based off total deal average, which was a little over $3,600 this quarter. So looking at individual percentages on margins isn't as relevant as looking at that because that will drive the bottom line profitability. I think when you think about our ability to procure, we spend a lot of dollars in personnel costs to procure, and that's got us to that 1:1 used to new ratio. I think what you're seeing now is some separation from just pure heavy lifting on personnel, and we're activating that with digital solutions that's helping us target the right inventory. And I think much differently than most of the other new or used car retailers, either pure plays or the new car retailers that are selling used, what we do is specifically look for scarcity, okay? So when you look at our numbers and you're looking at where do we build gross, we build gross profit and margin through value auto and core primarily, which is about 70% of our sales. Okay? And those are lower-cost cars that are very difficult to procure. So being top of funnel in terms of our trade-in cycle is very important because those new and certified cars are the first shot at those core vehicles. And if you remember those core vehicles, I mean, we're producing, let's see here, gross margins of a little over 10% in that bucket. Okay? And that is primarily the only way that we are able to procure the value auto vehicle, which is producing 17% gross margins, which is massive and that's on a $13,000 car base. So as we think about the digital solutions that we're finding, it's more about pointing people to scarcity and older products in that 5-year and older vehicle and how do we find those quicker by using digital solutions, which means querying the web and finding things on Craigslist or eBay or different types of sources. We're running those through Manheim or other things and hopefully pointing stores back to where can they find the right cars for our customers to be able to sell a wider spectrum of used vehicles.

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Armintas Sinkevicius, Morgan Stanley, Research Division - Associate [13]

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And I was looking at baierl.com, it's quite a nice website. How do you think about the time line of -- the inventory appears to be a bit limited on the website as you're in pilot mode. But how do you think about expanding that to the broader Lithia.com?

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Christopher S. Holzshu, Lithia Motors, Inc. - Executive VP & Secretary [14]

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Yes, this is Chris. I think it's a little too early to kind of gauge how we're going to expand that out nationwide, and we have a lot of positive things happening right now in the Pittsburgh market on baierl.com specifically. I mean, like, for example, we're seeing 6,000 unique visits right now to the baierl.com site. And when we start to do things like focusing on home delivery, looking at a streamlined online purchase for those consumers that can actually take a vehicle purchase end-to-end or having fixed pricing and buying F&I products directly online without a salesperson or even taking the site unseen offers for purchasing a customer's vehicle, I mean, all of these things are generating a lot of data for us to leverage, to figure out kind of what the next steps are in the evolution that we have. And so I think Bryan has got some more feedback on that as well, but that's the early signs we're seeing there.

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Bryan B. DeBoer, Lithia Motors, Inc. - CEO, President & Director [15]

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As we think about how do we leverage what we're learning in the Pennsylvania market, I think it's important to think about how we look at innovation. We have 185 centers around the country that are always working on best practices because we have a more decentralized model that we want decisions made closest to our consumers. And because of that we get incremental innovation, which I think is a more important way to think about our development. So it's not like there's some massive silver bullet that's going to change the world. We really believe that what's happening in Pennsylvania is the catalyst for other stores to begin to work on those same solutions. At some point, we will pull the trigger and have a national footprint with either lithia.com or a third party type of branding to really be able to leverage the inventory and the personnel that we have within our network. Right now, Pennsylvania, for the -- so far for the quarter was up 18 -- was up 6% in sales. But they're up 43% in profitability, which is a nice move. They're starting to produce. I think they were at 4% operating margin, which is a pretty good move in a short, almost 18 months that we've been together with them, when they were about half of that previously and their leadership teams are very in-tune with the consumers in that next wave of digital retail.

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Operator [16]

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Our next question comes from Steve Dyer with Craig-Hallum.

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Steven Lee Dyer, Craig-Hallum Capital Group LLC, Research Division - Managing Partner & Senior Research Analyst [17]

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Tina, welcome aboard, first of all. Secondly, just wondering if you could kind of go in a little bit more to what drove the F&I strength. Obviously, with new units down, same-store basis up 14%, so really, really strong number. Maybe just go into sort of if you could bucket how much of that is attachment as well as some of the ancillary products that make up that growth.

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Christopher S. Holzshu, Lithia Motors, Inc. - Executive VP & Secretary [18]

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Steve, this is Chris. We continue to focus on F&I as a core component of integrating the more recent acquisitions. I mean, the disparity that we have between kind of our legacy stores and the newer acquisitions, that $7 billion in revenue that we picked up over the last 5 years, is probably $400, $500. And in some cases, between our top-performing stores which are closer to $2,000 and the bottom stores that are still at that $700, $800, we have a lot of work to continue to do there and we see a lot of upside. We did see attachment rates up in virtually every one of our business lines. So -- all of our business products, sorry. And we continue to leverage the strength of our finance specialists to figure out ways to meet the customer's needs, protect their vehicles and put product offerings out there that customers want to buy. So it's really around people, products and making sure that we have a good process in the store to continue to improve that F&I PVR.

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Steven Lee Dyer, Craig-Hallum Capital Group LLC, Research Division - Managing Partner & Senior Research Analyst [19]

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Got it. That's helpful. And then I guess same thing really around parts and service. Is that primarily just bringing up a lot of the newer stores or the newly acquired stores sort of up to what you consider to be a standard? Or was there anything in particular, warranty work, anything like that, that jumped out in the quarter?

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Bryan B. DeBoer, Lithia Motors, Inc. - CEO, President & Director [20]

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Steve, this is Bryan. We're seeing good strength across all the business lines, which is nice. But most importantly, our CP, or customer pay, was up 8% in the quarter. That's a big number, and I think it speaks to our commodity type offerings in the service drives, and that more customer transparent type of environment where it's more affordable and convenient than most other types of businesses, where we're digging much deeper into the value base. If you remember, we've been doing non-OEM parts now for over a decade. So as the warranty expires, that becomes more prevalent. We are at about 20% premium over what the average is in terms of retaining our customers. And a lot of that starts with that F&I attachment that Chris was speaking to as well. But you're starting to really see some of that separation, which is what we really want to see is in our higher-margin businesses that we're able to extract those experiences and then profit from it.

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Operator [21]

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Our next question comes from Rajat Gupta with JPMorgan.

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Rajat Gupta, JP Morgan Chase & Co, Research Division - Research Analyst [22]

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I wanted to congratulate Tina on the appointment. Just wanted to follow up on the parts and services question. Tracking up double-digit so far in the first half. I mean, warranty, obviously helps a lot there. Could you break out within the parts and services gross profit or revenue, how much of that is volumes or transactions versus price or how much is parts versus service? I mean, could we get a little bit of color on that? And then, how should we expect that to trend in the second half? And are you seeing any market share shift versus the independent outlets out there?

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Bryan B. DeBoer, Lithia Motors, Inc. - CEO, President & Director [23]

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Sure, Rajat. This is Bryan. So in terms of revenue mix in those areas, in the service department, customer pay is 55% of the mix. Warranty is exactly a quarter, 25%. Wholesale parts is 14% and body shop parts is 6%. So that gets you to the 100%. When you look at the gross profit mix, 60% of the gross profit is coming from customer pay, followed by 30% from warranty. And as you can imagine, parts and body shop are really low margin at only 6% and 5%. If we extrapolate that forward, we actually had 1 less service day this year than we did last year. So we're pretty pleased with those results. We believe that looking forward we see strength in the warranty as complexity of vehicles still continues to be something that provides us opportunities to upsell consumers and provide other services and win them back to our service drives with more convenient and affordable experiences. And I think in terms of those commodity sales, it is something that is a little different than most new car dealers because I think we really think about the full life cycle of a customer. And it is the way to keep them as part of our family throughout their entire experience. So hopefully, they're able to buy another used or new car from us.

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Rajat Gupta, JP Morgan Chase & Co, Research Division - Research Analyst [24]

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Got it. Just a follow up on that. I mean, of the high single-digit growth on same-store sales, I mean, how much of that is just volume versus like price? I mean, is there a way to distinguish that, if we can get some color on how that trended in the quarter?

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Bryan B. DeBoer, Lithia Motors, Inc. - CEO, President & Director [25]

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Well, why don't we circle back with you on that. Eric, can we give them that information? I think it's important to remember that when we buy stores, they perform at about 15% less than average when it comes to units in operation, their ability to service units and operations, which is typically a 10-year model range. So -- and once they get to season, they're doing almost a 20% better-than-average. So keep that in mind as you think about building out your models. That is one of the drivers that we'll always have some pent-up demand in those service departments because of lack of experiences and lack of offerings in those service lanes when we buy those stores.

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Rajat Gupta, JP Morgan Chase & Co, Research Division - Research Analyst [26]

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Got it. That makes sense. And then just to follow-up on F&I, GPUs, could you break out where you're seeing latest (inaudible) used versus new there in terms of GPUs? And how much of the strength in the recent quarter has been driven by getting the prior acquisitions up to speed versus growth in the already well-established dealerships?

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Christopher S. Holzshu, Lithia Motors, Inc. - Executive VP & Secretary [27]

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Yes, so the GPUs are a little bit higher on new vehicles than used vehicles. But we're seeing opportunity in growth in both segments and about the similar overall GPU dollar amount. And your second question, sorry, was...

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Bryan B. DeBoer, Lithia Motors, Inc. - CEO, President & Director [28]

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Let me take the second question, Rajat. This is Bryan. When we buy stores, again, the average is $700 a car. And if you reflect back on the $1,450 that we did, that's about doubling of that F&I average. We usually get about half of it or about $400 in the first 6 to 12 months. And that typically comes through a more transparent selling process in F&I. If you recall, we have 100% fixed pricing in our F&I products across our network. So it's -- that's pretty easy to be able to talk about benefits and really meet our customers' needs. And that's where we get most of that. I believe the rest of it, we get over the next couple of years, and that comes through better personnel as well as more transparent, what I would call, vehicle purchasing process, so the consumer is more comfortable because they're in control of their buying experience. And because of that, they're less combative or they're more open to the idea of F&I attachments because they're actually looking at their budget and going this extra $30 on a finance, on a service contract or something is smart to do, whereas if you're pushing on the vehicle sales and then you push on the F&I product, it's not as easy to sell product as it is once that vehicle experience becomes better.

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Operator [29]

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Our next question comes from Chris Bottiglieri with Wolfe Research.

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Christopher James Bottiglieri, Wolfe Research, LLC - Research Analyst [30]

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I wanted to circle back on the parts and services. It was pretty prolific road. Just wondering if there is a way to help us think through the incremental margins in that business. I would imagine much higher than the auto business, and probably underappreciated piece of your business. Any way to contextualize that for us?

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Christopher S. Holzshu, Lithia Motors, Inc. - Executive VP & Secretary [31]

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Yes, I mean, I think, we -- Bryan hit on a lot of the items in the margins and the way they impact our bottom line. I mean, we had $170 million in gross profits in parts and service. We continue to see growth. Our UIO continues to grow. The technology advancements that we continue to see in vehicles make our certified technicians kind of the go-to place for any significant repairs, and we continue to focus on commodity sales. So I think the parts and service business that we have is a core part of what we're going to continue to do, and we expect to see continued growth in that area.

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Christopher James Bottiglieri, Wolfe Research, LLC - Research Analyst [32]

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Got it. But from an SG&A perspective is where I was more curious, like, when you put -- when you push the incremental sale, is there any rule of thumb to help us think through how much incremental SG&A you incurred when you drive more parts or is it not that simple.

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Christopher S. Holzshu, Lithia Motors, Inc. - Executive VP & Secretary [33]

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Yes, this is Chris, again. I mean, our overall goal that we have in all of our stores is continue to try and leverage 50%, what we call, throughput. So for each incremental dollar of gross that we generate, we want to see at least 50% of that come to the bottom line. And that's the way that we continue to focus on it. It does seem that in parts and service, that the opportunity to exceed that throughput is a little bit higher, but 50% is the target and if you look in the quarter, overall as a company, we saw about $42 million in incremental gross profit. And we hit our 50% throughput target on that line.

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Christopher James Bottiglieri, Wolfe Research, LLC - Research Analyst [34]

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That's really helpful. And then just wanted to talk about warranty specifically, like, that scripted right plus 90%, that's pretty unfathomable. Can you help us think through like how much more legs there is to this? I know it's not easy to forecast and it's lumpy. But is this all being driven just by more campaigns given the kind of SAAR has been flat for a period of time now. Are there other factors driving it, CPO or prior insurance contracts sold? Any way to just help us kind of think through the growth of warranty over the next, call it, like, 6 to 18 months would be helpful.

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Christopher S. Holzshu, Lithia Motors, Inc. - Executive VP & Secretary [35]

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Again, this is Chris. I mean, overall, on pretty much all of our main line manufacturers, we saw pretty good growth in warranty work. And you got to remember warranty work just isn't a function of a major problem. It's just general wear and tear that happens to vehicles that are covered by the main line manufacturers. So increase in UIO, increase in sales, increased focus on retention, which is another big component of when we do an acquisition, trying to grow the retention in our service departments are all driving to a really nice lift that we're seeing in overall warranty work. And if we do a good job in warranty work and we continue to push on good customer satisfaction, the goal is they come back in for the CP work down the road as they retain their vehicle past the warranty life cycle of the manufacturer.

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Operator [36]

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Our next question comes from Bret Jordan with Jefferies.

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Bret David Jordan, Jefferies LLC, Research Division - Equity Analyst [37]

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Question, I guess, sort of regional dispersion. Did you see any particular strength or weakness from an underlying demand standpoint? And then sort of follow up with the regional dispersion on performance within your stores as you talked about Pennsylvania being a 4% EBIT and maybe what are you seeing in a trajectory with DCH or Upstate New York stores as well?

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Bryan B. DeBoer, Lithia Motors, Inc. - CEO, President & Director [38]

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This is Bryan, Brett. We're seeing pretty balanced same-store sales growth across the country, which is great. Alaska was up 12%, Iowa was up 9%, Montana was up 10%, New Jersey was up 11%, Washington was up 18%. So you're seeing some of the better numbers, the double-digit numbers kind of broadly spread across the country. And I think pretax profit followed that similarly. We did also see some strength in brands such as Subaru and BMW, as well as a few other luxury, which was nice, and that translated into the bottom line as well. In terms of -- Chris, do you have numbers on each of those -- the other acquisitions? DCH, their operating margins? I saw that somewhere. I believe DCH is pushing 4% now, Baierl was at 4%. Our one weakness is still in Upstate New York in Carbone, which is a little bit -- it's really close to breakeven, which isn't where we would have liked to see that. But we got some good opportunity there to be able to grow.

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Christopher S. Holzshu, Lithia Motors, Inc. - Executive VP & Secretary [39]

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Yes, the one other one that Bryan already mentioned was Pennsylvania and the incremental lift that we're seeing right there in that market was with the Baierl and Day acquisition. So -- and again it comes down to people. So we can talk about regions, but then you look within the region at specific stores and we have pockets of stores that are doing extremely well and then a couple of opportunities that we continue to focus on.

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Operator [40]

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Our next question comes from Derek Glynn with Consumer Edge Research.

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Derek J. Glynn, Consumer Edge Research, LLC - Analyst [41]

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How do you think about your target leverage of 2 to 3x in the context of the new SAAR which may be turning? You still have a pretty robust pipeline of M&A opportunities. Do you have a preference or expectation to be at the low end of that range at this point of cycle?

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Bryan B. DeBoer, Lithia Motors, Inc. - CEO, President & Director [42]

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Derek, this is Bryan. I think the way that we look at 2 to 3x as our target is that we want to have headroom that if there is -- if we are late cycle, which I think most indicators are pointing towards, that we still have a number of years and that $17 million SAAR is pretty stable for the next couple of years. We still want to have that headroom. And I think our covenants go all the way up to 5x, so that gives us the ability to be able to grow at a quicker rate when we believe that pricing on deals maybe come down, which is one way to look at it. I think, as we think about our geographic positioning, the Southeast is an important part of our ability to activate digital solutions on a national basis. So I think we're willing to push that into the middle of that range if we can find the right opportunity in the Southeast and hopefully get a footprint so we can then go apply our typical value-based model to be able to do that.

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Operator [43]

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Our next question comes from Michael Ward with Seaport Global.

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Michael Patrick Ward, Seaport Global Securities LLC, Research Division - MD [44]

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First off, Tina, do you -- can you provide the -- what you spent on acquisitions in the second quarter?

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Tina Miller, Lithia Motors, Inc. - Senior VP & CFO [45]

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Sure. Can you give me a minute? So we invested about $80 million in acquisitions as well as any capital expenditures associated with acquisitions from the prior year in terms of capital deployed associated with that.

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Michael Patrick Ward, Seaport Global Securities LLC, Research Division - MD [46]

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Okay. And there was no share repurchase?

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Tina Miller, Lithia Motors, Inc. - Senior VP & CFO [47]

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The only share repurchases in the first half of the year that we've had have been associated with stock compensation that's vested. So no opportunistic share repurchases.

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Michael Patrick Ward, Seaport Global Securities LLC, Research Division - MD [48]

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Okay. And so it sounds like, if I can tie this together with the acquisition strategy, I think, last quarter, one of the comments you made -- the company made was that you're letting some of the other acquisitions that have been completed in the year or a year or 2 years before to kind of season and get back up to more close to the corporate average. And so now looks like the shift is now towards growth through acquisition. Is that a fair statement?

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Bryan B. DeBoer, Lithia Motors, Inc. - CEO, President & Director [49]

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Michael, this is Bryan. I think we always are balanced in terms of our approach. So I think you're seeing that we are doing more acquisitions. And I think we -- there's a belief that we stopped buying stores in 2018 because of maybe a lapse in performance of the existing stores that we were trying to capture the potential of. We don't believe that was why. We believe that there was a disconnect in stock price that made it more attractive for us to buy our own stock than it did to buy other acquisitions. And now that our stock price has recovered to a somewhat respectable level, we again turned to acquisitions rather than buy our own stock back. So it's kind of how we've always looked at things, is just to balance those 2 things as we look forward. I do believe that the market is pretty robust, and there's a lot of good deals out there. And I think the more that we find ways to activate our network with digital solutions or to find adjacencies to generate more profit out of our stores, it does make us more competitive because ultimately, our ROIs of 15% to 20% after-tax returns will still be achieved, but we'll be able to forecast those -- that profitability at even a higher number than what we currently forecast it at.

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Michael Patrick Ward, Seaport Global Securities LLC, Research Division - MD [50]

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And if you look at the acquired stores and specifically at the SG&A, it sounds like they're getting -- of the acquired stores over the last couple of years, they're getting closer to the corporate average. Can the corporate average get back to the 2017 levels with SG&A as a percentage of growth?

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Bryan B. DeBoer, Lithia Motors, Inc. - CEO, President & Director [51]

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Yes, this is Bryan, again. I mean, we believe that the corporate SG&A can get back to the 2014 level before we were buying a fair amount of stores. We bought that $7 billion in revenue where it was in the mid-65% range. So that really -- and remember this, Michael, I mean, our best stores operate in the mid to high 50 percentile range. So when we buy stores, they're typically at 90%. So it's really that equation of being able to grow your new car business, grow your used car business, that brings along the F&I and then over 3 to 5 years, their units in operations grows to be able to drive your service and parts business. And those things combined together create 2 to 4x more profitability, which is ultimately the entire basis of our value-based model and why our leverage ratios remain so much lower than even our peer group, while still growing at 2 to 4x faster than the rest of the peer group.

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Michael Patrick Ward, Seaport Global Securities LLC, Research Division - MD [52]

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One last question. I think -- and I may have missed this. Is Shift currently working with 3 stores? Is that correct? Or is it more now?

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Bryan B. DeBoer, Lithia Motors, Inc. - CEO, President & Director [53]

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It's 4, 3 in California and 1 in Oregon.

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Operator [54]

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Our next question comes from John Murphy with Bank of America Merrill Lynch.

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Unidentified Analyst, [55]

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This is (inaudible) on for John. So I think you touched upon this shortly in your opening remarks. But can you maybe give us an update on your portfolio optimization effort? I think it was about a year ago when you mentioned you were starting to focus a bit more on divesting underperforming stores. So what innings are we in with respect to this process?

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Bryan B. DeBoer, Lithia Motors, Inc. - CEO, President & Director [56]

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Sure. This is Bryan. So this is -- we believe that culling out our network is really important because it keeps the bar of performance really high. So we sold 12 stores in the last 12 months. All of those stores were purchased with a group or were open points to those, okay? They were all underperforming to some level. We sold 2 very small ones of that 12 in this quarter. One was in, what, Great Falls?

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Christopher S. Holzshu, Lithia Motors, Inc. - Executive VP & Secretary [57]

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Great Falls, yes.

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Bryan B. DeBoer, Lithia Motors, Inc. - CEO, President & Director [58]

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Great Falls. And the other was in the Pittsburgh market. So -- and I think that's something that we will always do. But I would say this. It's a minor part of what we do. And if you're talking about innings, we're probably in the seventh or eighth inning. I mean, we probably have half a dozen to 8, 9 stores that we believe are not as stronger asset as we typically buy. And if you recall, we have a pretty darn good success rate over 80% of hitting that 15-plus percent ROE achievement within that 5-year period. So -- and these are typically those outliers that we believe just don't quite fit the network. But occasionally we test and try to make sure that we're always capturing every part of growth that we can.

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Unidentified Analyst, [59]

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Great. Very helpful. And then on the M&A front, more broadly, I think you've expressed in the past an interest in potentially expanding internationally to Canada or the U.K. Is this an option you guys are still considering? Or do you still prioritize domestic acquisitions?

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Bryan B. DeBoer, Lithia Motors, Inc. - CEO, President & Director [60]

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This is Bryan, again. We definitely prioritize domestic acquisitions. And when the market is so lucrative and it's so plentiful, it's really hard to look at other countries and go this makes more sense than deploying dollars domestically, especially when we only touch 82% of the country today. We really want to get that closer to the 90, 95 percentile. So as we begin to codevelop these digital solutions, that we'll have the footprint there to be able to activate the entire country, to be able to gain many of those leverage benefits you can in marketing or other personnel type of benefit.

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Unidentified Analyst, [61]

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Okay. And then finally, can you maybe share with us how big were value auto sales in 2Q '18? I think you said it was 22% of total used vehicle sales this quarter. Just trying to have a better idea of how is that business evolving?

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Bryan B. DeBoer, Lithia Motors, Inc. - CEO, President & Director [62]

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So that is what we call the third tier of the waterfall. It's evolving very nicely. I would still say this. Over half of our stores don't play in the value auto game. And right now it's about 1/5 of our total sales in used cars. It's also somewhere that most other retailers don't play in, including the pure-play used car retailers. Part of the reason is it's a very difficult business to play in because of reconditioning standards, and for us, it's really important to sell supersafe vehicles. And I think what we found is jumping into that space that our guarantees and our offerings are much better than what Joe's Used Car retail store down the street or a wholesale place where people typically buy this. But consumers still aren't used to looking at new car dealerships to find those type of stores. And our salespeople aren't used to selling a car in that type of condition, which is typically over 80,000 miles. And our technicians don't typically want to fix those kinds of cars. So you're working on 3 different dichotomies that have to work in adjacency to be able to maximize that stream and that benefit. I'll throw in one more thing to think about, okay? As you think about the financing part and the ability to sell that type of car or, for that matter, a 3 to 5-year-old core product, the ability to finance those cars is something that Lithia Motors is specialist at. So we have nearly 100 lenders that are out there to meet each individual's specific needs, okay? And I think it's easy to get distracted that all consumers are going to be able to buy digitally online when we really believe that only 20% of the consumers can do that. And that's really because of their equity situation and their trade-in, okay, which means it translates into the loan to value on the car that they're purchasing. Combine that with their credit score and you get about 80% of the consumers that really need expertise to help them find financing for whatever type of vehicle they're looking at. And I think one of the things that Chris mentioned that I thought was really important, 71% of Lithia consumers that have trade-ins have this equity on the car that they're trading in. That's a big -- that's a large number of our customers. More importantly than that, the average disequity on those consumers in our company is $5,100, okay? So if you think now about value auto, core product, certified or for that matter even new vehicles, the ability to get into an equity position requires a lot of capital down. Okay? And that's where specialists are able to really stick credit scores and loan-to-values with what the consumer is trying to buy.

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Operator [63]

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Our next question comes from David Whiston with Morningstar.

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David Whiston, Morningstar Inc., Research Division - Strategist [64]

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Tina, congratulations. I wanted to go back to F&I. I guess I'm just trying to understand something at the market level in terms of what you see at stores you acquire because it sounded like -- I think, it was Chris earlier, you were basically saying that some stores they just focus on selling the vehicle and they don't do enough with all the add-ons. And what's surprising to me about that is that even if they are a smaller dealer, I would think he would really like 100% gross profit business. But it sounds like...

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Bryan B. DeBoer, Lithia Motors, Inc. - CEO, President & Director [65]

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You think?

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David Whiston, Morningstar Inc., Research Division - Strategist [66]

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Yes, you were saying, and that's what's confusing. I just want to confirm there's nothing structural that prevents a smaller 1 or 2 store, 8 store, 5-store group from pursuing F&I more. It's just purely a choice that those managers are making, right?

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Christopher S. Holzshu, Lithia Motors, Inc. - Executive VP & Secretary [67]

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David, this is Chris. I think partly it's a choice, that's correct. But the other thing that we are able to do is leverage our scale and size to work with a national vendor to create products that we knew was very difficult to do, and so I think it is partly a focus on the price of the product, the people that we have and then obviously the offerings, we really make sure we tailor our offerings to the individual markets, to individual brands and the individual regions, which may be more difficult for an individual dealer to do. But the opportunity is there specifically, and I mentioned this earlier, LAD, our traditional Lithia stores, almost $2,000 a copy in certain stores versus newer acquisitions trying to bust past that $1,000 per unit mark, and it's an area that is definitely on the radar. It's a constant source of discussion, it's front and center on our store performance scorecard, which is our key catalyst for many...

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Bryan B. DeBoer, Lithia Motors, Inc. - CEO, President & Director [68]

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And like you said, it all drops to the bottom line.

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Christopher S. Holzshu, Lithia Motors, Inc. - Executive VP & Secretary [69]

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Exactly, it brings to the bottom line.

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David Whiston, Morningstar Inc., Research Division - Strategist [70]

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Okay. Is there any -- moving on to light trucks and just your customer preferences. Is there any -- Two-part question there. Is there any change and perhaps a waning enthusiasm, or even slightly at the margin, for light trucks? And two, do -- have you gotten any feedback out from your customers, especially your pickup truck customers in terms of how much interested are they in any pure electric pickup truck, whether it's from the Detroit 3 or Rivian and/or Tesla.

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Bryan B. DeBoer, Lithia Motors, Inc. - CEO, President & Director [71]

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David, this is Bryan. The answer to your first question is there's been no weakness in trucks. And the answer to your second is there is virtually no interest in electric trucks, at least from the domestic side. And we really believe that it's not just about the power plan in the truck, it's about the build of the truck and the features in the truck and the utilization of the truck that makes it a different game than a sedan that you get in and you move people around. But over time, that can change and it will adapt. And I think we'll see some -- we'll see some demand for that over time as that becomes more available to consumers.

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Operator [72]

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Ladies and gentlemen, we've reached the end of the question-and-answer session. At this time, I'd like to turn the call back over to Bryan DeBoer for closing comments.

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Bryan B. DeBoer, Lithia Motors, Inc. - CEO, President & Director [73]

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Thanks, Rob, and thank you, everyone, for joining us today, and we look forward to updating you on third quarter results in October.

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Operator [74]

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This concludes today's conference. You may disconnect your lines at this time, and we thank you for your participation.