UNITED STATESSECURITIES AND EXCHANGE COMMISSIONWASHINGTON, D.C. 20549FORM 10-K
Commission File Number: 000-21789 LITHIA MOTORS, INC.(Exact name of registrant as specified in its charter)
541-776-6899(Registrant’s telephone number including area code)Securities registered pursuant to Section 12(b) of the Act:Class A Common Stock, without par valueSecurities registered pursuant to Section 12(g) of the Act: None(Title of Class)
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days: Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K, or any amendment to this Form 10-K. [ ]
The aggregate market value of the voting stock held by non-affiliates of the Registrant was $80,334,250 as of February 14, 2002 based upon the last sales price ($19.15) as reported by the New York Stock Exchange for the Company’s Class A Common Stock.
The number of shares outstanding of the Registrant’s Common Stock as of February 14, 2002 was: Class A: 9,226,701 shares and Class B: 4,039,719 shares.
The number of shares outstanding of the Registrant’s Preferred Stock as of February 14, 2002 was: Series M 2003: 4,499 shares.
Documents Incorporated by Reference
The Registrant has incorporated into Part III of Form 10-K, by reference, portions of its Proxy Statement for its 2002 Annual Meeting of Shareholders.
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TABLE OF CONTENTS
PART I
Item 1. Business
Forward Looking Statements and Risk Factors
Some of the statements under the sections entitled “Risk Factors,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Business” and elsewhere in this Form 10-K constitute forward-looking statements. In some cases, you can identify forward-looking statements by terms such as “may,” “will,” “should,” “expect,” “plan,” “intend,” “forecast,” “anticipate,” “believe,” “estimate,” “predict,” “potential,” and “continue” or the negative of these terms or other comparable terminology. The forward-looking statements contained in this Form 10-K involve known and unknown risks, uncertainties and situations that may cause our actual results, level of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by these statements. Some of the important factors that could cause actual results to differ from our expectations are discussed in Exhibit 99 to this Form 10-K.
Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. You should not place undue reliance on these forward-looking statements.
Overview
We are a leading operator of automotive franchise stores in the western United States. We sell new and used cars, light trucks and sport utility vehicles. We also provide vehicle maintenance, warranty and repair services and arrange finance, extended warranty and insurance contracts for our customers. We achieve gross margins above industry averages by selling a higher ratio of retail used vehicles to new vehicles and by arranging finance and extended warranty contracts for a greater percentage of our customers. In 2001 we achieved a gross margin of 16.4% compared with the industry average of 13.1%. We currently offer 24 brands of new vehicles, through 123 franchises in 65 stores. Our core markets are concentrated in the fastest growing regions in the United States with 16 stores in Oregon, 11 in California, 10 in Washington, 7 in Colorado, 7 in Idaho, 5 in Nevada, 4 in Texas, 3 in South Dakota and 2 in Alaska. Over 65% of our stores are located in markets where our store does not compete directly with any other franchised dealer selling the same brand.
We were founded in 1946. Our two senior executives have managed the company for more than 30 years. Since our initial public offering in 1996, we have grown from 5 to 65 stores primarily through an aggressive acquisition program, increasing annual revenues from $143 million in 1996 to $1.87 billion in 2001. We have achieved five-year compounded annual growth rates through December 31, 2001 of 67% for revenues, 53% for net income and 25% for earnings per share, together with a 5.3% average same store sales increase.
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The Industry
At approximately $1.0 trillion in annual sales, automotive retailing is the largest retail trade sector in the United States and comprises roughly 10% of the GDP. The industry is highly fragmented with the 100 largest automotive retailers generating approximately 16% of total industry revenues in 2000. The number of franchised stores has declined significantly since 1960 from more than 36,000 stores to approximately 22,000 in 2001. In the U.S., vehicles can be purchased from approximately 22,000 franchised dealers, 53,000 independent used vehicle dealers, or through casual (person to person) transactions. New vehicles can only be sold through automotive retail stores franchised by auto manufacturers. These franchise stores have designated trade territories under state franchise law protection, which limits the number of new stores that can be opened in any given area.
Consolidation is expected to continue as many smaller automotive retailers are now being forced to consider selling or joining forces with larger retailer groups, given the large capital requirements necessary to operate in today’s retail environment. With many owners reaching retirement age, often without clear succession plans, larger, well-capitalized automotive retailers provide an attractive exit strategy. We believe these factors, in conjunction with an uncertain economic forecast, provide an attractive environment for continuing consolidation.
Unlike other retailing segments, automotive manufacturers provide unparalleled support to the automotive retailer. Manufacturers often bear the burden of markdown risks on slow-moving inventory as they provide aggressive dealer incentives to clear aged inventory in order to free the inventory pipeline for new purchases. In addition, an automotive retailer’s net inventory investment is relatively small, given floorplan financing from manufacturers. Furthermore, manufacturers provide low-cost financing for working capital and acquisitions and credit to consumers to finance vehicle purchases, as well as pay retail prices to their dealers for servicing vehicles under manufacturers’ warranties.
Sales in the automotive sector are affected by general economic conditions including rates of employment, income growth, interest rates and general consumer sentiment. Since 1990, new vehicle revenues have grown at a 5.3% compound annual rate and used vehicles at a 4.7% compound annual rate. New and used unit sales, however, have increased at slower compound annual rates of 2.3% and 0.6%, respectively. Slower unit volume growth over this time period has been offset by rising prices associated with new vehicles as a result of a mix shift in the marketplace to the higher-priced light trucks and SUVs and the higher prices paid for later model used vehicles, which now comprise a growing portion of the used vehicle market. New vehicle sales usually decline during a weak economy; however, the higher margin service and parts business typically benefits in the same environment because consumers tend to keep their vehicles longer. Strong sales of new vehicles in recent years have provided a population of vehicles for future service and parts revenues. Automotive retailers benefit from their designation as an exclusive warranty and recall service provider of a manufacturer. For the typical manufacturer’s warranty, this provides an automotive retailer with a period of at least 3 years of repeat business for service covered by warranty. Extended warranties can add two or more years to this repeat servicing period.
Automotive retailers’ profitability varies widely and depends in part on product mix, effective management of inventory, marketing, quality control and responsiveness to customers. New vehicles account for an estimated 60% of industry revenues, but only 35% of gross profits.
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The remaining 40% of revenues are derived from used vehicles sales (26%), service and parts (10%) and finance and insurance (4%), which combine to contribute 65% of the sector’s gross profits. Gross margins on new vehicles typically average approximately 8.5%, versus 11.3% for retail used vehicles. The difference is primarily a function of the non-comparability among used vehicles and lack of standardized pricing.
Automotive retailers have much lower fixed overhead costs than automobile manufacturers, parts suppliers and most specialty retailers. Variable and discretionary costs, such as sales commissions and personnel, advertising and inventory finance expenses, can be adjusted to match new vehicle sales. Variable and discretionary costs account for an estimated 60-65% of the industry’s total expenses. Moreover, an automotive retailer can enhance its profitability from sales of higher margin products and services. Gross margins for the parts and service business are significantly higher at approximately 46%, given the labor-intensive nature of the product category. Gross margins for finance and insurance are virtually 100%. These supplemental, high margin products and services provide substantial incremental revenue and net income, decreasing the reliance on the highly competitive new vehicle sales.
Store Operations
Each store is its own profit center and is managed by an experienced general manager who has primary responsibility for inventory, advertising, pricing and personnel. In order to provide additional support for improving performance, we make available to each store a team of specialists in new vehicle sales, used vehicle sales, finance and insurance, service and parts, and back-office administration. The following tables set forth information about our stores:
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New Vehicle Sales
In 2001, we sold 24 domestic and imported brands ranging from economy to luxury cars, sport utility vehicles, minivans and light trucks.
Our unit and dollar sales of new vehicles were as follows:
We purchase our new car inventory directly from manufacturers, who allocate new vehicles to stores based on the number of vehicles sold by the store on a monthly basis and by the store’s market area. We attempt to exchange vehicles with other automotive retailers to accommodate customer demand and to balance inventory.
We post the manufacturer’s suggested retail price on every vehicle, as required by law. We negotiate the final sales price of a new vehicle individually with the customer except at our Saturn stores, where the final sales price does not deviate from the posted price.
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Used Vehicle Sales
At each new vehicle store, we also sell used vehicles. We employ a used vehicle manager at each location.
Retail used vehicle sales are an important part of our overall profitability. In 2001, retail used vehicle sales generated a gross margin of 12.7% compared with a gross margin of 8.7% for new vehicle sales. Our used vehicle operation gives us an opportunity to:
We currently sell approximately 0.93 retail used vehicles for every new vehicle sold, compared to the industry average ratio of approximately 0.77 to 1.
In addition to selling late model used cars, as do other new vehicle dealers, our stores emphasize sales of used vehicles three to ten years old. These vehicles sell for lower prices, but generate greater margins. Selling a larger number of used vehicles makes us less susceptible to the effects of changes in the volume of new vehicle sales that result from economic conditions.
We acquire most of our used vehicles through customer trade-ins, but we also buy them at “closed” auctions, attended only by new vehicle automotive retailers with franchises for the brands offered. These auctions offer off-lease, rental and fleet vehicles. We also buy used vehicles at “open” auctions of repossessed vehicles and vehicles being sold by other automotive retailers.
In addition to selling used vehicles to retail customers, we sell vehicles in poor condition and vehicles that have not sold promptly to other automotive retailers and to wholesalers.
Our used vehicle sales are as follows:
Vehicle Financing, Extended Warranty and Insurance
We believe that arranging financing is critical to our ability to sell vehicles and related products and services. We provide a variety of financing and leasing alternatives to meet customer needs. Offering customer financing on a “same day” basis gives us an advantage, particularly over smaller competitors who do not generate enough sales to attract our breadth of financing sources.
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Because of greater profit margins from sales of finance and insurance products, we try to arrange financing for every vehicle we sell. Our finance and insurance managers possess extensive knowledge of available financing alternatives and receive training in determining each customer’s financing needs so that the customer can purchase or lease a vehicle. The finance and insurance managers work closely with financing sources to quickly determine a customer’s credit status and to confirm the type and amount of financing available to each customer.
In 2001, we arranged financing for 77% of our new vehicle sales and 74% of our retail used vehicle sales, compared to the industry averages of 55% and 59%, respectively. Our average finance and insurance revenue per vehicle totaled $933 in 2001 compared to the industry average of $438.
We receive a portion of the financing charge as fee income for each sale we finance. In 2001 and 2002, automobile manufacturers have offered zero percent financing as sales incentives to new vehicle purchasers. Zero percent financing reduces, but does not eliminate, our per unit fee income from arranging financing, as we receive a payment from the manufacturers in connection with such financing. Many customers do not qualify for zero percent financing, either because of their credit standing or because they require longer financing terms than offered for zero percent financing. Incentive financing programs, including zero percent programs, usually offer cash rebates as an alternative to reduced interest rates. A majority of eligible customers elect to receive cash rebates instead of incentive financing, usually using the cash rebate as a down payment to complete the purchase of a new vehicle with little or no cash out of pocket.
We usually arrange financing for customers from outside sources on a non-recourse basis to avoid the risk of default. During 2001, we directly financed less than 0.01% of our vehicle sales.
Our finance and insurance managers also market third-party extended warranty contracts and insurance contracts to our new and used vehicle buyers. These products and services yield higher profit margins than vehicle sales and contribute significantly to our profitability. Extended warranty contracts provide additional coverage for new vehicles beyond the duration or scope of the manufacturer’s warranty. The service contracts we sell to used vehicle buyers provide coverage for certain major repairs.
We also offer our customers credit life, and health and accident insurance when they finance an automobile purchase and receive a commission on each policy sold. We also offer other products, such as protective coatings and automobile alarms.
Service, Body and Parts
Our automotive service, body and parts operations are an integral part of establishing customer loyalty and contribute significantly to our overall revenue and profits. We provide parts and service primarily for the new vehicle brands sold by our stores, but we also service other vehicles. In 2001, our service, body and parts operations generated $187.7 million in revenues, or 10.0% of total revenues. We set prices to reflect the difficulty of the types of repair and the cost and availability of parts.
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The service, body and parts businesses provide important repeat revenues to the stores. We market our parts and service products by notifying the owners of vehicles purchased at our stores when their vehicles are due for periodic service. This encourages preventive maintenance rather than post-breakdown repairs. We offer a lifetime oil and filter service, which in 2001 was purchased by 30% of our new and used vehicle buyers. This service helps us retain customers, and provides opportunities for repeat parts and service business. Revenues from the service, body and parts departments are important during economic downturns as owners tend to repair existing used vehicles rather than buy new vehicles during such periods. This limits the effects of a drop in new vehicle sales.
We operate twelve collision repair centers: two each in Oregon, Idaho and South Dakota and one each in California, Washington, Colorado, Nevada, Texas and Alaska. We work closely with the automobile insurance companies to provide collision repair services on claims at preferred rates based on the high volume of business. At our Medford, Oregon body shop, we provide office space to casualty insurers to process automobile claims. This helps generate further repair business.
Marketing
We market ourselves as “America’s Car & Truck Store.” We use most types of advertising, including television, newspaper, radio and direct mail, and an Internet web site. We advertise to develop our image as a reputable automotive retailer, offering quality service, affordable automobiles and financing for all buyers. The automobile manufacturers pay for many of our advertising and marketing expenditures. The manufacturers also provide us with market research, which assists us in developing our own advertising and marketing campaigns. In addition, our stores advertise discounts or other promotions to attract customers. By owning a cluster of stores in a particular market, we save money from volume discounts and other media concessions. We also participate as a member of advertising cooperatives and associations, whose members pool their resources and expertise with manufacturers to develop advertising campaigns.
We maintain a web site (www.lithia.com) that generates leads and provides information for our customers. We use the Internet site as a marketing tool to familiarize customers with us, our stores and the products we sell, rather than to complete purchases. Although many customers use the Internet to research information about new vehicles, nearly all ultimately visit a store to complete the sale and take delivery of the vehicle. Our web site enables a customer to:
We emphasize customer satisfaction and strive to develop a reputation for quality and fairness. We train our sales personnel to identify an appropriate vehicle for each of our customers at an affordable price.
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We believe that our “Priority You” customer-oriented plan differentiates us from other automotive retail stores. “Priority You” commits us to provide:
Management Information System
We consolidate, process and maintain financial information, operational and accounting data, and other related statistical information on computers at our headquarters. Our systems are based on an ADP platform for the main database, and information is processed and analyzed utilizing customized financial reporting software from Hyperion Solutions. Senior management can access detailed information from all of our locations regarding:
Each store’s general manager has access to this same information. With this information, we can quickly analyze the results of operations, identify trends and focus on areas that require attention or improvement. Our management information system also allows our general managers to respond quickly to changes in consumer preferences and purchasing patterns, maximizing our inventory turnover.
Our management information system is particularly important to successfully operating new stores. Following each acquisition, we immediately install our management information system at each location. This quickly makes financial, accounting and other operational data easily available throughout the company. With this information, we can more efficiently execute our operating strategy at the new store.
Franchise Agreements
Each of our store subsidiaries signs a franchise or dealer sales and service agreement with each manufacturer of the new vehicles it sells.
The typical automobile franchise agreement specifies the locations within a designated market area at which the store may sell vehicles and related products and perform certain approved services. The designation of such areas and the allocation of new vehicles among stores are at the discretion of the manufacturer. Except for Saturn franchises, franchise agreements do not guarantee exclusivity within a specified territory.
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A franchise agreement may impose requirements on the store with respect to:
Each manufacturer closely monitors compliance with these requirements and requires each store to submit monthly and annual financial statements. Franchise agreements also grant a store the right to use and display manufacturers’ trademarks, service marks and designs in the manner approved by each manufacturer.
Most franchise agreements expire after one to five years. However, all of our agreements have been renewed and we expect that manufacturers will continue to renew them in the future. In addition, state franchise laws limit the ability of manufacturers to terminate or fail to renew automotive franchises. Some franchise agreements, including those with DaimlerChrysler, have no termination date. Each franchise agreement authorizes at least one person to manage the store’s operations. The typical franchise agreement provides for early termination or non-renewal by the manufacturer upon:
We sign master framework agreements with most manufacturers that impose additional requirements on our stores. See Exhibit 99 “Risk Factors” for further details.
Competition
The retail automotive business is highly competitive, consisting of a large number of independent operators, many of whom are individuals, families and small retail groups. We compete primarily with other automotive retailers, both publicly and privately-held, near our store locations. In addition, regional and national car rental companies operate retail used car lots to dispose of their used rental cars.
We are larger and have more financial resources than the other automotive retailers with which we currently compete in most markets. As we enter other markets, we may face competitors that are larger or have access to greater financial resources. We do not have any cost advantage in purchasing new vehicles from manufacturers. We rely on advertising and merchandising, sales expertise, service reputation and location of our stores to sell new vehicles.
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In addition to competition for the sale of vehicles, we expect increased competition for the acquisition of other stores. We have faced only limited competition with respect to our acquisitions to date, primarily from privately-held automotive retailers. Other publicly-owned automotive retailers with significant capital resources may enter our current and targeted market areas in the future.
Regulation
Our business is subject to extensive regulation, supervision and licensing under federal, state and local laws, ordinances and regulations. State and federal regulatory agencies, such as the Occupational Safety and Health Administration and the U.S. Environmental Protection Agency, have jurisdiction over the operation of our stores, service centers, collision repair shops and other operations. They regulate matters such as consumer protection, workers’ safety and air and water quality.
Laws also protect franchised automotive retailers from the unequal bargaining power held by the manufacturers. Under those laws, a manufacturer may not:
Manufacturers may object to a sale of a store or change of management based on character, financial ability or business experience of the proposed new operator.
Automotive retailers and manufacturers are also subject to laws to protect consumers, including so-called “Lemon Laws.” A manufacturer must replace a new vehicle or accept it for a full refund within one year after initial purchase if:
We must provide written disclosures on new vehicles of mileage and pricing information. Financing and insurance activities are subject to credit reporting, debt collection, and insurance industry regulation.
Our business, particularly parts, service and collision repair operations, involves hazardous or toxic substances or wastes, such as motor oil, waste motor oil and filters, transmission fluid, antifreeze, freon, waste paint and lacquer thinner, batteries, solvents, lubricants, degreasing agents, gasoline and diesel fuels. Federal, state and local authorities establishing health and environmental quality standards regulate the handling, storage, treatment, recycling and disposal of hazardous substances and wastes and remediation of contaminated sites, both at our facilities and at sites to which we send hazardous or toxic substances or wastes for treatment, recycling or disposal. We are aware of contamination at certain of our current and former facilities, and we are in the process of conducting investigations and/or remediation at some of these properties. Based on our current information, any costs or liabilities relating to such contamination, other environmental matters or compliance with environmental regulations are not expected to have a material adverse effect on our results of operations or financial condition. There can be no assurances, however, that additional environmental matters will not arise or that new
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conditions or facts will not develop in the future at our current or formerly owned or operated facilities, or at sites that we may acquire in the future, or that these matters, conditions or facts will not result in a material adverse effect on our results of operations or financial condition.
Employees
As of December 31, 2001, we employed approximately 3,800 persons on a full-time equivalent basis. The service department employees at our Dodge, Ford and Volkswagen stores in Concord, California are unionized. We believe we have good relationships with our employees.
Item 2. Properties
Our stores and other facilities consist primarily of automobile showrooms, display lots, service facilities, twelve collision repair and paint shops, rental agencies, supply facilities, automobile storage lots, parking lots and offices. We believe our facilities are currently adequate for our needs and are in good repair. We own some of our properties, but also lease many properties, providing future flexibility to relocate our retail stores as demographics change. Most leases give us the option to renew the lease for one or more lease extension periods. We also hold some undeveloped land for future expansion.
Item 3. Legal Proceedings
We are a party to litigation that arises in the normal course of our business operations. We do not believe that we are presently a party to litigation that will have a material adverse effect on our business or operations.
Item 4. Submission of Matters to a Vote of Security Holders
No matters were submitted to a vote of our shareholders during the quarter ended December 31, 2001.
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PART II
Our Class A Common Stock trades on the New York Stock Exchange under the symbol LAD. The following table presents the high and low sale prices for our Class A common stock, as reported on the New York Stock Exchange Composite Tape for each of the quarters in 2000 and 2001:
The number of shareholders of record and approximate number of beneficial holders of Class A Common Stock at February 14, 2002 was 1,692 and 4,300, respectively. All shares of Lithia’s Class B Common Stock are held by Lithia Holding Company LLC.
Dividends
We have never declared or paid any cash dividends on our common stock and do not anticipate paying dividends for the foreseeable future. We intend to retain future earnings for acquisitions and operations. Our credit agreement with Ford Motor Credit Company precludes the payment of cash dividends without its prior consent. The payment of future dividends is also subject to the discretion of our Board of Directors.
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Item 6. Selected Financial Data
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We are a leading operator of automotive franchises and retailer of new and used vehicles and services. As of February 22, 2002, we offered 24 brands of new vehicles through 123 franchises in 65 stores in the western United States and over the Internet. As of February 22, 2002, we operate 16 stores in Oregon, 11 in California, 10 in Washington, 7 in Colorado, 7 in Idaho, 5 in Nevada, 4 in Texas, 3 in South Dakota and 2 in Alaska. We sell new and used cars and light trucks; sell replacement parts; provide vehicle maintenance, warranty, paint and repair services; and arrange related financing and insurance for our automotive customers.
During an economic downturn, customers tend to shift towards the purchase of more reasonably priced new vehicle models or used vehicles. Many customers decide to delay purchasing a new vehicle and instead repair existing vehicles. In addition, manufacturers typically offer increased dealer and customer incentives during an economic downturn in order to support new vehicle sales volume. These factors lead to less volatility in earnings for automobile retailers than for automobile manufacturers.
Historically, new vehicle sales account for approximately 50% of our total revenues but less than 30% of total gross profit. We emphasize sales of higher margin products, which generate over 70% of our gross profits. Our revenues and gross profit by product line were as follows for 2001:
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The following table sets forth selected condensed financial data for Lithia expressed as a percentage of total revenues for the periods indicated below.
Results of Operations — 2000 Compared to 2001
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Revenues. Total revenues increased 12.9% to record levels for 2001 compared to 2000 due to acquisitions, which were partially offset by same store retail sales decreasing 0.9%. The decrease in same store retail sales was due to a slower new vehicle sales environment in the first three quarters of 2001, offset in part by same store increases in used vehicle and finance and insurance sales. During the fourth quarter of 2001, manufacturers offered, and are continuing to offer in the first quarter of 2002, incentives, including low interest rates and rebates, in order to attract new vehicle buyers. These incentives, along with improvements in our core operations, contributed to same store sales growth of 11.4% in the fourth quarter of 2001 compared to the fourth quarter of 2000. The availability of cash rebates and zero percent and low interest rate financing have also enhanced our ability to sell finance, warranty and insurance products and services.
Other revenues include sales of finance, extended warranty and insurance contracts, presented net of administration fees and anticipated cancellations. It also includes fleet sales generally presented on a net basis.
Gross profit. Gross profit increased primarily due to increased total revenues and increased used vehicle and service, body and parts revenues as a percentage of total revenues. Incentives and rebates, including floorplan interest credits, received from manufacturers are recorded as a reduction to cost of goods sold. Gross margin expansion is common in the automotive retailing industry as new vehicle sales slow and higher margin product lines become a larger percentage of total revenues. Gross profit margins achieved in 2000 and 2001 were as follows:
The increase in the overall gross profit margin is primarily a result of a shift in mix to the more profitable used vehicle, service, body and parts and finance and insurance product lines.
Selling, general and administrative expense. Selling, general and administrative expense includes salaries and related personnel expenses, facility lease expense, advertising, legal, accounting, professional services and general corporate expenses. Selling, general and administrative expense increased due to increased selling, or variable, expenses related to the increase in revenues and the number of locations. As a percentage of revenue, selling, general and administrative expense increased in 2001 compared to 2000 due to continued investments in acquisition integration and operational support teams in preparation for continued growth and a shift towards our service and parts business, which has a higher selling, general and administrative component than our other business lines.
Depreciation and amortization. Depreciation and amortization expense increased primarily as a result of increased property and equipment and intangible assets related to acquisitions. As of December 31, 2001, we expect a reduction in annual amortization expense of approximately $3.7 million in 2002 based upon the adoption of SFAS No. 142, which relates to the accounting for goodwill and other intangible assets.
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Income from operations. Operating margins decreased 80 basis points, or eight-tenths of one percent, in 2001 compared to 2000 due to the increased operating expenses as a percentage of revenue as discussed above, partially offset by higher gross margins as a percentage of revenue.
Floorplan interest expense. The decrease in floorplan interest expense is primarily due to approximately $4.1 million in savings as a result of recent decreases in the effective interest rates on the floating rate credit lines, offset in part by an approximately $800,000 increase in interest expense as a result of higher average outstanding flooring debt. Floorplan interest expense includes the interest expense related to our current interest rate swaps. We were able to decrease our inventory levels despite the acquisition of several stores during 2001.
Other interest expense. Other interest expense includes interest on debt incurred related to acquisitions, real estate mortgages, our used vehicle line of credit and equipment related notes.
Income tax expense. Our effective tax rate was 38.6 percent in 2001 compared to 38.5 percent in 2000. Our effective tax rate may be affected in the future by the mix of asset acquisitions compared to corporate acquisitions, as well as by the mix of states where our stores are located.
Net income. Net income decreased to $21.8 million, a 10.5% decrease, for 2001 compared to 2000 as a result of the net effect of the changes discussed above.
Results of Operations — 1999 Compared to 2000
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Revenues. Same store retail sales increased 1.1% in 2000 compared to 1999. The increases in units sold and revenue from all sources are a result of acquisitions and internal growth.
Gross profit. Gross profit increased primarily due to increased total revenues and increased other revenues as a percentage of total revenues. Gross profit margins achieved in 1999 and 2000 were as follows:
The increases in the gross profit margins are primarily a result of operational improvements at our newly acquired stores, as we implemented our business model.
Selling, general and administrative expense. Selling, general and administrative expense increased due primarily to increased selling, or variable, expense related to the increase in revenues and the number of total locations. Selling, general and administrative expense, as a percentage of revenue, remained constant in 2000 compared to 1999.
Depreciation and amortization. Depreciation and amortization expense increased primarily as a result of increased property and equipment and goodwill related to acquisitions in 1999 and 2000.
Income from operations. Operating margins improved ten basis points in 2000 compared to 1999. In addition to gaining efficiencies related to economies of scale, we have improved the operating margins at acquired stores that we have operated for a full year, bringing them more in line with our pre-existing stores.
Floorplan interest expense. Seventy-five percent of the increase in floorplan interest expense is due to additional flooring notes payable as a result of higher inventory levels from acquisitions. Twenty-five percent of the increase is due to an overall rise in borrowing rates during 2000.
Other interest expense. Eighty percent of the increase in other interest expense is due to higher debt levels as a result of acquisitions. Twenty percent of the increase is due to an overall rise in borrowing rates during 2000.
Income tax expense. Our effective tax rate declined to 38.5 percent in 2000 from 40.2 percent in 1999 as a result of an increasing mix of asset acquisitions compared to corporate acquisitions and the increased weighting of deductible goodwill, as well as an increase in the mix of states with lower or no state income taxes.
Net income. Net income increased primarily as a result of increased revenues as discussed above.
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Selected Consolidated Quarterly Financial Data
The following tables set forth the company’s unaudited quarterly financial data for the quarterly periods presented.
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Liquidity and Capital Resources
Our principal needs for capital resources are to finance acquisitions and capital expenditures, as well as for working capital. We have relied primarily upon internally generated cash flows from operations, borrowings under our credit agreements and the proceeds from public equity offerings to finance operations and expansion. We believe that our available cash, cash equivalents, available lines of credit and cash flows from operations will be sufficient to meet our anticipated operating expenses and capital requirements for at least twelve months from December 31, 2001. These resources will be sufficient to fund our anticipated acquisitions through 2002.
In June 2000, our Board of Directors authorized the repurchase of up to 1,000,000 shares of our Class A common stock. We have purchased 40,000 shares under this program and may continue to do so from time to time in the future as conditions warrant.
We have credit facilities with Ford Motor Credit Company totaling $530 million, which expire December 1, 2003, with interest due monthly. The facilities include $250 million for new and program vehicle flooring, $150 million for used vehicle flooring and $130 million for store acquisitions. We also have the option to convert the acquisition line into a five-year term loan.
The credit lines with Ford Motor Credit are cross-collateralized and are secured by inventory, accounts receivable, intangible assets and equipment. We pledged to Ford Motor Credit the stock of all of our subsidiaries except entities operating BMW, Honda, Nissan or Toyota stores.
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The financial covenants in our agreement with Ford Motor Credit require us to maintain compliance with, among other things, (1) specified ratios total debt to tangible base capital; (2) specified ratios of total adjusted debt to tangible base capital; (3) specific current ratio; (4) specific fixed charge coverage ratio; and (5) positive net cash. The Ford Motor Credit agreements also preclude the payment of cash dividends without prior consent. We were in compliance with all such covenants at December 31, 2001.
Toyota Financial Services, DaimlerChrysler Financial Corporation and General Motors Acceptance Corporation have agreed to floor all of our new vehicles for their respective brands with Ford Motor Credit serving as the primary lender for all other brands. These new vehicle lines are secured by new vehicle inventory of the relevant brands.
We also have a real estate line of credit with Toyota Financial Services totaling $18 million, which expires July 2, 2006. This line of credit is secured by the real estate financed under this line of credit. In February 2002, this line of credit was increased to $40 million.
In addition, U.S. Bank N.A. has extended a $27.5 million revolving line of credit for leased vehicles and equipment purchases, which expires January 31, 2004.
Interest rates on all of the above facilities ranged from 3.38% to 4.63% at December 31, 2001. Amounts outstanding on the lines at December 31, 2001 together with amounts remaining available under such lines were as follows (in thousands):
At December 31, 2001, we had capital commitments of approximately $9.0 million for the construction of three new store facilities and additions to two existing facilities, all of which is anticipated to be incurred in 2002. We expect to pay for the construction out of existing cash balances until completion of the projects, at which time we anticipate securing long-term financing and general borrowings from third party lenders for 85% to 100% of the amounts expended.
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Seasonality and Quarterly Fluctuations
Historically, our sales have been lower in the first and fourth quarters of each year due to consumer purchasing patterns during the holiday season, inclement weather and the reduced number of business days during the holiday season. As a result, financial performance may be lower during the first and fourth quarters than during the other quarters of each fiscal year. We believe that interest rates, levels of consumer debt, consumer confidence and buying patterns, as well as general economic conditions, also contribute to fluctuations in sales and operating results. Historically, the timing and frequency of acquisitions has been the largest contributor to fluctuations in our operating results from quarter to quarter.
Recent Accounting Pronouncements
In July 2001, the Financial Accounting Standards Board issued SFAS No. 141, “Business Combinations,” and SFAS No. 142, “Goodwill and Other Intangible Assets.” SFAS No. 141 requires that the purchase method of accounting be used for all business combinations initiated after June 30, 2001. SFAS No. 142 requires that goodwill and intangible assets with indefinite useful lives no longer be amortized, but instead tested for impairment at least annually in accordance with the provisions of SFAS No. 142. SFAS No. 142 also requires that intangible assets with estimable useful lives be amortized over their respective estimated useful lives to their estimated residual values, and reviewed for impairment in accordance with SFAS No. 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of.”
We adopted the provisions of SFAS No. 141 on July 1, 2001, and SFAS No. 142 on January 1, 2002. Goodwill and intangible assets determined to have indefinite useful lives acquired in a purchase business combination completed after June 30, 2001 but before SFAS No. 142 was adopted in full, were not amortized, but evaluated for impairment in accordance with the appropriate pre-SFAS No. 142 accounting literature. Goodwill and intangible assets acquired in business combinations completed before July 1, 2001 continued to be amortized and tested for impairment in accordance with the appropriate pre-SFAS No. 142 accounting requirements prior to the adoption of SFAS No. 142.
SFAS No. 141 requires, upon adoption of SFAS No. 142, that we evaluate our existing intangible assets and goodwill that we acquired in prior purchase business combinations, and make any necessary reclassifications in order to conform with the new criteria in SFAS No. 141 for recognition apart from goodwill. We do not anticipate reclassifying any intangibles to intangibles with determinable useful lives. For intangible assets identified as having indefinite useful lives, we are required to test them for impairment in accordance with the provisions of SFAS No. 142 within the first interim period and recognize any impairment losses as the cumulative effect of a change in accounting principle in the first interim period. We do not anticipate incurring any impairment loss charges upon adoption of SFAS No. 142.
The adoption of SFAS No. 141 did not have a significant impact on our financial condition or results of operations. As of December 31, 2001, we expect a reduction in annual amortization expense of approximately $3.7 million in 2002 upon adoption of SFAS No. 142.
25
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Variable Rate Debt
We use variable-rate debt to finance our new and program vehicle inventory. The interest rate on the flooring debt is tied to either the one-month LIBOR, the three-month LIBOR or the prime rate. These debt obligations therefore expose us to variability in interest payments due to changes in these rates. The flooring debt is based on open-ended lines of credit tied to each individual store from the various manufacturer finance companies. If interest rates increase, interest expense increases. Conversely, if interest rates decrease, interest expense decreases.
Our variable-rate flooring notes payable and other credit line borrowings subject us to market risk exposure. At December 31, 2001, we had $344.2 million outstanding under such agreements at interest rates ranging from 3.38% to 4.63% per annum. A 10% increase in interest rates would increase interest expense by approximately $675,000, net of tax, in 2002 based on amounts outstanding on the lines of credit at December 31, 2001.
Hedging Strategies
We believe it is prudent to limit the variability of a portion of our interest payments. Accordingly, we have entered into interest rate swaps to manage the variability of our interest rate exposure, thus leveling a portion of our interest expense in a rising or falling rate environment. We currently have hedged approximately 17.8% of our flooring debt.
The interest rate swaps change the variable-rate cash flow exposure on a portion of the flooring debt to fixed rate cash flows by entering into receive-variable, pay-fixed interest rate swaps. Under the interest rate swaps, we receive variable interest rate payments and make fixed interest rate payments, thereby creating fixed rate flooring debt.
We have entered into the following interest rate swaps with U.S. Bank Dealer Commercial Services:
We earn interest on both of the $25 million interest rate swaps at the one-month LIBOR rate adjusted on the first and sixteenth of every month and we are obligated to pay interest at the fixed rate set for each swap (6.88% or 6.47% per annum) on the same amount. The difference between interest earned and the interest obligation accrued is received or paid each month and is recorded in the statement of operations as flooring interest expense. The one-month LIBOR rate at December 31, 2001 was 1.87% per annum.
We do not enter into derivative instruments for any purpose other than to manage interest rate exposure. That is, we do not speculate using derivative instruments.
The fair value of interest rate swap agreements and the amount of hedging losses deferred on interest rate swaps was $3.4 million at December 31, 2001. Changes in the fair value of the interest rate swaps are reported, net of related income taxes, in accumulated other comprehensive income. These amounts are subsequently reclassified into interest expense
26
as a yield adjustment in the same period in which the related interest on the flooring debt affects earnings. Because the critical terms of the interest rate swap and the underlying debt obligation are the same, there was no ineffectiveness recorded in interest expense.
Incremental interest expense incurred as a result of the interest rate swaps was $1.4 million in 2001. Interest expense savings on un-hedged debt as a result of decreasing interest rates during 2001 was approximately $6.4 million.
At current interest rates, we estimate that we will incur additional interest expense, net of tax, of approximately $1.5 million related to our interest rate swaps during 2002.
Risk Management Policies
We assess interest rate cash flow risk by continually identifying and monitoring changes in interest rate exposures that may adversely impact expected future cash flows and by evaluating hedging opportunities.
We maintain risk management control systems to monitor interest rate cash flow attributable to both our outstanding and our forecasted debt obligations as well as our offsetting hedge positions. The risk management control systems involve the use of analytical techniques, including cash flow sensitivity analysis, to estimate the expected impact of changes in interest rates on our future cash flows.
As of December 31, 2001, approximately 80% of our total debt outstanding was subject to un-hedged variable rates of interest. As a result, interest rate declines during 2001 have resulted in a net reduction of our interest expense for 2001 compared to what it would have been at similar debt levels with no interest rate decline. We intend to continue to gradually hedge our interest rate exposure if market rates continue to decline.
Item 8. Financial Statements and Supplementary Financial Data
The financial statements and notes thereto required by this item begin on page F-1 as listed in Item 14 of Part IV of this document. Quarterly financial data for each of the eight quarters in the two-year period ended December 31, 2001 is included in Item 7.
None.
27
PART III
Item 10. Directors and Executive Officers of the Registrant
Information required by this item will be included under the captionsElection of Directors, Executive Officers and Section 16(a) Beneficial Ownership Reporting Compliance, respectively, in our Proxy Statement for our 2002 Annual Meeting of Shareholders and is incorporated herein by reference.
Item 11. Executive Compensation
The information required by this item will be included under the captionExecutive Compensation in our Proxy Statement for our 2002 Annual Meeting of Shareholders and is incorporated herein by reference.
The information required by this item will be included under the captionSecurity Ownership of Certain Beneficial Owners and Management in our Proxy Statement for our 2002 Annual Meeting of Shareholders and is incorporated herein by reference.
Item 13. Certain Relationships and Related Transactions
The information required by this item will be included under the captionCertain Relationships and Related Transactions in our Proxy Statement for our 2002 Annual Meeting of Shareholders and is incorporated herein by reference.
28
PART IV
(a) Financial Statements and Schedules
The Consolidated Financial Statements, together with the report thereon of KPMG LLP, are included on the pages indicated below:
There are no schedules required to be filed herewith.
(b) Reports on Form 8-K
The Company did not file any reports on Form 8-K during the quarter ended December 31, 2001.
(c) Exhibits
The following exhibits are filed herewith and this list is intended to constitute the exhibit index:
29
30
31
32
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities indicated on February 22, 2002:
33
Independent Auditors’ Report
The Board of Directors and StockholdersLithia Motors, Inc. and Subsidiaries:
We have audited the accompanying consolidated balance sheets of Lithia Motors, Inc. and Subsidiaries as of December 31, 2001 and 2000, and the related consolidated statements of operations, changes in stockholders’ equity and comprehensive income, and cash flows for each of the years in the three-year period ended December 31, 2001. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Lithia Motors, Inc. and Subsidiaries as of December 31, 2001 and 2000, and the consolidated results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2001, in conformity with accounting principles generally accepted in the United States of America.
As discussed in note 1 to the financial statements, effective January 1, 2001, the Company adopted the provisions of Statement of Financial Accounting Standards (SFAS) No. 133, "Accounting for Derivative Instruments and Hedging Activities," as amended. As discussed in note 15 to the financial statements, effective July 1, 2001, the Company adopted the provisions of SFAS No. 141, "Business Combinations," and certain provisions of SFAS No. 142, "Goodwill and Other Intangible Assets," as required for goodwill and intangible assets resulting from business combinations consummated after June 30, 2001.
KPMG LLP
Portland, OregonFebruary 7, 2002
F-1
LITHIA MOTORS, INC. AND SUBSIDIARIESConsolidated Balance Sheets(In thousands)
See accompanying notes to consolidated financial statements.
F-2
LITHIA MOTORS, INC. AND SUBSIDIARIESConsolidated Statements of Operations(In thousands, except per share amounts)
F-3
LITHIA MOTORS, INC. AND SUBSIDIARIESConsolidated Statements of Changes in Stockholders’ Equity and Comprehensive IncomeFor the years ended December 31, 1999, 2000 and 2001(In thousands, except share data)
F-4
LITHIA MOTORS, INC. AND SUBSIDIARIESConsolidated Statements of Cash Flows(In thousands)
F-5
LITHIA MOTORS, INC.AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTSDECEMBER 31, 2001, 2000 and 1999
Organization and Business
Lithia is a leading operator of automotive franchises and retailer of new and used vehicles and services through a well-developed franchise system with its automotive manufacturer partners. As of February 22, 2002, we offered 24 brands of new vehicles through 123 franchises in 65 stores in the western United States and over the Internet. As of February 22, 2002, we operate 16 stores in Oregon, 11 in California, 10 in Washington, 7 in Colorado, 7 in Idaho, 5 in Nevada, 4 in Texas, 3 in South Dakota and 2 in Alaska. Lithia sells new and used cars and light trucks; sells replacement parts; provides vehicle maintenance, warranty, paint and repair services; and arranges related financing and insurance for its automotive customers.
Principles of Consolidation
The accompanying financial statements reflect the results of operations, the financial position, and the cash flows for Lithia Motors, Inc. and its directly and indirectly wholly-owned subsidiaries. All significant intercompany accounts and transactions, consisting principally of intercompany sales, have been eliminated upon consolidation.
Cash and Cash Equivalents
For purposes of reporting cash flows, the Company considers contracts in transit and all highly liquid debt instruments with a maturity of three months or less when purchased to be cash equivalents.
Inventories
The Company accounts for inventories at the lower of market value or cost, using the specific identification method for vehicles and the first-in first-out (FIFO) method for parts (collectively, the FIFO method).
Property, Plant and Equipment
Property, plant and equipment are stated at cost and are being depreciated over their estimated useful lives, principally on the straight-line basis. The range of estimated useful lives is as follows:
The cost for maintenance, repairs and minor renewals is expensed as incurred, while significant renewals and betterments are capitalized. When an asset is retired or otherwise disposed of, the related cost and accumulated depreciation are removed from the accounts, and any gain or loss is credited or charged to income.
Leased property meeting certain criteria is capitalized and the present value of the related lease payments is recorded as a liability. Amortization of capitalized leased assets is computed on a straight-line basis over the shorter of the useful life or the term of the lease and is included in depreciation expense.
F-6
Investment in Affiliate
The Company has a 20% interest in Lithia Properties, LLC, of which the other members are Sidney DeBoer (35%), M. L. Dick Heimann (30%) and three of Mr. DeBoer’s children (5% each). The investment is accounted for using the equity method, with a carrying value of $34,000 and $131,000 at December 31, 2001 and 2000, respectively.
Environmental Liabilities and Expenditures
Accruals for environmental matters, if any, are recorded in operating expenses when it is probable that a liability has been incurred and the amount of the liability can be reasonably estimated. Accrued liabilities are exclusive of claims against third parties and are not discounted.
In general, costs related to environmental remediation are charged to expense. Environmental costs are capitalized if the costs increase the value of the property and/or mitigate or prevent contamination from future operations.
We are aware of contamination at certain of our current and former facilities, and we are in the process of conducting investigations and/or remediation at some of these properties. Based on our current information, any costs or liabilities relating to such contamination, other environmental matters or compliance with environmental regulations are not expected to have a material adverse effect on our results of operations or financial condition. There can be no assurances, however, that additional environmental matters will not arise or that new conditions or facts will not develop in the future at our current or formerly owned or operated facilities, or at sites that we may acquire in the future, that will result in a material adverse effect on our results of operations or financial condition.
Income Taxes
Income taxes are accounted for under the asset and liability method as prescribed by Statement of Financial Accounting Standards No. 109 “Accounting for Income Taxes.” Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.
Computation of Per Share Amounts
Basic earnings per share (EPS) and diluted EPS are computed using the methods prescribed by Statement of Financial Accounting Standards No. 128,Earnings per Share (SFAS 128). Following is a reconciliation of basic EPS and diluted EPS (in thousands, except per share amounts):
F-7
451,000, 683,000 and 34,000 shares issuable pursuant to stock options have not been included in the above calculations for 2001, 2000 and 1999, respectively, since they would have been antidilutive, or “not in the money.”
Advertising
The Company expenses production and other costs of advertising as incurred. Advertising expense was $15.7 million, $15.3 million and $11.2 million for the years ended December 31, 2001, 2000 and 1999, respectively.
Goodwill
Goodwill represents the excess purchase price over fair value of net assets acquired, which is not allocable to separately identifiable intangible assets. Goodwill acquired prior to July 1, 2001 continued to be amortized on the straight-line basis over the expected period to be benefited of forty years. Pursuant to SFAS No. 142, “Goodwill and Other Intangible Assets,” which will be fully adopted in the first quarter of 2002, goodwill acquired after June 30, 2001 was not amortized, but, instead, will be tested for impairment at least annually in accordance with the provisions of SFAS No. 142. Upon full adoption of SFAS No. 142, all goodwill will cease to be amortized. See also Note 15 “Recent Accounting Pronouncements.”
Other Intangible Assets
Other intangible assets represent the franchise value of stores acquired since July 1, 2001. All of the Company’s other intangible assets have indefinite useful lives and therefore are not amortized, but instead will be tested for impairment in accordance with SFAS No. 142. See also Note 15 “Recent Accounting Pronouncements.”
Concentrations of Credit Risk
Concentrations of credit risk with respect to trade receivables are limited due to the large number of customers comprising the Company’s customer base. Receivables from all manufacturers accounted for 33.4% and 36.4%, respectively, of total accounts receivable at December 31, 2001 and 2000. Included in the 33.4% are two manufacturers who accounted for 12.6% and 7.4%, respectively, of the total accounts receivable balance at December 31, 2001. Included in the 36.4% are two manufacturers who accounted for 12.5% and 10.3%, respectively, of the total accounts receivable balance at December 31, 2000.
Financial instruments, which potentially subject the Company to concentrations of credit risk, consist principally of cash deposits. The Company generally is exposed to credit risk from balances on deposit in financial institutions in excess of the FDIC-insured limit.
F-8
Financial Instruments and Market Risks
The carrying amount of cash equivalents, trade receivables, trade payables, accrued liabilities and short term borrowings approximates fair value because of the short-term nature of these instruments. The fair values of long-term debt and notes receivable for leased vehicles accounted for as sales-type leases were estimated by discounting the future cash flows using market interest rates and do not differ significantly from that reflected in the financial statements.
Fair value estimates are made at a specific point in time, based on relevant market information about the financial instrument. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates.
Lithia has variable rate floor plan notes payable and other credit line borrowings that subject it to market risk exposure. At December 31, 2001 Lithia had $344.2 million outstanding under such facilities at interest rates ranging from 3.38% to 4.63% per annum. An increase or decrease in the interest rates would affect interest expense for the period accordingly.
Lithia also subjects itself to credit risk and market risk by entering into interest rate swaps. See Note 5. The Company minimizes the credit or repayment risk in derivative instruments by entering into transactions with high quality institutions, whose credit rating is higher than Aa.
Derivative Financial Instruments
Lithia enters into interest rate swap agreements to reduce its exposure to market risks from changing interest rates. The difference between interest paid and interest received, which may change as market interest rates change, is accrued and recognized as interest expense. If a swap is terminated prior to its maturity, the gain or loss is recognized over the remaining original life of the swap if the item hedged remains outstanding, or immediately if the item hedged does not remain outstanding. If the swap is not terminated prior to maturity, but the underlying hedged item is no longer outstanding, the interest rate swap is marked to market, and any unrealized gain or loss is recognized immediately.
Effective January 1, 2001, Lithia adopted the provisions of Statement of Financial Accounting Standards (SFAS) No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended by SFAS No. 138, “Accounting for Certain Derivative Instruments and Certain Hedging Activities-an amendment of FASB Statement No. 133” and SFAS No. 137, “Accounting for Derivative Instruments and Hedging Activities” (collectively, “the Standards”). The Standards require that all derivative instruments (including certain derivative instruments embedded in other contracts) be recorded on the balance sheet as either an asset or liability measured at its fair value, and that changes in the derivatives fair value be recognized currently in earnings unless specific hedge accounting criteria are met. Upon adoption of the Standards, the Company recorded a liability of $1.5 million and a corresponding, net-of-tax, cumulative-effect-type adjustment of $948,000 in accumulated other comprehensive income to recognize, at fair value, all derivatives that are designated as cash-flow hedging instruments.
F-9
Use of Estimates
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and related notes to financial statements. Changes in such estimates may affect amounts reported in future periods.
Revenue Recognition
Revenue from the sale of vehicles is recognized upon delivery, when the sales contract is signed, down payment has been received and funding has been approved from the lending agent. Fleet sales of vehicles whereby the Company does not take title are shown on a net basis in other revenue.
Finance fees represent revenue earned by the Company for notes placed with financial institutions in connection with customer vehicle financing net of estimated chargebacks. Finance fees are recognized in income upon acceptance of the credit by the financial institution. Insurance income represents commissions earned on credit life, accident and disability insurance sold in connection with the vehicle on behalf of third party insurance companies. Commissions from third party service contracts are recognized upon sale. Insurance commissions are recognized in income upon customer acceptance of the insurance terms as evidenced by contract execution. Finance fees and service contract and insurance commissions, net of administration fees and anticipated cancellations, are classified as other operating revenue in the accompanying consolidated statements of operations.
Comprehensive Income
Comprehensive income includes the unrealized gain on investments and the fair value of cash flow hedging instruments that are reflected in stockholders’ equity instead of net income.
Major Supplier and Dealer Agreements
The Company purchases substantially all of its new vehicles and inventory from various manufacturers at the prevailing prices charged by the auto maker to all franchised dealers. The Company’s overall sales could be impacted by the auto maker’s inability or unwillingness to supply the dealership with an adequate supply of popular models.
The Company enters into agreements (Dealer Agreements) with the manufacturers. The Dealer Agreements generally limit the location of the dealership and provide the auto maker approval rights over changes in dealership management and ownership. The automakers are also entitled to terminate the Dealer Agreements if the dealership is in material breach of the terms. The Company’s ability to expand operations depends, in part, on obtaining consents of the manufacturers for the acquisition of additional dealerships.
F-10
Stock-Based Compensation Plans
The Company accounts for its stock-based compensation plans under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (APB 25). The Company adopted the disclosure option of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (SFAS 123). SFAS 123 requires that companies, which do not choose to account for stock-based compensation as prescribed by this statement, shall disclose the pro forma effects on earnings and earnings per share as if SFAS 123 had been adopted. Additionally, certain other disclosures are required with respect to stock compensation and the assumptions used to determine the pro forma effects of SFAS 123.
Segment Reporting
The Company adopted Statement of Financial Accounting Standards No. 131 (SFAS 131), “Disclosures about Segments of an Enterprise and Related Information,” for the year ended December 31, 1998. Based upon definitions contained within SFAS 131, the Company has determined that it operates in one segment, automotive retailing.
Reclassifications
Certain items previously reported in specific financial statement captions have been reclassified to conform with the current presentation.
The new and used vehicle inventory, collateralizing related notes payable, and other inventory were as follows (in thousands):
The inventory balance is generally reduced by manufacturer’s purchase discounts. Such reductions are not reflected in the related floor plan liability.
All new vehicles are pledged to collateralize floor plan notes payable to financial institutions. The floor plan notes payable bear interest, payable monthly on the outstanding balance, at a rate of interest determined by the lender, subject to incentives. The new vehicle floor plan notes are due when the related vehicle is sold. As such, these floor plan notes payable are shown as a current liability in the accompanying consolidated balance sheets.
Used vehicles are pledged to collateralize a $150 million line of credit. The line of credit is due in November 2003.
F-11
Vehicles leased to others are stated at cost and depreciated over their estimated useful lives (5 years) on a straight-line basis. Lease receivables result from customer, employee and fleet leases of vehicles under agreements that qualify as operating leases. Leases are cancelable at the option of the lessee after providing 30 days written notice.
We believe it is prudent to limit the variability of a portion of our interest payments. Accordingly, we have entered into interest rate swaps to manage the variability of our interest rate exposure, thus leveling a portion of our interest expense in a rising or falling rate environment. At December 31, 2001, we had hedged approximately 17.8% of our flooring debt.
F-12
The fair value of interest rate swap agreements and the amount of hedging losses deferred on interest rate swaps was $3.4 million and $1.5 million, respectively, at December 31, 2001 and 2000. Changes in the fair value of the interest rate swaps are reported, net of related income taxes, in accumulated other comprehensive income. These amounts are subsequently reclassified into interest expense as a yield adjustment in the same period in which the related interest on the flooring debt affects earnings. Because the critical terms of the interest rate swap and the underlying debt obligation are the same, there was no ineffectiveness recorded in interest expense.
Incremental interest expense incurred as a result of the interest rate swaps was $1.4 million and $10,000, respectively in 2001 and 2000. Interest expense savings on un-hedged debt as a result of decreasing interest rates during 2001 was approximately $6.4 million.
At one of its locations, the Company leases vehicles to customers under sales-type leases. The following lists the components of the net investment in sales-type leases, classified as a component of notes receivable in the consolidated balance sheets (in thousands).
Future minimum lease payments to be received on the notes receivable after December 31, 2001 are as follows (in thousands):
F-13
Interest rates on all of the above facilities are variable and ranged from 3.38% to 4.63% at December 31, 2001. Amounts outstanding on the lines at December 31, 2001 together with amounts remaining available under such lines were as follows (in thousands):
F-14
Long-term debt consists of the following (in thousands):
The schedule of future principal payments on long-term debt after December 31, 2001 is as follows (in thousands):
The shares of Class A Common Stock are not convertible into any other series or class of the Company’s securities. However, each share of Class B Common Stock is freely convertible into one share of Class A Common Stock at the option of the holder of the Class B Common Stock. All shares of Class B Common Stock shall automatically convert to shares of Class A Common Stock (on a share-for-share basis, subject to the adjustments) on the earliest record date for an annual meeting of the Company stockholders on which the number of shares of Class B Common Stock outstanding is less than 1% of the total number of shares of Common Stock outstanding. Shares of Class B Common Stock may not be transferred to third parties, except for transfers to certain family members and in other limited circumstances.
Holders of Class A Common Stock are entitled to one vote for each share held of record, and holders of Class B Common Stock are entitled to ten votes for each share held of record. The Class A Common Stock and Class B Common Stock vote together as a single class on all matters submitted to a vote of stockholders.
F-15
In 1999, the Company authorized 15,000 shares of Series M Redeemable, Convertible Preferred Stock (“Series M Preferred Stock”). In May 1999, in connection with the acquisition of Moreland Automotive Group, the Company issued 10,360 shares of Series M Preferred Stock. The Series M Preferred Stock votes with Class A Common Stock on an as if converted basis. The Series M Preferred Stock is convertible into Class A Common Stock at the option of the Company at any time and at the option of the holder under limited circumstances. The Series M Preferred Stock is redeemable at the option of the Company. The Series M Preferred Stock converts into Class A Common Stock based on a formula that divides the average Class A Common Stock price for a certain 15-day period into one thousand and then multiplies by the number of Series M Preferred Shares being converted. The Series M Preferred Stock does not have a dividend preference, but participates in any dividends on an as if converted basis. The Series M Preferred Stock has a $1,000 per share liquidation preference.
In the first quarter of 2000, the Company issued 303,542 shares of Class A Common Stock and 4,499 shares of Series M Preferred Stock in order to satisfy contingent payout requirements related to the Moreland acquisition.
In June 2001, the Company converted 5,183 shares of Series M Preferred Stock with an aggregate conversion price of $5.2 million into an aggregate of 265,247 shares of Class A Common Stock.
Income tax expense for 2001, 2000 and 1999 was as follows (in thousands):
Individually significant components of the deferred tax assets and liabilities are presented below (in thousands):
F-16
The reconciliation between amounts computed using the federal income tax rate of 35% and the Company’s income tax expense for 2001, 2000 and 1999 is shown in the following tabulation.
Recourse Paper
The Company is contingently liable to banks for recourse paper assumed at the time of acquisition when the Company does a corporate purchase. Following the acquisition, the Company does not enter into further recourse transactions. The contingent liability, net of reserves, at December 31, 2001 and 2000 was approximately $322,000 and $907,000, respectively.
The Company’s potential loss is limited to the difference between the present value of the installment contract at the date of the repossession and the amount for which the vehicle is resold. Based upon historical loss percentages, an estimated loss reserve of $573,000 and $540,000 is reflected in the Company’s consolidated balance sheets as of December 31, 2001 and 2000, respectively. The reserves were established as a purchase price adjustment as the result of several acquisitions.
Leases
The Company leases certain of its facilities under noncancelable operating leases. These leases expire at various dates through 2021. Certain lease commitments are subject to escalation clauses of an amount equal to the cost of living based on the “Consumer Price Index — U.S. Cities Average — All Items for all Urban Consumers” published by the U.S. Department of Labor.
The minimum lease payments under the operating leases after December 31, 2001 are as follows (in thousands):
Rental expense for all operating leases was $15.9 million, $13.8 million and $9.6 million for the years ended December 31, 2001, 2000 and 1999, respectively.
F-17
Capital Commitments
At December 31, 2001, the Company had capital commitments of approximately $9.0 million for the construction of three new store facilities and additions to two existing facilities, all of which is anticipated to be incurred in 2002. Lithia expects to pay for the construction out of existing cash balances until completion of the projects, at which time Lithia anticipates securing long-term financing and general borrowings from third party lenders for 85% to 100% of the amounts expended.
Litigation
The Company is involved in various claims and legal actions arising in the ordinary course of business. In the opinion of management, the ultimate disposition of these matters will not have a material adverse effect on the Company’s financial position, results of operations or liquidity.
The Company has a defined contribution plan and trust covering substantially all full-time employees. The annual contribution to the plan is at the discretion of the Board of Directors of the Company. Contributions of $1.1 million, $166,000 and $591,000 were recognized for the years ended December 31, 2001, 2000 and 1999, respectively. Employees may contribute to the plan under certain circumstances.
The Company’s 2001 Stock Option Plan (‘the 2001 Plan”), which was approved by the stockholders of the Company in May 2001, allows for the granting of up to a total of 600,000 incentive and nonqualified stock options to officers, key employees and consultants of the Company and its subsidiaries. Upon approval of the 2001 Plan, the Company’s 1996 Stock Incentive Plan (the “1996 Plan”) and its Non-Discretionary Stock Option Plan for Non-Employee Directors (the “Directors’ Plan”) were terminated. However, options then outstanding under the 1996 Plan and the Directors’ Plan remained outstanding and exercisable pursuant to their original terms. Options canceled under the 1996 Plan and the Directors’ Plan do not return to the pool of options to be granted again in the future. All of the option plans are administered by the Compensation Committee of the Board and permit accelerated vesting of outstanding options upon the occurrence of certain changes in control of the Company. Options become exercisable over a period of up to ten years from the date of grant and at exercise prices as determined by the Board. At December 31, 2001, 1,697,345 shares of Class A Common Stock were reserved for issuance under the plans, of which 287,600 were available for future grant.
F-18
Activity under the plans is as follows (in thousands):
The Board of Directors approved the issuance of non-qualified options during 2000 to certain members of senior management at an exercise price of $1.00 per share. These options were issued with five-year cliff vesting as a means to encourage long-term employment from certain members of the senior management group. Compensation expense, which is equal to the difference between the market price and the exercise price, is recognized ratably in accordance with the vesting schedules.
In 1998, the Board of Directors of the Company and the stockholders approved the implementation of an Employee Stock Purchase Plan (the “Purchase Plan”), and reserved a total of 250,000 shares of Class A Common Stock for issuance under the Purchase Plan. In 2000, the stockholders approved an increase in the total number of shares of Class A Common Stock reserved for issuance under the Purchase Plan to 500,000 shares. The Purchase Plan is intended to qualify as an “Employee Stock Purchase Plan” under Section 423 of the Internal Revenue Code of 1986, as amended, and is administered by the Compensation Committee of the Board. Eligible employees are entitled to invest up to 10 percent of their base pay for the purchase of stock. The purchase price for shares purchased under the Purchase Plan is 85 percent of the lesser of the fair market value at the beginning or end of the purchase period. A total of 142,433, 133,762 and 49,808 shares of the Company’s Class A Common Stock were issued under the Purchase Plan during 2001, 2000 and 1999, respectively, and 165,071 remained available for issuance at December 31, 2001.
During 1995, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 123 Accounting for Stock-Based Compensation (SFAS 123), which defines a fair value based method of accounting for employee stock options and similar equity instruments. As permitted under SFAS 123, the Company has elected to continue to account for its stock-based compensation plans under Accounting Principal Board Opinion No. 25 Accounting for Stock Issued to Employees (APB 25), and related interpretations. Accordingly, no compensation expense has been recognized for any of the Company’s option plans or for the Purchase Plan (collectively the “Plans”).
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The Company has computed, for pro forma disclosure purposes, the value of options granted under the Plans, using the Black-Scholes option pricing model as prescribed by SFAS 123, using the weighted average assumptions for grants as follows:
Using the Black-Scholes methodology, the total value of options granted during 2001, 2000 and 1999 was $3.9 million, $6.5 million and $2.9 million, respectively, which would be amortized on a pro forma basis over the vesting period of the options, typically four to five years. The weighted average fair value of options granted during 2001, 2000 and 1999 was $8.30, $7.79 and $9.17 per share, respectively. If the Company had accounted for its stock-based compensation plans in accordance with SFAS 123, the Company’s net income and net income per share would approximate the pro forma disclosures below (net income in thousands):
The following table summarizes stock options outstanding at December 31, 2001:
At December 31, 2000 and 1999, 245,980 and 306,986 shares were exercisable at weighted average exercise prices of $9.01 and $5.03, respectively.
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Lithia Properties, LLC, owned certain of the real property on which the Company’s business is located. The Company owns a 20% interest in Lithia Properties, LLC. Through 2000, the Company leased such facilities under various lease agreements from Lithia Properties, LLC. Selling, general and administrative expense includes rental expense of $0, $19,000, and $706,000 and for the years ended December 31, 2001, 2000, and 1999 respectively relating to these properties.
In June 1999, Lithia Properties, LLC completed its sale of certain real estate holdings in the Southern Oregon region to Capital Automotive Real Estate Investment Trust (“Capital”), an unrelated party, for $18.3 million. As a result of this sale, the Company received a distribution for its portion of the realized gain, totaling approximately $1.2 million, which will be realized ratably over the 12-year life of the new lease. The Company now leases such properties from Capital for amounts that are not materially different from the lease amounts under the previous lease agreements.
The Company provides management services to Lithia Properties, LLC. Other income includes management fees of $1,000, $1,000, and $7,000 for the years ended December 31, 2001, 2000 and 1999, respectively.
During 2001, 2000 and 1999, Lithia Real Estate, Inc. paid Mark DeBoer Construction, Inc. $7.9 million, $6.8 million, and $2.6 million, respectively, for remodeling certain of the Company’s facilities. These amounts included $7.1 million, $6.1 million, and $2.3 million, respectively, paid for subcontractors and materials, $16,000, $32,000 and $171,000, respectively for permits, licenses, travel and various miscellaneous fees, and $780,000, $624,000, and $226,000, respectively, for contractor fee. The Company believes the amount paid is fair in comparison with fees negotiated with independent third parties.
In May 1999, the Company purchased certain dealerships owned by W. Douglas Moreland for total consideration of approximately $66.0 million, at which time, Mr. Moreland became a member of the Company’s Board of Directors. During the normal course of business, these dealerships paid $2.5 million, $2.8 million and $672,000 in 2001, 2000 and 1999, respectively, to other companies owned by Mr. Moreland for vehicle purchases, recourse paid to a financial lender and management fees. The Company also paid rental expense of $3.0 million, $3.2 million and $1.6 million in 2001, 2000 and 1999, respectively, to other companies owned by Mr. Moreland.
The terms of the acquisition agreement with Mr. Moreland provided for additional consideration to be paid if the acquired entity results of operations exceeded certain targeted levels in 1999. Targeted levels were set substantially above the historical experience of the acquired entity at the time of acquisition. Such additional consideration was paid in cash and with shares of the Company’s stock and was recorded when earned in the fourth quarter of 1999 as additional purchase price. Additional consideration totaled $18.0 million, including $9.0 million in cash, $4.5 million in Class A Common Stock and $4.5 million in Series M Preferred Stock with a fair value of $2.7 million.
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The following acquisitions were made in 2001:
The above acquisitions were accounted for under the purchase method of accounting. Pro forma results of operations assuming all of the above acquisitions occurred at the beginning of the respective periods are as follows (in thousands, except per share amounts):
There are no future contingent payouts related to any of the 2001 acquisitions. The purchase price for the 2001 acquisitions was allocated as follows (in thousands):
The Company anticipates that approximately 70 percent of the goodwill acquired in 2001 will be deductible for tax purposes.
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In addition to the above acquisitions, in August 2001, Lithia completed the construction of and opened Lithia Dodge of Anchorage.
The Company acquired eight dealerships during 2000, with total estimated 1999 revenues of approximately $254 million. None of the acquisitions were individually significant and all of them were accounted for as purchase transactions.
In May 1999, the Company acquired all of the stock of seven commonly controlled automotive dealerships constituting the Moreland Automotive Group (“Moreland”) for approximately $19.7 million in cash (which is net of $16.0 million of cash acquired), 1,272,919 shares of the Company’s Class A Common Stock with a value of approximately $24.1 million at the time of issuance, and 10,360 shares of Lithia’s newly created Series M Preferred Stock with a value of approximately $6.2 million at the time of issuance. At closing, Moreland had approximately $18.2 million of used vehicles available for flooring under the Company’s used vehicle line of credit, reducing the net investment in the acquired dealerships by that amount to a total of $47.8 million. Based on the Moreland dealerships achieving certain performance targets for 1999, additional consideration totaling $18.0 million, including $9.0 million in cash, $4.5 million in Class A Common Stock and $4.5 million in stated value Series M Preferred Stock with a fair value of $2.7 million was paid and recorded as additional purchase price.
Unaudited pro forma results of operations including Moreland Automotive are as follows. The results of operations for other acquisitions are not included in the unaudited pro forma information as they are not materially different from actual results of the Company (in thousands, except per share amounts).
The unaudited pro forma results are not necessarily indicative of what actually would have occurred had the acquisitions been in effect for the entire period presented. In addition, they are not intended to be a projection of future results that may be achieved from the combined operations.
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The Company adopted the provisions of SFAS No. 141 during 2001, and is adopting SFAS No. 142 effective January 1, 2002. Under SFAS No. 141, goodwill and intangible assets determined to have an indefinite useful life acquired in a purchase business combination completed after June 30, 2001, were not amortized, but continued to be evaluated for impairment in accordance with the appropriate pre-SFAS No. 142 accounting literature. Goodwill and intangible assets acquired in business combinations completed before July 1, 2001 continued to be amortized and tested for impairment in accordance with the appropriate pre-SFAS No. 142 accounting requirements prior to the adoption of SFAS No. 142.
SFAS No. 141 requires, upon adoption of SFAS No. 142, that the Company evaluate its existing intangible assets and goodwill that were acquired in prior purchase business combinations, and make any necessary reclassifications in order to conform with the new criteria in SFAS No. 141 for recognition apart from goodwill. The Company does not anticipate reclassifying any intangibles to intangibles with determinable useful lives. For intangible assets identified as having indefinite useful lives, the Company is required to test them for impairment in accordance with the provisions of SFAS No. 142 within the first interim period and recognize any impairment losses as the cumulative effect of a change in accounting principle in the first interim period. Lithia does not anticipate incurring any impairment loss charges upon adoption of SFAS No. 142.
The adoption of SFAS No. 141 did not have a significant impact on the financial condition or results of operations of the Company. The amount of goodwill amortization relating to acquisitions after July 1, 2001 that was not recognized in 2001 as a result of the adoption of SFAS No. 141 was approximately $130,000. As of December 31, 2001, Lithia expects a reduction in annual amortization expense of approximately $3.7 million in 2002 upon adoption of SFAS No. 142.
In August 2001, the FASB approved SFAS No. 143, “Accounting for Asset Retirement Obligations,”, which became effective beginning in 2002. SFAS No. 143 addresses the financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. In October 2001, the FASB approved SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” which supersedes SFAS No. 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of” and the accounting and reporting provisions of APB No. 30, “Reporting the Results of Operations — Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions” for the disposal of a segment of a business. SFAS No. 144 retains many of the fundamental provisions of SFAS No. 121, but resolves certain implementation issues associated with that Statement. SFAS No. 144 is effective beginning in 2002. Lithia does not anticipate that the adoption of SFAS No. 143 and SFAS No. 144 will have a material impact on its financial condition or results of operations.
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Conversion of Series M Preferred Stock
In January 2002, 5,177 shares of Series M Preferred Stock were converted at a price of $20.77 per common share into 249,311 shares of the Company’s Class A Common Stock. After this conversion, 4,499 shares of Series M Preferred Stock remained outstanding.
Acquisitions in 2002
The following acquisitions were closed in the first quarter of 2002 to date:
None of the above acquisitions were individually significant to the Company’s financial position or results of operations.
Offering of Class A Common Stock
In January 2002, the Company filed a registration statement on Form S-3 for the registration and sale of 4.0 million (4.5 million with the underwriters’ over allotment option) newly issued shares of its Class A Common Stock and 1.0 million (1.25 million with the underwriters’ over allotment option) shares from existing stockholders.
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