Lithia Motors - 10-Q quarterly report FY

(Mark One)

[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2001
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from to

Commission file number: 000-21789

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 the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date.

LITHIA MOTORS, INC.

FORM 10-Q

INDEX

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Item 1. Financial Statements

PART I - FINANCIAL INFORMATION

LITHIA MOTORS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(In thousands)
(Unaudited)

The accompanying notes are an integral part of these consolidated statements.

LITHIA MOTORS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(Dollars in thousands, except per share amounts)
(Unaudited)

The accompanying notes are an integral part of these consolidated statements.

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LITHIA MOTORS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)

The accompanying notes are an integral part of these consolidated statements.

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Potentially dilutive securities that are not included in the diluted EPS calculations because they would be antidilutive are as follows:

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The following table sets forth selected condensed financial data for the Company, expressed as a percentage of total revenues for the periods indicated below.

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*bp stands for basis point (ten basis points equals one-tenth of one percent)

The increases in the overall gross profit margin are primarily a result of shifts in mix to the more profitable used vehicle, service, body and parts and finance and insurance business lines.

Selling, General and Administrative Expense. Selling, general and administrative ("SG&A") expense increased due primarily to increased selling, or variable, expense related to the increase in revenues and the number of locations. As a percentage of revenue, SG&A expense increased in the three and nine month periods ended September 30, 2001 compared to the three and nine month periods ended September 30, 2000 due to a shift in mix to more parts and service business, which has a higher SG&A expense component, and continued investments in acquisition integration and operational support teams in preparation for continued growth.

Depreciation and Amortization. Depreciation and amortization expense increased primarily as a result of increased property and equipment and intangible assets related to acquisitions.

Income from Operations. Operating margins decreased 30 basis points, or three-tenths of one percent, and 70 basis points, or seven-tenths of one percent, respectively, in the three and nine month periods ended September 30, 2001 as compared to the same periods of 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 recent decreases in the effective interest rates on the floating rate credit lines in conjunction with an overall decrease in the flooring debt outstanding. Lithia has also been able to decrease its inventory levels despite the acquisition of several dealerships during 2001.

Other Interest Expense. The increase in other interest expense is due to higher debt levels as a result of acquisitions, offset in part by lower interest rates.

Income Tax Expense. Lithia's effective tax rate declined to 38.6 percent in the first nine months of 2001 from 39.2 percent in the first nine months of 2000 as a result of an increasing mix of asset acquisitions compared to corporate acquisitions, which resulted in an 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 to $7.7 million, a 2.3% increase, for the quarter ended September 30, 2001 compared to the same quarter of the prior year. This net income was a record quarterly net income for the Company.

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At September 30, 2001, Lithia had capital commitments of approximately $10.5 million for the construction of five new store facilities and two additions to existing facilities, of which $6.4 million is anticipated to be incurred through the end of 2001 and the balance in 2002. Approximately $5.8 million has already been paid for these commitments from available cash balances. 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.

Seasonality and Quarterly Fluctuations

Historically, Lithia's 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. Management believes 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. The timing of acquisitions may cause substantial fluctuations of 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.

The Company is required to adopt the provisions of SFAS No. 141 immediately, and SFAS No. 142 effective January 1, 2002. Furthermore, goodwill and intangible assets determined to have an indeterminable useful life acquired in a purchase business combination completed after June 30, 2001, but before SFAS No. 142 is adopted in full will not be amortized, but will continue 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 will continue 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 will be 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.

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Lithia does not expect that the adoption of SFAS 141 will have a significant impact on the financial condition or results of operations of the Company. As of September 30, 2001, Lithia expects a reduction in annual amortization expense of approximately $3.7 million in 2002 upon adoption of SFAS No. 142.

See also Note 6. Derivative Instruments and Hedging Activities in Notes to Consolidated Financial Statements above.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Variable Rate Debt

Lithia has variable rate floor plan notes payable and other credit line borrowings that subject it to market risk exposure. At September 30, 2001, Lithia had $346.8 million outstanding under such facilities at interest rates ranging from 4.09% to 5.34% per annum. A 10% increase in interest rates would increase interest expense by approximately $212,000, net of tax, for the remaining three months of 2001 based on amounts outstanding on the lines of credit at September 30, 2001.

Cash Flow Hedging

Objectives and Context

Lithia uses variable-rate debt to finance its new and program vehicle inventory ("flooring debt"). The interest rate on the hedged flooring debt is tied to the one month LIBOR. These debt obligations therefore expose the Company to variability in interest payments due to changes in the one month LIBOR. 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.

Management believes it is prudent to limit the variability of a portion of its interest payments. To achieve this objective, Lithia currently has hedged approximately 16.5% of its flooring debt.

Strategies

Management has entered into interest rate swaps to manage the variability of its interest rate exposure, thus leveling a portion of its interest expense in a rising or falling rate environment.

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, Lithia receives variable interest rate payments and makes fixed interest rate payments, thereby creating fixed-rate flooring debt.

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Lithia has entered into the following interest rate swaps:

• Effective September 1, 2000, Lithia entered into a five year, $25 million interest rate swap with U.S. Bank Dealer Commercial Services at a fixed rate of 6.88% per annum.
• Effective November 1, 2000 Lithia entered into a three year, $25 million interest rate swap with U.S. Bank Dealer Commercial Services at a fixed rate of 6.47% per annum.

Lithia earns 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 is 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 September 30, 2001 was 2.63% per annum.

Lithia does not enter into derivative instruments for any purpose other than to manage its interest rate exposure. That is, Lithia does 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 $3.8 million at September 30, 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 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 $381,000 and $789,000, respectively, for the three and nine month periods ended September 30, 2001. Interest expense savings on un-hedged debt as a result of decreasing interest rates from December 31, 2000 through September 30, 2001 was approximately $3.8 million.

At current interest rates, Lithia estimates that it will incur additional interest expense of $510,000 related to its interest rate swaps during the last quarter of 2001. Lithia expects to save approximately $2.0 million on its un-hedged debt during the last quarter of 2001 due to lower interest rates, assuming debt levels and interest rates consistent with those at September 30, 2001 compared to December 31, 2000.

Risk Management Policies

Lithia assesses 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.

Lithia maintains risk management control systems to monitor interest rate cash flow attributable to both the Company's outstanding or forecasted debt obligations as well as the Company's 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 the Company's future cash flows.

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As of September 30, 2001, approximately 77% of Lithia's total debt outstanding was subject to un-hedged variable rates of interest. As a result, recent interest rate declines have resulted in a net reduction of Lithia's interest expense compared to what it would have been at similar debt levels with interest rates unchanged. The Company intends to continue to gradually hedge its interest rate exposure if market rates continue to decline.

PART II - OTHER INFORMATION

Item 6. Exhibits and Reports on Form 8-K

a. Exhibits

The exhibits filed as a part of this report are listed below and this list constitutes the exhibit index.

b. Reports on Form 8-K

There were two reports on Form 8-K filed during the quarter ended September 30, 2001 as follows:

• Report dated July 25, 2001 under Item 9. Regulation FD, related to the issuance of a press release with respect to the Company's second quarter 2001 earnings.
• Report dated August 3, 2001 under Item 9. Regulation FD, related to the issuance of a press release with respect to earnings per share guidance for fiscal 2002.

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