Lithia Motors - 10-Q quarterly report FY

LITHIA MOTORS, INC.

FORM 10-Q

INDEX

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PART I - FINANCIAL INFORMATION

Item 1.  Financial Statements

LITHIA MOTORS, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(In thousands)

(Unaudited)

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

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LITHIA MOTORS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(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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LITHIA MOTORS, INC. AND SUBSIDIARIES

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Note 1. Basis of Presentation

These condensed consolidated financial statements contain unaudited information as of June 30, 2007 and for the three and six-month periods ended June 30, 2007 and 2006. The unaudited interim financial statements have been prepared pursuant to the rules and regulations for reporting on Form 10-Q. Accordingly, certain disclosures required by accounting principles generally accepted in the United States of America are not included herein. In management’s opinion, these unaudited financial statements include all adjustments necessary for a fair presentation of the information when read in conjunction with our audited consolidated financial statements and the related notes thereto. The financial information as of December 31, 2006 is derived from our 2006 Annual Report on Form 10-K. The interim condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and the notes thereto included in our 2006 Annual Report on Form 10-K. The results of operations for the interim periods presented are not necessarily indicative of the results to be expected for the full year.

Note 2. Inventories

Inventories are valued at the lower of market value or cost, using the specific identification method for vehicles and parts. The cost of new and used vehicle inventories includes the cost of any equipment added, reconditioning and transportation. Inventories consisted of the following (in thousands):

Note 3. Earnings Per Share

Following is a reconciliation of the income from continuing operations and weighted average shares used for our basic earnings per share (“EPS”) and diluted EPS (in thousands, except per share amounts):

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Note 4.  Comprehensive Income

Comprehensive income for the three and six-month periods ended June 30, 2007 included the change in the fair value of cash flow hedging instruments, since their designation date of December 31, 2006, that are reflected in stockholders’ equity, net of tax, instead of net income. Comprehensive income was the same as net income for the three and six-month periods ended June 30, 2006. The following table sets forth the calculation of comprehensive income for the three and six-month periods ended June 30, 2007 (in thousands):

Note 5.  Acquisitions

The following acquisitions were made in the first six months of 2007:

·                  In February 2007, we acquired Jordan Motors, Inc., which was comprised of four stores, in Ames, Johnston and Des Moines, Iowa. The stores had annualized combined revenues of approximately $100 million. The stores were renamed Honda of Ames, Lithia Nissan of Ames, Acura of Johnston, Lithia Infiniti of Des Moines, Lithia Volkswagen of Des Moines and Audi Des Moines. The three stores in Des Moines are considered one location; and

·                  In May 2007, we acquired the operations of a Jeep franchise in Pocatello, Idaho that was added to our existing Chrysler store.

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The above acquisitions were accounted for under the purchase method of accounting. Pro forma results of operations, assuming the above acquisitions and the previously disclosed 2006 acquisitions occurred as of January 1, 2006, were as follows (in thousands, except per share amounts):

There are no future contingent payouts related to the 2007 acquisitions and no portion of the purchase price was paid with our equity securities. During the first six months of 2007, we acquired the four stores and the Jeep franchise discussed above for $13.3 million in cash, which included $8.2 million of goodwill and $3.2 million of other, primarily indefinite lived, intangible assets. The purchase price for the balance of the assets acquired was funded by borrowings. In addition, we acquired new vehicle inventory and associated floorplan debt in the amount of $13.4 million in connection with the above acquisitions.

Within one year from the purchase date of each store, we may update the value allocated to its purchased assets and the resulting goodwill balances as a result of information received regarding the valuation of such assets and liabilities that was not available at the time of purchase. All of the goodwill from the above acquisitions is expected to be deductible for tax purposes.

Note 6.  Dividend Payments

Cash dividends at the rate of $0.14 per common share, which totaled approximately $2.7 million, were paid on each of January 30, 2007 and April 30, 2007 to shareholders of record on January 16, 2007 and April 16, 2007, respectively.

Note 7.  Stock-Based Compensation

In the first quarter of 2007, we issued our annual non-qualified stock option grants to executive officers and restricted stock grants to other employees. The non-qualified stock option grants cover a total of 108,000 shares of our common stock and were granted at the fair market value on the date of grant at $28.34 per share. These options vest 100% on the fifth anniversary of the grant date and expire on the sixth anniversary. Restricted stock grants covering 60,821 shares of our common stock were also granted and have varying vesting provisions with full vesting occurring between four and five years. Total compensation related to these stock-based awards was $2.1 million as calculated pursuant to the fair value methods prescribed by Statement of Financial Accounting Standards (“SFAS”) No. 123R, “Share-Based Payments.” Of the $2.1 million, approximately $0.4 million will be recognized in 2007.

In the second quarter of 2007, we granted 5,600 shares of common stock to members of our Board of Directors and one consultant. The fair market value on the date of grant was $27.13 per share and the shares were 100% vested on the date of grant. Total compensation expense related to these shares in the second quarter of 2007 was $152,000.

Note 8.  Discontinued Operations

We continually monitor the performance of each of our stores and make determinations to sell a store based primarily on return on capital criteria.  When a store meets the criteria of “held for sale,” as defined in SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” the results of operations are reclassified into discontinued operations. All stores included in discontinued operations have been, or will be, eliminated from our on-going operations upon completion of the sale. We anticipate the completion of the sale for each store to occur within 12 months from the date of determination.

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During the second quarter of 2007, we classified three stores and one body shop as discontinued operations. As of June 30, 2007 and December 31, 2006, we had five and two stores, respectively, held for sale and classified as discontinued operations. The body shop was closed and is not held for sale. Certain financial information related to discontinued operations was as follows (in thousands):

(1) The impairment loss is related to goodwill and other intangible assets.

The pre-tax loss in the six-month period ended June 30, 2006 included legal settlements related to stores in California that were sold in prior years.

Interest expense is allocated to stores classified as discontinued operations for actual flooring interest expense directly related to the new vehicles in the store. Interest expense related to our working capital, acquisition and used vehicle credit facility is allocated based on the amount of assets pledged towards the total borrowing base.

Assets held for sale included the following (in thousands):

Liabilities held for sale included the following (in thousands):

Note 9. Adoption of Interpretation No. 48

In June 2006, the Financial Accounting Standards Board (“FASB”) issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes,” which is an interpretation of FASB Statement No. 109.  Interpretation No. 48 applies to all tax positions accounted for under Statement No. 109. The interpretation applies to situations where the uncertainty is to the timing of the deduction, the amount of the deduction, or the validity of the deduction. Interpretation No. 48 is effective as of the beginning of the first fiscal year beginning after December 15, 2006 (January 1, 2007 for us). At adoption, companies must adjust their financial statements to reflect only those tax positions that are more-likely-than-not to be sustained as of the adoption date. Positions that meet this criterion should be measured using the largest benefit that is more than 50 percent likely to be realized. The necessary adjustment should be recorded directly to the beginning balance of retained earnings in the period of adoption and reported as a change in accounting principle, if material. However, because of the immaterial nature of the adjustment, we have not presented this item separately on the face of the balance sheet.

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At adoption, important information in regard to our reporting for Interpretation No. 48 was as follows:

Note 10. Repurchases of Common Stock

In the first quarter of 2007, we repurchased 124,809 shares of our Class A common stock for $3.4 million, or an average price of $26.88 per share. Of these repurchases, 121,800 were pursuant to the program approved by our Board of Directors in June 2000, which authorized the repurchase of up to 1,000,000 shares of our Class A common stock. Through June 30, 2007, we have purchased a total of 378,631 shares under this program.

Note 11. Reclassifications

Reclassifications related to discontinued operations were made to the prior period financial statements to conform to the current period presentation in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.”

Note 12.  Contingencies

Litigation

We are party to numerous legal proceedings arising in the normal course of our business. While we cannot predict with certainty the outcomes of these matters, we do not anticipate that the resolution of these proceedings will have a material adverse effect on our business, results of operations, financial condition, or cash flows.

On November 25, 2003, Aimee Phillips filed a lawsuit in the U.S. District Court for the District of Oregon (Case No. 03-3109-HO) against Lithia Motors, Inc. and two of its wholly-owned subsidiaries alleging violations of state and federal RICO laws, the Oregon Unfair Trade Practices Act (“UTPA”) and common law fraud. Ms. Phillips seeks damages, attorney’s fees and injunctive relief. Ms. Phillips’ complaint stems from her purchase of a Toyota Tacoma pick-up truck on July 6, 2002. On May 14, 2004, we filed an answer to Ms. Phillips’ Complaint.  This case was consolidated with the Allen case described below and has a similar current procedural status.

On April 28, 2004, Robert Allen and 29 other plaintiffs (“Allen Plaintiffs”) filed a lawsuit in the U.S. District Court for the District of Oregon (Case No. 04-3032-HO) against Lithia Motors, Inc. and three of its wholly-owned subsidiaries alleging violations of state and federal RICO laws, the Oregon UTPA and common law fraud. The Allen Plaintiffs seek damages, attorney’s fees and injunctive relief. The Allen Plaintiffs’ Complaint stems from vehicle purchases made at Lithia stores between July 2000 and April 2001. On August 27, 2004, we filed a Motion to Dismiss the Complaint. On May 26, 2005, the Court entered an Order granting Defendants’ Motion to Dismiss plaintiffs’ state and federal RICO claims with prejudice. The Court declined to exercise supplemental jurisdiction over plaintiffs’ UTPA and fraud claims.  Plaintiffs filed a Motion to Reconsider the dismissal Order. On August 23, 2005, the Court granted Plaintiffs’ Motion for Reconsideration and permitted the filing of a Second Amended Complaint (“SAC”). On September 21, 2005, the Allen Plaintiffs, along with Ms. Phillips, filed the SAC. In this complaint, the Allen plaintiffs seek actual damages that total less than $500,000, trebled, approximately $3.0 million in mental distress claims, trebled, punitive damages of $15.0 million, attorney’s fees and injunctive relief. The SAC added as

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defendants certain officers and employees of Lithia. In addition, the SAC added a claim for relief based on the Truth in Lending Act (“TILA”). On November 14, 2005 we filed a second Motion to Dismiss the Complaint and a Motion to Compel Arbitration. In two subsequent rulings, the Court has dismissed all claims except those under Oregon’s Unfair Trade Practices Act and a single fraud claim for a named individual.   We believe the actions of the court have significantly narrowed the claims and potential damages sought by the plaintiffs. Lithia’s motion to Compel Arbitration of Plaintiff’s remaining claims was denied. We filed a Motion to Reconsider and a Notice of Appeal relating to the denial of our motion to Compel Arbitration.

On September 23, 2005, Maria Anabel Aripe and 19 other plaintiffs (“Aripe Plaintiffs”) filed a lawsuit in the U.S. District Court for the District of Oregon (Case No. 05-3083-HO) against Lithia Motors, Inc., 12 of its wholly-owned subsidiaries and certain officers and employees of Lithia, alleging violations of state and federal RICO laws, the Oregon UTPA, common law fraud and TILA. The Aripe Plaintiffs seek actual damages of less than $600,000, trebled, approximately $3.7 million in mental distress claims, trebled, punitive damages of $12.6 million, attorney’s fees and injunctive relief. The Aripe Plaintiffs’ Complaint stems from vehicle purchases made at Lithia stores between May 2001 and August 2005 and is substantially similar to the allegations made in the Allen case. We expect certain of the rulings in the Allen case to apply equally to this case and proceedings in this matter are awaiting further rulings in the Allen case. Once resolved, we further expect to file motions directed at all claims.

On May 30, 2006 four of our wholly owned subsidiaries located in Alaska were served with a lawsuit alleging that the stores failed to comply with Alaska law relating to various disclosures required to be made during the sale of a used vehicle.  The complaint was filed by Jackie Lee Neese et al v. Lithia Chrysler Jeep of Anchorage, Inc. et al in the Superior Court for the State of Alaska at Anchorage, case number 3AN-06-04815CI. The complainants seek to represent other similarly situated customers. The court has not certified the suit as a class action.

We intend to vigorously defend all matters and management believes that the likelihood of a judgment for the amount of damages sought in any of the cases is remote.

Note 13.  Subsequent Events

Disposal

On August 3, 2007, we disposed of one of our stores that was held for sale at June 30, 2007.

Dividend

In July 2007, we announced a dividend on our Class A and Class B common stock of $0.14 per share for the second quarter of 2007. The dividend, which totaled approximately $2.8 million, was paid on July 30, 2007 to shareholders of record on July 16, 2007.

Debt Modification

On July 6, 2007, we entered into a modification of certain mortgage loans held by Toyota Mortgage Credit Corporation. Under the modification, the maturity dates on the loans were extended for a period of 24 months, with the interest rate on the loans re-pricing to a fixed or floating rate, at our choice, as of the original maturity date. As a result of this modification, we classified $31.0 million in debt obligations from current to long-term liabilities as of June 30, 2007.

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Item 2.                       Management’s Discussion and Analysis of Financial Condition and Results of Operations

Forward Looking Statements and Risk Factors

Some of the statements in this Form 10-Q 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-Q 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 Item 1A to our 2006 Form 10-K, which was filed with the Securities and Exchange Commission on March 9, 2007. These risk factors have not significantly changed since the filing of the 2006 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 franchises and retailer of new and used vehicles and services.  As of August 7, 2007, we offered 30 brands of new vehicles in 107 stores in the Western United States and over the Internet.  As of August 7, 2007 we operated 16 stores in Oregon, 15 in California, 14 in Texas, 11 in Washington, 8 in Iowa, 7 in Idaho, 7 in Colorado, 7 in Alaska, 7 in Montana, 6 in Nevada, 3 in Nebraska, 2 in South Dakota, 2 in North Dakota, 1 in New Mexico and 1 in Wisconsin. We sell new and used cars and light trucks; sell replacement parts; provide vehicle maintenance, warranty, paint and repair services; and arrange related financing, service contracts, protection products and credit insurance for our automotive customers.

We currently achieve gross profit 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.

Our acquisition model is focused on acquiring new vehicle stores where the store is the dominant or the only franchise of that brand in the market. Our goal is to improve the operations of all four departments of every store we acquire. We have had success with this strategy since our initial public offering in 1996. Since 1996, our ability to integrate the stores that we acquire continues to improve. We have also developed a better process for identifying acquisition targets that fit our operating model. Our cash position, substantial lines of credit, plus an experienced and well-trained staff are all available to facilitate our continued growth as opportunities develop.

Our current brand mix is weighted towards domestic brands at approximately 60%. Our strategy is to target a more balanced mix between our domestic, import and luxury brands in the years ahead. Approximately 60% of our acquisition revenues in the last four quarters were from import and luxury brands, contributing to an improvement in our import/domestic mix, especially as we continue to dispose of our lowest performing domestic stores.

In keeping with this model, we acquired four stores and one franchise in the first seven months of 2007 with total estimated annual revenues of approximately $100 million.  At August 7, 2007, we had four stores held for sale and listed as discontinued operations with combined annual revenues of approximately $127 million.

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We expect that manufacturers will continue to offer incentives on new vehicle sales during 2007 through a combination of repricing strategies, rebates, lease programs, early lease cancellation programs and low interest rate loans to consumers. To complement the manufacturers’ incentive strategy, we employ a volume-based strategy for our new vehicle sales.

We have completed, or are currently working on, the following initiatives that we expect will improve our operations in future periods:

·                  Under the automated car deal process, our showrooms are equipped with interactive personal computers, which allows the salesperson to quickly and efficiently enter data and interact with the customer to speed up the sales process;

·                  Improved functionality of our centralized inventory control and procurement process;

·                  IT initiatives related to automating our offices, centralizing certain office functions and establishing independent used vehicle operations;

·                  In August 2007, we opened our first independent used vehicle outlet, L2 Auto in Loveland, Colorado; and

·                  Our assured vehicle selling program has been fully installed in Alaska and will be rolled out to additional locations in future periods.

Results of Continuing Operations

Certain revenue, gross profit margin and gross profit information by product line was as follows:

(1)          Commissions reported net of anticipated cancellations.

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

(1)  The percentages may not add due to rounding.

The following tables set forth the changes in our operating results from continuing operations in the three and six-month periods ended June 30, 2007 compared to the three and six-month periods ended June 30, 2006:

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Revenues

Total revenues increased 10.5% and 10.2%, respectively, in the three and six-month periods ended June 30, 2007 compared to the same periods of 2006, as a result of acquisitions, partially offset by a 2.0% and a 1.8% decrease, respectively, in same-store sales, excluding fleet. The three and six-month periods ended June 30, 2007 faced difficult comparisons with the comparable periods of 2006 when total same store sales grew by 9.3% and 7.5%, respectively. The decreases in the 2007 periods were also impacted by a weak retail sales environment, especially with our domestic brands in the metro markets. We believe that sales have been affected by the slowdown in residential construction, high fuel prices and consumer concerns over personal debt.

Same-store sales percentage increases (decreases) were as follows:

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Same store sales are calculated for stores that were in operation as of June 30, 2006, and only including the months of operations for both comparable periods. For example, a store acquired in April 2006 would be included in same store operating data beginning in May 2006, after its first full complete comparable month of operation. Thus, operating results for same store comparisons would include only the periods of May through June of both comparable years.

New vehicle same store sales declined 2.8% and 3.0%, respectively, in the three and six-month periods ended June 30, 2007 compared to the same periods of 2006. The decreases were primarily due to a challenging sales environment in the first half of 2007 and declining sales of domestic manufacturers’ vehicles that represent a large percentage of our new vehicle sales. Prior year comparisons were high due to aggressive manufacturer incentive programs which have not been sustained in 2007. Same store unit sales were down 7.3% and 5.8%, respectively, in the three and six-month periods ended June 30, 2007 compared to the same periods of 2006. The decreases in same-store unit sales were partially offset by a 4.9% and a 3.0% increase, respectively, in same-store average selling prices.

Used retail vehicle same store sales declined 4.3% and 4.4%, respectively, in the three and six-month periods ended June 30, 2007 compared to the same periods of 2006. The decreases in same-store sales were primarily due to the challenging sales environment mentioned above. Same-store retail unit sales decreased 6.0% and 5.3%, respectively, in the three and six-month periods ended June 30, 2007 compared to the same periods of 2006. These same-store decreases were partially offset by a 1.8% and a 0.9% increase in same-store average selling prices.

Used wholesale vehicle same-store sales increased 4.1% and 9.6%, respectively, in the three and six-month periods ended June 30, 2007 compared to the same periods of 2006. Same store unit sales declined 1.6% in the three-month period and increased 2.8% in the six-month period.  The same-store average selling price increased 5.8% and 6.6%, respectively, in the same periods.

The combined used retail and wholesale same store sales decreased 2.9% and 2.1%, respectively, in the three and six-month periods compared to the same periods of 2006. This decrease is in line with new vehicle same-store sales declines due to the challenging sales environment discussed above.

Same-store finance and insurance sales were negatively affected in the three and six-month periods ended June 30, 2007 compared to the same periods of 2006 by decreases in same-store vehicle unit sales, which lowered the overall opportunity for finance and insurance sales. This was offset by a 1.5% and a 4.0% increase, respectively, in the finance and insurance sales per unit in the three and six-month periods ended June 30, 2007 compared to the same periods of 2006.

The increases in service, body and parts sales in the three and six-month periods ended June 30, 2007 compared to the same periods of 2006 were primarily due to a 3.8% and a 5.2% increase, respectively, in the same-store customer-pay portion of the business, where all three business lines increased. The customer-pay portion of the business currently represents approximately 81% of total service, body and parts sales. In addition, we realized an 8.1% and a 4.7% increase, respectively, in same-store warranty sales.

Penetration rates for certain products were as follows:

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Gross Profit

Gross profit increased $12.0 million and $24.8 million, respectively, in the three and six-month periods ended June 30, 2007 compared to the same periods of 2006 due to increased total revenues. Our gross profit margin by business line was as follows:

* A basis point is equal to 1/100th of one percent.

Gross profit margins were negatively affected by a more competitive retail sales environment in the 2007 periods compared to the 2006 periods. The negative effect from the competitive retail sales environment was partially offset by a shift in mix back towards more trucks and SUVs, which typically have higher gross profit margins.

Retail used vehicle gross profit margins decreased in the 2007 periods compared to the 2006 periods, primarily due to more aggressive pricing strategies. However, they remain consistent with our 5-year historical average of 15.0%.

Gross profit margins in the service, body and parts business line decreased in the three and six-month periods ended June 30, 2007 compared to the same periods of 2006 due to a shift in mix towards selling more parts and accessories, which carry lower margins than the service side of the business. However, our same-store gross profit increased 1.3% and 2.7%, respectively, as a result of increased volume.

Selling, General and Administrative Expense

Selling, general and administrative expense (“SG&A”) includes salaries and related personnel expenses, facility lease expense, advertising (net of manufacturer cooperative advertising credits), legal, accounting, professional services and general corporate expenses.

SG&A increased $11.7 million and $25.3 million, respectively, in the three and six-month periods ended June 30, 2007 compared to same periods of 2006. SG&A increased to 12.7% and 13.2% of revenue, respectively, in the three and six month periods ended June 30, 2007 compared to 12.5% and 12.9%, respectively, in the comparable periods of 2006.

The increases in dollars spent were primarily due to the following: