John F. North - Chief Accounting Officer, Vice President of Finance and Corporate Controller Bryan B. Deboer - Chief Executive Officer, President and Director Christopher S. Holzshu - Chief Financial Officer, Senior Vice President and Secretary Sidney B. DeBoer - Founder and Executive Chairman.

Steven L. Dyer - Craig-Hallum Capital Group LLC, Research Division Andrew Kinder - Crédit Suisse AG, Research Division N. Richard Nelson - Stephens Inc., Research Division Scott L. Stember - Sidoti & Company, LLC John Murphy - BofA Merrill Lynch, Research Division Bret David Jordan - BB&T Capital Markets, Research Division James J.

Albertine - Stifel, Nicolaus & Company, Incorporated, Research Division Ravi Shanker - Morgan Stanley, Research Division Brett D. Hoselton - KeyBanc Capital Markets Inc., Research Division David Whiston - Morningstar Inc., Research Division.

Greetings, and welcome to Lithia Incorporated Second Quarter 2014 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to your host today, Mr. John North. Thank you, sir. You may begin..

Thanks and good morning. Welcome to Lithia Motors second quarter 2014 earnings conference call. Before we begin, the company wants you to know this conference call includes forward-looking statements.

Forward-looking statements are not guarantees of future performance and our actual results of operations, financial condition and liquidity and development of the industries in which we operate may differ materially from those made in or suggested by forward-looking statements in this call.

Examples of forward-looking statements include statements regarding expected operating results, projections for our third and fourth quarter performance, expected increases in our annual revenues related to acquisitions, our belief in the DCH Auto Group transaction will close in the fourth quarter, and anticipated available liquidity, free cash flow, and leverage after the transaction.

We urge you to carefully consider this information and not place undue reliance on forward looking statements. We undertake no duty to update our forward-looking statements, including our earnings outlook, which are made as of the date of this release.

During the call, we may discuss certain non-GAAP items, such as adjusted net income and diluted earnings per share from continuing operations, adjusted SG&A as a percentage of revenues and gross profit and adjusted pretax margin.

Non-GAAP measures do not have definitions under GAAP and may be defined differently and not comparable to similarly titled measures used by other companies. We caution you not to place undue reliance on such non-GAAP measures, but also to consider them with the most directly comparable GAAP measures.

We believe the non-GAAP financial measures we present improve the transparency of our disclosures, provide a meaningful presentation of our results from core business operations because they exclude items not related to core business operations and improve the period-to-period comparability of our results from core business operations.

This presentations should not be considered alternative to GAAP measures. A full reconciliation of these non-GAAP items is provided in the financial tables of today's press release. We've also posted an updated Investor Presentation on our website, lithiainvestorrelations.com, highlighting our second quarter results.

On the call today are Bryan Deboer, President and CEO; Chris Holzshu, Senior Vice President and CFO; and Sid DeBoer, Executive Chairman. At the end of our prepared remarks, we will open the call to questions. I'm also available in my office after the call for any follow-up questions you may have. With that, I'll turn the call over to Bryan..

Good morning, everyone, and thank you for joining us. Today we reported second quarter adjusted net income from continuing operations of $35.2 million compared to $27.4 million a year ago. We earned $1.34 per share in the first quarter compared to $1.05 per share last year or an increase of 28%.

Our revenue exceeded $1.2 billion in the second quarter, a 21% increase over the prior year. From this point forward, all comparisons will be on a same-store basis. For the first time in our company's history, this quarter, we saw double-digit increases in all 4 business lines.

Total sales increased 11% and the SAAR accelerated throughout the quarter, reaching a level of $16.9 million in June, the highest level since July 2006. In the quarter, new vehicle revenues increased 12%. Our new vehicle average selling price increased 3%. Unit sales increased 9%, which was above the national average of 7%.

Domestic unit sales increased 7% compared to 6% nationally, import sales increased 10% compared to 7% nationally and luxury unit sales were up 11%, in line with the national average. Retail used vehicle revenues increased 11% in the quarter. Our Retail used vehicle average selling price increased 6%.

We retailed 5% more used units over the prior year, resulting in our used-to-new ratio of 0.8:1. Our performance improved in all 3 used vehicle categories in the second quarter. On a unit basis, certified preowned grew 11%, core product or vehicles 3 to 7 years old increased 3% and finally, value autos or vehicles 80,000 miles or greater increased 4%.

An increasing supply of late-model vehicles caused our certified preowned segment to grow more quickly than the other categories, resulting in revenue outpacing unit growth. We sold a monthly average of 55 used vehicles per store, up from 51 units in the second quarter of 2013 and 43 units in the second quarter of 2012.

Going forward, we will continue to focus our efforts to procure core product and gain ground on our 75 units per store used vehicle sales initiative. Our F&I per vehicle was $1,206 compared to $1,102 last year, or an increase of $104 per vehicle.

Of the vehicles we sold in the quarter, we arranged financing on 73%, sold a service contract on 44% and sold a lifetime oil product on 38%. Our penetration rates in the service contracts and lifetime oil sales increased 140 and 40 basis points, respectively. Our service, body and parts revenue increased a record 10% over the second quarter of 2013.

This was on top of last year's 7% increase over the second quarter of 2012. Customer pay work increased 10%, which is the 20th consecutive quarter of improvement. Warranty sales increased 15%, which is the seventh consecutive quarter of improvement. Wholesale parts increased 8% and body shop increased 10%.

Gross profit for new vehicle retailed was $2,269 compared to $2,278 in the second quarter of 2013, or a decrease of $9 per unit. Gross profit per used vehicle retailed was $2,788 compared to $2,765 in the second quarter of 2013, or an increase of $23 per unit.

In the second quarter, the blended overall gross profit per unit was $3,749 compared to $3,625 last year, or an increase of $124. As we have previously discussed, our store personnel monitor overall gross profit per retail vehicle sale to evaluate their performance.

While there has been a shift in the allocation of gross profit by business line within the vehicle sale, the overall result increased its operating profits. Our total gross margin was 15.7%, down slightly compared to 15.9% in the same period last year.

Increases in vehicle sales continue to outpace our growth in service, body and parts and this mix shift explains the decline in overall margin. As of June 30, new vehicle inventories were at 741 million or a day supply of 71 days, a decrease of 5 days over a year ago.

Used vehicle inventories were at 204 million or a day supply of 60 days, an increase of 9 days from a year ago. I'd like to provide an update on the acquisition climate and current conditions within the marketplace.

We continue to seek exclusive domestic and import franchises in midsize role markets and exclusive luxury franchises in metropolitan markets. During the quarter, we acquired Access Ford in Corpus Christi, and expanded our operations in Portland, Oregon market with the acquisition of Vic Alfonso Cadillac and Braley & Graham Buick GMC.

Including these transactions, we have acquired or opened 8 stores with estimated annual revenues of $290 million in 2014. Additionally, in June, we announced the combination of Lithia and DCH Auto Group Inc., 1 of the 10 largest dealer groups in the country. The 27 stores in their network are located in New Jersey/New York and Southern California.

They predominantly import brands with over 82% of their sales in Honda/Acura and Toyota/Lexus and will generate approximately $2.3 billion in annual revenue. Since the date of the announcement, our teams have been working diligently together to learn more about each other and solidify our plan to combine our organizations later this year.

We believe the addition of Shau-wai Lam, and George Liang and their seasoned team of leaders will create a powerful alliance for the future. This team allows a second growth strategy for Lithia, unlocking stores in metropolitan markets across the United States.

The end result more than doubles the number of acquisition candidates available to the combined organization. Chris will have a further update on our combined outlook in a few minutes, but we are pleased with the progress we have made and still anticipate a closing in the fourth quarter of this year.

Additionally, our core Lithia operational team continues to focus on seeking opportunities that fit within our exclusive market strategy. Our appetite for additional acquisition remains steady and we will continue on the path, while maintaining our discipline on our return thresholds and strategic objectives.

With that, I will turn the call over to Chris, our CFO..

Thank you, Bryan. As we've previously discussed, we grew overall same-store sales 11% in the quarter. We continue to focus on increasing overall gross profit in order to leverage our cost structure. As a result, our second quarter adjusted SG&A, as a percentage of gross profit, dropped 80 basis points to a record 65.2%.

This improvement was primarily related to leverage in advertising expense of 70 basis points and rent and facility cost of 50 basis points. Throughput, by the percentage of each additional gross profit dollar over the prior year we retained after selling cost and adjusted to reflect same store comparison, was 51%.

We continue to target incremental throughput of 50% in the future. At the end of the quarter, we had $28 million in cash and $84 million available on our credit facilities. Currently, $216 million of our operating real estate is unfinanced. These assets can provide up to an additional $162 million of available liquidity in 60 to 90 days.

This brings our total liquidity to $274 million, and we're being comfortable with our overall level of available credit. At the June 30, excluding new vehicle floor plan financing, we had $260 million in debt, of which $167 million is mortgage financing, $96 million is used vehicle financing with the balance on our revolver.

We have no mortgages maturing until 2016, we have no high-yield bonds or convertible notes outstanding. We were in compliance with our debt covenants at the end of the quarter. Our free cash flow, as outlined in our Investor Presentation, was $18 million for the second quarter of 2014.

Capital expenditures, which reduces free cash flow figure, were $23 million for the quarter. Over the past 30 days, we have been in discussions with many of our lender partners to expand our credit facility and to obtain mortgage financing in order to position us for the integration of the DCH later this year.

We anticipate funding the transaction through the expansion of Lithia's existing credit facility by $600 million and by obtaining incremental mortgage financing of approximately $200 million. As we contemplate the combined organization, we estimate our 2014 full CapEx will be $110 million.

This budget is based on $30 million of lease buyouts, $30 million in new or remodeled facilities as a result of prior acquisitions, $9 million for open points granted by the manufacturer and $41 million related to facility improvements, maintenance CapEx and other business development opportunities.

Based on the DCH integration, our combined CapEx estimates and full year guidance, our 2014 free cash flow is estimated to be $97 million. After financing the DCH combination, our year end leverage ratio will be approximately 1.8x net debt to EBITDA excluding floor plan debt.

This higher leverage ratio will increase the interest on our line of credit, which is variable and adjust monthly. Therefore, we expect modestly higher interest expense in 2015 and beyond. Our capital strategy is unchanged as we maintain a balanced approach to acquisition, internal investment, dividends and share repurchases.

In the quarter, we repurchased 30,000 shares, bringing the year-to-date repurchases to 45,000 shares at a weighted average price of $72 per share.

This modest repurchase program is intended to offset dilutive effects of employee stock plans and our current authorization of 1.7 million shares remains in place for opportunistic repurchase, if available. However, we will continue to maintain our strict ROE thresholds required before we commit to deploy capital in any avenue.

We have been closely monitoring the availability of credit within our customer base, as we believe it's 1 of the main drivers of continued recovery in SAAR. Of the vehicles we financed in the second quarter, 12% were to subprime customers, an increase of 90 basis points over the second quarter of 2013.

Despite this improvement, this is still below the national average penetration for subprime at 20%. More importantly, the percentage of subprime customers, that we're able to obtain financing, increased 220 basis points from the second quarter of last year to 17% of the customers who completed a credit application.

While this rate improved year-over-year, a 17% approval rate still means 8 out of 10 subprime customers were declined credit. We continue to carefully monitor registration levels in our markets to gauge our progress in the economic recovery.

While overall, our markets are equal with 2006 and our Western markets registration levels remained 7% below 2006 through April of 2014, the most recent data available. We believe this indicates market expansion that will come to fruition over the next few years as credit availability returns and unemployment levels decline.

We have updated our guidance for 2014 and project earnings of $1.36 to $1.38 per share for the third quarter of 2014. Additionally, we have provided guidance for the fourth quarter of $1.10 to $1.12 for Lithia, $0.13 to $0.14 per share for DCH and $1.23 to $1.26 per share for the combined organization, assuming an October 1 integration with DCH.

As contemplated, this will increase full year earnings to a range of $4.95 to $5 per share for 2014. For additional assumptions, and the additional color promised on last month's DCH call, I will refer you to today's press release at lithiainvestorrelations.com. This concludes our prepared remarks, we would now like to open the call to questions.

Operator?.

[Operator Instructions] Our first question comes from Steve Dyer with Craig-Hallum..

You guys put out such a comprehensive pack of slides that takes away a lot of the easy ones. One question that I do have, is SG&A to gross keeps working down to levels that seem hard to believe 3 or 4 years ago.

After you make the DCH acquisition, would you expect those to kind of pop back up a bit until you kind of get the throughput there to where you want it?.

Yes, Steve, this is Chris. Yes, definitely. I mean, when you look at the opportunities that we see, with the combined organization with DCH, leverage -- continued leverage is 1 of those things that we anticipate. We're going to be working on with them. And so as we look to keep forward in 2015, we believe that SG&A is going to go up.

But our goal is to work together to leverage those expenses back down and get back to something that we're more comfortable and used to longer term..

Okay, great. And then just another quick one for me. As that relates to your used inventory, happy with where that is sitting.

Are you having success sort of procuring the used trade, now that some of the late model kind of lease returns are certain to come back? How do you feel about that piece of the business?.

Steve, this is Bryan. I think we're up about 8 days, 9 days or something, in relationship to where we were last year. We're comfortable with where we're at. What's really happening is it's much easier to procure those certified and late model vehicles. And a lot of our stores, it is the path of least resistance to find those cars.

We do believe that there is some training and some opportunities in really staying focused on that core product. And if you remember that core products have 3- to 8-year-old vehicle, if you look at the bucket of 3- to 8-year-old vehicles or that 6 years of vehicle, about half of those years are sub 14 million SAAR years.

So they are difficult cars to find, it's something that we've known. But also now with an increasing SAAR in current vintages, that is easier to find those cars and people are trading them in and they take dollars.

So it's quite a balance to be able to keep our teams and our General Manager are pretty attentive on helping their used car people and managers, divest those cars that are late-model and continue to try to find those core products.

So I think as we move forward, we'll be dropping off a 10 million, 8 million SAAR and a 12 million, 2 million SAAR something like that, that are really those 8- and 7-year-old vehicles right now. So that should help things and keep our focus back on core product and driving towards that 75 units..

Got you, okay. And then last one for me. As you look forward to additional acquisition opportunities, how would you anticipate funding those? I think you have a little bit left on your revolver, I think you could probably do more there.

Would you do mortgages or just kind of general framework as to how you think about that?.

Yes, Steve, this is Chris. As we laid out, kind of in our prepared remarks, we expect to expand our facility to $1.6 billion and take on about $200 million in mortgage financing.

At the completion of that, we should have between $200 million and $250 million in liquidity, which would give us plenty of dry powder to continue to execute on acquisitions as they come up..

Our next question comes from Gary Balter with Crédit Suisse..

Andrew on for Gary. One quick question for you guys. You guys are running so strong right now.

When you evaluate the DCH Auto transaction, how did you weigh the strong opportunities ahead from the acquisition against the possibility that the company that -- that this company with an entirely different operating strategy could distract you, somewhat, from the underlying strength that you're currently seeing?.

Andrew, this is Bryan. I think that as we began to meet the management team of DCH, it became pretty apparent that they run their operation and are very solid. And how they do that? Their culture was very similar to ours. So we didn't really look at it as a distraction, rather an ability to challenge each other to do better.

So I think when we look at the DCH organization, we really rely that Shau-wai, who will be invited onto our Board of Directors. George and T.Y, are really who his 2 field generals are, have good grasp of that organization.

And I think the ability to bring them in and integrate is less risk when you have the ability and a strong trust to challenge each other. And I think the goals, that we've established for each other, are reasonable..

Our next question comes from Rick Nelson with Stephens Inc..

Thinking about the DCH acquisition and the building out our models through next year, how should we think about the SG&A to grow at DCH, as it relates to Lithia?.

Yes, Ricky, this is Chris. What we try to do with the guidance, that we gave out in Q4, was layout what we're comfortable kind of showing as a combined integration of the Lithia and DCH team. But we did, I think, we gave some color on what we expect the DCH to look like on a full year basis, down to really that the EPS contribution.

And while we're not calling out specifics related to the EBITDA or op margin or SG&A, you can see the opportunity and the difference between the Lithia and the DCH team.

But I'll tell you that there are several things that we're considering as we bring these companies together, 1 being the metro strategy, which typically brings in a lower net margin, as well as the time that's going to take for integration.

And so as we think about the things that we've gone through with Lithia over the years, and the improvements that we found, as we apply those to the DCH organization and work with their team, we know there's opportunity there and we're going to continue to work towards. But it's not something that's going to happen in a quarter or in a year.

It's going to be something that's transformational that takes 3 to 5 years to fully integrate..

Also as a follow-up, I was looking at your updated PowerPoint on Page 18, where you talked about the integration results for the 2010 acquisitions and the 2011 acquisitions, just how pretty meaningful margin expansion for those stores acquired in 2010. It's still meaningful for the 2011 growth, but below the 2010 acquisitions.

If you could comment, thereon, what's the operating margin for the 2011 lags and the 2010 and Lithia's operating margin?.

Rick, this is Bryan. I think, anytime you have an acquisition, there's integration differences. There's people changes that come and it appears that 2011 is just a little slower than what it was. It could be franchise mix to some extent of what we purchased.

But we don't foresee any serious issues there and believe that it's just opportunity that's still sitting there..

And Rick, the one thing I will say is that every single one of the acquisitions, that we've done or at or exceeding are our initial hurdle rates, that we've set when we set our capital deployment up on that acquisition. So overall, we feel very good about that the acquisitions that we purchased in 2010.

And we know that, yes, there's a few other opportunities in certain stores, but we're exceeding the hurdle rates that we've laid in front of us back then..

Our next question comes from Scott Stember with Sidoti & Company..

Could you maybe talk about brand mix or how the brands performed on the new site within the quarter? You already gave out by luxury, domestic and foreign imports.

Can you just talk about maybe by brand specific?.

Hi Scott, they're scrambling. Now, Scott, we're just pulling the notes that we have. I mean, revenue for domestics were up 13%, imports were up 10%, luxury was up 12% as we laid out in the call.

So maybe to be more specific when you're talking about the individual franchise?.

Yes, if there was any brand that stood out, good or negative?.

Yes, I mean, we had several brands that were up double digits. I mean, Chrysler, GM are strong domestic franchises, continue to be above double-digit growth..

Subaru was up 38% -- sorry, Hyundai was up 38%, Subaru was up 18%. There's some highlights there. Kia was up substantially. But remember, it's only -- it's actually in one store in here. So there were some hotspots, but like Chris said, Chrysler, General Motors both double digit. Ford, double digits..

Okay, got you. And on the used gross margin, down 80 basis points in the second quarter, 90 for the first half of the year.

Is that just simply a mix shift towards the CPOs, away from the growth that you had saw in the last couple of years in the value side?.

This is Bryan, good work, Scott, you got it exactly. Our ASPs are up a little bit, and it's primarily the certified cars and they bring about the same amount of gross per deal and obviously at a higher cost..

Okay. And on the customer pay side, you're on the parts and service customer payment and it continues to go up.

Is this just further evidence of the benefit of increasing UIOs? And is there anything else to it? Is there anything else that you're doing, at the store level, that's helping that along?.

Scott, this is Bryan again. I would say, there's definitely a tailwind when it comes to UIO. But remember, we've also installed our idea of commodity sales, where we're more of that one-stop shopping experience. We're seeing the benefits of that. And obviously, they're outpacing a little bit.

So we really believe that our markets may perform a little differently. We're able to capture that warranty work at a little higher retention rate.

And we really believe that, that can continue because just like I discussed in UIO, if you look at our core product that set 3- to 8-year-old vehicle, that's kind of the heart of our off warranty business in our service department as well. And we still have 3 of those 6 years that are below 14 million SAARs.

So if that continues to grow, it's imperative that our teams are open eared when our customers are coming in and trying to meet all the needs that they really desire..

Got you.

And last question, can you just talk about what you guys seen in July, so far, at the store level?.

We're on track, Scott..

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

Just a question on M&A financing, sort of the 1 piece of currency that you've not mentioned is the potential source to do deals is your stock.

I'm just curious, have you considered that in DCH acquisition? And also pretty importantly, there's 1 of your public peers that's trading at a pretty extreme discount to you that seems like they need some help executing. And your stock for their stock would be a very accretive deal.

I'm just curious if you thought about that as a currency or even thought about more, bigger, larger acquisitions out there?.

John, this is Chris. Yes, we definitely continue to look at optimizing the capital structure that we have and leveraging our ability, 1, to take on debt. And 2, to leverage our stock. I mean, the other access, that we haven't tapped yet, was the bond and debt markets. So we continue to look at our capital structure.

Our goal to maximize our borrowings obviously at the lowest possible cost. And right now, we feel comfortable that for the acquisitions that we're doing, expanding our facility, continuing to take on, earn or use the free cash flow that we're generating, in excess of $100 million a year, is what's prudent.

But if and when a larger acquisition comes to market, we'd understand that we have currency, with the stock that we have, and we will use it when the time is right..

And assuming financing is really not that big a hurdle because it doesn't seem like it's a hurdle right now.

Operationally, and in execution as well, another large acquisition, maybe the size of DCH or maybe something even a bit bigger, do you think you have the team in place that can handle that? Or is that something that might -- you might have hit pause, on doing something that large again, because there's lot of integrations going on with DCH already?.

John, this is Bryan. Albeit that we believe that we have a good, humble, yet confident team, I think it's fair to say that we have some work in front of us. We need to focus on the DCH program. But we also never rule out other opportunities. And I think if it's a larger type of transaction, I think we'll cross that bridge when we come to it.

And I think in Q1, Q2, we can probably give you more color as the DCH and the Lithia teams begin to grow together..

Okay. And then just on parts and service, you're having a great -- I mean, you're having great same-store sales comp there, I'm sure a focus of yours.

But it also seems like we're finally seeing the benefit of the consolidation in the Chrysler/GM dealership -- GM and Ford dealerships, and you're seeing more UIOs come through yours, as smaller base of dealerships.

I mean, have you done any studies or could you sort of illustrate to us the benefits that you're getting from a lot of those store closures, particularly on parts and service and ultimately, on the new vehicle sales in the future?.

John, this is Bryan. I don't know that we're seeing benefit to store closures. A lot of the store closures occurred in metropolitan areas. Remember, we're a single point market. So there may have been a franchise or 2.

The benefits that we're seeing is really the growing UIO base and then our ability to attract through better customer service by providing a lower cost product and a quicker time in our dealerships. And I think outside of that, we need to just keep our head down and just stay focused on that.

And we'll be capturing a lot of that UIO that's -- really, the bulk of it still not even been tapped..

Okay.

And then on the online investment, that a lot of your peers are making an investment on line potentially taking the consumer through the full transactions through an online process, there are some companies that seem like they're almost betting the farm literally on that investment, yet you guys aren't really kind of highlighting that as a big drag on our investment, and that's sort of a huge focus.

Is that the kind of thing that you're working on in the background and you feel like you can do sort of an ongoing basis and don't need to run a big tear up, like a lot of your competitors are? Just kind of curious how you're thinking about that..

John, I think you've got it. I mean, remember, we're an entrepreneurial base model. We really are focused on allowing our stores to make those decisions and test those within the individual markets.

And what we'll find is that each of them are growing at a very fast rate and they're able to meet the needs of in-home with our stores, much like our Reno Subaru store that probably has an 800- to 1,000-mile radius of who they touch. They do those type of things online and in the dealership.

And I think anything to help speed up the customer process is beneficial. But we are an entrepreneurial base model. We do focus on some of those things at corporate. But we really believe that, that innovation and that change starts at the ground level with the demand coming straight from our consumers..

Okay. And then just lastly on subprime, you guys cited that you're 12% of your sales were subprime. Is that new and used? And also the figure that you quoted of 20% of all vehicle sales being subprime, was that new and used? Because my understanding is that new is significantly higher than that -- lower than that and used as a bit higher than that..

Yes, John, this is Chris, and it is new and used on both..

Okay.

Do you have a figure for just new vehicle sales roughly?.

No. We don't break that out separately, no..

John, it is lower though, John, you're right..

Our next question comes from Bret Jordan with BB&T Capital Markets..

Just a couple of quick questions. And one of them, I guess, we're looking at parts and service, and it being higher than peers and higher than expected.

Are you getting much attachment from the recalls that you're bringing cars in for ignition switch and selling a break job? And is there some near-term correlation to what's been historic high recall?.

Bret, Bryan. Absolutely, there is attachment especially when it comes to the older product, like the General Motors product, it's as old as 7-, 8-years-old. We're seeing in Chrysler, about a 40% increase in our warranty business. General Motors was 34.3%, Toyota was 2 out of 4 and some of those were even pretty high, and that ability to upsell.

And hopefully, I mean, the big thing is can you do it in an expedient manner. I mean, they're so used to if it hadn't been in the dealership in 5- to 7 years, sitting around for 2-, 3-, 4 hours and these are 0.2, 0.3, 0.4 flat rate hours and it's a very quick service and now we have the show that we can do that. So we are getting some attachment.

And I think, maybe another point to make, our 10.4% S&P same-store sales growth also does not include used vehicle recon..

Okay. And then a question on finance side or I guess, the transaction side.

Do you have a feeling for lease penetration relative to your new unit volumes in the quarter? And I guess, how you stack up relative to industry average, it seems like maybe your regional and product mix might under index to leasing, but maybe is that -- is there upside there....

Bret, this is Bryan again. So you just touched on one of the big opportunities our company has, much like our 75-units per store in used. We only lease at 6% to 7% of our new car population.

This is something that we really believe that the DCH organization and their team can help teach us, because they lease in the high 30s and low 40 percentile in their stores. So this is an opportunity for Lithia and it may be additional volume that has been uncaptured because of our, to some extent, ineffectiveness when it comes to leasing..

Our next question comes from James Albertine with Stifel, Nicolaus..

First on parts and service, really want to touch on few things, gross margins, as well as what we're hearing across the sectors seems, with respect to capacity constraint.

So first on gross margin, how should we think about, and understanding of course if you don't have internal recons flow through your P&S business, but how should we think about it, for the back half of this year, based on the recall work you're seeing, the UIO influx you're seeing and so on and so forth? And then separately, the metrics of capacity constraints, I would imagine that's the biggest sort of SG&A item for your parts and service business.

So given that a lot of dealers are looking for more technicians, are there implications to your SG&A to gross, or your throughput in general, that will be considered for the back half?.

Okay, Jamie, that's a lot of questions, we'll try to answer all of those together here. So the first one, related to parts and service gross margin, we did guide the full year. I think 1 of the sensitivities that we run into with guidance on parts and services. Warranty, it comes second to customer pay and the gross margin contribution.

So if warranty is outpacing customer pay, I mean, there's a slight headwind there as far as gross margins are concerned. But both of those, that were up 10% and 15%, respectively, in the quarter, far outpace wholesale parts in the body shop business. So I'll answer that question.

And then the second question related to SG&A, when you look at sales versus parts and service, the parts and service business generates about 60% throughput versus sales, which is just slightly below 50%. So obviously, there is a benefit for throughput there in the service departments.

And yes, I mean, we do have a lot of initiatives right now to find techs. I think, our tech count is up about 11% year-over-year and that's an opportunity for us. But I think ultimately, if we can get techs in the shops, generating that CP and warranty work, that's a tailwind that we're going to have.

So as far as capacity, Bryan, do you want to take that or Sid?.

This is Sid. When you think about the tech tool out there, it's huge. And if we can have a better place to work, with more opportunity, with a good, stable plan for health and benefits and -- which Lithia has, I think we can access that pool that's out there, without really growing our own techs.

So, I think we can solve the tech shortage better than some others maybe. And that's 1 advantage of our size and our credit, our reputation as a great employer. So it's the same thing with General Managers, it's the same thing with salespeople.

I mean, if we can have a better place to work and we can grow, because there's a huge pool of people out there in the private. Because we're still as a group, what, 10% of sales of public companies and we probably are a better place to work. So that can really be a tailwind for us. So that's kind of a view on that..

Jamie, did we answer your capacity question? Want me to give you a little color on that?.

I think a different color is always welcome..

Okay. So in terms of capacity, this is Bryan, by the way. We currently utilize about 55% to 60% of our existing shop space with our current business. That's also without expanding our hours, okay? So we have lots of headroom for growth when it comes to our facilities.

The exciting thing is DCH also has spent considerable dollars over the last couple of years expanding their facilities. So they actually have had spaces well to be able to handle that incoming UIOs that we're also anxious to be able to bring into our dealerships..

Our next question comes from Ravi Shanker with Morgan Stanley..

Question on F&I per unit. You guys are 1 of the few dealers or 1 of the few dealers, that's only seeing so far to report improving sequential F&I per unit and it went up a nice of the chunk.

How much of that has to do with the sold initiatives, you've put in place, with pricing? And where do you think that can go in the next few quarters?.

Ravi, this is Chris. Specifically on how much was related to pricing, when we had a price increase, we didn't disclose what that was on our fixed-price F&I product. So unlike most dealers, we don't negotiate on the price of our F&I products. We actually negotiate term and deductible. And so yes, there's a benefit there.

I don't think it covered the difference between what we saw last year. What we really noticed is that the penetration, both for service contracts, lifetime oil and our GAAP products are improving.

I think our service contracts were up -- it was 120 basis points and lifetime oil was up 130 basis points and those products are great, not just for generating F&I product or profits, but also for retention back in the service drives.

And we think that those products have been key to us, and have allowed us to see the last 2 quarters, some really strong parts and service comps. So where can it go? I mean, when you compare us to our public peer group, we know we're kind of on the bottom end of that.

We make about $300 less in the used vehicle F&I business than we do in new vehicle F&I business. And so our used-to-new ratio, which is somewhat stronger, affects that. But there's definitely opportunity there and like everything we do, we have a list of 20, 25 stores that we're focused in on and have opportunity.

And we're working to improve overall F&I PBR in those stores, which will bring up that $1,200, hopefully, to $1,250 and to $1,300 to something that we're actively working on..

Understood.

A couple of question on DCH, how do we think of the seasonality of the business compared to yours, just given the different geographic and brand mix?.

Ravi, this is Bryan. So remember, some of it's in the Northeast, which is pretty seasonal. And then there's obviously LA, which is not quite so seasonal. So I think if you compared it to how Lithia, it appears very similar to how we respond to the season's quarterly..

Okay. Probably follow-up with John on that too. Just one more question on DCH, I mean, this is obviously 1 of the biggest deals, the industry's seen in a long time.

Have you seen this kind of open the doors, if you will, either for other dealers who try -- other privates who try and sell or maybe some of the other publics try and respond to your action by doing something similar?.

Ravi, this is Bryan again. I don't know what the appetite is and I don't know what the mentality is of all dealers across the country. We have been in discussions with other dealer groups. And it's a matter of whether it's the right timing for their succession planning or for their, to some extent, for their pocketbook.

And I think, what it may show is that the ability to do something like this is out there. And I think that's fair to say and it may spark some interest in other groups to look at exit strategies or, in this case, look at partnership-type of strategies.

And I think when you look at Lithia, and you look at the ability for us to allow dealerships and groups to operate as entrepreneurs as they always have, we believe it's a pretty important part of the acquisition formula as to who are the suitors that they choose..

This is Sid. Ravi, our entrepreneurial focus at the store level, store-by-store, really allows something like this, maybe better than someone who's trying to control everything that happens at the store..

Understood. We certainly think that's one of the best qualities of Lithia. So I certainly believe that..

[Operator Instructions] Our next question comes from Brett Hoselton with KeyBanc..

I kind of wanted to talk about debt capacity and M&A for a bit. So if I understand you correctly, you're kind of saying, we've got, give or take, around $274 million of available capacity at this point in time. If I take the DCH acquisition of it, met your return on equity criteria, you kind of get a couple different of ideas there, in my mind.

You've got, 1, there's 20% idea and then you've got the 75% to 100% return over 5 years. So if I just take the 20% idea, and take a $0.70 accretion, I get $90 million in after tax under current share count, 20% return on equity suggests that you're paying $93 million in equity, that's a net purchase price.

I'm kind of guessing that number's probably low, I'm thinking probably paying more net. But then I look at the $274 million capacity and I'd knocked of, let's say, $100 million for net purchase price, it kind of gives me $174 million left of capacity.

Can you kind of -- I mean, it runs a lot of numbers there, but I know you'd know them pretty well, Chris.

Can you kind of talk through where I might be, overly optimistic, less optimistic, where I'm wrong, what adjustments I want to make to that math?.

I think, Brett, Chris, you did run through a lot of numbers there, and I know you've done a lot on this model and I think when we get into the detail of this, maybe we take some of these offline. But I will say that what we've laid out, as far as guidance, is no different than the guidance that we lay out for our company.

I mean, we look at current trends and we look at the current trends that we're seeing and we roll those forward into our forecast and yes, there's upside there.

And we're working diligently with George and his team, to identify where that upside is and where the markets may improve, and the things that we can leverage together to generate a 5-year return that meets our hurdle rates. And yes, we pay more than $93 million obviously, for the DCH group.

So I think probably that's loosely what we're going to share. John might be able to provide a little bit more color on the specifics related to the guidance that we laid out. But at this point in time, our goal is to continue to work to integrate with DCH, focus on the transaction and then, over time, provide more color longer term..

And I guess, what I'm kind of driving at is not necessarily how much money that you're going to make at DCH or how accretive it is and so forth.

I guess, what I'm asking is, if I've got $274 million capacity, after the DCH acquisition, give or take, roughly how much do I have left? And I'm thinking if you've paid somewhere in that, I'm guessing, $150 million for DCH net. I'm thinking that leads you with, give or take, $150 million of additional capacity left.

And I -- net of the DCH acquisition, am I way right [ph] or am I way of?.

Brett, I think what we've been able to share is that after the DCH acquisition, we'll have about $200 million of availability.

If you go back to our standard formulas on how we purchase, it's usually 10% to 20% of revenue, which gives us the ability to purchase, what, $2 billion to $3 billion in revenue -- sorry, $1 billion to $2 billion in revenue, Freudian slip.

So there is still headroom even after DCH, and we still believe that there will still be opportunities maintaining the strict disciplines and ROE thresholds that we've established over the last half a decade or so..

We do have capacity. This is Sid. You know what to do, subdebt as well, it has not been ever tapped here in the last 15 years, 10 years with us. So I mean, it's always out there..

Well, it also sounds like, based on your answer to an earlier question, that you might be willing to tap the equity market as well, if the right opportunity came along, is that a fair statement?.

That's fair, Brett. At some point, we would do that if the time is right..

As I looked at the list of dealers out there, based on what I can see, like for example, in automotive news, there's probably another, I don't know, I think kind of 30 or 40 dealers that do $1 billion in sales. And so there's clearly not an infinite amount, but there's a lot.

And so generally speaking, what do you think the possibility of doing another large acquisition might be? I mean, is there anybody out there, that you're talking to, that has $1 billion in sales? Or is it just like, "Look, the DCH was really unique. I kind of don't think that's likely to happen here in the future.".

Brett, this is Bryan. If you recall, I mean, we looked at a number of different groups.

It is unique that the management teams of both organizations, being that we've known each other in different parts for a number of years and the way that we were able to quickly be able to get on the same page in terms of what are we trying to accomplish, how do we go to market, what are we expecting with our consumers, how do we grow our internal employees and teams? It was pretty natural.

And I don't think that any of the discussions, we've had with other groups, were quite as natural as that. And I think that's why it's so clearly made it that the DCH team will be the Lithia Metropolitan strategy. And I think if we look past that, what we really look to is, how is DCH's ability to possibly integrate a group of Metropolitan stores.

We have a pretty good grasp for Lithia, in terms of who are the groups that are in those exclusive type of markets, of which there's only 10 or 11 in the country. So that's a pretty limited number of group. But we believe that we have a pretty good pulls on those. We believe that there is still opportunity to do other deals like that.

But I think for the time being, the fit with DCH is just so nice that it will be hard to look at other ones..

Our next question comes from David Whiston with Morningstar..

First for Chris, on the debt-to-EBITDA ratio. Should we assume that, I believe, at your DCH press release, you talked about 2.5x.

Should we assume that's the ceiling that you don't want to go above that?.

Yes, David, I don't know if that's the ceiling. I mean, I think it depends on what the acquisition market looks like and what else is going on in the business. I would call out that, that 2.5x is not included in the integration of the EBITDA from the DCH group.

So as we stated on the prepared remarks, I mean, if you include, kind of, what our expectations are on the EBITDA basis for '15, we believe that number's somewhere in the 1.8x. And we're very comfortable there and have plenty of room and capacity to continue to take on debt to take on more deals or other expansion as it comes up..

Okay, that's helpful. And then on for future acquisitions.

On the brand side between domestic and import premium luxury, is there any 1 of those 3 segments you want to SKU yourself towards more, going forward?.

David, this is Bryan. I think when we look forward, the DCH transaction balances our portfolio nicely. We'll have 3 major brands, Honda, Toyota and Chrysler with about 25%, 21% and 18% of our mix, respectively.

I think going forward, it gives us the ability to put everyone on the balance scorecard, to some extent, and not have any real attraction to anyone, but more the attraction to what we believe their 5-year and 10-year ROE and returns are, which allows us to be a little bit more open minded and a little more strong, in terms of different areas, such as a Chrysler or a General Motors that we really we're pretty heavily weighted in previous to the DCH transaction..

Okay. And I want to go back to the earlier question on leasing. DCH is in the high 30s, but they have a lot of luxury customers, too.

So it's probably not realistic to assume Lithia can get up in the high 30s, right?.

David, this is Bryan again. So remember 82% of their business is Honda, Toyota. However, there is Lexus and Acura on that. But the majority is Honda, Toyota which is mainstream franchise as much like us. Now there -- it is fair to say that the domestics do not have a stronger leasing presence, even in metropolitan areas.

So I think it's unrealistic to say that we're going to get 35% or 38%. But I think it is realistic to say that there is an opportunity in the 20 percentile range. And some of our stores in these type of markets, even in domestic stores, are able to accomplish those numbers.

And I think it's a matter of teams understanding that all consumers are different, that all consumers' financial needs and trading patterns are different and that we need to provide different alternatives to each and every customer. So I think you nailed it pretty good. It's probably not going to be 35%, but it can be somewhere north of 6% to 7%..

Okay, and just 1 more. I believe in May you sold Mercedes-Benz of Wilsonville. I was just surprised you would want to move away from the Mercedes franchise.

Was that something that's very specific to that store, that prompted to sell?.

Good question, David. So that was actually agreed to, when we purchased the Rasmussen deal in 2010? And when we added the point in Beaverton, Mercedes requested that we didn't control the entire market and that we had a competitor. And we had the right to choose 1 of the 3 stores to divest and we chose to divest Wilsonville..

There are no further questions in queue. At this time, I would like to turn back over to management for closing comments..

Thank you for joining us today and we look forward to giving you updates again in October..

Thank you. This does conclude today's teleconference. You may disconnect your lines at this time. And thank you for your participation..