Bryan DeBoer - President & CEO John North - SVP & CFO Christopher Holzshu - EVP & Chief Human Resources Officer.

Steve Dyer - Craig-Hallum Rick Nelson - Stephens James Albertine - Consumer Edge Research Bret Jordan - Jefferies John Murphy - Bank of America Brett Hoselton - KeyBanc Armintas Sinkevicius - Morgan Stanley Chris Bottiglieri - Wolfe Research David Whiston - Morningstar Andrew Fung - Berenberg Capital Markets.

Good morning, and welcome to the Lithia Motors Third Quarter 2017 Conference Call. Management may make statements about future events, including financial projections and expectations about the company's products, markets, and growth.

Such statements are forward-looking and subject to risks and uncertainties that can cause actual results to differ materially from the statements made. The company discloses material risks and uncertainties in its filings with the Securities and Exchange Commission.

The company urges you to carefully consider these disclosures and not to place undue reliance on forward-looking statements. Management undertakes no duty to update any forward-looking statements, which are made as of the date of this release. Management may also discuss non-GAAP financial measures.

Please refer to the text of the earnings release for a reconciliation of comparable GAAP measures. Management will provide prepared remarks and then open the call for questions. I will now introduce Bryan DeBoer, President and CEO. Mr. DeBoer, you may begin..

Good morning and thank you for joining us today. On the call with me are Chris Holzshu, our Executive Vice President; and John North, Senior Vice President and CFO. Earlier today, we reported adjusted third quarter earnings of $2.18 per share which marks our 28th consecutive quarter of record performance.

We grew revenue 19% and adjusted earnings 5% and anticipate total 2017 revenue of over $10 billion. Our mission is simple; growth powered by people. For the last several years, the hallmark of our success has been high-performing, empowered entrepreneurs making decisions closest to our customers.

We continue to identify, develop, and inspire our leaders to drive substantial and profitable growth. We buy attractive underperforming assets at compelling rates of return. Utilizing best-in-class measurement systems, we identify an unlocked earnings dry powder as we integrate acquisitions.

Acquisition and operational improvement fuel our capital engine, providing further tasks to deploy in a virtuous cycle of growth. This formula will serve us well as we continue to target double-digit top and bottom line growth annually.

From an operational perspective on a same-store basis, total sales grew 1%, new vehicle sales were up 1%, retail used vehicle sales increased over 4%, F&I increased 1%. And service, body and parts sales were up 3%. The new vehicle SAAR was 17 million units for the quarter.

Adjusted to exclude storm effects, which had little impact on us, the quarterly SAAR would have been on the lower end of our expected 16.5 million to 17.5 million units. Our stores responded well to the market and held gross margin while growing revenue.

We are pleased with our top-line performance although opportunities for expense control remain plentiful. Chris will be discussing these in more detail in just a moment. We sold 67 used vehicles per store per month, up from 65 units in the comparable period last year.

In the quarter, same-store certified units decreased 4%, core units increased 7% and value auto units increased 4%. We are making incremental progress towards our goal of 85 used units per store, more than offsetting the effect of acquisitions that sell fewer used vehicles than our seasoned stores do.

We continue to see growth in our service, body, and parts business which was up 3% despite flat warranty sales and one fewer service day compared to last year, which reduced revenue by approximately 2%.

Our stores continue to unlock earnings through capturing more new vehicle market share, increasing used vehicle unit sales, and retaining more service and parts customers. At the same time, we continue our focus on controlling expenses, while innovating to connect with customers in convenient and engaging ways.

I'd like to take a few minutes to share greater visibility and some of the ways technology is impacting our results. We emphasize the omni-channel nature of our retail offerings through personalized experiences, targeted marketing, and intuitive easy-to-use websites.

Two-thirds of our marketing spend is now digital, promoting the efficient delivery of information and connecting with consumers online. In the quarter our Web traffic was up 16%, and 50% of our total visits were via mobile devices.

Our online sales initiatives reached consumers digitally and facilitates the delivery of vehicles directly to their homes. This saves our customers three to four hours, is more convenient, and boost salesperson productivity.

We have also strategically acquired dealership platforms in metropolitan areas of New York, Pittsburgh, and Los Angeles where we can respond to consumer behavioral changes involving affordability, sustainability, and usage. This allows us to stay ahead of consumer preferences driven by evolving vehicle technology and automation.

We're participating in the maintenance of electric and hybrid vehicles with our charging and service network. The majority of our stores maintain charging stations. Additionally, our West Coast footprint allows us to efficiently serve the needs of vehicles along the I-5 Corridor from Canada to Mexico.

This infrastructure allows us to engage with early-adopting customers and learn from their behaviors. Since we last spoke, we completed the acquisition of the Downtown Los Angeles Auto Group with estimated annual revenues of $1 billion. So far in 2017, we've acquired over $1.5 billion in revenue.

The Downtown LA transaction utilized just under half of the $300 million dollars in proceeds raised with our debt issuance in July, and we anticipate deploying the remainder in the near term. Looking forward, we are establishing a 2018 earnings target of $9.25 per share.

We are committed to the annual double-digit top and bottom line growth we have accomplished for the last seven years or so. We continue to unlock incremental EBITDA in our existing store base, augmented with the creative acquisitions purchased at attractive forward multiples. We view these as in a related drivers.

If organic growth flattens, acquisitions will become more prevalent. In summary, we see a stable operational environment, a massive amount of earnings upside available through improvement in our unseasoned stores, and a robust acquisition market.

This environment, coupled with the most liquidity in our history and sector-leading low leverage, gives us confidence that we can drive significant growth in both top and bottom line performance. With that, I'd like to turn the call over to John..

Thanks Bryan. I'd like to provide more detail on the results in the quarter. Our numbers from this point forward will be on a same-store basis. In the quarter, new vehicle revenue increased 1%. Our unit sales were flat, better than national results which decreased 1% from the prior year.

Our average selling price increased 1% compared to third quarter of 2016. Gross profit for new vehicle retail was $1,910 compared to $1,978 in the third quarter of 2016, a decrease of 3%. Retail used vehicle revenues increased 4% of which 3% was due to greater unit sales and 1% to increase in selling prices. Our used and new ratio was 0.80 to 1.

Gross profit per unit was $2,364 compared to $2,338 last year, an increase of $26. Our F&I per vehicle was $1,286 compared to $1,297 last year or a decrease of $11. Other vehicles we sold in the quarter, we arranged financing on 72%, sold a service contract on 45% and sold a lifetime oil product on 26%.

Our penetration rate decreased 40 basis points for financing, increased 60 basis points for service contracts and decreased to 100 basis points for lifetime oil contract. In the third quarter, the blended overall gross profit per unit was $3,412 compared to $3,446 last year, a decrease of $34 per unit.

Our service, body and parts revenue increased 3% over the third quarter of 2016, customer pay work increased 4%, warranty was flat, wholesale parts increased 3% and our body shops increased 6%. Our total gross margin was 15.2%, an increase of 30 basis points from the same period last year primarily due to mix.

As of September 30, consolidated new vehicle inventories were at a day supply of 69, an increase of 4 days from a year ago. Used vehicle inventories were at a day supply of 59, an increase of 2 days.

At September 30, 2017, we had approximately $307 million in cash and available credit, as well as unfinanced real estate that could provide another $211 million in 60 to 90 days for an estimated total liquidity of over $0.5 billion. At the end of the third quarter, we were in compliance to all of our debt covenants.

Our leveraged EBITDA, defined as adjusted EBITDA less used floorplan interest and capital expenditures, was $76 million for the third quarter of 2017. Capital expenditures were $40 million for the quarter. We predict leveraged EBITDA of nearly $340 million in 2017.

Our free cash flow, as outlined in our investor presentation, was $40 million for the third quarter of 2017. We predict free cash flow after capital expenditures of nearly $167 million in 2017. Our net debt to EBITDA is 2.4 times, which remains among the lowest in our sector and within our targeted range of 2 to 2.5 times.

As Bryan mentioned earlier, our 2018 target is revenues of $11 billion to $11.5 billion and earnings per share of $9.25. Adjusting for our third quarter results, we expect 2017 earnings in the range of $8.30 to $8.35 per share. Achieving our target for next year will provide approximately 11% growth for both revenue and earnings.

And now a few comments from Chris..

Thank you, John. We remain focused on cultivating a high-performing culture to generate opportunities in our core business lines while leveraging our cost structure. This is the foundation of growth powered by people. We have over 13,000 team members that drive our success.

We continue to develop tools, training, and growth opportunities that accelerate the depth of our talent. As Bryan mentioned, we are innovating and making investments at the store level to use technology to improve the customer interactions and to increase productivity.

Earlier this year, we realigned our store leadership within our core group of operational vice presidents who have proven success motivating leaders to improve performance. This group is core to integrating new stores and helping existing stores achieve their potential.

We remain focused on accelerating the continued development of a strong and dynamic leadership team. Our Accelerated Management Program or AMP is welcoming its third cohort of individuals. This program is designed to develop leadership skills to better position participants for consideration as future general managers.

In 2017, 8 of 37 team members that attended the inaugural trainings have been promoted to store leadership positions. Additionally year-to-date, we have increased the number of management positions filled from within our company by over 90%.

As Brian mentioned, we had a few areas of opportunity and some atypical expenses in the quarter we'd like to provide more color on.

We estimate approximately $0.20 in headwinds in the quarter associated with corporate charges related to reserve adjustments, accelerated depreciation associated with modified asset life and in-service dates and increased flooring in interest expense. Third quarter adjusted SG&A as a percentage of gross profit on a same-store basis was 68.5%.

While this is an industry-leading performance, opportunity remains to better leverage expenses in personnel and advertising. We have identified these areas of opportunity and are aggressively working to improve our performance. We continue to target SG&A to gross in the mid-60% range and sector-leading operating margins.

Our dynamic operating model empowers our store leaders at different levels and allows us to manage by thirds. The top third of our stores which includes our Lithia Partners Group members received the highest level of autonomy in decisions and strategy.

The middle level has more oversight and influence from the operational vice president, and the bottom third are typically newly acquired stores or have newly installed general managers who receive the most frequent attention and development.

Utilizing our best-in-class measurement systems, we identified trends and underlying market dynamics to challenge store leaders, identify opportunities, and develop further expertise within the personnel closest to our customers.

Our reporting and measurement system allows us to respond to the opportunities we identified in our third quarter performance. We continue to emphasize a culture of high-performing teams, entrepreneurial spirit, and innovative employees who live our core values each and every day.

This concludes our prepared remarks, and we'd now like to open the call to question.

Operator?.

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

Just trying to drill down a little bit on the $0.20 cent delta, I guess, between the time you closed the acquisition in mid-August and then, the end of the quarter.

As you look at the reserves, could you give a little bit more color, is that around sort of self-insurance or what sort of change that calculation in that period of time?.

I think the $0.20 is really we could bifurcate into two buckets. About $0.10 if it was in our SG&A, and it was really two accounting reserve adjustments. One of our medical expense and one on our auto finance portfolio where we've seen some lower auction values on repossessions and needed reserve pickup. So that's about half of it.

The other half is about evenly split in two different lines, one in depreciation expense and the other in our interest expense around flooring. LIBOR moved a little higher than we expected. Our days supply was a little more in some stores than we had anticipated, and so that was the driver on the flooring side.

The D&A, we’ve got about $1 billion of land and building and we made some adjustments to our assumptions around useful lives there, and that caused a bit of variance. So I think that's kind of the $0.20 we called out. And, Chris, maybe you want to talk a little bit about SG&A more broadly and the opportunities you see there..

I think just kind of going off of that. One of the things we said in our prepared remarks is that we remain focused on driving our SG&A to gross down to that mid-60 percentage range.

And when you think about the opportunity that we have with an annualized basis of $1.6 billion in gross and $1.1 billion in SG&A, the majority of that, over 75% of that being personnel and advertising, we're going to continue to execute on what we do which is whether it's a new store or an existing store, we stay focused and diligent on the opportunity on an individual store basis.

And we continue to drive down and leverage the cost that we can as we continue to focus on driving top line growth.

And when you look at the differences in the range that we have between kind of our seasoned platform of stores that are SG&A to gross in the 65% range, and then we have the newer integrations which we've said historically take three to five years to integrate which they're running in the 75% range, we know where those opportunities are and we're going to continue to focus on getting all of our stores down to that Lithia partner group level which is in the 62% range of SG&A to gross.

So we realize we have some opportunities to focus in on. And we have some anomalies in the quarter, but broadly speaking, looking forward in the 2018, 2019, and 2020, we have lots of opportunity ahead of us..

And I guess if I could dive into F&I a little bit just because it's so profitable, it looked like it was a bit softer than anticipated in the quarter, particularly I think the newly acquired dealerships.

Could you just give some color as to what you're seeing there overall, and then sort of your partner's group and then all the way down to the newly acquired, anything changing there?.

I mean kind of a similar focus that we have on SG&A. It's the same thing on each incremental line in business, F&I being one of those. And you've got it – I mean our season Lithia stores are running north of $1,400 a copy of F&I. And our newly acquired platforms are well south of that, anywhere from $800, $900 to $1,100.

And so, we remain focused on making sure that we have the right people with the right compensation plans and the right products to deliver to the customers and to continue to drive up to where the industry standards are right now..

But otherwise nothing - you're not seeing anything necessarily shifting there on a per copy basis trend-wise?.

No, nothing at all..

Lastly then for me, just as it relates to inventory, it sounds like it was maybe a touch higher than you anticipated. In holiday sales, it continues to tick up. Any color there? I'm guessing you'll say that – particularly on the used side, that's opportunity and that's what you're looking for.

But is that at, like, a comfortable level for you guys going forward or how do you think about it going into year-end?.

I think, really, it's a great question. Let’s talk about the use specifically. You think it’s important to point out, we're buying stores that typically are doing significantly lower use to new volume than we do. So as a company, we're doing 0.8 to 1 as I mentioned in the prepared remarks. Our acquisitions, in many cases, doing less than 0.5 to 1.

And so, as you ramp up inventory on the used side and the cost sales hasn't caught up to that yet. You can see a tickup in days supply. When you look at the aging overall, we’re really comfortable with where the level is. We think that those are investments. That’s the incremental dry powder we’re trying to unlock.

On the new side, we give our stores a little more autonomy, and occasionally they choose to stock up. Again, I think it's at a pretty comfortable level. We're at around 70 days’ supply, and we can work through any anomalies at a store-by-store basis pretty quickly. So, I wouldn't say that that's a concern.

I think it just – it was an area where our modeling maybe wasn't conservative enough around what our stores are going to do operationally. But we'll get our returns pretty quickly..

Our next question comes from Rick Nelson with Stephens. Please proceed with your question..

$0.20 that you called out for the reserve adjustment and the floorplan and depreciation.

Curious, what do you think is transitory or onetime in nature and what will be an ongoing expense?.

I mean, the reserve adjustments are transitory. Obviously, they are core to our business. It's hard to predict when they're going to necessarily crop up, but we have to pick them up when they come. But they're not something we see every quarter. The depreciation increase is going to be in prospectively.

That's already assumed in the guidance update we provided in the inventory levels or in adjustments that have been made. So, we've kind of balanced all that calculus to come up with where we are today..

And what's the guidance for next year? Do you need acquisitions to hit those estimates, or is it based on what you've acquired to-date?.

Maybe I can jump in, and then if Bryan has some color, I think he can add it maybe when we're done, but I think you're seeing an evolution in how we talk about our outlook. I think as you see, the market is pretty stable. Our expectation is that without any acquisitions, there's double-digit earnings power in our company.

So the idea is how quickly can we get there and what are we going to lay out in terms of opportunity. Conversely, the acquisitions are in large part catalyzed by what happens in the broader market. And so as we've seen this year, if the SAAR is plateauing or maybe even slowing down, that's going to increase acquisitions.

And conversely, if the SAAR is strong, it's going to keep acquisitions maybe on the sidelines a bit more.

And so I think instead of us trying to update you every quarter with where things are running, what we're trying to do is explain how we're managing the company which is to deliver double-digit top and bottom line growth in the current environment. And as long as GDP is flat, I think we can achieve that.

And I think we're trying to kind of lay out the vision of how we're managing the business. Clearly, we're trying to attack the dry powder end acquisitions, but I think that's the runway we're laying out for 2018 and beyond..

And just a final question on the L.A. Auto Group, how that is and coming in relative to your expectations and do you continue to expect $0.55 accretion there..

Downtown L.A. started out with a 20-day month which is it can always be a little bit difficult to get your feet underneath you. But September came through on target. We're really pleased with Eli and her team. They're very tech savvy much like our DCH teams.

They care about people and they care about our customers much like the culture of Lithia Motors and we really believe that they're poised to be able to really attack that downtown L.A. market. L.A. market. I think some of the other critical things on downtown L.A.

were that, that real estate in that location is pre-key meaning that we are not going to be able – we're not going to have additional competition come into that marketplace probably forever because of the barriers to entry and the cost of real estate. And as we all know, the downtown L.A.

market is growing vertically which means that our customer base is going to grow and the deter body isn’t. So we're pretty pleased and like where we're at on that, and should be able to expand from that base and develop another growth acquisition platform..

Our next question comes from James Albertine with Consumer Edge Research. Please proceed with your question..

Wanted to maybe ask - drill down a little bit more in service, body and parts if I could.

Can you talk a little bit about the drivers of that business to get to the 3.2% comp growth? And then as well, sort of if you can marry that with your outlook on particularly the customer pay business? And what you see as opportunities to retain vehicles that are slightly older than perhaps your historical average? Thanks..

I think when we - anytime we approach our service, body and parts business, we look at that as the continuation of the buying cycle. And how do we retain a larger portion of that business? We do it through convenience service process and cost effective offerings to our consumers.

So I think we've spoke in the past about we focus on OEM part because we're the only place we can get them. But as the life of the vehicle becomes closer to the end of warranty periods and when budgets become a little bit more restricted, then we move to non-OEM parts and we have our own branded parts to be able to retain and attract that customer.

We also spend a fair amount of time in customers’ homes on the Web to draw them back into the dealership to keep their cars fully maintained. So we call it a one-shop-stop shopping experience where they can do wipers and they can do tires and make new batteries and they can do their maintenance and they can do their warranty work.

We also do home delivery in many of our stores which means we go pick up cars and we take in loaner cars in the interim. So it's very convenient. And I think when we look at a 3%, 4% growth rate in same-store sales and service body and parts, that's mostly driven by customer pay work. Our warranty rate was flat, as John mentioned.

So it's coming through this idea that it's a better service experience and a more well-rounded one-stop shopping experience.

Now, the other thing to keep in mind, Jamie, and Chris spoke to this a little bit on the SG&A, is if we look at retention of the stores that we buy, they're typically about minus 5% of where the average retention is for their consumer base based on the last 10 years of service experience, okay? And our seasoned Lithia partners stores are upwards of 20%; and after a couple of years, we get it to about 15%.

So we're able to make some pretty good moves in the first year or two to be able to attack that and still grow same-store sales, and I think that's why acquisitions are so critical to be able to be the elixir of dry powder in future same-store sales growth..

Understood, and extraordinarily helpful. If I may follow up related to some comments that I think Chris made on SG&A, particularly on the advertising side.

Can you sort of help us break down the advertising – your outlook on advertising and advertising spending as it relates to fueling your new and used vehicle business relative to some of the things that you're doing on the service, body, and parts side? Is it material on the service, body, and parts side in terms of incremental investments, or how should we sort of think about the different buckets within advertising? Thanks..

This is Bryan. I mean, our advertising is broken down about 90-plus percent is vehicle sales, okay? The other 5% to 10% is service, body, and parts. And typically when you think about service, body, and part, it's typically targeted e-mail. It can be direct mail with certain manufacturers.

And it’s scheduling and convenience-type of advertising to be able to keep the processes moving in service and part.

When we look at the vehicle side of marketing, I mentioned in the prepared comments that we spend about two-thirds of our budget on Web marketing, which means we sites, which means SEO, SEM, targeting consumers when they’re at the point of making a decision.

The other one-third is split between a lot of traditional things, as well as production and development. If we look back three to five years ago, that budget was split about 50/50, Web versus traditional. So it is moving to more of a digital world, and many of our stores are spending upwards of 80%, 90% of their budget on digital..

Our next question comes from Bret Jordan with Jefferies. Please proceed with your question..

On the sort of unusual expenses, you mentioned useful lives on buildings.

Is there anything tied to any particular transaction or acquisition recently that you're writing down quicker because of the asset or could you explain that a little bit more?.

It's really just around intent, Bret, and you evaluate your intent periodically and you make assumptions. And a good example would be a leasehold improvement you make. If you are expecting a lease renewal and then for a particular reason maybe you're going to relocate, you're no longer going to keep the lease renewal.

You'll need to accelerate depreciation. So I mean I don't want to get into in the weeds on it. We can go off line if you want, but it's primarily related with things like that..

And then a follow-up on a question earlier, on the 2018 guide. I think you've said that you could get double digit earnings growth out of the core business.

So, I think you're guiding to 11, so that implies that you do not have acquisitions built into next year?.

I mean I think the idea here is we're trying to really communicate the outlook for what we're achieving as a management team. And I think the question is we want to manage the quarter, but we want to communicate what we're trying to build in terms of a dynamic company that's delivering growth in a relatively stable economic environment.

And so, frankly, I mean there is a scenario that would be both. If the SAR is healthy and we're making good progress operationally, acquisitions are going to be a smaller part of the number. If the SAR is moderating and private dealers seeing profitability decline, acquisitions are going to be a bigger part of it.

And then it's also a function of when they come in and how they're performing. So I think if you look back at our historical trends the last two or three years, we've been delivering 10% to 20% top line growth and delivering 15%-plus EPS growth on average. And our intention is to continue that.

And how do we get there? I mean, frankly, there's a couple a different path but we're confident we can deliver $9.25 and hopefully better in the years to come..

Great. And then….

One additional comment, I think when we think about targeting a number of years ago, we used to work off of milestone targets and this management team thinks about the different levers that it can pull to accomplish a milestone or a target or so on.

And I think when we think about our growth and our development, the dry powder is there, but it can come in waves and it can it can be more difficult at times. And I think when there's difficulty, then we can accelerate acquisitions to be able to do that. And I think it is a combination of those two things.

Ultimately, our target of 925 would not include obviously a transformative-type acquisition that would be like a DCH or possibly even larger than that..

And then one last question.

John, you mentioned seeing some lower auction values and some repo vehicles, is that just mix, are you seeing more passenger cars coming in and not getting the value out of those or what's changing on that side?.

I mean it's really kind of a case specific. And obviously, auction value has picked back up post kind of Harvey. So it's a pretty fluid market. We're looking at a portfolio and trying to anticipate over the next four years what our delinquencies are going to be, what repossessions are going to be and what the proceeds are going to be at auction.

We’re using the best information we can. So it’s also a function of mix that we’re underwriting and so without kind of sharing the analytics, it's hard to really peel the layers of the onion back. But I think you're well aware of the market dynamics and that there's been some pretty significant shifts there also recently.

So, stay tuned on that front, but we think it's pretty manageable..

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

First question on 2018 targets, and I know you just kind of alluded to it could be variable. But, I mean, as you look at the outlook for 2018 U.S. sales, I'm just curious what you're thinking sort of as a baseline. And recognizing if it's tougher, you'll do more acquisitions; and if it's better, maybe you'll do less acquisitions.

But just curious what your thought process is there on the market size next year..

I think we've set a pretty broad target of –16.5 million to 17.5 million SAAR. We're now in the three years of stability in SAAR that's floating within that range. I think more – it's about execution within that range and our ability to capture that dry powder.

It's a pretty broad range, but ultimately every single individual market responds differently. And I think that was the color we gave around the storm that it didn't affect us any. So, I mean, we didn't get any pop from an additional 300,000 to 400,000 units that may come in over the next month or so..

And then if we consider what the automakers might do in response to a slowing SAAR, and they're doing a little bit of this, but increase incentives or take price actions in whatever way they decide, I mean, would that have any impact on how you run the business, and are you seeing any more incremental or aggressive incentives in the market?.

John, incentives look pretty typical for this time of year. It's close out time, and typically, the luxuries have a really good run in November and December. So we have that tailwind going into the fourth quarter, and obviously adding DTLA at some large, highline stores. So, we're looking forward to a good close by them.

I think when we think about incentives, really incentives are there to help balance out supply and demand, and I think manufacturers to us as a retailer, it helps take out some of the bumps more than anything and just keeps us from hitting peaks and valleys. And I think our management team looks at it that way, and our stores look at it that way..

Then just a second question on the used opportunity. I mean, there seemed like there's three things, I mean, your online efforts and just your in-store efforts. Second, getting your sort of new acquired stores sort of up to snuff to where you are at 0.8:1 and maybe even better over time.

And then there's a tsunami of vehicles coming off of lease really over the next two to probably three years.

As you look at this opportunity, how do you think you're really going to attack it and take advantage of it, and how big an opportunity is it for you as these kind of factors roll in over the next couple few years?.

I think if you think about the two to three years that drive certified sales, keep in mind that certified is about a quarter of our used car volume, okay? And that actually was down a little bit this quarter, and it's because we're going to need to do a better job because ultimately the supply line is full, okay? Because we - like I just mentioned, we have three years of stable SAAR environment, which is what generates those trades.

I think our opportunity is coming in the three- to eight-year-old vehicle, which is still somewhat depressed. And that's what's going to really take us up to that next level and get to that 85 units per store.

Keep in mind when we buy stores, we buy underperformance, okay? Our typical store sells 38 used vehicles per store that we buy, okay? We sell 67, and that includes some of those stores.

So that 85 number over a static environment is achievable and I mean that built-in growth that's going to happen and it comes from that core product growth as well as that value auto growth which is the eight years and older.

And I think that's when you start to compare and contrast different retailers whether specifically used or new vehicle retailers with used vehicle businesses. That's the difference of Lithium Motors and those joining Lithium Motors that we believe that we’re at the top of the food chain.

And we want to make sure to go deep into that market to be able to capture customers early in their buying cycle. So eventually, they can buy certified cars or new cars as they begin to stabilize their lives and their disposable incomes..

And then, just lastly, has there been any changes in floor plan assistance. I know you guys highlighted floor plan interest expense is going up just on LIBOR and slightly higher inventory.

But are the automakers doing anything on the floor plan as just inside to pull it back or maybe even to help out in any direction?.

I think that's refreshed every model year. So it's model-specific, by make. And then if by model year, it's adjusted. And so, I think as you see the 2018 vehicles come out, we'll have better insight into what that's going to look like for next year.

It's certainly helpful if they increase the flooring assistance because that raises the inventory price of our units from the OEM, and most of our operational leaders are pricing kind of cost up. So to the extent that gets baked in, it should provide a tailwind.

We still were net positive on flooring assistance relative to expense even as interest rates have gone up. And what we see on our acquisitions is that our cost of funds given our credit facility is significantly cheaper than what a typical private dealer would pay even some of these platform group dealers.

So, I think it's pretty healthy and we'll see what 2018 looks like..

Our next question comes from Brett Hoselton with KeyBanc. Please proceed with your question..

Chris, I was kind of hoping you could dive into SG&A. You're at 68.5%. You kind of talked about targeting the mid-60% range.

Do you have any sort of formal expectations as to when you might be able to achieve that mid-60% range? Is that kind of a one-year or a five-year or a 10-year? What are your thoughts there?.

I think it all depends. I mean, it depends on what's happening in the local store, depends on where they're at in kind of those thirds that we talked about. I mean, the store that's reached its potential maybe on top line growth then has more opportunity to fine-tune and move to the right cost structure.

But a store that’s just working on generating growth, which is our first priority, it may take a little bit longer in order to hit those targets. But, again, I mean, each individual store is unique. We look at the results of all 170 locations on a regular basis, and then our platform leaders then diagnose the opportunity one store at a time.

So, I don’t have an outlook of whether it’s 1-year or 3-year or 10 years. But I can tell you that we’re diligently diving into each and every day and are confident we’re going to execute that quickly..

A little bit more color on that.

When we think about SG&A, about 25% of it comes from hard cost reductions, meaning there's an expense and I'm going to cut budget, okay? The other 75% of the SG&A improvement comes from new vehicle market share improvement, which, if you remember, the stores that we buy are about a minus 30, and we eventually get them to a plus 20, okay, which adds tons of top line gross profit and margin.

It comes from used vehicle improvements from that 38 units to the 75 to 85 units. It comes from F&I moving $8.51 when we buy the store to $14.50 when it's seasoned in a partner.

It comes from a minus 5% in-service retention that gets to a plus 20% over 5 years or so because units and operations are always the slowest to move because you have to build that new and used car business. And I think – so it's like Chris is saying. It is a process to be able to develop it, and it doesn't move linearly.

And to be fair, our mission of growth powered by people is probably as big a factor of anything.

And when we buy new platforms or they choose to join us, or we buy underperformance, a lot of the ways that we gain performance is by growing people, okay? And that moves at different rates, and we monitor and manage trends at a what I would call a very doggedly level even at my level, Chris’ level and John's level.

But I think that's what makes Lithia very unique and has this ability that most other retailers or, for that matter, most other industries don't have that dry powder built in, and I think you're relying on a management team that understands that there's five or six levers that are driven through people that need to be pulled to be able to extract that SG&A that you're really talking about..

And, John, on the purchase service side, you mentioned once, you're selling day kind of – if you were to look at the same-store sales up 3% and you were to adjust for that selling day, I'm sure you've done this calculation, do you have an idea of what that number would look like?.

I mean, the rule of thumb is typically 20 service days a month and there's – so it’s about 2% in a quarter..

Got it..

So it’s 60 days. If you lose a day, it’s about 2%..

From 3% to 5%..

Our next question comes from Adam Jonas with Morgan Stanley. Please proceed with your question..

This is Armintas for Adam. I was hoping – I know you're not in the markets that were affected by the storms.

But is that having any impact to the potential M&A market?.

We haven't seen any impact to the M&A market. I think what we do see in M&A is that we've done $1.5 billion in revenue thus far this year and still have a few other things in the hopper. The market is extremely robust in terms of M&A. It seems like pricing have subsided some, and we really believe that there is a lot of opportunity for growth.

When you look at the specific storm markets, there was some pull in inventory into the Houston market to be able to replace those markets, but I don't think it had a large effect on any of the surrounding dealers by any great part..

And can you remind us here your acquisition criteria? I know you get underperforming assets and fix them up.

But what are you looking for and what should we be looking for to track the acquisitions?.

So as you know, we're value investor. We purchase stores or stores choose to combine with us at around 10% to 20% of revenue for our all-in investment. That typically comes out to about a 3 to 5 times future EBITDA number which ultimately returns us at a 15% to 20% annual return on investment after tax..

And then last one, just I know you mentioned that excluding the storm impact, sales of SAAR would have been below 16.5 million to 17.5 million.

Can you just talk about the health of the consumer today?.

Sure. If you think about the quarter, I believe July and August were 16.2 million to 16.7-ish million. And then we had an 18.5 million which obviously came from – we had calculated roughly that there was about 100,000 units that went into the Houston market or the Corpus Christi market as a nation.

And if you annualize that, that's about 1.2 million units which gets you back to about low-17 range. You put that together with a 6 – that 16.3 million or 16.4 million, and we end up at towards the lower end of our range in the 16 million to 16.8 million SAAR as more of a natural number.

Now, there was a little bit of drought probably towards the end of August as well that may have adjusted for that but that’s how we got to that expectation. But again, we look at 16.5% to 17.5% as being a nice strong stable marketplace..

The next question comes from Chris Bottiglieri with Wolfe Research. Please proceed with your question..

I have more of a strategic question.

Was this – I guess with provision, was this for the Cascades business you referenced last quarter of like $60 million, $70 million portfolio?.

That’s right. It’s the $75 million to $80 million sub-prime loan portfolio. We've been running it since 2011..

As of 2011? Okay. That’s a long time, still pretty small. But what’s the end vision here with this? Like, why do you need this? Is it just kind of you’re trying to pick up incremental sale? Are you exploring it? Do you want to do something with used down the road? Just want to get your overall view there..

I mean, I think from a strategic perspective, we're really comfortable with it at the size it is, in the subprime category. We're obviously always looking for ancillary opportunities and I think you can see in our investor deck.

We lay out some of those as we see over time that might develop, and clearly there's a wonderfully respected peer in CarMax that has a great auto loan portfolio that's a great part of business. And we're studying and experimenting with it.

Now, it doesn't mean that we're going to change our strategy going forward, which is to go out and buy underperforming stores and integrate them. But I think if this is a component of business that we can augment over time to drive profitability, we're going to look to do that.

But it's going to be done at a very gradual and balanced pace and consistent with what you come to expect from us as a management group..

And then I wanted to dig on used a little bit further. So it looks like your GPU was positive for the first time in seven quarters. I would imagine the mix of less CPO probably helped there.

I wanted to get a sense with, like, volumes decelerating, maybe you can tell us you're seeing less value and more core on the mix there and kind of what your view is for underlying used car unit volume trend..

You're absolutely right. I mean the reason there was margin growth was typically because of the mix. Value auto in units was up 4%. Revenues were up 9%. Relative to the total, we were up 4% and 3%. Core, which is those 17,000, 18,000 our vehicles that we make good margin on as well, were up 8% in revenue and 7% in units.

So I think that's the primary driver of why you saw margin growth and I think that should likely continue because certified is a flat now of supply.

So we should still though continue to see core growing as value starts to take hold in many of our new stores which is the biggest opportunity that we typically find, much like DCH that’s still not quite there. We find that that's what really drives it. And if you think about our gross profit actual margin, we make about 18% on value auto cars.

We make about 12% on core and 8%, 9% on certified, so that quickly tweaks your mix like you had assessed..

And then just a question - follow-up question on you keep referencing that the supply of CPO is kind of flat.

So obviously when looking at this writing off lease numbers, what has been on the supply that’s going to be flat? Is it just that like CPO was more than off lease and there's trade-ins and rental cars that become certified or is it more the OEM is just saturating like the level they want to certify or more demand-driven, I guess? Maybe just kind of comment there directionally..

I think it’s a combination of all of those. I mean, I really believe it doesn't hit us all at once, I mean, and obviously now with three years of supply, it’s pretty static. So the fallacy, to some extent, of off-lease vehicles is always there, and it happens every single month. So it's not like if this is some heart attack.

It is that it can affect prices a little bit. But remember, we have a month-and-a-half supply on our used cars. So it's not really relative to a retailer. So the idea of off-lease vehicles to us as a retailer is just another avenue of supply, and I think when we think about used cars, most of what we do is mine used cars.

Well, when certified are pretty plentiful, which they are now, they're easy to find, okay, which means we can spend our time on going and mining core product and value product which is where we make all of our money. So I think it's a healthy transition to having no supply in all three buckets three years ago..

Our next question is from David Whiston with Morningstar. Please proceed with your question..

I wanted to go back to the idea of buying underperformance. Can you just talk a bit about when you're deciding whether or not to buy a group, what are things – some specific examples is what I'm looking for, things you see that make you say, yes, we can fix that versus something that makes you say, we should walk away..

David, we get to have fun here. So we actually have acquisition meetings every other week, and everyone in our organization understands what we look for.

We look very specifically at a couple of different things, okay? We look at market share as the primary driver, okay? So, we actually run in the entire country what market share registrations are by dealer relative to what that manufacturer does in the state.

That gives us the indication of success of that dealer, which will give us indications that it's undervalued, right, or it's underperforming. We combine that with used vehicle research, okay? And then once we get that information, we target our efforts with our people as well as our brokers to go find those stores.

Once the store is active or in play, then we typically do a little bit deeper dive into retention and service and parts. So, the first thing that I would look at is how much is our service and parts growth relative to units in operation or new vehicle sales.

Are you following me? Then we also quickly look at what rent factors are and can we own the real estate.

And those things then get developed into who are the people in that store, who are people in that market, do we have mitigation plans for people in the event that we're not able to capture that dry powder immediately? And those things all combine together to be able to quickly be able to extrapolate whether or not it’s a store for us.

So, we typically can make a decision within two to three days because we've done most of the leg work before we even get P&Ls from a seller. So, it's a pretty easy process. It boils down to this.

The market sells stores at somewhere between five and seven times pre-tax earnings and in the last, we see that the store is performing at about half or a quarter of that potential. Then, we don’t spend a lot of time on that opportunity because ultimately we need to buy stores at between two and four times pre-tax numbers on a forward looking basis.

So unless they’re vastly underperforming, we don’t need to spend any time on those stores. Now, that can give you a little bit of a miss number, but we know what the strong assets are.

So these are underperforming strong assets and that’s why we talk specifically to between 600 stores or so that we’ve targeted that we believe fall within this underperformance but still fundamentally have a strong franchise in the right market with the right consumer base and I think ultimately then it’s a people formula to be able to extract the dry powder..

So looking all those metrics, at what point you’re going to be doing the – people to be sure that they can - they’re willing to switch owners and work with you to improve the stores that early or late in the process?.

So David, because we know it’s a people formula, that’s less important to us. We know the underlying asset can perform.

So it’s a matter of finding the right people or growing the right people that can accomplish that and remember our success rate since 2010 and this is on over 100 acquisitions is 86-plus-percent of hitting these ROE targets that I mentioned a little bit ago. So the people part of it comes later, okay.

Now, we’re going to do some diagnostics of who are the general sales manager, the service manager and the general manager, and we obviously want to know about that person.

But remember our model is growth powered by people which means we’re there to inspire and challenge whoever it is, in whatever approach they have to business, to become better than what they are today. We fundamentally believe as leaders of our organization and we hire people that believe there is no such thing as the best.

We believe that there is only better. Okay? And because of that, the idea of continuous improvement, we can usually extract that out of any type of people. So the people part of that formula is really irrelevant.

And the success at 86-plus percent, hitting those ROE targets, is pretty at a high rate and that's why we call it greenfield-like growth rather than acquisitions because there's very little integration risk..

Just to add on to that on the people side.

I mean, the majority of the people in an acquisition stay with us and what we do is we work to bridge the culture that the stores had historically in a local market with our high-performance culture where we share best practices, ideas, clear measurements and really motivate each individual to get to a higher performance level based on the peer group we have.

And over 95% of the associates that come with an acquisition are there one year, three year, or five years later..

And, Chris, one more for you. Actually, you mentioned the AMP program earlier.

Just curious, how do you balance the Lithia culture and training you put into that program versus the company's decentralized approach to give stores some autonomy?.

So, first off, anybody that's coming into AMP program is a recommendation that's coming from either the market, the general manager that they work for at their existing store, or their operational leader that's overseeing the platform.

And so what we're doing is we're bringing them together really as a peer group in order to have them see what other people are doing in different markets and open their minds to what performance looks like in the organization. And so, we're not taking away that training at the local level.

We're just working to inspire them to make sure that they're the best qualified candidate when a new general manager position becomes open in the organization..

Our next question comes from Andrew Fung with Berenberg Capital Markets. Please proceed with your question..

You had mentioned a lot of opportunities for additional SG&A leverage. I was wondering if you could provide some color around what opportunities come from the digital aspect and initiatives that you guys are working on.

And then also with regards to in-house capabilities versus third-party platforms, do you guys have a preference around that?.

I think when we think about our SG&A, we think about it individually in a store and each leadership team within that store has different go-to-market strategies and are deeper into digital or deeper into a brick-and-mortar.

Most of our stores have transitioned to a digital platform where they’re a multiple-point delivery site, okay? Meaning, that consumers will come into the store, consumers will do Web business, consumers will have home delivery and those type of things, and I think that's growing in our organization.

And as stores begin the season, that becomes much more prevalent. I think when you also start to develop the ability in store, it's important that they can do the blocking and tackling.

So young stores, it’s more about can I answer the phones and have an inviting friendly attitude, okay? And when people come through our service or visit our storerooms, does that accomplish how we typically want? And that takes SG&A dollars to get that going.

As you become more seasoned, you're able to lean-out your SG&A dollars and utilize it more targeted, meaning that you can rely on the fact that the blocking and tackling get done appropriately. So when we are chatting with customers online or we have telephone or e-mail communications with them, that those things are occurring in an efficient manner.

But as stores develop, what happens is you began to expand your radius, and we have stores now that are touching 500 and 1,000 miles out, which is ultimately how we want our partners to become.

But that takes time, and I think when you think about SG&A, you need to look at what is market share, how many used cars per site, how does that affect UIO and service and parts.

And the downstream effect of that is what are the people doing, and how are they developing in terms of their digital ability? But our stores make their own decisions in terms of whether they use developed software which is developed in-house, or whether they use third-party vendors, and we’re in a what I would call vendor robust industry that provide wonderful solutions that proprietary systems quickly become outdated.

And it’s easy to move vendors rather than be attached to a boat anchor that you believe is the end-all solution to automotive retail when every environment is changing and every individual market is different. Hopefully that adds enough color for you there, Andrew..

And then, I guess as a follow-up lastly, I noticed that the new unit, new vehicle unit profitability softened a bit in the third quarter.

Is this a reflection of the recent acquisitions or is it is it something else? And then I guess longer term, how should we think about the cadence of the contribution from your dry powder initiatives, is that kind of equal parts over the next few years, or should we see, I guess, a larger contribution in a certain year?.

Andrew, so all the numbers that we've given – same-store sales and used or new were up about 1% because of price and they were flat on volume. The market, if you remember, was down 1% but it also had the storm anomaly. So we had calculated that it was down somewhere between 4% and 5%.

So we are growing that, but our numbers are same-store numbers that we're looking at and we were still flat in general. I'm not sure I got – I answered your question fully..

I think the question was on vehicle..

The unit profitability..

It was down 3.4%, but used was up 1%, and F&I was basically down a little bit. Net-net, we were down, I think, $30 on a same-store basis which, plus or minus, is just a function of the market and mix. So, no, I wouldn't say there's a structural shift there..

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

Thank you, everyone, for joining us today. We look forward to updating you again on our results in February. Bye, bye..

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