Lithia Motors Inc Q2 FY2020 Earnings Call

Good morning, and welcome to the Lithia Motors Second Quarter 2020 Conference Call. All lines have been placed on mute to prevent background noise. After the speakers’ remarks, there will be a question-and-answer session. I would now like to turn the call over to Eric Pitt, Vice President of Investor Relations and Treasurer. Please begin.

Thank you, and welcome to the Lithia Motors second quarter 2020 earnings call. Presenting today are Bryan DeBoer, President and CEO; Chris Holzshu, Executive Vice President and COO; and Tina Miller, Senior Vice President and CFO. Today’s discussions may include statements about future events, financial projections and expectations about the company’s products, markets, and growth. Such statements are forward-looking and subject to risks and uncertainties that could cause actual results to differ materially from the statements made. We disclose those risks and uncertainties we deem to be material in our filings with the Securities and Exchange Commission. We urge you to carefully consider these disclosures and not to place undue reliance on forward-looking statements. We undertake no duty to update any forward-looking statements, which are made as of the date of this release. Our results discussed today include references to non-GAAP financial measures. Please refer to the text of today’s press release for a reconciliation to comparable GAAP measures. We have also posted an updated investor presentation on our website, lithiainvestorrelations.com, highlighting our second quarter results. With that, I would like to turn the call over to Bryan DeBoer, President and CEO.

Thank you, Eric. Good morning and welcome, everyone. To begin, as our local communities around the country continue to reopen and adjust, our priority remains to ensure the health and well-being of our team members, customers, and communities. We would like to thank our team members for their strength, adaptability, and courage they have demonstrated while navigating the impacts of this pandemic. Earlier today, we reported the highest adjusted second quarter earnings in company history at $3.72 per share, a 26% increase over last year. These results were driven by strong sequential improvement throughout the quarter in all business lines, culminating with used vehicle sales increasing by 23%, returning to the year-over-year growth levels experienced pre-COVID-19. Our rapid growth continues to be powered by people and innovation, and our teams remain committed to safely meeting customers' needs through the entire ownership lifecycle while elevating the experience through affordability, transparency, and convenience. Our omni-channel strategy led us to another quarter of record earnings and a step closer to our recently shared five-year plan to achieve $50 billion of revenue and $50 of earnings per share. During the quarter, we experienced one of the lowest monthly new vehicle sales in history, and not only maintained profitability, but achieved the strongest net income levels in our history for both May and June, with net income increasing 44% and 97% respectively over the prior year. As noted in our interim quarterly updates, with sequential improvements recognized throughout the quarter, total revenues decreased 2%, and total gross profit increased 15% for the month. Our declines in revenue were offset by significant improvements in margins that Chris will speak to in just a few minutes. While we focus on executing each day, we are guided by our long-term vision, and will now discuss the details of our five-year plan and the introduction of our new national digital home channel and brand. We are entering an exciting time as we embark on our five-year plan to expand our presence in the over $2 trillion market of automotive products and services. Our strategy focuses on the most expansive addressable market of any retailer in the automotive space. This plan was designed to address both the full vehicle ownership lifecycle and all levels of affordability. It includes new and certified vehicle sales from 30 manufacturers, a full spectrum of non-certified used cars, and high-margin aftermarket businesses, including service, body, and parts. Our history of exponential growth within the industry, coupled with our team's ability to execute, has positioned us with a self-generating cash engine producing over a half billion dollars annually to pragmatically and profitably disrupt this industry. Our strategy for disruption begins by combining our proprietary technology with the scale of our people, inventory, and network to modernize the industry. As we continue to develop and bring to market our digital home solutions in the second half of the year, our teams are ready to serve not only our traditional customers but also incremental e-commerce customers through our new national brand. The past few years of research and development on our new revenue channel and the recent acceleration of consumer demand for in-home solutions has culminated in this brand launch. With much anticipation, we are excited to announce our new national brand name: Driveway, as the guiding light for our all-new experiences and relationships. As the foundation of our e-commerce digital home solutions, Driveway is designed to reach consumers seeking transparent, empowered, flexible, and simple buying and servicing experiences. Driveway pricing is completely negotiation-free, providing shopping experiences across our new vehicle, certified vehicle, used vehicle, and service body and parts revenue streams. Driveway is home-enabled with the ability to deliver anywhere in the country through our coast-to-coast network and will include our own inventory of over 55,000 vehicles, providing consumer selection alongside leveraging 2000 of our existing employees as customer-facing valets and behind-the-scenes specialists to fulfill the Driveway experience. Our 190 existing locations will retain their local brands, while a few future locations may carry the Driveway name or utilize Driveway in their branding messages. Over time, we expect marketing efforts from our local brands to also support the Driveway national brand through the My Driveway Portal, a customer experience hub. The My Driveway Portal will allow our 5 million paying customers from our local brands, as well as new Driveway brand customers, to shop, sell, and service their vehicles. Simply put, in a single location, a customer can manage their vehicle ownership lifecycle, from vehicle information and maintenance history to finance and insurance products subscriptions. Now I would like to walk through each of the consumer interaction points and revenue generation opportunities within this e-commerce strategy. Let's begin with our in-home Driveway service experience that will launch later this quarter here in the Northwest. This experience will allow consumers to schedule service work with free home pickup and delivery, including loaner vehicles within a predefined geo-fenced area. This service is the key differentiator in our model as it allows for over ten times the brand impressions compared to digital experiences that only sell a customer a vehicle once every five to six years. This revenue stream will include premium-level pricing and allow consumers to subscribe to services for the lifetime that they own their vehicle. The next consumer interaction point is our used vehicle revenue stream, which has two components: inventory procurement and vehicle sales. The inventory procurement component expands our five channels of procurement and is key to generating incremental vehicle sales through our e-commerce platform. Our procurement technology, which was deployed in the third quarter of 2019, included the key components of geo-fencing, workflow management, and scheduling that are the engines for the other home digital solutions. This selling experience and structure of the impending other components can be seen live today on driveway.com. The used vehicle sales experience is also coming to market in the fourth quarter and will be a one-price digitally enabled experience that will include immediate financing and a massive selection of vehicles that can be delivered anywhere in the country. Our selection will include the entire spectrum of used vehicles, from certified vehicles to 20-year-old value autos. All vehicles will include a seven-day return policy and other brand guarantees to reassure consumers of their purchase and include home delivery fulfilled by our existing logistics network. Lastly, our new vehicle revenue stream will launch early next year as we continue to perfect the digital integration of manufacturer rebates, leasing options, and other variables unique to new vehicles. All of our business lines offered through Driveway will leverage our Virtual Centers of Excellence (VCEs) to provide a helping hand behind the scenes for buyers that need support along the way. Our VCEs include finance and sales managers to assist in financing the more complex transactions, used vehicle specialists to value the few one-off vehicles that our AI has enabled difficulty in valuing, and service advisors to offer customer support on pricing for the more complex repairs, generated from upsell opportunities for their service work. Though not assumed in our model, which can be found on Page 11 of our updated investor presentation, we believe there is an opportunity for margin expansion and considerable SG&A reduction as we further leverage our extremely profitable network. With that, we look forward to sharing further details on Driveway over the coming months as each component becomes a reality. The foundation to our omni-channel plan is the growth and expansion of our physical network. Having the ability for consumers to conveniently access all of our businesses is a competitive advantage to ensuring a highly profitable digital experience across the United States. Our customers' proximity to our physical network is a key element to our design. This enables us to supply convenient and affordable touchpoints throughout the ownership lifecycle, especially related to our highest margin service and associated parts solutions. Increasing our physical network to approximately 400 locations in six regions gives us the ability to reach over 90% of U.S. consumers in two hours or less. As such, our top priority for allocating capital will continue to be accretively expanding our network by acquiring strong new locations. With less than 1% of the $2 trillion market, our physical network will be leveraged through Driveway and continuing to grow our core business, allowing consumers to create the experience that they desire. The opportunities for consolidation within our industry remain plentiful and our pipeline for acquisitions remains full. Our plan models acquiring approximately $4 billion in revenues annually over the next five years. This highly fragmented market has allowed us to consistently invest in increasing the reach and density of our physical network by acquiring strong assets. For more than a decade, we have successfully purchased and integrated acquisitions that have yielded an after-tax return of over 25% annually. After a strong sequential recovery throughout the second quarter, we renegotiated and restarted acquisitions in the latter half of the year. We have completed three acquisitions thus far: smallest Chrysler Dodge Jeep Ram and Nissan in Bend, Oregon; and Ladin Subaru in Thousand Oaks, California. These locations increase our revenues by $160 million annually, while further improving density within our Northwest and Southwest regions, including the addition of two Lexus stores acquired earlier this year. This brings our total network expansion to $320 million thus far in 2020. With more than a billion dollars in cash and available credit, plus financed real estate that can add an additional $250 million in liquidity and over $500 million in EBITDA production annually, and an adjusted leverage ratio below two times, we are poised for accelerated growth. Assuming an average equity investment of approximately 20% of revenues, our available liquidity and annual free cash flows could add another $7 billion in revenue or more than 50% growth. In just a few minutes, Tina will discuss additional avenues of liquidity to expand a robust and disciplined capital strategy to support our strategic goal. Despite reporting our highest adjusted earnings in company history, we're just getting started. Our company and all of our team members live our mission of growth powered by people and the corresponding value to constantly improve. As such, we remain humble and never quite satisfied as we are tenaciously committed to improving, growing, and finding new opportunities. To summarize, our diversified high-growth business strategy is highly complex and has been built despite the considerable barriers to entry in new vehicles, making it difficult, if not impossible, to replicate. Our industry remains ripe for considerable consolidation and is thirsting for modernization. Our growing network composed of our people, inventory, and physical network, combined with our Driveway digital home solutions completes our unique omni-channel strategy. The advantages of a responsive and adaptable team with a multi-decade track record of executing together is the driving force behind our ability to outperform and compete in any environment. This strategy positions us to continue to lead our industry's transformation and progress towards making our five-year plan of $50 billion in revenue and $50 earnings per share a reality. With that, I'd like to turn the call over to Chris.

Thank you, Bryan. I want to start by recognizing our operational leaders who have lived our mission of growth powered by people and focusing on what they can control and identifying the levers that allowed them to persevere through these unprecedented times. Our team's ability to be agile and nimble led us to solutions that continue to meet our customers' needs safely and conveniently, resulting in one of the most profitable quarters in the company's history. With that, I'd like to discuss our same-store quarterly results. For the three months ended June 30, 2020, total same-store sales were down 18%, led by a 24% decrease in new vehicle sales, a 1% increase in used vehicle sales, a 7% decrease in finance and insurance revenue, and a 21% decrease in service body and parts revenues. As previously reported, results improved throughout the quarter with total same-store sales improving for June to a decrease of only 6% compared to the prior year. The new vehicle business line was down 24% for the entire quarter but improved to a decrease of 13% for the month of June. For the quarter, our average selling price increased 5%, and unit sales decreased 27%. Gross profit per unit increased to $2,625 compared to $2,095 last year, a $530 increase or 25%. Total new vehicle gross profit per unit, including finance and insurance, was $4,291, an increase of $685 per unit or 19%. At approximately $4,300 of gross profit per unit, new vehicles remained highly profitable with a 10.5% margin, similar selling cost per unit as used vehicles, and inventory carrying costs that are subsidized by our manufacturer partners. Our OEMs have reopened their factories and adjusted plans to avoid any significant disruption in the availability of new vehicle inventory. As of right now, our stores are positioned with the inventory necessary to meet the increased demand that we are seeing throughout the network. For used vehicles, we saw a 22% increase in revenues for June and a 1% increase for the quarter. Gross profit per unit for the quarter was $2,243, an increase of 2% or $48 over last year. Total used vehicle gross profit per unit, including finance and insurance was $3,774, an increase of $185 or 5%. Our strategy of selling deep into the used vehicle age spectrum through a high margin, core value, and value auto vehicles provided us with inventory that had valuations resistant to short-term market fluctuations. In addition, our ability to procure the right scarce vehicles through the five different channels is a catalyst for the future success and growth of Driveway. Additionally, in weaker economic times, these already scarce vehicles are in high demand as consumers move to less expensive monthly payments and more affordable product options. New and used vehicle sales are supported by our experienced finance specialists that help match the complexity of a consumer’s financial position with the lending options in over 150 financial institutions. In the quarter, our finance and insurance business line showed massive improvements averaging $1,590 per retail unit compared to $1,454, an increase of $136 per unit over the prior year as consumers continue to take advantage of the product offerings available that protect their mobility investment, as well as the record incentives from our OEM partners and historical low interest rates. Overall, new and used vehicle sales create incremental profit opportunities through the resale of additional trading vehicles, greater manufacturer incentives, finance and insurance sales, and future service and parts work. We continue to monitor this through the growth of our gross profit per unit, which was $4,030 this quarter, an increase of $412 per unit or 11% over last year. As a result of the accelerated demand seen in the second half of the quarter, total gross profit per unit improved to $4,418 for June. In addition, our stores remain focused on the highest margin business lines, our service body and parts, which decreased 21% over the prior year, but down only 4% in June. Our service body and parts business captured over 5 million paying consumers and brand impressions annually, generating over 50% margin, and this remains a huge competitive advantage at Lithia. The increasing demand from consumers asking our stores to offer home solutions has shifted the mindset of our team and has accelerated the ability to leverage our digital home solutions. Combined with online vehicle sales, used vehicle inventory purchases, and at-home service solutions, the Driveway launch positions our company to leverage our growing network, which has the largest reach in the industry. Our facilities, inventory, and people are ready to deliver online, in-dealership, and in-home solutions to non-traditional auto consumers that we previously may have not appealed to. Store leaders continue to take prudent and decisive cost savings measures and personnel and advertising expenses, which comprise approximately 75% of our SG&A. These actions lead to significant sequential improvements throughout the quarter. Same-store adjusted SG&A to gross profit was down to 64.8% in the quarter, an improvement of 480 basis points over the prior year. To reinforce the SG&A opportunities we have ahead, for the month of June, our company SG&A to gross profit improved to 57.4%, while our high-performance stores consistently maintain SG&A to gross profit metrics at these levels. Significant leverage in the cost structure is attainable as we maintain discipline and look to our e-commerce and digital home solutions to provide incremental sales with lower delivery costs. In summary, our teams continue to adapt and operate in ways that best match each of their local markets and meet the needs of evolving consumers wherever, whenever, and however they desire. With the information provided by our data science, our teams are nimble and responsible for the changing environment. We are innovating and improving the consumer experience through our incremental and pragmatic modernization and are poised for growth in the back half of the year. Our team's ability to achieve high performance in any environment continues to be the foundation as we remain focused on our longer-term goals. With that, I'd like to turn the call over to Tina.

Thank you, Chris. For the quarter, we generated free cash flows of $96 million. As a result, we ended the quarter with over $750 million in cash and available credit. Earlier this month, we completed an over $250 million syndicated real estate credit facility, bringing our total current cash and available credit to over $1 billion. As of June 30, we had $2.9 billion outstanding in debt of which $1.5 billion was floor plan, used vehicle, and service owner financing. A unique aspect of debt in our industry is the financing of vehicle inventory with floor plan debt. This financing is integral to our operations and collateralized by these assets. The industry treats the associated interest expense as an operating expense in EBITDA, an exclusive set from balance sheet leverage calculations. On an adjusted basis, our total debt-to-EBITDA is overstated at 5.3 times; adjusted to treat these items as an operating expense, our net debt-to-adjusted EBITDA is 1.8 times. Additionally, this week we filed an equity shelf registration statement allowing us to issue equity periodically at opportunistic points through various avenues such as an aftermarket equity program or a follow-on equity offering. This will allow us to expand liquidity options within our capital structure and ensure we have the necessary firepower to accelerate and execute our growth plan in any environment. In line with our overall capital discipline, our intent is to issue equity if and when our share price meets our internal hurdle rates and deploy the proceeds quickly to expand our network in an accretive way. Any offer we make under the registration statement will be pursuant to a capital strategy that remains unchanged. We target 65% investment in acquisitions, 25% internal investment including capital expenditures, modernization, and diversification; and 10% in shareholder return in the form of dividends and share repurchases. Earlier this morning, we announced a 3% increase in our dividend to $0.31 per share. As Bryan and Chris mentioned earlier, we are well-positioned for continued growth throughout the second half of 2020. We have over $1 billion in available liquidity to deploy in acquisitions that meet our strategic objectives and internal hurdle rates. Additionally, in the upcoming year, we plan to pragmatically invest in modernizing the consumer experience through Driveway and building the teams needed to support our growth. Fundamentally, the diversity in our revenue streams, growth plan, variable cost structure, and continued consumer innovation allow us to be responsive to any economic environment and position us well as we continue to drive towards our aspirational five-year goal of $15 billion in revenue and $50 of earnings per share. This concludes our prepared remarks. We would now like to open the call for questions. Operator?

Thank you. Our first question comes from Rick Nelson with Stephens. Please go ahead with your questions.

Hi. Good morning.

Good morning, Rick.

How is omni-channel going to be a significant factor in achieving these long-term goals? Bryan, can you provide more details about omni-channel, the key differentiators you see compared to franchise dealers and online-only platforms?

Sure, Rick, that would be great. It's exciting. You are one of the few people who figured out the Driveway name even before today, so congratulations on that as well. It was impressive that people were able to find that URL over the last couple of months. The key difference with Lithia Motors is that we focus on an omni-channel strategy to attract consumers based on their financing preferences. We have developed a model that provides products covering all aspects of the financing spectrum, along with the vehicle inventory to match, addressing the entire lifecycle of the consumer. Our capability to create brand impressions for consumers on a semi-annual or annual basis through our service and parts is fundamental to our growth as an organization. Lithia Motors originated in a small town in Southern Oregon in 1946, focusing on customer loyalty and relationships. As we developed our product, we aimed to attract consumers at all levels of the marketplace early in their buying processes to retain them for the decades they drive vehicles.

Great. Acquisitions are clearly a significant component of our long-term growth strategy. Are you still targeting underperforming companies? Can you provide an update on the current landscape for acquisitions? Any insights would be appreciated.

Sure, Rick. I would say absolutely that value-based acquisition strategy is fundamental to who we are. I will say that we are looking in regions four and six, which is the lower Midwest, as well as the southeast, for business partners and people that have great consumer relationships. In those instances, we typically have to pay a little bit of a premium to be able to get those, much like the Williams acquisitions in Tampa Bay. But the fundamentals of our value-based strategy are still there. When we think about $4 billion in acquisition revenue annually, it's very difficult to be able to buy that much value-based strategy, so we had to expand and open up those expectations to buy higher performance as well to be able to achieve that targeted $4 billion. I would also say that the acquisition pipeline we announced about 60 days ago, we had 14 acquisitions under contract, and we've since announced three of those. We still have 11 that will be closing in the coming months, and we look forward to them joining our team and expanding our network. The pipeline is still continuing to build on top of that. We have somewhere between $10 billion and $15 billion of revenues that are under negotiation or in discussion. It's really a matter of time and price as to whether or not we're able to accommodate the needs of those sellers and find the right fit for our network development as an organization.

What is the timing for putting inventory on the website and starting business transactions? Will this process be gradual with all your dealers, or will it happen all at once?

So, that's a great question. We plan on going live with the used vehicle revenue generation stream in Q4, and that should include a good portion of our inventory. We have about 25,000 used vehicles in stock. Our data science is showing that the current pricing we have on our inventory indicates that 88% of those vehicles will fit the Driveway model, meaning that they will sell and clear within 38 days at the price that our current stores have those listed at. We're really expanding our reach as we go about that. We plan on rolling our strategy out market-by-market, and we've modeled into Page 11 of our new investor deck that the rollout plans are a three-year strategy across the country depending on how big or what that network looks like.

Thanks a lot, very exciting stuff. Good luck, Bryan.

Thanks, Rick.

Thanks, Rick.

Our next question is from the line of Armintas Sinkevicius with Morgan Stanley. Please proceed with your question.

Great. Thank you for taking the question. Congrats on the quarter and the announcement with some great detail here. A question around core growth, you know, you mentioned a 10% CAGR here. If I look at the same-store sales over the last several years, you know, 6% in 2019, 1% in 2018, 2% in 2017, can you provide us with the moving parts to get to that 10% CAGR for the core business?

Sure, Armintas. Our model is actually at nine, just under, and we rounded it up. So, we looked at what you observed and believe that our 2020 trend rate was pushing over 10% in regards to where we were at. We are finding that best practices within our traditional core network are starting to gain momentum, and I’m sure Chris can share some of that information in the following questions, but we are seeing that best practices and behavioral shifts within our traditional network are creating greater customer attraction through more transparent and simple experiences within the traditional channel as well. We thought it was still fairly conservative being that's what our run rate has really averaged to be able to model that in, and it's something that we're pretty confident we can achieve. We also believe we can achieve a 65% SG&A gross profit within the traditional channel, and for those new to this company, we were achieving that pre-growth. We acquired about 50% of our business over the last five to seven years, and as most of you know, those acquisitions are of lower-performing entities with high SG&A around 85%, and it usually takes five years for those parts of the network to season. We are at steady state now and really believe that a 65% SG&A is achievable. For the month of June, I believe we were at 57%, which is where our benchmarked top stores really perform at, providing guidance for us to find leverage within our cost structure as well.

Okay, great. And then on the Driveway side, the $9 billion by year five, can you walk us through some of the key drivers to getting to that $9 billion?

Sure. I would say the fundamental opportunity is the ability to procure inventory; our company has shown the ability to procure inventory not only from trade-ins, which about 50% of our vehicles come from trade, generating approximately $1,200 higher front-end gross margin than vehicles purchased at auction. We also obtain that new vehicle trade. Thus, we believe that competitive advantage in terms of cost can help us grow that portion of the business. We have also modeled in an additional $1,000 per unit on top of our $300 traditional marketing spend. That combined with the SEO and SEM through the My Driveway Portal gives us a massive cost advantage against competitors in regards to going to market. So if we need to buy market, we have not only the $1,300 to drive national branding or local branding, but we also have a lower cost to market for consumers compared to price competitors, which highlights the four other business lines that create substantial margins to compete in the used vehicle battleground, where we really believe any battles are going to be fought because there are no barriers to entry for used vehicles. New vehicles and certified used vehicles, much like service, body, and parts, feature massive barriers to entry because you need to buy a franchise. We like how we built the model, and we believe our growth ability hinges on this capacity to compete and procure inventory.

Great. Thank you for taking the question.

You bet, Armintas.

Our next question is from the line of Ryan Sigdahl with Craig-Hallum Capital. Please proceed with your question.

Good morning and congratulations on the strong profitability. I also appreciate the additional detail on Driveway and the medium-term targets. To start, I want to focus on Slide 11, where you outline the targets for Driveway. It suggests a lower EBITDA margin but a better net margin in five years. Could you explain the factors affecting profitability in the core legacy dealership business compared to online?

Sure, Ryan. I can give you a little bit of color on that. So within the Driveway channel, we believe that SG&A can get below 60%. I think we were at 57%, 58%, Tina, in our model, okay. The key driver in differentiation is the core model. Our primary cost and SG&A is personnel costs at about $1,600 a unit and within the Driveway channel, we aim to bring that down to about $1,000 a unit, which reflects about a $600 saving; this is the primary cost difference within the model. We will have to ramp up an Internet sales center, which we've had in Medford for the last 10 years or so, but that team will ramp up on a negotiation-free basis, which will replace some of the personnel costs. We also have the VCEs, or the Virtual Centers of Excellence in those three disciplines, but that will not cause additional costs for personnel in the field, as we're paying their expertise for more modest functions that are customer-facing to be able to achieve leverage and synergies within those channels. That's really the biggest difference in how we have thought about the logic, but there are nuances in marketing as well. In terms of facility costs, we're utilizing about 25% of our shop space or service department in terms of our 24 hours of capacity, and if you compare that against some competitors, our actual physical network costs are running at about the same price per dollar of revenue compared to what our competitors are. But if you look at it on dollars per growth, our cost for our network is much lower than independent used car retailers.

Good, helpful. And then, as it relates to Driveway, and then Shift is coming public, you know, SPAC merger, just anything you can share on what your plans are for your financial investments there, and then any current and future operational partnerships going forward?

Sure. Driveway is entirely separate from Shift. Shift is a wonderful little company that we share best practices with. We share a portion of our network along the I-5 corridor, and we look to continue with that partnership. We love what they've done and they've taught us a lot about what consumers are demanding and how to look at it in a more peer sense. I think it was three years ago that we began to reinvent ourselves and consider how we could be more things to more people, discussing the strategy of going to market whenever, wherever, and however our consumers desire. Shift was a big part of helping us understand that purity of what consumers are looking for. That modernization wasn't occurring at a fast enough rate internally. I think we'll continue to share those best practices and execution with both organizations.

Great. One more for me, and then I'll turn it over. So very tight supply of new and used vehicles going on right now, how do you feel about your current inventory levels by category? I know you talked a lot about trade-ins and how you procure, but how do you feel about your inventory today? Thanks.

Hey, Ryan, this is Chris. Good morning. You know, right now, I think from an inventory perspective on new, we feel like we do have some pockets of inventory that are very tight. We have certain inventory that we have plenty of, and I think as you look at the production that's coming down the pipeline with manufacturers trying to keep up with the demand that we're seeing based on the shutdowns they had due to COVID, we feel like we'll have more normalized new car inventories in kind of August-September timeline. But for the most part, we have the inventory that we need to meet consumer demand. On the used car side, with the increases we have seen, I guess we'd say we could never have enough inventory because of the demand we see right now in our model, especially in that core and value auto product, which is difficult to procure. We're working to make sure we backfill the improvements we’re seeing, especially in June with our used car sales up 19% and ensure that we have plenty of used vehicles moving past August because we are well-positioned for July and we're seeing great trends in used car sales in July.

Great. Thanks, guys. Good luck.

Thanks, Ryan.

The next question is from the line of Rajat Gupta with JPMorgan. Please proceed with your question.

Good morning, everyone, and congratulations on the quarter and the launch. I have a few follow-up questions from earlier. You provided details on the economics of Driveway going forward and shared insights into the SG&A profile. Regarding advertising, you're currently at $250 per unit in a steady state and mentioned $300 for Driveway. However, your online competitors are spending upwards of $1,000 to $1,500 per unit. How can investors be assured that you'll manage to grow without increasing your advertising expenses significantly? The goal of $9 billion in five years seems quite ambitious from a CAGR perspective, so I'm interested in how you plan to handle that spending. I have a follow-up as well. Thank you.

Sure, Raj. That's a great question. We might have had a slight misunderstanding. We currently invest $300 in traditional advertising for our core business. Our model allows for an additional budget of $1,000 to $1,300 per unit to compete directly with others in the market. It's important to keep that in mind. Additionally, we generate 5 million impressions annually with our service body and parts customers. We believe the effectiveness of our marketing, due to the advertising strategy we've developed, enhances our visibility on search engines based on user engagement with our website. The My Driveway Portal will function as our customer portal under the 190 local brands we have. It will facilitate appointment scheduling for service body and parts, payments, vehicle history and maintenance reviews, and trade-in payments, enabling direct communication with consumers through driveway.com. We anticipate that our investment of $1,300 may lead to a two to threefold improvement compared to the efficiencies experienced by other retailers.

Got it, that's helpful. Regarding the expenses related to building out the platform and the IT infrastructure, is most of that behind us? How can we expect that to improve during this ramp-up phase?

Sure, Raj. As a traditional retailer transitioning into digital, we only recently grasped the concepts of capitalizing on R&D. About 60% of our expenses related to our digital solutions have already been incurred. Looking ahead through the remainder of 2020, as we complete the minimum viable products, we will capitalize a significant portion of the development costs. You won't see any impact on SG&A because the organization is growing rapidly and effectively managing costs, ensuring that this does not become a burden on cash flow.

Got it, that's helpful. And will we be getting quarterly updates on revenue, profits from Driveway going forward? Or is this more, I mean, I'm just curious, is it going to be a different segment? Or is it going to be intertwined with the overall company; like how are you going to give us details going forward?

It's a great question, Raj. At some point, we may break out the individual revenues of Driveway, but at this stage, we really look at the 22% used car lift we had pre-COVID and the 23% post-COVID now. These improvements come through sharing our best practices, as well as digital solutions, so it's hard to delineate, but we're going to do our best to transparently portray what's occurring within both channels, okay? We'll work on that in the coming quarters. We'll also share with you that new vehicle margins have to grow as well; it's important to remember that though automotive new vehicle retailers show a 5% to 6% margin on very high dollar revenue products, we also make another 4.5% in finance and insurance. So our actual margins on vehicles are 10.5%, including finance and insurance, and the only way to get that finance and insurance is to sell the vehicle. So for us, we think about the modeling or strategy, there’s nuance where new cars have to grow because it’s the catalyst to drive downstream business of trade-in certified service, body, and parts. Just a little color on how you think about the aggregated model, Raj, but we understand and we will continue to provide insights on the performance of both the core network growth and Driveway.

Got it. So, I just had one last follow-up: you gave some color on the inventory situation and how July was tracking; any quantification of the volumes have looked like here for used and new, and just parts and service activity into the first three weeks here? Thanks.

Sure, Rajat. I know it's a tough environment. We had shared that we noticed a direct tie-in with the shelter-at-home orders. After that, we noted that it was not just shelter at home but the severity of the outbreak. However, we are seeing similar trends in July to what we saw in June. I would also note that in service, we were down 2% in June. Keep in mind that we did have two extra days, so as you're modeling service, we had two extra days in June, which you can likely adjust by another 8%-10% on a year-over-year monthly basis.

No, that’s super helpful. Thanks so much, and good luck.

Thanks, Rajat.

The next question comes from the line of Bret Jordan with Jefferies. Please proceed with your question.

Hey, good morning, guys.

Good morning, Bret.

Hi, Bret.

Could you talk a little bit about the AI strategy on used sourcing? I guess, are you buying all of your used inventory with a system instead of the used manager at the dealership? And maybe what you're seeing from a conversion rate, how many of your offers are being accepted by the seller?

Sure. Let me start by saying we believe that used car procurements starts with heavy lifting. It's not something you're going to perfect in AI. We procure about 8% of our products directly from consumers. Since we are upstream, we can procure more inventory by being more aggressive in our valuations on trade-ins, which is our primary focus. Regarding our AI, we are seeing good adhesion. When we make offers on vehicles, we're seeing about a 50% take rate once they receive that offer; they can either do that directly in their home or bring it into our fulfillment network. We are spending about $15,000 a month to procure in the Pittsburgh market, so about $300 per car to acquire. This ramped about three weeks ago as we launched the Driveway brand in Pittsburgh, our one of the two or three launch markets. For those that have followed us, Pittsburgh market and barrel.com has been the shelter where we have built our proprietary procurement technology. The early stages are promising; we're able to buy vehicles at a slight premium to the trade-ins, moving from 6% to 7% or 8%, which is still minimal. Remember, 50% of our vehicles come from trade, but as we push those same-store growth rates up, we'll need to procure more through AI or networking with Mannheim or ADESA to track vehicles or directly from rental agencies, which is an easy way to procure as well.

Okay. I think you mentioned that 80% of your current inventory will be posted on Driveway when it goes live. Will all of your physical products be available there, or will it always just be a portion?

So, 88% of our vehicles will be showcased on Driveway. We also believe in growth powered by people and decision-making close to the customer; Chris and our group leaders have spent considerable time preparing stores for the behavioral shift where their people will not be involved in the sale beyond as valets, which represents lower experienced personnel following the workflow management systems. It's a bit different for them, but we believe we'll achieve an 80%-90% acceptance of the stores' inventories since they must also commit to a seven-day return policy and meet certification levels from a 140-point inspection. They also need to adhere to certain warranty guidelines and participate in the Driveway network to fulfill logistics as valets. Progress is well underway, and we are pleased that the behavioral shift pre-COVID, which might have taken us two to three years, has progressed more quickly due to demand for convenience and transparency driving incremental growth in used cars, even within our traditional networks, even before a full rollout.

Thank you. I have a housekeeping question. You mentioned cost reductions during the pandemic and that some would be permanent. Is your SG&A experience during the recovery aligned with what you observed earlier regarding the ability to manage costs as volumes return?

Yes, good morning. This is Chris. The SG&A improvement that we saw in the quarter culminating with a 57% SG&A growth in June is a testament to the variable cost structure we have in our stores. Our empowered GMs in every single market based on market demand are working to maximize revenue and growth while minimizing costs. I'd say these two items comprise the main drivers of SG&A and have been aligned to bring down our SG&A to growth, and much of that we hope is sustainable into the third quarter.

Thanks. Good morning. First on the quarter, is it fair to say the big SG&A improvement was primarily due to less headcount?

Yes, David, Chris. We saw in the quarter a 20% reduction in our personnel cost, but we also saw a 40% reduction in our ad spend. I’d say those two things, typically being the main drivers of SG&A, worked hand-in-hand to lower our SG&A to growth in a sustainable way through the third quarter.

Okay, and in terms of this hyper growth plan laid out, your net debt adjusted EBITDA is quite low; where are you comfortable taking that for the right deal?

Hi, David, this is Bryan. We are looking at high single-digit growth in the core, with network development and acquisition purchases providing most of the uplift. Driveway’s growth rate is similar to new entrants in the used car space. Additionally, we foresee new vehicle revenues contributing through the Driveway channel alongside our service and parts business. As you contemplate, we model low to mid 2s to high 3s, and it assumes a capital need for about $900 million in equity at some point, matching acquisitions. This is how we built our strategy to keep leverage intact.

Okay, and on the I think the slide say 3 billion to 5 billion acquired revenue annually; you talked about $4 billion on the call today. That's a huge number from what you've done even with DCH. Is this coming from a huge quantity of deals relative to the past or also from bigger targets? There are not many large, really large groups out there, but you know the market way better than I.

David, yes. I see what you're asking. Let me clarify that you are talking about leverage not in terms of expenses but with balance sheet. Our model shows leverage below 2.0 times, capable of reaching upwards toward three. We hit that by year three, which assumes a capital need of about $900 million in equity at constructive times. This keeps our model intact. Everything else generates from free cash flow in the model. Regarding the size of acquisitions, this will be a combination of staple diet or value-type investing; right now, about 20-30 people across general managers and corporate staff are focused on level acquisitions. We have mid-sized groups with revenues between $500 million to $1 billion. This may take us a while to aggregate and find partners that believe in our strategy, network development, and the depth of the Driveway brand across the United States or, potentially, other English-speaking countries in the future. Thank you, everyone for joining us today. We hope each and every one of you remain safe, and we look forward to updating you again on our third quarter results in October and sharing additional incremental information as we continue to roll out our strategies, particularly surrounding Driveway over the rest of this year.

Thank you. This will conclude today's conference. Please disconnect your lines at this time. Thank you for your participation.