Lithia Motors, Inc. (NYSE:LAD) Q1 2023 Earnings Call Transcript April 19, 2023
Lithia Motors, Inc. misses on earnings expectations. Reported EPS is $8.44 EPS, expectations were $8.77.
Operator Good morning, and welcome to the Lithia & Driveway First Quarter 2023 Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. I would now like to turn the call over to Amit Marwaha, Director of Investor Relations. Please begin.Amit Marwaha Thank you. With me today are Bryan DeBoer, President, and CEO; Chris Holzshu, Executive Vice President and COO; Tina Miller, Senior Vice President and CFO; and Chuck Lietz, Senior Vice President of Driveway Finance. Today’s discussion 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 investors.driveway.com, highlighting our first-quarter results. With that, I would like to turn the call over to Bryan DeBoer, President and CEO.Bryan DeBoer Thanks, Amit. Good morning and welcome to our first-quarter earnings call. We appreciate everyone joining us today and the opportunities to update you on our business strategy, growth and progress toward our 2025 plan.
In Q1, Lithia & Driveway grew revenues to $7 billion, up 4% from 2022, resulting in adjusted diluted earnings per share of $8.44. Sequentially, GPUs were more resilient than expected across new and used and F&I, and we continue to focus on profitability, driving high-performance and improved efficiency.Our model and vehicle operations allowed our stores to be nimble while offering customers a variety of products and services to fit all budgets. By managing a wide variety of channels to interact with our customers, our responsiveness and adaptable model delivers the best experiences for our customers wherever, whenever and however they desire.Our store teams continue to proactively respond to the varying climate in each of our regions. Our captive finance operations, Driveway Finance Corporation or DFC, continues to grow at a balance pace with nearly $630 million in originations in loans in the quarter, with the weighted average rate of 9%.Our focus remains on selectively growing the portfolio and increasing our net margin as we continue to invest in this adjacency.
DFC continues to mature with near-term performance, reflecting the investment related to CECL reserves for a growing portfolio. We have a clear line of sight to how DFC will meaningfully increase our profitability over time. I’ll let Chris and Chuck provide more details on the results of both vehicle and financing operations later in the call.Acquisitions are the foundation to how we build convenient proximity to our consumers and fundamental to our strategy. Our target of being within a 100 miles of consumers allows us to leverage our physical infrastructure for vehicle procurement logistics, utilize our reconditioning and storage network, and expand our captive finance arm as we grow our customer base.Our team and core competencies are executing a consistent acquisition cadence and we remain unchanged in our hurdle rates, seeking after tax returns of 15% or more and targeting of 15% to 30% of revenues or three to seven times EBITDA normalized earnings.For the quarter, our acquisitions have yielded a 95% success rate as compared to mid-80% rate this time last year.
In the first quarter, we completed two acquisitions, including our entrance into the United Kingdom market with our purchase of Jardine Motors Group, which operates more than 37 premium luxury retail locations and over 50 franchises and it is expected to generate over $2 billion in annualized revenues. Our strong cultural alignment drive to provide exceptional customer service and focus on OEM partnerships make this the ideal platform to enter the United Kingdom.Like our purchase of the Pfaff Group in Canada a couple of years ago, this team provides a launchpad to extend our growth in the coming years. We are excited to welcome Neil and his team to the LAD family and look forward to working together and learning from each other.We expect to achieve a historical acquisition annual run rate of $3 billion to $5 billion in acquired revenues a year with a continued prioritization to the United States.
Whether motivated by succession planning or monetization, sellers are attracted by Lad’s track record of completing deals in a timely and confidential manner, retaining over 95% of their employees and becoming part of this industry’s future. The deal pipeline remains robust and we are confident in our ability to execute, integrate smoothly and reach our $50 billion revenue target as planned in 2025.Now on to an update on our five-year plan. We have just passed the halfway mark and are well underway towards achieving the objective we originally outlined in July of 2020. Since the launch of our plan, we have acquired nearly $16 billion in revenues. Our captive finance arm, DFC, has established itself as the top lender in our network and our through the painful days of heavy capital requirements and extreme CECL reserves.
Though DFC is still a drag to earnings today, this investment drives our future profitability as loans on average are three times more profitable over its lifetime compared to third-party finance commissions.Lastly, our omnichannel strategy is resonating with consumers and gaining traction across North America. LAD is truly an international omnichannel mobility provider with an expanding strategy set to service consumers across all segments and markets.Key to our plan is de-linking $1 of EPS for every $1 billion in revenue and achieving a $1.10 to a $1.20 for every $1 billion by 2025. This will be driven by several key factors as follows: achieving a blended U.S. market share of 2.5% or more through both acquisitions, channel expansion and same sort growth improvements.Secondly, driving SG&A as a percentage of gross profit to 60% through increased leverage of our cost structure in a normalized GPU’s environment and optimized networks; continuing to scale DFC and achieving profitability in 2024, driveway.com continuing to expand revenue and consumer optionality by attracting 98% new consumers through a simple and transparent one price experience, directly to your home; size and scale will continue to drive down borrowing costs and achieving an investment-grade rating will help as well.
And finally, continued return of value to shareholders through dividends and flexibility in capital allocations for share buybacks when it makes sense.Layering on the contributions of additional future aspirations, we see opportunity for each billion dollars in revenue to produce $2 of EPS in a normalized environment. Key factors underlying our future state and totally within our control are as follows. Optimizing our network through divesting of small, less efficient locations; expanding reach of our omnichannel platform; maximizing leverage of our physical infrastructure; and maintaining a portfolio of high-performing locations.Financing of up to 20% of our units through DFC and maturing beyond the headwind of the recording of CECL Reserves.
Leveraging our cost structure and customer life cycle designed to reduce our SG&A as a percentage of gross profit to 50%; and finally, maturing contributions from other horizontals, fleet, lease management, charging infrastructure, consumer insurance and other future new verticals.In closing, Lithia & Driveway is a unique mobility platform that provides various transportation solutions and redefining customer experience, revenue scale and the profitability equation. We have built a strong foundation through growing our network, meeting shifting consumer preference with our variety of online and in-store experiences and investing in adjacencies like DFC, all while navigating the current environment.With this unique formula and our experienced team, we’re confident in our ability to reach $50 billion in revenue by 2025 according to $55 plus in dollars of EPS and ultimately targeting $1 billion in revenue translating into $2 in EEPs.With that, I’d like to turn the call over to Chris.Chris Holzshu Thank you, Bryan.
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Good morning. I want to start by acknowledging our operational team’s continued focus on executing our plan with a disciplined and pragmatic approach to deliver our customer-centric omnichannel operating model. There is no doubt our associates will continue to execute at a high level as we march towards achievement of our $50 billion in revenue and $55 plus EPS milestone.We recently gathered in person with our top performing operators to share best practices and gain insights into the steps we need to continue to reinforce to ensure success. We left our time together confident in our ability to drive results at the local market level and live our culture of high performance under our mission of growth powered by people for Lithia and Driveway.Now as it relates to the quarter; overall results were as expected as we continue to see a rebalancing of supply and demand in the new vehicle market, coupled with affordabilities associated with rising interest rates.
Consistent with last quarter, there was a disproportionate number of fleet vehicles being transacted outside the retail network as national fleet was up 60%, which significantly impact comparability with several of our OEMs when considering the total US versus retail.As a result, overall customer incentives remain limited. Consequently, while inventory availability is improving, several OEMs have not invested in additional consumer incentives to meet the retail demand. We expect incentives to increase throughout the year, which should have a positive impact on new car volumes.Varying regional performance continues to impact where we operate. For example, our west and north central regions, which we refer to as regions one, two and three, continue to see a negative growth trend in the quarter as total same store new vehicle sales fell 6% compared to our Eastern and South Central regions, which we refer to as regions four, five and six that were up 2% at delta of eight percentage points.We continue to rely on local market leaders to dominate market share, regardless of the economic environment and are proud that our teams achieve record market share according to our reports from our OEMs. Even though some of our markets may have registered a lower number of vehicles, we’re gaining a larger market share up five percentage points in the most recent reporting period.The dynamics we have seen play out over the past several years is a major reason for our diversified network development strategy that allows us to spread our investment across multiple unique markets.
10 years ago, for example, the Western region made up 80% of our revenue. Even with the growth we have seen in that region and now makes up 44% of our revenue.We will continue to be disciplined in our growth strategy. Our focus on the highly profitable regions like the Southeast where we have a limited footprint compared to our peers will continue. Same store new vehicle revenues were down 3% for the quarter, driven by unit volume declining 6% offset by ASPs increasing 3%, new vehicle GPUs including F&I were 7,500 per unit down from 7,719 in Q4 and 8,555 in Q1 of 2022.As touched on previously, affordability is a focus for consumers as interest rates for new and used vehicles have increased three percentage points since last year and factory incentives have yet to match relative demand.
However, with early recovery in new vehicle inventory and most domestic and luxury nameplates, modest increase in incentive, strong used vehicle trade-in values a decrease in the average amount finance, leave consumers monthly payments relatively flat year-over-year.Shifting to used vehicles, same-store used vehicle revenues were down 9% driven by unit volumes declining 2% and ASPs decreasing 7%. Including F&I, GPUs were 4,028, flat compared to Q4 and down from $5,196 in the prior year.In March, we continue to see improvement in the used vehicles market as inventory adjustments were made to meet demand of lower priced units. Used vehicle ASPs have declined $2,000 since Q1 of last year and a $1,000 since Q4 2022.Growing our franchise dealer network, which maximizes top of funnel inventory procurement from trade-ins, off-lease and closed OEM auctions is a key differentiator compared to used-only retailers.
In the quarter, this top of funnel position resulted in solid performance in our certified segment or like brand new vehicles, typically three years or newer, which were up 7%, compared to our core and value auto segments that were down 2% in volume.Our used strategy will continue to focus on the massive network of procurement specialists we have in the local markets, certified and trained technicians that can service all makes and models, specialty tools that mote the capability of competitors to repair and recondition the technologically complex vehicles being produced, while continuing to support our ability to create inventory stocking plans that match all levels of affordability.In addition, driveway sell or procurement channel helped us resupply inventory in the quarter and will continue to contribute to the competitive advantage of our omnichannel strategy as the vehicles purchased on driveway.com contributed in an additional $400 in gross profit per unit over our auction purchases.At the end of March, new and used vehicle inventory day supply were 52 days compared to 47 days and 55 days at the end of the fourth quarter.
In this constantly changing environment, our decentralized model and culture of taking personal ownership at the local market level allows our teams to proactively manage inventory, focused on market share and drive profitability.Combining our in-store footprint of over 300 locations with our in-home e-commerce channel, we offer convenience to our consumers an optionality to the retail experience they desire. In the quarter, Lithia & Driveway’s online channels average 11 million unique visitors, an increase of nearly 96% over the same period last year, with essentially the same advertising spend, demonstrating a continued demand by consumers to expand the shopping experience from home.Reinforcing Driveway’s model is incremental to the overall network of sales we generate.
The average distance for deliveries was over 900 miles and over 98% of those consumers had never shopped with us before. This means that we have expanded our network reach nearly 30 times and are able to connect with 50 times more consumers without fixed investment as we continue to expand the power of Driveway. Leveraging our underutilized network to facilitate the majority of the auto retail transaction is critical to delivering a profitable online and in-home experience.During the quarter service body and parts delivered strong same-store growth, up over 9%. Customer pay, which represents the majority of our after sales business, was up 9% while warranty sales were up 15%. With the continued aging units in operation, which is now over 13 years in North America and the increasing complexity of vehicles, our certified factory trained technicians are well positioned to continue to meet the customers after sales needs.This will ensure that the consumer lifecycle and overall retention from our sales to service continues to grow.
Additionally, the design and extension of our F&I product offerings that promote the retention of customers help us maintain the relationship through the entire lifecycle of the vehicle for consumers at all affordability levels.Excluding Driveway, we reported SG&A as a percentage of gross profit close to 60% or 62.7% on a consolidated basis. This does not include the full benefit of the cost reduction plans discussed on our February call. During the month of March, we began to see the early signs of the benefits flowing to the bottom line, particularly amongst our lowest quartile group of stores and are confident that we now have captured over 30% of our stated target.We’re confident in our ability to get our bottom quartile stores to at least an average level of operating leverage.
As a reminder, we targeted savings of $150 million or about 250 basis points and our largest and highest performing stores are achieving an SG&A level of 46%.In closing, it’s good to reflect that over the past decade, we’ve acquired over $20 billion in revenues and more than doubled the average revenue per store to a $100 million by growing, acquiring, and operating larger locations with more efficient structures, often in sizeable metropolitan markets. Our goal is to continue improving our performance and optimizing the network where it makes sense by continuing to attract and grow the best performing leaders.In each location, our leaders are navigating the current operating environment by expanding consumer optionality in sales and service, utilizing services like at-home solutions, while integrating acquisitions and leveraging costs across the network, all focused areas for 2023.
This will undoubtedly ensure we deliver on our 2025 plan.With that, I’d like to turn the call over to Chuck.Chuck Lietz Thanks Chris. DFC had another consistent quarter and continued his Lithia & Driveway as number one lender. This is a testament to the entire DFC team, which delivers its superior value proposition to our dealerships as a captive finance company, balanced against managing portfolio risk. Our near term objectives continue to be growing the portfolio of high credit quality paper, creating a systemic and scalable capital structure and providing accretive financial returns.In Q1, the portfolio grew to over $2.4 billion, driven by the quarterly originations of $629 million, which equated to a 14% penetration rate. We originated contracts with a weighted average FICO of 731 and were able to achieve this while continuing to increase average yield, which ended at 9%.For the quarter, our financing operations achieved a net interest margin of $16 million with a loss of $21 million.
Though DFC is a drag to earnings today, as Bryan mentioned, this investment drives our future profitability as each loan is three times more profitable at full maturity, which more than offsets the upfront $26 million provision accruals included in our loss.From a portfolio performance management perspective, DFC continues to leverage the positive impact of moving upmarket in terms of credit quality. The portfolio average FICO scores increased to 713 from 679 a year ago. We also reduced front end LTVs for four consecutive quarters with Q1 originations at 95.9%, a 130 basis point reduction sequentially and an over 800 basis point reduction from Q1 2022.At the end of March, our allowance for loan losses as a percentage of managed receivables remained at 3.1%.
Overall, delinquency rates improved in the first quarter as our 30-day plus delinquency fell approximately 40 basis points to 3.7%. This was driven by a combination of DFC’s improved credit quality, investments in servicing technology and a positive impact from first quarter seasonality.Net charge-offs declined quarter-over-quarter on a dollar basis, primarily because of the impact of the shift to higher credit quality contracts, but also due to the changes in our repossession strategy and a modest improvement in used vehicle auction values.In addition, originations from 2022 forward have a lower average LTV, which will help mitigate reductions in use car values going forward. DFC continues to be active in the ABS term market, posing our third offering in February.
DFC remains committed to utilizing the ABS term market as its primary near term source of capital, as this is a critical step towards becoming a materially self-funding entity. We expect to complete at least two additional ABS term offerings later this year.Becoming a programmatic ABS term issuer will lessen DFC’s reliance on parent company capital and support becoming a self-funding entity. DFC will continue to assess and adjust our short-term capital sources to ensure that we have a diversified adequate capital structure. The 2023 business fundamentals across DFC continue to focus on profitability by increasing spread rate, mitigating credit risk by improving both credit quality and structure of our contracts and prudently managing our SG&A expenses.
DFC’s unique position as a true captive lender gives us a proven competitive advantage to be agile to quickly mitigate volatility in the general economy and capital markets.In closing, in another quarter that had instability in the financial markets, DFC continues to manage risk effectively, which is the key to meeting our financial objectives. Once fully scaled past the startup investment phase with a mature portfolio, FFC will generate more than $650 million in pre-tax income, which represents a material contribution towards Lad’s future state of generating $2 of earnings per share for every $1 billion in revenue.I’ll now turn the call over to Tina.Tina Miller Thanks Chuck and thank you, everyone for joining us today. In the first quarter, we reported adjusted EBITDA of $406 million down 26% from last year.
This result was driven by normalizing GPUs, impact of higher flooring interest costs driven by both rate and increasing inventory levels and continued investments associated with growing our adjacencies. We ended the quarter with net leverage, excluding the floor plan and debt related to DFC at 1.6 times, essentially unchanged from last quarter.During the quarter, we generated free cash flow of $323 million and remain committed to our capital allocation strategy of 65% of our free cash flows targeted to acquisitions, 25% for internal investment, including capital expenditures and 10% for shareholder return in the form of dividends and share purchases when they are opportunistic. The acquisitions completed in the first quarter were funded through a combination of using free cash flows and working capital facilities.Additionally, we increased our dividend 19% to $0.50 per share for the quarter.
We’re committed to achieving an investment grade rating over time with a prioritization of growth and acquisitions in the near term. During our growth, our goal is to maintain financial discipline was leveraged below three times.After reviewing feedback from our investors, we decided to simplify our reporting prospectively flowing through all activity tied to DFC through the financing operations income loss line, ultimately making it easier for investors to compare results between our peers. We’ve added a slide with information on this topic in the appendix of our investor presentation.For 2023, we expect a loss of $40 million from financing operations. This compares to a total $47 million loss in 2022, which was presented as a $4 million financing operations loss that excluded $43 million in expense for net charge-offs presented as part of SG&A.Additionally, we reaffirm the expected DFC future state contribution of $650 million at a fully mature portfolio on a $50 billion base of revenue.
We are confident we are positioned with sufficient liquidity to achieve our 2025 plan. We focus on continued acquisition growth, while preserving the quality of the balance sheet and achieving profitability in our maturing adjacencies. As we work toward achieving $55 to $60 in earnings per share as part of our 2025 plan and driving further profitability in the long term, we are committed to growing our company and generating value for our shareholders.This concludes our prepared remarks. With that, I’ll turn the call over to the audience for questions. Operator?
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Question-and-Answer Session Operator [Operator instructions]
Our first question comes from the line of Daniel Imbro with Stephens. Please proceed with your question.Daniel Imbro Hey, good morning, everybody.
Thanks for taking our questions. I actually – I had two questions. And if I could start over in the UK, I wanted to ask about the flow-through that you’d expect there. Brian, you mentioned, overall maybe a $1.10, $1.20 for every $1 billion in revenue, but given that it’s a new market, and given that I think historically the UK carries higher expenses, should we maybe anticipate a lower flow-through in the near term as you ramp up Jardine? And then how quickly would you expect to add scale over there as you’re just kind of learning the market and getting your feet wet over there? And I do have a follow up.Bryan DeBoer Great, Daniel. This is Bryan. I think most importantly, this is planting seeds into Western Europe. Our primary focus is still domestically in the United States and we’ll have a good year of acquisitions here as well.
Remember also that Jardine is a lot of premium luxury, a lot of Porsche, a lot of Mercedes, lot of Audi and some other – even higher luxury brands like Ferrari and stuff.So their margins historically, even pre-COVID, were at pretty high levels and we do not see any differentiation between it and what we see in the United States. Most importantly, the economics on what we paid were about 40% discount off of the same type of franchises that we’re typically seeing in the United States. And Neil and his team are a great cultural fit and we think that have all the abilities to be able to exemplify what our beliefs are in people and what our offerings are to our consumers.Daniel Imbro Great. That’s really helpful color, Bryan. And then maybe just one on DFC, the most common kind of investor questions today focused around kind of the DFC outlook.
If I look at the slides, next year dropped a little over I think a $100 million in earnings. Could we just dig into what the assumptions are? The KPIs look similar, 2.5% losses, normalized spreads in future, but obviously substantially lower earnings.Penetration looks like it’s going down, so that shouldn’t be a headwind anymore. So can we kind of just walk through what the changes were between the $105 million and maybe the $1 million next year in DFC earnings, if loss expectations are the same and everything else feels more similar, what changed?Chuck Lietz Thanks, Daniel. This is Chuck. Thanks for your question. Essentially as we look out, you have to remember first of all, the Lithia & Driveway is going to continue to grow. And so a lot of this, as we look forward to next year, is the incremental notional originations that still is going to require a larger CECL reserve to take the provision accrual for future expected losses.So when we sort of break out that next year number, profitability will go down as a result of that headwind, but then, as that portfolio starts to amortize and starts to generate positive returns and normalizes out those CECL reserves, it should be accretive as – on a forward-looking basis.Daniel Imbro There’s been no change to what you think like the core loss expectation of your customer would be given the macro changes.
Chuck, sorry to squeeze one more in there.Chuck Lietz Yeah, I think from forward-looking perspective, we’re fairly conservative in how we’re managing forward-looking rev. First, our primary strategy has been to move up market. We still feel very confident that that’s the right strategy. And when we look at sort of the core fundamentals in terms of the FICO score, as well as our structure, and that’s really borne out by the lower delinquency rates that we’re really starting to experience. And so, we already have a little bit of conservatism and over provisioning versus what our models are saying, and we feel that that’s prudence both today and on a go-forward basis.Daniel Imbro Great. I appreciate all the color and best of luck.Operator Thank you.
Our next question comes from the line of John Murphy with Bank of America. Please proceed with your question.John Murphy Good morning, guys. I just had a question around Bryan, you’re sort of opening – in your kind of opening statement, you sort of seem to voice some frustration with a lack of incentives and it sounded like you expect more to come, but also expect, it sounded like you were pushing for those a little bit as well to help move the metal to some degree.So I’m just curious, what your take is if incentives don’t step up, what it means for pricing and grosses and why you think they really should just give them what’s going on in a reasonably tight market.Chuck Lietz John, I’m going to — why don’t I let Chris handle that? He has a pretty good grasp on that and some different reference points with some of the domestics as well.Chris Holzshu Yeah.
Hey John, good morning. It’s Chris. I think kind of looking back a little bit historically where incentives were at, looking back to 2021, lease incentives are probably in line with where we’ve been historically. They’re still about 10% off of where we’ve been, leasing only about 20% of our overall mix and really focused more on our luxury brands, right?But when you look at finance incentives, they’re still 50% of what they worked two years ago. And when you see that we have inventory on the ground right now, especially in the domestic lines that is not moving, it’s starting, it – we’re — our day supply is building and you look at this fleet business, which was up 60% in the quarter, you start to see that there’s a timing of when incentives are definitely going to have to flow back to the consumers, which is going to help us drive more retail.
