Form 10-K
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D. C. 20549

FORM 10-K

 

 

 

x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Fiscal Year Ended: December 31, 2008

OR

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission File Number: 001-14733

LITHIA MOTORS, INC.

(Exact name of registrant as specified in its charter)

 

Oregon   93-0572810
(State or other jurisdiction of
incorporation or organization)
  (I.R.S. Employer
Identification No.)
360 E. Jackson Street, Medford, Oregon   97501
(Address of principal executive offices)   (Zip Code)

541-776-6899

(Registrant’s telephone number including area code)

Securities registered pursuant to Section 12(b) of the Act:

 

Title of each class

 

Name of each exchange on which registered

Class A common stock, without par value   New York Stock Exchange

Securities registered pursuant to Section 12(g) of the Act: None

(Title of Class)

 

 

Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act:    Yes  ¨    No  x

Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act:  ¨

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days:    Yes  x    No  ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K, or any amendment to this Form 10-K.    ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definition of “accelerated filer,” “large accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer  ¨    Accelerated filer  x    Non-accelerated filer  ¨    Smaller reporting company  ¨
     

(Do not check if a smaller

reporting company)

  

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

The aggregate market value of the voting and non-voting common equity held by non-affiliates of the Registrant was approximately $77,865,790, computed by reference to the last sales price ($4.92) as reported by the New York Stock Exchange for the Registrant’s Class A common stock, as of the last business day of the Registrant’s most recently completed second fiscal quarter (June 30, 2008).

The number of shares outstanding of the Registrant’s common stock as of March 16, 2009 was: Class A: 16,918,350 shares and Class B: 3,762,231 shares.

Documents Incorporated by Reference

The Registrant has incorporated into Part III of Form 10-K, by reference, portions of its Proxy Statement for its 2009 Annual Meeting of Shareholders.

 

 

 


Table of Contents

LITHIA MOTORS, INC.

2008 FORM 10-K ANNUAL REPORT

TABLE OF CONTENTS

 

          Page
PART I   
Item 1.    Business    2
Item 1A.    Risk Factors    13
Item 1B.    Unresolved Staff Comments    21
Item 2.    Properties    21
Item 3.    Legal Proceedings    21
Item 4.    Submission of Matters to a Vote of Security Holders    24
PART II   
Item 5.    Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities    24
Item 6.    Selected Financial Data    26
Item 7.    Management’s Discussion and Analysis of Financial Condition and Results of Operations    27
Item 7A.    Quantitative and Qualitative Disclosures About Market Risk    56
Item 8.    Financial Statements and Supplementary Data    58
Item 9.    Changes in and Disagreements With Accountants on Accounting and Financial Disclosure    58
Item 9A.    Controls and Procedures    58
Item 9B.    Other Information    58
PART III   
Item 10.    Directors, Executive Officers and Corporate Governance    59
Item 11.    Executive Compensation    59
Item 12.    Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters    59
Item 13.    Certain Relationships and Related Transactions, and Director Independence    59
Item 14.    Principal Accountant Fees and Services    59
PART IV   
Item 15.    Exhibits and Financial Statement Schedules    60
Signatures       63

 

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PART I

 

Item 1. Business

Forward Looking Statements

Some of the statements under the sections entitled “Risk Factors,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Business” and elsewhere in this Form 10-K constitute forward-looking statements. In some cases, you can identify forward-looking statements by terms such as “may,” “will,” “should,” “expect,” “plan,” “intend,” “forecast,” “anticipate,” “believe,” “estimate,” “predict,” “potential,” and “continue” or the negative of these terms or other comparable terminology. The forward-looking statements contained in this Form 10-K involve known and unknown risks, uncertainties and situations that may cause our actual results, level of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by these statements. Some of the important factors that could cause actual results to differ from our expectations are discussed in Item 1A. to this Form 10-K.

Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. You should not place undue reliance on these forward-looking statements.

Where You Can Find More Information

We file annual, quarterly and special reports, proxy statements and other information with the Securities and Exchange Commission (“SEC”) under the Securities Exchange Act of 1934 as amended (the “Exchange Act”). You can inspect and copy our reports, proxy statements, and other information filed with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Washington, D.C. 20549. Please call the SEC at 1-800-SEC-0330 for further information on the Public Reference Room. The SEC maintains an Internet Web site at http://www.sec.gov where you can obtain some of our SEC filings. We also make available, free of charge on our website at www.lithia.com, our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act as soon as reasonably practicable after they are filed electronically with the SEC. The information found on our website is not part of this Form 10-K. You can also obtain copies of these reports by contacting Investor Relations at 541-776-6591.

Compliance with Section 303A of the NYSE Listed Company Manual

As required by the NYSE Corporate Governance Standards, we filed the appropriate certifications with NYSE in 2008 confirming that our CEO is not aware of any violations of the NYSE Corporate Governance Standards and we also filed with the SEC in 2008 the Chief Executive Officer and Chief Financial Officer certifications required under Section 302 of the Sarbanes-Oxley Act.

Overview

We are a leading operator of automotive franchises and retailer of new and used vehicles and services. As of March 16, 2009, we offered 27 brands of new vehicles and all brands of used vehicles in 92 stores in the United States and over the Internet. We sell new and used cars and light trucks; sell replacement parts; provide vehicle maintenance, warranty, paint and repair services; and arrange related financing, service contracts, protection products and credit insurance for our automotive customers.

During 2008, overall macroeconomic issues have reduced consumers’ desire and ability to purchase automobiles. An additional factor negatively impacting auto sales has been a reduction in available options for consumer auto loans. The manufacturers’ captive financing companies have suffered additional pressure as the financial crisis has raised their cost of funds and reduced their access to

 

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capital. This and financial stress on manufacturers has prevented them from offering as many incentives designed to drive sales, such as subsidized interest rates and the amount of loan to value they are willing to advance on vehicles.

In addition, both new and used vehicle sales were impacted in 2008 by declining valuations for most used vehicles. Fewer customers are trading in their used vehicles as the value they could receive may be less than what they currently owe. This has negatively affected our new vehicle sales as potential customers are not able to obtain financing in sufficient amounts to absorb the amount owed on their trade in as well as the cost of the new vehicle.

In October 2008, the domestic automakers approached Congress seeking government assistance. As part of these hearings, each manufacturer provided an update on their current financial situation as well as their outlook for 2009 and beyond. In the course of the hearings, it became clear that without immediate assistance, both Chrysler and General Motors (“GM”) faced the possibility of insolvency as soon as January 2009.

In December 2008, GMAC received approximately $6 billion in funds from the federal government. Also in December 2008, the federal government provided $17.4 billion in bridge loans to both Chrysler and GM. Both manufacturers were required to present to the Treasury in February 2009 a restructuring plan.

At the time of this filing, both Chrysler and GM have provided their plans to the Treasury, requesting up to $39 billion in total support, including the $17.4 billion already provided, and are acting on those plans. However, the response by the federal government to these strategies and its willingness to loan additional funds remains unknown. See Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for additional information.

The Industry

At approximately $1.0 trillion in annual sales, automotive retailing is the largest retail trade sector in the U.S. and has historically comprised roughly 7% of the GDP. New vehicles are sold through more than 20,000 automotive retail stores franchised by automotive manufacturers. These franchise stores have designated trade territories under state franchise law protection, which limits the number of new stores for any one brand that can be opened in any given area. New vehicle sales are highly fragmented with the 100 largest automotive retailers generating less than 15% of total industry revenues. In addition to these new vehicle outlets, used vehicles are sold by approximately 50,000 independent used vehicle dealers and through private (person to person) transactions.

Unlike many other retailing segments, automotive manufacturers provide unparalleled support to the automotive retailer. Manufacturers often bear the burden of markdown risks on slow-moving inventory as they provide aggressive dealer and customer incentives to clear aged inventory in order to free the inventory pipeline for new purchases. In addition, an automotive retailer’s cash investment in new vehicle inventory is relatively small, given floorplan financing from manufacturers’ captive finance companies or bank lenders. Manufacturer captives have historically provided financing for working capital and acquisitions and loans to consumers to finance vehicle purchases. In addition, the manufacturers pay market-rate prices to their dealers for servicing vehicles under manufacturers’ warranties.

Automotive retailers have much lower fixed overhead costs than automobile manufacturers and parts suppliers. Variable and discretionary costs, such as sales commissions and personnel, advertising and inventory finance expenses, can be adjusted to more closely match vehicle sales. Variable and discretionary costs account for an estimated 60-65% of the retail industry’s total expenses. Moreover, an automotive retailer can enhance its profitability from sales of higher margin products and services. Gross profit margins for the parts and service business are approximately 47%. Gross profit margins for finance and insurance are virtually 100% as they are fee driven income items. These supplemental, high margin

 

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products and services provide substantial incremental revenue, decreasing reliance on the highly competitive new vehicle sales component.

2008 was an unprecedented year of change in the industry. U.S. new vehicle sales were 13.2 million units in 2008 compared to 16.1 million units in 2007 and the trend during the year was even weaker as the year progressed. Early trends in 2009 indicate a continuation of the weak sales environment. We expect that manufacturers will continue to offer incentives on new vehicle sales during 2009 through a combination of repricing strategies, rebates, lease programs, early lease cancellation programs and low interest rate loans to consumers.

Dealerships are expected to close or consolidate at a greater rate in 2009 than has been seen historically. Given the large capital requirements necessary to operate a dealership, a more challenging retail environment, and more intense dealer competition the automotive retail industry is experiencing financial strain. Additionally, wholesale credit lines required to finance new vehicle inventories have become more expensive, been limited in overall size, and in extreme cases, have been terminated. Domestic manufacturers are under pressure to reduce their dealer networks for strategic reasons, which will likely be accomplished through natural attrition. A significant number of dealerships closed in 2008, with the expectation for more to close in 2009.

New vehicle sales usually decline during a weak economy; however, the higher margin service and parts businesses typically benefit, because consumers tend to keep their vehicles longer. Automotive retailers benefit from their designation as an exclusive warranty and recall service provider of a manufacturer. For the typical manufacturer’s warranty, this provides an automotive retailer with a period of at least 3 years of repeat business for service covered by warranty. Extended warranties can add two or more years to this repeat servicing period.

Profitability of automotive retailers will vary and depends in part on local economic conditions, local competition and product mix, effective management of inventory, marketing, quality control and responsiveness to customers. In the industry, new vehicles sales typically account for an estimated 59% of a store’s revenues, used vehicles sales typically account for approximately 29% of revenues and the remaining 12% is typically derived from service and parts sales. In a recessionary environment, those revenue percentages typically trend higher toward service and parts, and lower toward new and used sales as customers are more inclined to service the vehicle they have. Finance and insurance sales are included in the new and used vehicle sales numbers. Industry gross profit margins were 13.6% in 2007. Our gross profit margin was 17.3% and 17.0% in 2008 and 2007, respectively.

The macroeconomic challenges the country faces today are expected to continue through most, if not all of 2009. Constrained credit markets, gas price fluctuations, falling home equity and stock prices, and low consumer confidence, are all significant factors taken into account when looking forward in the industry. Conversely, tighter cost structures, a smaller dealer base, and the scrappage of vehicles due to age and usage are all factors that will have a positive effect on the industry upon the recovery of the broader economy.

Store Operations

Our store operations are supported by centralized inventory control, centralized processing of administrative and office functions and centralized marketing. This allows our store management personnel to concentrate on customer and employee satisfaction.

During 2008, we:

 

   

Improved functionality of our centralized vehicle inventory control, pricing and procurement process;

 

   

Implemented IT initiatives related to centralizing back office car deal processing;

 

   

Implemented cost-cutting initiatives in our stores reducing staffing and other expenses;

 

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Realigned operations and created a ‘flatter’ organization to improve communication and accountability.

The following tables set forth information about our stores that were part of operations as of December 31, 2008:

 

State

   Number of
Stores
   Percent of
Annualized
2008 Revenue
 

Oregon

   16    14 %

Texas

   15    25  

California

   12    13  

Washington

   9    9  

Alaska

   7    8  

Iowa

   7    7  

Idaho

   7    6  

Colorado

   7    5  

Montana

   6    6  

Nevada

   5    4  

North Dakota

   3    1  

Nebraska

   1    1  

New Mexico

   1    1  
           

Total

   96    100 %
           

At December 31, 2008, we had 18 stores held for sale as part of discontinued operations, three of which were disposed of in the first quarter of 2009. We also disposed of an additional store in March 2009 that was not part of discontinued operations.

New Vehicle Sales

In 2008, we represented 27 domestic and imported brands ranging from economy to luxury cars, sport utility vehicles, crossovers, minivans and light trucks.

 

Manufacturer

   Percent of
Total
Revenue
    Percent of
New Vehicle
Sales in 2008
 

Chrysler (Chrysler, Dodge, Jeep)

   17.2 %   31.1 %

General Motors (GMC, Chevrolet, Buick, Saturn, Cadillac)

   10.8     19.7  

Toyota, Scion

   8.3     15.2  

BMW

   4.5     8.3  

Honda, Acura

   4.3     7.8  

Ford (Ford, Lincoln, Mercury)

   2.2     4.1  

Nissan

   1.8     3.3  

Volkswagen, Audi

   1.7     3.1  

Hyundai

   1.3     2.4  

Subaru

   1.2     2.2  

Mercedes

   0.7     1.2  

Mazda

   0.3     0.5  

Porsche

   0.2     0.4  

Kia

   0.2     0.4  

Suzuki

   0.2     0.3  

Saab

   *     *  
            
   54.9 %   100.0 %
            

 

* Less than 0.1%

 

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Our unit and dollar sales of new vehicles from continuing operations were as follows:

 

     Year Ended December 31,
     2008    2007    2006    2005    2004

New car units

     16,836      20,018      20,881      16,845      14,718

New car sales (in thousands)

   $ 426,135    $ 496,025    $ 468,293    $ 379,663    $ 327,684

Average selling price

   $ 25,311    $ 24,779    $ 22,427    $ 22,539    $ 22,264

New truck units(1)

     23,370      32,494      31,459      28,360      25,482

New truck sales (in thousands)

   $ 746,672    $ 1,032,221    $ 980,719    $ 872,944    $ 784,791

Average selling price

   $ 31,950    $ 31,767    $ 31,175    $ 30,781    $ 30,798

Total new vehicle units

     40,206      52,512      52,340      45,205      40,200

Total new vehicle sales (in thousands)

   $ 1,172,807    $ 1,528,246    $ 1,449,012    $ 1,252,607    $ 1,112,475

Average selling price

   $ 29,170    $ 29,103    $ 27,685    $ 27,709    $ 27,674

 

(1) Truck units include trucks, light trucks, vans, SUVs and crossovers.

As discussed above, new vehicle unit sales were negatively affected by the declining economic conditions and reduced showroom traffic in our stores throughout 2008.

We purchase our new car inventory directly from manufacturers, who generally allocate new vehicles to stores based on availability, the number of vehicles sold by the store on a monthly basis and by the store’s market area. Accordingly, we rely on the manufacturers to provide us with vehicles that consumers desire and to supply us with such vehicles at suitable locations, quantities and prices. However, high demand vehicles often are in short supply. We attempt to exchange vehicles with other automotive retailers (and amongst our own stores) to accommodate customer demand and to balance inventory.

Used Vehicle Sales

At each new vehicle store, we also sell used vehicles, which are significant contributors to our gross profit. In 2008, retail used vehicle sales generated a gross profit margin of 11.3% compared to a gross profit margin of 7.8% for new vehicle sales.

As part of our restructuring plan in 2008, our investment in our used vehicle L2 locations was placed on hold and certain development personnel were terminated as we were unwilling to continue to absorb the expected startup losses.

Since the beginning of 2002, the used vehicle market has been negatively impacted by strong competition from the new vehicle market. However, in 2008, a shift towards used vehicle retail sales was experienced due to primarily to three factors. First, the incentives that have become a mainstay of new vehicle sales were reduced. Second, due to the reduction in available credit, fewer customers qualified for new vehicle financing, or the total amount they could finance was reduced, which shifted demand towards used vehicles which have a lower transaction price and associated monthly payment. Finally, lower consumer confidence made customers less willing to make a larger investment through a new vehicle purchase.

In spite of the shift towards used vehicles sales, the challenging retail environment nonetheless led to a decline in same-store used vehicle combined retail and wholesale sales of 18.4% in 2008 compared to 2007.

The following policies and procedures are utilized for our used vehicle sales:

 

   

Most used vehicles are sold with a sixty-day, 3000 mile bumper-to-bumper warranty. We are piloting “as-is” vehicles in certain facilities to maximize incremental retail opportunities.

 

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In addition, as a complement to our ongoing used vehicle operation at each store, we use personnel in our support services group to identify and acquire a better mix of used vehicles desired by the customer.

 

   

We conduct our own closed used vehicle auctions in select markets and manage the disposal of used vehicles at larger auctions. The process is centralized and controlled at the corporate level.

During 2008, we implemented a centralized appraisal and redistribution center to help set the purchase and sales price of our used vehicles and to direct delivery to the appropriate retail location. This center provides analytical and market information to assist the store personnel in making decisions. We redistribute cars between Lithia locations based on inventory needs. Centralizing and distributing used vehicle inventories allows customers access to a greater pool of vehicles.

Our used vehicle operations give us an opportunity to:

 

   

generate sales to customers financially unable or unwilling to purchase a new vehicle;

 

   

increase new and used vehicle sales by aggressively pursuing customer trade-ins; and

 

   

increase service contract sales and provide financing to used vehicle purchasers.

In 2008, we sold approximately 0.72 retail used vehicles for every retail new vehicle sold, compared to approximately 0.62 retail used vehicles for every new vehicle sold in 2007. Our longer-term strategy is to achieve a ratio of 1:1. In the current year, the improvement in this ratio is primarily due to sharply declining new vehicle sales and a shift in demand for used vehicles.

We acquire most of our used vehicles through customer trade-ins, but we also buy them at “closed” auctions, attended only by new vehicle automotive retailers with franchises for the brands offered. These auctions offer off-lease, rental and fleet vehicles. We also buy used vehicles at traditional “dealer only” auctions.

In addition to selling used vehicles to retail customers, we wholesale used vehicles that are in poor condition, are aged in our inventory or are not suitable for our brand mix.

Our used vehicle sales from continuing operations were as follows:

 

     Year Ended December 31,
     2008    2007    2006    2005    2004

Retail used vehicle units

     28,853      32,700      33,225      32,468      29,902

Retail used vehicle sales (in thousands)

   $ 476,720    $ 552,487    $ 541,517    $ 504,990    $ 449,232

Average selling price

   $ 16,522    $ 16,896    $ 16,298    $ 15,553    $ 15,023

Wholesale used vehicle units

     16,631      20,264      19,244      17,180      15,824

Wholesale used vehicle sales (in thousands)

   $ 97,653    $ 134,241    $ 119,071    $ 99,139    $ 83,079

Average selling price

   $ 5,872    $ 6,625    $ 6,187    $ 5,771    $ 5,250

Total used vehicle units

     45,484      52,964      52,469      49,648      45,726

Total used vehicle sales (in thousands)

   $ 574,373    $ 686,728    $ 660,588    $ 604,129    $ 532,311

Average selling price

   $ 12,628    $ 12,966    $ 12,590    $ 12,168    $ 11,641

Vehicle Financing

We believe that arranging financing is critical to our ability to sell vehicles and related products and services. Our sales personnel and finance and insurance managers possess extensive knowledge of available financing alternatives and receive training in securing customer financing. We try to arrange financing for every vehicle we sell and offering customer financing on a “same day” basis gives us an advantage, particularly over smaller competitors who do not generate enough sales to attract our breadth of finance sources.

 

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The tightening of the credit markets experienced in 2008 reduced the number of loans originated, restricted loans to more credit-worthy customers, reduced vehicle leasing programs and increased the overall cost of financing. The manufacturers’ captive financing companies have suffered additional pressure as the financial crisis has raised their cost of funds and reduced their access to capital, which has prevented them from offering as many incentives designed to drive sales and the level of loan-to-value they are willing to finance on vehicles.

Despite these negative factors, we were still able to arrange financing on 73% of our vehicles sold during the fourth quarter of 2008 but on a significantly lower volume of sales. Changes in technology surrounding the credit application process have allowed us to tap a larger network of lenders across broader geographic areas. Additionally, some of the smaller, local banks and credit unions are picking up where some of the larger financial institutions have cut back.

We earn a portion of the financing charge by discounting each finance contract we write and subsequently sell to a lender. We normally arrange financing for customers by selling the contracts to outside sources on a non-recourse basis to avoid the risk of default. During 2008, we did not directly finance any of our vehicle sales.

Service Contracts and Other Products

Our finance and insurance managers also market third-party extended warranty contracts and insurance contracts to our new and used vehicle buyers. These products and services yield higher profit margins than vehicle sales and contribute significantly to our profitability. Extended warranty contracts provide additional coverage for new vehicles beyond the duration or scope of the manufacturer’s warranty. The service contracts we sell to used vehicle buyers provide coverage for certain major repairs. We believe the sale of extended warranty and service contracts increases our service and parts business as well.

We also offer our customers GAP coverage when they finance an automobile purchase to cover any loss the customer might otherwise incur based upon a difference in the amount owed and the proceeds received under a comprehensive insurance claim. We receive a commission on each policy sold.

Service, Body and Parts

Our service, body and parts operations are an integral part of establishing customer loyalty and contribute significantly to our overall revenue and profits. We provide parts and service primarily for the new vehicle brands sold by our stores, but we also service other vehicles. In 2008, our service, body and parts operations generated $306.7 million, or 14.3% of total revenues.

Our service, body and parts business was less affected by the challenging economic environment in 2008 than our other business lines. This reflects the counter-cyclicality of this segment of our business.

For all service work we perform, we provide a three-year, 50,000 mile warranty, including parts and labor, and a guaranteed price based on the estimate given at the time the service order is written.

The service and parts business provides important repeat revenues to the stores. We market our parts and service products by notifying the owners of vehicles when their vehicles are due for periodic service. This encourages preventive maintenance rather than post-breakdown repairs. We offer a lifetime oil and filter service, which, in 2008, was purchased by 34% of our new and used vehicle buyers. This service helps us retain customers and provides opportunities for repeat parts and service business. Revenues from the service, body and parts departments are particularly important during economic downturns as owners tend to repair their existing used vehicles rather than buy new vehicles during such periods. This mitigates some of the effects of a drop in new vehicle sales that may occur in recessionary economic environment.

 

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We operate fifteen collision repair centers: four in Texas, two each in Oregon and Idaho, and one each in Alaska, Washington, Montana, Colorado, Nevada, Nebraska and Iowa.

Marketing

We market ourselves as Lithia Auto Stores-Serving our Communities Since 1946. In most markets our stores are identified as Lithia Auto Stores; except where prohibited by franchise requirements.

Our Fixed Operations provides us an opportunity to build the Lithia Automotive brand regardless of new vehicle franchise. In early 2008, we began branding our Service processes as “Assured Service.” Assured Service provides superior customer benefits like same day service, upfront price guarantees, and a three-year/50,000 mile warranty on repairs. We have also launched “Assured Automotive Products,” which provide a higher margin on various commodity items such as tires, filters and batteries.

We emphasize customer satisfaction and we realize that customer retention is critical to our success. Through a combination of Lithia owner marketing (utilizing direct mail and email) and customer concern resolution we aim to have customers that refer us to the their families and friends.

To increase consideration and shopping at our stores we employ all the traditional advertising media including television, newspaper, radio, direct mail, and web sites. Advertising expense, net of manufacturer credits, was $17.4 million during 2008, with 20% of the total amount used for print media, 26% for television, 21% for radio, 16% for Internet and 17% for direct mail and other sources. All of our advertising messages seek to differentiate us from our competitors based on pricing, selection and available financing options.

Some of our advertising and marketing expenditures are offset by manufacturer co-op programs. Our stores also receive marketing support by our membership in various advertising cooperatives and associations, whose members pool their resources and expertise with manufacturers to advertise collectively. In addition, by owning a cluster of stores in a particular market, we are able to advertise as a group realizing savings through volume discounts and the efficiencies of shared media.

The role of the Internet in automotive retail marketing continues to grow. Most people now shop online before visiting our stores. We maintain websites for all of our stores and a corporate site (www.lithia.com) dedicated to generating customer leads for our stores. Today, our web site enables a customer to:

 

   

locate our stores and identify the new vehicle brands sold at each store;

 

   

view new and used vehicle inventory; including current special pricing

 

   

conduct a live chat for customer assistance

 

   

submit a credit application

 

   

schedule service appointments;

 

   

obtain Kelley Blue Book values;

 

   

visit our investor relations site; and

 

   

view employment opportunities.

We are very active in search engine optimization, search engine marketing, and behavioral targeting of online advertising to generate traffic to our websites. We also have a number of mobile website pilots underway as this new platform provides increased convenience to our customers and employees.

Management Information System

We consolidate, process and maintain financial information, operational and accounting data, and other related statistical information on centralized computers. We have a fully operational intranet with each store directly connected to headquarters. Our systems are based on an ADP platform for the main

 

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database, and information is processed and analyzed utilizing customized financial reporting software from Oracle Corporation.

Senior management can access detailed information from all of our locations regarding:

 

   

inventory;

 

   

cash balances;

 

   

total unit sales and mix of new and used vehicle sales;

 

   

lease and finance transactions;

 

   

sales of ancillary products and services;

 

   

key cost items and profit margins; and

 

   

the relative performance of the stores.

Each store’s general manager has access to this same information. With this information, we can quickly analyze the results of operations, identify trends and focus on areas that require attention or improvement. Our management information system also allows our general managers to respond quickly to changes in consumer preferences and purchasing patterns, maximizing our inventory turnover.

Our management information system is particularly important to successfully operating acquired stores. Following each acquisition, we immediately install our management information system at each location. This quickly makes financial, accounting and other operational data easily available throughout the company. With this information, we can more efficiently execute our operating strategy at each new store.

Franchise Agreements

Each of our Lithia store subsidiaries operates under a separate franchise agreement with each manufacturer of the new vehicles it sells.

The typical automobile franchise agreement specifies the locations within a designated market area at which the store may sell vehicles and related products and perform certain approved services. The designation of such areas and the allocation of new vehicles among stores are at the discretion of the manufacturer. Franchise agreements do not guarantee exclusivity within a specified territory, but do have some protection under state laws.

A franchise agreement may impose requirements on the store with respect to:

 

   

facilities and equipment;

 

   

inventories of vehicles and parts;

 

   

minimum working capital;

 

   

training of personnel; and

 

   

performance standards for market share and customer satisfaction.

Each manufacturer closely monitors compliance with these requirements and requires each store to submit monthly financial statements. Franchise agreements also grant a store the right to use and display manufacturers’ trademarks, service marks and designs in the manner approved by each manufacturer.

Most franchise agreements are generally renewed after one to five years, and, in practice, have indefinite lives. Some franchise agreements, including those with Chrysler, have no termination date. Historically, all of our agreements have been renewed. In addition, state franchise laws protect franchised automotive retailers. Under certain of those laws, a manufacturer may not:

 

   

terminate or fail to renew a franchise without good cause; or

 

   

prevent any reasonable changes in the capital structure or financing of a store.

The typical franchise agreement provides for early termination or non-renewal by the manufacturer upon:

 

   

a change of management or ownership without manufacturer consent;

 

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insolvency or bankruptcy of the dealer;

 

   

death or incapacity of the dealer/manager;

 

   

conviction of a dealer/manager or owner of certain crimes;

 

   

misrepresentation of certain sales or inventory information by the store, dealer/manager or owner to the manufacturer;

 

   

failure to adequately operate the store;

 

   

failure to maintain any license, permit or authorization required for the conduct of business; or

 

   

poor market share or low customer satisfaction index scores.

Agreements generally provide for prior written notice before a franchise can be terminated under most circumstances. We also sign master framework agreements with most manufacturers that impose additional requirements on our stores. See Item 1A. “Risk Factors.”

In the event of a manufacturer bankruptcy filing, any franchise agreement could be unilaterally rejected by the manufacturer as part of their plan to reorganize. However, if the agreement was not rejected but was assumed in a confirmed plan, it could continue with the same rights and conditions that existed prior to the filing.

In the event of a Chapter 11 bankruptcy filing by a manufacturer, several factors should be considered. First, franchise points represent a low-cost distribution network for the manufacturer and it is the automotive dealer that purchases their vehicles for resale to the consumer. Therefore, terminating franchises reduces the number of outlets selling vehicles to the public and is counter to the broader objective of keeping factories in operation emerging from reorganization. Second, the majority of our franchises are in ‘single-point’ locations, meaning there are not multiple franchises in the same market area. These locations are the only distribution point in the area, and we believe the manufacturers would endeavor to keep their products widely available to the general public. However, we operate certain facilities in locations with competing operators holding the same franchise rights in the area or nearby including five stores with three or more dealers of the same brand in the market. Further, should a manufacturer in bankruptcy elect to cease producing certain brands, related franchises would be expected to be terminated. No assurances can be given that our franchise rights would not be terminated in a manufacturer bankruptcy filing.

Competition

The retail automotive business is highly competitive, consisting of a large number of independent operators, many of whom are individuals, families and small retail groups. We compete primarily with other automotive retailers, both public and privately-held.

Vehicle manufacturers have designated specific marketing and sales areas within which only one dealer of a vehicle brand may operate. In addition, our franchise agreements typically limit our ability to acquire multiple dealerships of a given brand within a particular market area. Certain state franchise laws also restrict us from relocating our dealerships or establishing new dealerships of a particular brand within any area that is served by another dealer with the same brand. Accordingly, to the extent that a market has multiple dealers of a particular brand, as some of our markets do, we are subject to significant intra-brand competition.

We are larger and have more financial resources than most private automotive retailers with which we currently compete in most of our regional markets. We compete directly with retailers like ourselves in our metropolitan markets in Denver, Colorado, Seattle, Washington and Concord, California. If we enter other metropolitan markets, we may face competitors that are larger or have access to greater financial resources. We do not have any cost advantage in purchasing new vehicles from manufacturers. We rely on advertising and merchandising, pricing, our customer guarantees and sales model, our sales expertise, service reputation and location of our stores to sell new vehicles.

 

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Regulation

Automotive and Other Laws and Regulations

We operate in a highly regulated industry. A number of state and federal laws and regulations affect our business. In every state in which we operate, we must obtain various licenses in order to operate our businesses, including dealer, sales and finance and insurance licenses issued by state regulatory authorities. Numerous laws and regulations govern our conduct of business, including those relating to our sales, operations, financing, insurance, advertising and employment practices. These laws and regulations include state franchise laws and regulations, consumer protection laws, privacy laws, escheatment laws, anti-money laundering laws and other extensive laws and regulations applicable to new and used motor vehicle dealers, as well as a variety of other laws and regulations. These laws also include federal and state wage-hour, anti-discrimination and other employment practices laws.

Our financing activities with customers are subject to numerous federal, state and local laws and regulations. Claims arising out of actual or alleged violations of law may be asserted against us or our stores by individuals, a class of individuals, or governmental entities. These claims may expose us to significant damages or other penalties, including revocation or suspension of our licenses to conduct store operations and fines.

Our operations are subject to the National Traffic and Motor Vehicle Safety Act, Federal Motor Vehicle Safety Standards promulgated by the United States Department of Transportation, and the rules and regulations of various state motor vehicle regulatory agencies.

Environmental, Health, and Safety Laws and Regulations

Our operations involve the use, handling, storage and contracting for recycling and/or disposal of materials such as motor oil and filters, transmission fluids, antifreeze, refrigerants, paints, thinners, batteries, cleaning products, lubricants, degreasing agents, tires and fuel. Consequently, our business is subject to a complex variety of federal, state and local requirements that regulate the environment and public health and safety.

Most of our stores utilize aboveground storage tanks, and, to a lesser extent, underground storage tanks, primarily for petroleum-based products. Storage tanks are subject to periodic testing, containment, upgrading and removal under the Resource Conservation and Recovery Act and its state law counterparts. Clean-up or other remedial action may be necessary in the event of leaks or other discharges from storage tanks or other sources. In addition, water quality protection programs under the federal Water Pollution Control Act (commonly known as the Clean Water Act), the Safe Drinking Water Act and comparable state and local programs govern certain discharges from our operations. Similarly, certain air emissions from operations, such as auto body painting, may be subject to the federal Clean Air Act and related state and local laws. Certain health and safety standards promulgated by the Occupational Safety and Health Administration of the United States Department of Labor and related state agencies also apply.

Some of our stores are parties to proceedings under the Comprehensive Environmental Response, Compensation, and Liability Act, or CERCLA, typically in connection with materials that were sent to former recycling, treatment and/or disposal facilities owned and operated by independent businesses. The remediation or clean-up of facilities where the release of a regulated hazardous substance occurred is required under CERCLA and other laws.

We incur certain costs to comply with applicable environmental, health and safety laws and regulations in the ordinary course of our business. We do not anticipate, however, that the costs of such compliance will have a material adverse effect on our business, results of operations, cash flows or financial condition, although such outcome is possible given the nature of our operations and the extensive environmental,

 

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public health and safety regulatory framework. We do not have any material known environmental commitments or contingencies. However, no assurances can be given that material environmental commitments or contingencies will not arise in the future, or that they do not already exist but are unknown to us.

Employees

As of December 31, 2008, we employed approximately 4,868 persons on a full-time equivalent basis.

 

Item 1A. Risk Factors

You should carefully consider the risks described below before making an investment decision. The risks described below are not the only ones facing our company. Additional risks not presently known to us or that we currently deem immaterial may also impair our business operations.

A majority of our new vehicles sales are from domestic brands. A restructuring of operations by any of the three U.S. manufacturers may have an adverse effect on our operations. A cessation of operations and/or liquidation or a material interruption in operations by any of the three U.S. manufacturers would likely have a material adverse effect on our operations.

We are subject to a concentration of risk in the event of financial distress, including potential bankruptcy, of a major vehicle manufacturer. Chrysler accounted for over 31%, General Motors accounted for 20% and Ford accounted for 4% of our new vehicle sales in 2008.

Particularly with respect to the three domestic manufactures (General Motors, Chrysler and Ford), the current recession, volatile fuel prices and tightening credit markets have resulted in significantly lower vehicle sales and a deteriorating financial condition that could affect their ability to survive. Specifically, both General Motors and Chrysler have publicly announced that they have depleted their available cash resources and recently received loans from the federal government but in amounts announced to be inadequate to address their intermediate-term cash needs. The Treasury has conditioned any further loans upon the presentation of a restructuring plan to reflect the ability of such manufacturer to stabilize its financial condition and survive in the increasingly competitive industry. It is unknown at this time whether such funding will be made available or if provided, would be adequate to make them viable and competitive.

In a Chapter 11 reorganization in Bankruptcy Court: (1) the manufacturer could cease producing certain makes of vehicles and terminate all or any of our franchises even on continuing brands without consideration, (2) we may not be able to collect some or all of our significant receivables that are due us from such manufacturer, (3) we may not be able to obtain financing for our new vehicle inventory, or arrange financing for our customers for their vehicle purchases and leases and (4) consumer demand for such manufacturer’s products could be adversely affected.

If any of these events were to occur, our sales and earnings may be adversely impacted. These events would also result in a partial or complete write-down of our remaining intangible franchise rights with respect to any affected franchises and would likely cause us to incur valuation allowances related to receivables due from such manufacturers. Any associated franchise terminations would likely cause us to incur charges related to operating leases and/or impairment of long-lived assets. Additionally, there is a continued risk to both the new and used vehicle inventory valuations for the respective brand or manufacturer. If the impact on us results in a “material adverse change” to our condition, covenants and cross default provisions in certain debt agreements may be triggered, resulting in the immediate demand for amounts outstanding under the agreements.

In a Chapter 7 liquidation in Bankruptcy Court, the manufacturer would seek protection from its creditors and would commence an orderly wind-down of operations. The impact of a liquidation would likely have a

 

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material adverse effect on our results from operations, cash flows and financial condition unless the operations were promptly sold to and assumed by another manufacturer.

A continuing recession and tight credit markets can be expected to reduce consumer demand for new and used vehicles.

In 2008, automotive sales nationwide have dropped significantly. While the sales reduction was felt mostly by the U.S. domestic manufacturers, sales levels by nearly all manufacturers, including import and luxury brands, are down as well, some precipitously. Unless and until the economy, credit availability and consumer confidence improves, it is unlikely that sales will increase significantly, and they may be reduced further.

Our success depends in large part upon the overall demand for the particular lines of vehicles that each of our stores sell and the ability of the manufacturers to continue to deliver such vehicles.

Demand for our primary manufacturers’ vehicles as well as the financial condition, management, marketing, production and distribution capabilities of these manufacturers can significantly affect our business. Events that adversely affect a manufacturer’s ability to timely deliver new vehicles may adversely affect us by reducing our supply of popular new vehicles and leading to lower sales in our stores during those periods than would otherwise occur.

In addition, vehicle manufacturers would be adversely impacted by economic downturns or recessions, adverse fluctuations in currency exchange rates, significant declines in the sales of their new vehicles, increases in interest rates, declines in their credit ratings, labor strikes or similar disruptions (including within their major suppliers), supply shortages or rising raw material costs, rising employee benefit costs, adverse publicity that may reduce consumer demand for their products (including due to bankruptcy), product defects, vehicle recall campaigns, litigation, poor product mix or unappealing vehicle design, or other adverse events. These and other risks could materially adversely affect any manufacturer and limit its ability to profitably design, market, produce or distribute new vehicles, which, in turn, could materially adversely affect our business, results of operations, financial condition, stockholders’ equity, cash flows and prospects.

Additionally, federal and certain state’s laws mandate minimum levels of vehicle fuel economy and establish emission standards which levels and standards could be increased in the future including the use of renewable energy sources. Such laws often increase the costs of new vehicles, generally, which would be expected to reduce demand. Further, changes in these laws could result in fewer vehicles available for sale by manufacturers unwilling or unable to comply with the higher standards.

As part of the restructuring currently underway by the domestic automakers, there could be a reduction in the makes or models associated with certain franchise agreements. The cessation of any makes for which we hold a franchise would be expected to result in a termination of that franchise.

Our business may be adversely affected by unfavorable conditions in our local markets, even if those conditions are not prominent nationally.

Our performance is also subject to local economic, competitive and other conditions prevailing in our various geographic areas. Our dealerships currently are located in limited markets in 13 states and the results of our operations therefore depend substantially on general economic conditions and consumer spending levels in those markets. In 2008, our markets in Oregon, California, Nebraska and Idaho were particularly slow, which exacerbated our sales declines.

 

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The decline of available financing, particularly in the sub-prime lending market and with captive financing companies, has adversely affected our sales of both new and used vehicles.

A significant portion of vehicle buyers finance their vehicle purchases. Sub-prime finance companies have historically provided financing for consumers who, for a variety of reasons, including poor credit histories and lack of a down payment, do not have access to more traditional finance sources. Recent economic developments have significantly reduced credit availability even for more credit-worthy buyers. Increasing minimum credit standards of the remaining sub-prime lenders has severely reduced the ability of those consumers to purchase vehicles, which has and is expected to have a material adverse effect on our new and used vehicle sales, cash flows and profitability until these conditions abate.

We are dependent on manufacturer affiliated financing companies to provide flooring sources for our new vehicle inventories. If flooring sources are eliminated, no assurances can be given that we will be able to secure additional borrowing facilities. Additionally, our flooring debt is due upon demand, and it may be called at any time.

We currently have relationships with a number of manufacturers or their affiliated finance companies including Chrysler Financial, Mercedes Financial, Toyota Motor Credit Corporation, Ford Motor Credit Company, General Motors Acceptance Corporation LLC, Volkswagen Credit, Inc., American Honda Finance Corporation and BMW Financial Services NA, LLC. Certain of these companies have indicated current financial constraints. Other companies may currently, or in the future, have additional financial uncertainty. As a result, credit that has typically been extended to us by the companies may be modified with terms unacceptable to us or revoked entirely.

If these events were to occur, we may not be able to pay our flooring debts or borrow sufficient funds to refinance the vehicles. Even if new financing were available, it may not be on terms acceptable to us.

Our restructuring plan to reduce our operating losses, exposure to domestic brands, and level of debt has resulted in our placing numerous domestic stores in discontinued operations. Our ability to dispose of such stores without further losses is not assured.

The recent drop in new vehicle sales, particularly with respect to domestic brands, has resulted in an increased effort to reduce both the number and the percentage of our stores selling domestic brands. Further, the continuing challenges we have in successfully competing in metropolitan markets that are heavily concentrated with domestic stores, has resulted in our efforts to dispose of those stores as well. Currently, we have 15 stores remaining in discontinued operations. The uncertainty surrounding the strength or survivability of certain domestic manufacturers, the poor financial performance of most of the stores selected and the tight credit market for the few interested purchasers for those stores, may make it impossible to sell the remaining stores placed in discontinued operations and could result in further operating losses and/or the closure of the stores.

If manufacturers discontinue or change sales incentives, warranties and other promotional programs, our results of operations, cash flows, or financial condition may be materially adversely affected.

We depend upon the manufacturers for sales incentives, warranties and other programs that are intended to promote new vehicle sales or support dealership profitability. Manufacturers historically have made many changes to their incentive programs during each year. Some of the key incentive programs include:

 

   

customer rebates;

 

   

dealer incentives on new vehicles;

 

   

special rates on certified, pre-owned cars;

 

   

below-market financing on new vehicles and special leasing terms;

 

   

warranties on new and used vehicles; and

 

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sponsorship of used vehicle sales by authorized new vehicle dealers.

A discontinuation or change in our manufacturers’ incentive programs could adversely affect our business. Recently, some manufacturers have tightened or eliminated certain financing incentives including leasing programs which have resulted in the loss of sales. Further, some manufacturers use a dealership’s CSI scores as a factor governing participation in incentive programs. We may not meet such minimum scores, and as a consequence, may be precluded from receiving certain incentives.

Volatility in vehicle fuel prices changes consumer demand and significant increases can be expected to reduce vehicle sales.

Historically, in times of rapid increase in crude oil and fuel prices, sales of vehicles have dropped, particularly in the short term, as the economy slows, consumer confidence wanes and fuel costs become more prominent to the consumer’s buying decision. That condition existed in mid-2008 and was a significant contributor to reduced sales, particularly for less fuel-efficient vehicles. While gasoline prices significantly abated by year-end 2008, limited supply and an increasing demand over time is expected to result in significant price increases in the future. In sustained periods of higher fuel costs, consumers who do purchase vehicles tend to prefer smaller, more fuel efficient vehicles or hybrid powered vehicles currently in limited supply.

The ability of our stores to make new vehicle sales depends in large part upon the manufacturers and, therefore, any disruption or change in our relationships with manufacturers may materially and adversely affect our profitability.

We depend on the manufacturers to provide us with a desirable mix of new vehicles. The most popular vehicles usually produce the highest profit margins and are frequently in short supply. If we cannot obtain sufficient quantities of the most popular models, our profitability may be adversely affected. Sales of less desirable models may reduce our profit margins.

Each of our stores operates pursuant to a franchise agreement with each of the respective manufacturers for which it serves as franchisee. Manufacturers exert significant control over our stores through the terms and conditions of their franchise agreements, including provisions for termination or non-renewal for a variety of causes. From time-to-time, certain of our stores have failed to comply with certain provisions of their franchise agreements. These agreements and state law, however, generally afford us the opportunity to cure violations and no manufacturer has terminated or failed to renew any franchise agreement with us. If a manufacturer terminates or fails to renew one or more of our significant franchise agreements, such action could have a material adverse effect on our results of operations, cash flows and financial condition.

Our franchise agreements also specify that, in certain situations, we cannot operate a franchise by another manufacturer in the same building as the manufacturer’s franchised store. This may require us to build new facilities at a significant cost. In addition, some manufacturers are in the process of realigning their stores along defined channels, such as combining Chrysler and Jeep in one location. As a result, manufacturers may require us to move or sell certain stores. Moreover, our manufacturers generally require that the store meet defined image standards. All of these commitments could require us to make significant capital expenditures.

Some of our franchise agreements prohibit transfers of ownership interests of a store or, in some cases, its parent. The most prohibitive restriction, which has been imposed by various manufacturers, provides that, under certain circumstances, we may lose a franchise if a person or entity acquires an ownership interest in us above a specified level (ranging from 20% to 50% depending on the particular manufacturer’s restrictions and falling as low as 5% if another vehicle manufacturer is the entity acquiring the ownership interest) without the approval of the applicable manufacturer. Violations by our stockholders or prospective stockholders are generally outside of our control and may result in the

 

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termination or non-renewal of one or more of our franchises, which may have a material adverse effect on our results of operations, cash flows and financial condition.

Import product restrictions and foreign trade risks may impair our ability to sell foreign vehicles profitably.

Certain vehicles we sell, as well as certain major components of vehicles we sell, are manufactured outside the United States. Accordingly, we are affected by import and export restrictions of various jurisdictions and are dependent to some extent on general economic conditions in, and political relations with, a number of foreign countries. Additionally, fluctuations in currency exchange rates may increase the price and adversely affect our sales of vehicles produced by foreign manufacturers. Imports into the United States may also be adversely affected by increased transportation costs and tariffs, quotas or duties, any of which could have a material adverse effect on our results of operations, cash flows and financial condition.

Environmental, health or safety regulations could have a material adverse effect on our results of operations, cash flows, or financial condition or cause us to incur significant expenditures.

We are subject to various federal, state and local environmental, health and safety regulations governing, among other things, the generation, storage, handling, use, treatment, recycling, transportation, disposal and remediation of hazardous material and the emission and discharge of hazardous material into the environment. Under certain environmental regulations or pursuant to signed private contracts, we could be held responsible for all of the costs relating to any contamination at our present or our previously owned facilities, and at third party waste disposal sites. We are aware of contamination at certain of our facilities, and we are in the process of conducting investigations and/or remediation at some of these properties. In certain cases, the current or prior property owner is conducting the investigation and/or remediation or we have been indemnified by either the current or prior property owner for such contamination. There can be no assurances that these owners will remediate or continue to remediate these properties or pay or continue to pay pursuant to these indemnities. We are also required to obtain permits from governmental authorities for certain operations. If we violate or fail to fully comply with these regulations or permits, we could be fined or otherwise sanctioned by regulators.

Environmental, health and safety regulations are becoming increasingly more stringent. There can be no assurances that the costs of compliance with these regulations will not result in a material adverse effect on our results of operations or financial condition or that additional environmental, health or safety matters will not arise or new conditions or facts will not develop in the future at our currently or formerly owned or operated facilities, or at sites that we may acquire in the future, which will require us to incur significant expenditures.

With the breadth of our operations and volume of transactions, compliance with the many federal and state laws and regulations cannot be assured. New regulations are enacted on an ongoing basis. These regulations can impact our profitability and require continued training and vigilance. Fines, judgments and administrative sanctions can be severe.

We are subject to federal, state and local laws and regulations in each of the 13 states in which we have stores. New laws and regulations are enacted on an ongoing basis. With the number of stores we operate, the number of personnel we employ and the large volume of transactions we handle, it is likely that technical mistakes will be made. It is also likely that these regulations may impact our profitability and require ongoing training. Current practices in stores may become prohibited. We are responsible for ensuring that continued compliance with laws is maintained. If there are unauthorized activities of serious magnitude, the state and federal authorities have the power to impose civil monetary penalties and sanctions, suspend or withdraw dealer licenses or take other actions. These actions could materially impair our activities or our ability to acquire new stores in those states where violations occurred. Further,

 

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private causes of action on behalf of individuals or a class of individuals could result in significant monetary damages or injunctive relief.

Our ability to increase revenues through acquisitions depends on our ability to acquire and successfully integrate additional stores.

General. While we are not currently purchasing new stores, when market conditions stabilize, our financial performance improves and funding is available, we would intend to again renew our growth strategy. The U.S. automobile industry is considered a mature industry in which minimal growth is expected in unit sales of new vehicles. Accordingly, a principal component of our growth in sales would be to make acquisitions in our existing markets and in new geographic markets. To complete the acquisitions of additional stores, we need to successfully address each of the following challenges.

Limitations on our capital resources may prevent us from capitalizing on acquisition opportunities. Acquisitions of additional stores will require substantial capital investment. Limitations on our capital resources would restrict our ability to complete new acquisitions.

We have financed our past acquisitions from a combination of the cash flow from our operations, borrowings under our credit arrangements, issuances of our common stock and proceeds from our private debt offering. The use of any of these financing sources could have the effect of reducing our earnings per share.

Manufacturers may restrict our ability to make new acquisitions. We are required to obtain consent from the applicable manufacturer prior to the acquisition of a franchised store. In determining whether to approve an acquisition, a manufacturer considers many factors, including our financial condition, ownership structure, the number of stores currently owned and our performance with those stores. Most major manufacturers have now established limitations or guidelines on the:

 

   

number of such manufacturers’ stores that may be acquired by a single owner;

 

   

number of stores that may be acquired in any market or region;

 

   

percentage of market share that may be controlled by one automotive retailer group;

 

   

ownership of stores in contiguous markets;

 

   

frequency of acquisitions; and

 

   

requirement that no other manufacturers’ brands be sold from the same store location. In addition, each manufacturer has site control agreements in place that limit our ability to change the use of the facility without their approval.

A manufacturer also considers our past performance as measured by their customer satisfaction index, or CSI, scores and sales performance at our existing stores. At any point in time, some of our stores may have CSI scores below the manufacturers’ sales zone averages or have achieved sales performances below the targets manufacturers have set. Our failure to maintain satisfactory CSI scores and to achieve market share performance goals could restrict our ability to complete future acquisitions. We currently have, and at any point in the future may have, manufacturers that restrict our ability to complete future acquisitions.

Competition with other automotive retailers for attractive acquisition targets could restrict our ability to complete new acquisitions. In the current economic environment, we are presented with an increasing number of attractive acquisition opportunities. However, when the economy improves, we would expect to compete with several other public and private national automotive retailers, some of which have greater financial and managerial resources.

 

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Indefinite-lived intangible assets (franchise value) comprise a meaningful portion of our total assets ($42.0 million at December 31, 2008). We must test our intangible assets for impairment at least annually, which may result in a further non-cash write down of franchise rights and could have a material adverse impact on our results of operations, shareholders’ equity and loan covenants.

Indefinite-lived intangibles are subject to impairment assessments at least annually (or more frequently when events or circumstances indicate that an impairment may have occurred) by applying a fair-value based test. Our remaining principal intangible assets are our rights under our franchise agreements with vehicle manufacturers. The risk of impairment losses increases if operating losses are suffered at those stores, if a manufacturer files for bankruptcy or if the stores are closed. Impairment losses result in a non-cash write-down of the affected franchise values. Furthermore, impairment losses could have an adverse impact on our ability to satisfy the financial ratios or other covenants under our debt agreements and could have a material adverse impact on our results of operations and shareholders’ equity.

A deferred tax asset position comprises a meaningful portion of our total assets (approximately $46.5 million at December 31, 2008). We are required to assess the recoverability of this asset on an ongoing basis. Future negative operating performance or other negative evidence may result in a valuation allowance being recorded against some or all of this amount. This could have a material adverse impact on our results of operations, shareholder’s equity and loan covenants.

Deferred tax assets are evaluated on a quarterly basis to determine if they are expected to be recoverable in the future. This evaluation considers positive and negative evidence in order to assess whether it is more likely than not that a portion of the asset will not be realized. The risk of a valuation allowance increases if continuing operating losses are incurred. A valuation allowance on our tax asset could have an adverse impact on our ability to satisfy the financial ratios or other covenants under our debt agreements and could have a material adverse impact on our results of operations and shareholders’ equity.

Our operating losses as well as our indebtedness and lease obligations could materially adversely affect our financial health, limit our ability to finance future acquisitions and capital expenditures, and prevent us from fulfilling our financial obligations.

Our indebtedness and lease obligations could have important consequences to us, including the following:

 

   

our ability to obtain additional financing for acquisitions, capital expenditures, working capital or general corporate purposes may be impaired in the future;

 

   

a substantial portion of our current cash flow from operations must be dedicated to the payment of principal on our indebtedness, thereby reducing the funds available to us for our operations and other purposes; and

 

   

some of our borrowings are and will continue to be at variable rates of interest, which exposes us to the risk of increasing interest rates.

In addition, our debt instruments contain numerous covenants that limit our discretion with respect to business matters, including acquisitions, paying dividends, redeeming our convertible notes prior to maturity, repurchasing our common stock, incurring additional debt or disposing of assets. Other covenants are financial in nature, including current and fixed-charge ratios or minimum net-worth requirements. A breach of any of these covenants could result in a default under the applicable agreement or indenture. In addition, a default under one agreement or indenture could result in a default and acceleration of our repayment obligations under the other agreements or indentures under the cross default provisions in those agreements or indentures.

 

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Certain debt agreements contain subjective acceleration clauses based on a lender deeming itself insecure or if a ‘material adverse change’ in our business has occurred. If these clauses are implicated and the lender declares that an event of default has occurred, the outstanding indebtedness would likely be immediately due and owing.

If these events were to occur, we may not be able to pay our debts or borrow sufficient funds to refinance them. Even if new financing were available, it may not be on terms acceptable to us. As a result of this risk, we could be forced to take actions that we otherwise would not take, or not take actions that we otherwise might take, in order to comply with these agreements and indentures.

The loss of key personnel or the failure to attract additional qualified management personnel could adversely affect our operations and growth.

Our success depends to a significant degree on the efforts and abilities of our senior management, particularly Sidney B. DeBoer, our Chairman and Chief Executive Officer, and Bryan B. DeBoer, our President and Chief Operating Officer. Further, we have identified Sidney B. DeBoer and/or Bryan B. DeBoer in most of our store franchise agreements as the individuals who control the franchises and upon whose financial resources and management expertise the manufacturers may rely when awarding or approving the transfer of any franchise.

The sole voting control of our company is currently held by Sidney B. DeBoer who may have interests different from your interests. Further, all of the Class B shares of the company held by Lithia Holdings are pledged, with other assets, to secure personal indebtedness of Mr. DeBoer. The failure to repay the indebtedness could result in the sale of such shares and the loss of such control, which may violate agreements with certain manufacturers, including Toyota Motor Sales USA.

Lithia Holding Company, LLC, of which Sidney B. DeBoer, our Chairman and Chief Executive Officer, is the sole managing member, holds all of the outstanding shares of our Class B common stock. A holder of Class B common stock is entitled to ten votes for each share held, while a holder of Class A common stock is entitled to one vote per share held. On most matters, the Class A and Class B common stock vote together as a single class. As of March 16, 2009, Lithia Holding controlled approximately 69% of the aggregate number of votes eligible to be cast by stockholders for the election of directors and most other stockholder actions. Therefore, Lithia Holding will control the election of our Board of Directors and will be in a position to control the policies and operations of the company. In addition, because Mr. DeBoer is the managing member of Lithia Holding, he currently controls and will continue to control, all of the outstanding Class B common stock, thereby allowing him to control the company. So long as at least 16 2/3% of the total number of shares outstanding are shares of Class B common stock, the holders of Class B common stock will be able to control all matters requiring approval of 66 2/3% or less of the aggregate number of votes.

Lithia Holdings has pledged all of the Class B common stock with other personal assets of Mr. DeBoer, to secure a personal loan to Mr. DeBoer from U S Bank, NA. Should he be unable to repay the loan, the bank could foreclose against the Class B common stock, which would result in the automatic conversion of such shares to Class A common stock. In such event, Mr. DeBoer would no longer be in control of the company and this loss (change) in control, if not consented to by the manufacturers, would be a technical violation under most of the dealer sales and service agreements held by the company. However, applicable state franchise laws prohibit manufacturers from unreasonably withholding consent to a change in control or the appointment of a new individual responsible for the operations of a store should a loss in control also result in the removal of both Sid DeBoer and Bryan DeBoer who are currently named.

Further, the current pledge of Class B common stock does not comply with the exception to such pledges provided in the Framework Agreement between the company and Toyota Motor Sales, U.S.A, Inc. Mr. DeBoer is in the process of seeking from Toyota Motors Sales approval of this pledge. Failure to receive such approval could result in disallowance of future Toyota store acquisitions by the company but would not be a violation of any of the sales and service agreements on existing Toyota stores.

 

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Item 1B. Unresolved Staff Comments

None.

 

Item 2. Properties

Our stores and other facilities consist primarily of automobile showrooms, display lots, service facilities, collision repair and paint shops, supply facilities, automobile storage lots, parking lots and offices. We believe our facilities are currently adequate for our needs and are in good repair. We own some of our properties, but also lease many properties, providing future flexibility to relocate our retail stores as demographics, economics, traffic patterns or sales methods change. Most leases give us the option to renew the lease for one or more lease extension periods. We also hold some undeveloped land for future expansion.

 

Item 3. Legal Proceedings

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

Phillips/Allen Cases

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

On April 28, 2004, Robert Allen and 29 other plaintiffs (“Allen Plaintiffs”) filed a lawsuit in the U.S. District Court for the District of Oregon (Case No. 04-3032-HO) against Lithia Motors, Inc. and three of its wholly-owned subsidiaries alleging violations of state and federal RICO laws, the Oregon UTPA and common law fraud. The Allen Plaintiffs seek damages, attorney’s fees and injunctive relief. The Allen Plaintiffs’ Complaint stems from vehicle purchases made at Lithia stores between July 2000 and April 2001. On August 27, 2004, we filed a Motion to Dismiss the Complaint. On May 26, 2005, the Court entered an Order granting Defendants’ Motion to Dismiss plaintiffs’ state and federal RICO claims with prejudice. The Court declined to exercise supplemental jurisdiction over plaintiffs’ UTPA and fraud claims. Plaintiffs filed a Motion to Reconsider the dismissal Order. On August 23, 2005, the Court granted Plaintiffs’ Motion for Reconsideration and permitted the filing of a Second Amended Complaint (“SAC”). On September 21, 2005, the Allen Plaintiffs, along with Ms. Phillips, filed the SAC. In this complaint, the Allen plaintiffs seek actual damages that total less than $500,000, trebled, approximately $3.0 million in mental distress claims, trebled, punitive damages of $15.0 million, attorney’s fees and injunctive relief. The SAC added as defendants certain officers and employees of Lithia. In addition, the SAC added a claim for relief based on the Truth in Lending Act (“TILA”). On November 14, 2005 we filed a second Motion to Dismiss the Complaint and a Motion to Compel Arbitration. In two subsequent rulings, the Court has dismissed all claims except those under Oregon’s Unfair Trade Practices Act and a single fraud claim for a named individual. We believe the actions of the court have significantly narrowed the claims and potential damages sought by the plaintiffs. Lithia’s motion to Compel Arbitration of Plaintiff’s remaining claims was denied. We have filed a Notice of Appeal relating to the denial of our Motion to Compel Arbitration. This appeal was argued before the Ninth Circuit Court of Appeals (No. 07-35670) with a ruling anticipated in Spring 2009.

 

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On September 23, 2005, Maria Anabel Aripe and 19 other plaintiffs (“Aripe Plaintiffs”) filed a lawsuit in the U.S. District Court for the District of Oregon (Case No. 05-3083-HO) against Lithia Motors, Inc., 12 of its wholly-owned subsidiaries and certain officers and employees of Lithia, alleging violations of state and federal RICO laws, the Oregon UTPA, common law fraud and TILA. The Aripe Plaintiffs seek actual damages of less than $600,000, trebled, approximately $3.7 million in mental distress claims, trebled, punitive damages of $12.6 million, attorney’s fees and injunctive relief. The Aripe Plaintiffs’ Complaint stems from vehicle purchases made at Lithia stores between May 2001 and August 2005 and is substantially similar to the allegations made in the Allen case. On April 18, 2006, the Court stayed the proceedings in the Aripe case, pending resolution of certain motions in the Allen case. The relevant motions in the Allen case have now been resolved, and we anticipate that the stay in the Aripe case will soon be lifted.

Alaska Service and Parts Advisors and Managers Overtime Suit

On March 22, 2006, seven former employees in Alaska brought suit against the company (Dunham, et al. v. Lithia Support Services, et al., 3AN-06-6338 Civil, Superior Court for the State of Alaska) seeking overtime wages, additional liquidated damages and attorney fees. The complaint was later amended to include a total of 11 named plaintiffs. The court ordered the dispute to arbitration. In February 2008, the arbitrator granted the plaintiffs’ request to establish a class of plaintiffs consisting of all present and former service and parts department employees totaling approximately 150 individuals who were paid on a commission basis. We have filed a motion requesting reconsideration of this class certification, but the arbitrator died before issuing his opinion. The reconsideration seeks a ruling whether these employees or some of these employees are exempt from the applicable state law that provides for the payment of overtime under certain circumstances. A new arbitrator has now been appointed who has advised he intends to make an independent opinion with respect to the request by the plaintiff for a class certification. A supplemental brief was recently filed by the company with respect to this issue but no ruling has yet been rendered.

Alaska Used Vehicles Sales Disclosures

On May 30, 2006, four of our wholly owned subsidiaries located in Alaska were served with a lawsuit alleging that the stores failed to comply with Alaska law relating to various disclosures required to be made during the sale of a used vehicle. The complaint was filed by Jackie Lee Neese, et al. v. Lithia Chrysler Jeep of Anchorage, Inc., et al. in the Superior Court for the State of Alaska at Anchorage, case number 3AN-06-04815CI. The complainants seek to represent other similarly situated customers. The court has not certified the suit as a class action. During the pendency of the Neese case, the State of Alaska brought charges against Lithia’s subsidiaries alleging the same factual allegations, and also alleging violations related to the practice of charging document fees. We settled the State action, which we believe resolves the disputes. However, the plaintiffs in the private action moved to intervene in the State of Alaska matter, and they also filed a second putative class action lawsuit, Jackie Lee Neese, et al, v. Lithia Chrysler Jeep of Anchorage, Inc., case number 3AN-06-13341CI, related to the document fee claims identified in the State of Alaska’s complaint. The second Neese lawsuit was consolidated with the first case. The court denied the plaintiffs’ request to intervene in the State of Alaska matter and the plaintiffs have filed an appeal with the Alaska Supreme Court challenging that denial. Oral arguments on the appeal have been held, but no ruling has been issued. The trial court dismissed two of the stores involved in the first lawsuit because none of the named plaintiffs had purchased any vehicles from the two stores. The plaintiffs have also appealed that dismissal to the Alaska Supreme Court. Oral arguments were held and the parties are awaiting a decision from the Court. Both the private lawsuits, as well as the implementation of the settlement with the State of Alaska, have been stayed pending a ruling in the appeal of the State of Alaska case.

Washington State B&O Tax Suit

On October 19, 2005, Marcia Johnson and Theron Johnson (the “Johnsons”), on their own behalf and on behalf of a proposed plaintiff class of all other similarly situated individuals and entities, filed suit in the Superior Court for the State of Washington, Spokane County (Case No. 05205059-9). The Johnsons sued Lithia Motors, Inc., and one of Lithia’s wholly-owned subsidiaries, individually and as representatives

 

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of a proposed defendant class of other motor vehicle dealers, asking for an award of declaratory and injunctive relief, and damages, based on defendants’ allegedly illegal practice of itemizing and collecting the Washington State Business and Occupation Tax (“B&O Tax”) from customers buying vehicles from defendants.

The allegations in the Johnson case involve legal issues similar to those that were litigated in the case of Nelson vs. Appleway Chevrolet, Inc. (the “Nelson case”). By agreement of the parties, the Johnson case was stayed while the Nelson case, which had been filed in 2004, was appealed to the Washington State Supreme Court.

In April 2007, the Washington Supreme Court upheld the lower court decisions in favor of the plaintiffs in the Nelson case. The decision was based on the Appleway dealer’s practice of adding a B&O tax charge to a vehicle’s purchase price after the customer and the dealer reached agreement on the vehicle’s price.

Because Lithia’s subsidiary negotiated with the Johnsons over a proposed B&O tax charge before reaching agreement with the Johnsons on a purchase price for the Johnsons’ new vehicle, Lithia and its subsidiary believe the subsidiary’s actions are permissible under the law as established by the Supreme Court’s decision in the Nelson case. They moved for summary judgment based on the Washington Supreme Court’s decision in the Nelson case.

Shortly after the filing of that motion, the Johnsons filed an amended complaint. They added an allegation that the defendants’ actions also violated Washington’s Consumer Protection Act, and requested an award of treble damages up to $10,000 for each alleged violation of the Act.

The Johnsons then cross-moved for partial summary judgment, contending that the Supreme Court’s decision in the Nelson case established that Lithia and its subsidiary had violated Washington’s tax and Consumer Protection Act laws. After hearing oral argument on the motions, the trial court judge, on October 12, 2007, issued an oral ruling in favor of the Johnsons and against the Lithia subsidiary. The court denied Lithia’s and its subsidiary’s summary judgment motion. The court entered its written order to that effect on November 9, 2007.

Lithia and its subsidiary asked the trial court to certify its order as a final judgment. After the trial court denied their request, Lithia and its subsidiary petitioned the Washington Court of Appeals for discretionary review of the summary judgment decision, which was granted in April 2008. In January 2009, the Court of Appeals reversed the trial court judge’s ruling and directed the entry of a summary dismissal order in the case. Plaintiff’s may appeal this decision to the Washington Supreme Court or attempt to pursue some other claims in the trial court proceeding.

VanSyoc Case

On August 14, 2002, Steven H. VanSyoc filed a lawsuit in the Superior Court of California for the County of Fresno (Case No. 08CECG02785) against a Lithia Motors subsidiary alleging fraud, deceit, intentional misrepresentation, concealment and failure to disclose, and negligence. Further, plaintiff asserts violations of California Civil Code § 1770(a)(2),(5),(6), (7), (9), (13), (14), (16) and (19) (a pattern, plan or scheme with intent to deceive or induce the purchase and increase the cost of vehicles; and California Civil Code § 17200, et.seq. (Unfair Competition Law)) and seeks an order enjoining the practice, unstated actual damages and an order certifying the case a class-action. Plaintiff alleges that we failed to disclose the vehicle he purchased was a former daily rental vehicle and misrepresented the terms and conditions of the Extended Service Agreement purchased by Plaintiff, and failed to disclose that the time and mileage limits actually started at a date significantly earlier than the purchase date. We have filed an answer denying all liability. Preliminary discovery is being undertaken.

We intend to vigorously defend all matters noted above, and to assert available defenses. We cannot make an estimate of the likelihood of negative judgment in any of these cases at this time. The ultimate resolution of the above noted cases is not reasonably expected to have a material adverse impact on our

 

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results of operations, financial condition or cash flows. However, the results of these matters cannot be predicted with certainty, and an unfavorable resolution of one or more of these matters could have a material adverse effect on our results of operations, financial condition or cash flows.

 

Item 4. Submission of Matters to a Vote of Security Holders

No matters were submitted to a vote of our shareholders during the quarter ended December 31, 2008.

PART II

 

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

Sale of Unregistered Securities

We sold 22,408 shares of Class A Common Stock on July 1, 2008 and 220,499 shares of Class A Common Stock on October 1, 2008 in a limited non-public offering to certain employees participating in the shareholder approved 1998 Employee Stock Purchase Plan, as amended. We received proceeds of $4.58 per share for shares sold on July 1, 2008 and $3.83 per share for those shares sold October 1, 2008 for total consideration of $102,629 and $844,511, respectively. The sales were sold under an exception from registration afforded by section 4.1 of the Securities Act of 1933.

Stock Prices and Dividends

Our Class A common stock trades on the New York Stock Exchange under the symbol LAD. The following table presents the high and low sale prices for our Class A common stock, as reported on the New York Stock Exchange Composite Tape for each of the quarters in 2007 and 2008:

 

2007

   High    Low

Quarter 1

   $ 31.56    $ 26.00

Quarter 2

     29.02      25.22

Quarter 3

     26.19      16.54

Quarter 4

     21.31      13.21

2008

         

Quarter 1

   $ 15.72    $ 8.91

Quarter 2

     10.94      4.89

Quarter 3

     6.76      3.51

Quarter 4

     4.99      1.53

The number of shareholders of record and approximate number of beneficial holders of Class A common stock at March 16, 2009 was 1,369 and 5,128, respectively. All shares of Lithia’s Class B common stock are held by Lithia Holding Company LLC.

Dividends declared and paid on our Class A and Class B common stock during 2007 and 2008 were as follows:

 

Quarter related to:

   Dividend
amount per
share
   Total amount of
dividend (in
thousands)

2006

     

Fourth quarter

   $ 0.14    $ 2,745

2007

     

First quarter

     0.14      2,749

Second quarter

     0.14      2,762

Third quarter

     0.14      2,762

Fourth quarter

     0.14      2,776

2008

     

First quarter

     0.14      2,806

Second quarter

     0.14      2,837

Third quarter

     0.05      1,025

Fourth quarter

     —        —  

 

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Our working capital, acquisition and used vehicle credit facility (the “Credit Facility”) with U.S. Bank National Association, DaimlerChrysler Financial Services Americas LLC (“Chrysler Financial”), DCFS U.S.A. LLC (“Mercedes Financial”) and Toyota Motor Credit Corporation (“TMCC”) allows cash dividends based on a formula. In addition, repurchases by us of our common stock are not permitted without the prior approval of our lenders.

We reduced our cash dividend in the third quarter and did not declare a dividend related to the fourth quarter of 2008. While it is our intent to re-instate a quarterly cash dividend once conditions improve and our bank covenants permit, no assurances can be given that a cash dividend will be resumed. The payment of any dividends is subject to the discretion of our Board of Directors. Dividends paid in 2008 totaled $9.4 million and stock repurchased due to options exercises in 2008 totaled $2,000.

Equity Compensation Plan Information

Information regarding securities authorized for issuance under equity compensation plans is included in Item 12.

Stock Performance Graph

The following line-graph shows the annual percentage change in the cumulative total returns for the past five years on an assumed $100 initial investment and reinvestment of dividends, on (a) Lithia Motors, Inc.’s Class A common stock; (b) the Russell 2000; and (c) a peer group index composed of United Auto Group, Inc., AutoNation, Sonic Automotive, Inc., Group 1 Automotive, Inc. and Asbury Automotive Group, the only other comparable publicly traded automobile dealerships in the United States as of December 31, 2008. The peer group index utilizes the same methods of presentation and assumptions for the total return calculation as does Lithia Motors and the Russell 2000. All companies in the peer group index are weighted in accordance with their market capitalizations.

LOGO

 

    

Base

Period

   Indexed Returns for the Year Ended

Company/Index

   12/31/03    12/31/04    12/31/05    12/31/06    12/31/07    12/31/08

Lithia Motors, Inc.

   $ 100.00    $ 106.39    $ 124.71    $ 114.08    $ 54.46    $ 12.93

Auto Peer Group

     100.00      100.91      111.02      125.72      85.37      43.18

Russell 2000

     100.00      118.33      123.72      146.44      144.15      95.44

 

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Item 6. Selected Financial Data

You should read the Selected Financial Data in conjunction with Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” our Consolidated Financial Statements and Notes thereto and other financial information contained elsewhere in this Annual Report on Form 10-K.

 

(In thousands, except per share amounts)    Year Ended December 31,  

Consolidated Statement of Operations Data:

   2008     2007     2006     2005     2004  

Revenues:

          

New vehicle

   $ 1,172,807     $ 1,528,246     $ 1,449,012     $ 1,252,607     $ 1,112,475  

Used vehicle

     574,373       686,728       660,588       604,129       532,311  

Finance and insurance

     78,970       99,727       97,036       86,121       73,719  

Service, body and parts

     306,743       304,302       261,949       227,033       198,635  

Fleet and other

     4,911       5,279       5,250       3,626       6,109  
                                        

Total revenues

     2,137,804       2,624,282       2,473,835       2,173,516       1,923,249  

Cost of sales

     1,767,760       2,177,493       2,048,070       1,788,206       1,591,421  
                                        

Gross profit

     370,044       446,789       425,765       385,310       331,828  

Goodwill impairment

     272,503       —         —         —         —    

Other asset impairments

     23,402       —         —         —         —    

Selling, general and administrative

     316,183       349,283       319,854       278,713       249,916  

Depreciation and amortization

     17,732       16,862       13,383       10,855       9,931  
                                        

Operating income (loss)

     (259,776 )     80,644       92,528       95,742       71,981  

Floorplan interest expense

     (20,398 )     (24,373 )     (25,156 )     (11,223 )     (8,680 )

Other interest expense

     (17,350 )     (15,985 )     (12,081 )     (9,496 )     (6,792 )

Other income, net

     6,673       641       798       815       562  
                                        

Income (loss) from continuing operations before income taxes

     (290,851 )     40,927       56,089       75,838       57,071  

Income tax (provision) benefit

     91,703       (16,485 )     (21,597 )     (29,372 )     (22,113 )
                                        

Income (loss) from continuing operations

     (199,148 )     24,442       34,492       46,466       34,958  

Income (loss) from discontinued operations, net of tax

     (53,438 )     (2,893 )     2,812       7,161       10,654  
                                        

Net income (loss)

   $ (252,586 )   $ 21,549     $ 37,304     $ 53,627     $ 45,612  
                                        

Basic income (loss) per share from continuing operations

   $ (9.95 )   $ 1.25     $ 1.77     $ 2.42     $ 1.86  

Basic income (loss) per share from discontinued operations

     (2.67 )     (0.15 )     0.14       0.38       0.57  
                                        

Basic net income (loss) per share

   $ (12.62 )   $ 1.10     $ 1.91     $ 2.80     $ 2.43  
                                        

Shares used in basic per share

     20,017       19,530       19,485       19,175       18,773  
                                        

Diluted income (loss) per share from continuing operations

   $ (9.95 )   $ 1.19     $ 1.65     $ 2.22     $ 1.75  

Diluted income (loss) per share from discontinued operations

     (2.67 )     (0.13 )     0.13       0.33       0.52  
                                        

Diluted net income (loss) per share

   $ (12.62 )   $ 1.06     $ 1.78     $ 2.55     $ 2.27  
                                        

Shares used in diluted per share

     20,017       22,082       22,102       21,807       20,647  
                                        

Cash dividends declared per common share

   $ 0.47     $ 0.56     $ 0.54     $ 0.44     $ 0.31  
                                        

Factors Affecting Comparability

          

Stock-based compensation expense included as a component of selling, general and administrative expense

   $ 1,725     $ 3,384     $ 3,534     $ 490     $ 164  

Loss (gain) related to undesignated interest rate swaps included as a component of floorplan interest expense

     545       —         (1,921 )     4,081       3,726  

Ineffectiveness related to interest rate swaps included as a component of floorplan interest expense

     363       73       —         —         —    
(In thousands)    As of December 31,  

Consolidated Balance Sheet Data:

   2008     2007     2006     2005     2004  

Working capital

   $ 99,524     $ 193,447     $ 149,701     $ 156,446     $ 124,277  

Inventories

     422,812       601,759       603,306       606,047       535,347  

Total assets

     1,133,459       1,626,735       1,579,357       1,452,714       1,255,720  

Flooring notes payable

     337,700       451,590       499,679       530,452       450,860  

Current maturities of long-term debt

     78,634       13,327       16,557       6,868       6,565  

Long-term debt, less current maturities

     265,184       455,495       392,383       290,551       267,311  

Total stockholders’ equity

     248,343       508,212       493,393       460,231       405,246  

 

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

You should read the following discussion in conjunction with Item 1. “Business,” Item 1A. “Risk Factors” and our Consolidated Financial Statements and Notes thereto.

Overview

We are a leading operator of automotive franchises and retailer of new and used vehicles and services. As of March 16, 2009, we offered 27 brands of new vehicles and all brands of used vehicles in 92 stores in the United States and over the Internet. We sell new and used cars and light trucks; sell replacement parts; provide vehicle maintenance, warranty, paint and repair services; and arrange related financing, service contracts, protection products and credit insurance for our automotive customers.

While the U.S. has not experienced a slower auto retail environment in 50 years, in January and February 2009, traffic in our stores was up over our December 2008 traffic. In addition, we believe that we are realizing success from our recent marketing efforts and our continuing cost cutting initiatives to help mitigate the slowing sales environment.

We believe that adhering to strict cost-cutting measures and improving our balance sheet by reducing debt and preserving cash, while still focusing on satisfying our customers, should enable us to come through the tough economic times as a stronger, more viable company. However, no assurances can be given that industry sales will not experience a further decline, or that our restructuring plan will be of sufficient magnitude to guarantee success in a declining market.

Economic Environment During 2008

As discussed in Overview in Item 1, “Business,” above, during 2008, overall macroeconomic issues have reduced consumers’ desire and ability to purchase automobiles. An additional factor negatively impacting auto sales has been a reduction in available options for consumer auto loans. The manufacturers’ captive financing companies have suffered additional pressure as the financial crisis has raised their cost of funds and reduced their access to capital. This has prevented them from offering as many incentives designed to drive sales, such as subsidized interest rates and the amount of loan to value they are willing to advance on vehicles.

The number of customers visiting our stores has significantly declined from prior years. We believe one of the reasons showroom traffic has suffered is that customers are assuming that financing is not available or that they would not qualify for vehicle financing. One of the main objectives of our recent advertising has focused on overcoming this obstacle and communicating that consumer vehicle financing continues to be available. This is evidenced by the fact that we were still able to arrange financing on approximately 73% of the vehicles we sold during the fourth quarter of 2008, although at substantially lower volumes.

In addition, both new and used vehicle sales have been impacted in 2008 by declining valuations for most used vehicles. Fewer customers are trading in their used vehicles as the value many could receive is less than what they currently owe. This has negatively affected our new vehicle sales as many potential customers are not able to obtain financing to absorb the amount owed on their trade in as well as the cost of the new vehicle.

Restructuring and Cost-Cutting Initiatives

As the economic environment continued to deteriorate in the second half of 2008, we continued to take steps to achieve profitably in the current adverse market conditions, as well as to position ourselves for our long-term growth objectives. The restructuring plan we announced on June 2, 2008 was subsequently expanded to include additional initiatives. As of March 16, 2009, we identified a total of 31 stores for divestiture and, as of this date, 12 of these stores had been sold, 4 had been closed, and 15 remained for sale, one of which had a preliminary agreement signed for its sale. These actions will reduce our store count by approximately one-fourth and will move us closer to our goal of a long term 50/50 domestic/import new vehicle sales mix.

 

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Our restructuring plans also included the following cost cutting measures:

 

   

Re-aligning store management personnel and duties;

 

   

Reducing non-production headcount across the company;

 

   

Reducing non-essential store expenses;

 

   

Consolidating vendors and negotiating favorable payment terms;

 

   

Reducing all corporate level expenses where possible; and

 

   

Further centralizing offices by region.

In addition to the store divestitures discussed above, the following restructuring actions are underway to help preserve capital and improve profitability:

 

   

Deferring all uncommitted capital expenditures;

 

   

Selling certain development property and other assets, including aircraft and excess land;

 

   

Financing certain unfinanced real estate;

 

   

Postponing acquisitions until prices stabilize; and

 

   

Adjusting inventory levels to meet consumers’ shift in demand for new and used vehicles.

The above actions have allowed us to achieve approximately $43 million of annualized savings through December 31, 2008 and we will continue to identify additional cost savings in the future without impacting customer service.

As part of our restructuring plan, the investment in additional L2 locations was placed on hold as we were unwilling to continue to absorb the expected startup losses. After we placed the initiative on hold, certain personnel associated with the project were terminated and others were re-assigned to other areas.

The existing L2 stores have been integrated into the Lithia platform and we are utilizing all of the Lithia systems in the locations. We closed our Loveland L2 location in June 2008 and are currently using the facility in a re-formatted used car operation. In September 2008, we completed the sale of our Cedar Rapids L2 location. We closed our Amarillo L2 location in November 2008 and are currently using the facility in a re-formatted used car operation. We currently operate an L2 location in Lubbock, Texas. However, the Lubbock location has been revamped to essentially operate as a traditional Lithia store to gain operational efficiencies and to unify selling systems across the organization.

We did not incur any material severance, lease termination or other restructuring charges related to any of these restructuring actions in 2008.

Manufacturer Information

Historically, manufacturers have offered incentives on new vehicle sales through a combination of repricing strategies, rebates, lease programs, early lease cancellation programs and low interest rate loans to consumers. Through the first half of 2008, this strategy continued. However, in response to tightening in credit markets, in the third quarter of 2008, we saw a shift away from leasing and subsidized financing to dealer and consumer rebates and repricing strategies.

In July 2008, Chrysler Financial announced the termination of its lease program. We have not seen a significant impact due to this change as the majority of our transactions with Chrysler Financial are retail installment contracts, not leases. We have received additional retail incentives as a result of the termination of its lease program and may receive additional incentives in the future.

In October 2008, the domestic automakers approached Congress seeking government assistance. As part of these hearings, each manufacturer provided an update on their current financial situation as well as their outlook for 2009 and beyond. In the course of the hearings, it became clear that without immediate assistance, both Chrysler and General Motors (“GM”) faced the possibility of insolvency as early as January 2009.

 

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In December 2008, the federal government provided $17.4 billion in bridge loans to both Chrysler and GM. Stipulated with the loans was the condition that both manufacturers return to the Treasury in February 2009 and provide a restructuring plan.

At the time of this filing, both Chrysler and GM have provided their plans to the Treasury requesting up to $39 billion in total support, including the $17.4 billion already provided, and are acting on those plans. However, the response by the federal government to these strategies remains unknown. We believe that in the event either or both plans are rejected, a Chapter 11 bankruptcy filing would occur. We have developed contingency plans to respond in the event of such a filing. No assurances can be given that our contingency plans will be adequate to address the magnitude of these scenarios.

Goodwill and Other Asset Impairment Charges

Our financial results for 2008 included $301.0 million of goodwill and other asset impairment charges included as a component of operating loss and an additional $70.1 million as a component of discontinued operations. See Notes 1, 5, 6 and 19 of Notes to Consolidated Financial Statements for additional information.

Gain on Early Retirement of Senior Subordinated Convertible Notes

During the third and fourth quarters of 2008, we redeemed a total of half, or $42.5 million principal amount, of our senior subordinated convertible notes at a discount, which resulted in a gain on early retirement of $5.2 million, which was included as a component of other income, net on our consolidated statement of operations. As of December 31, 2008, $42.5 million of our senior subordinated convertible notes remained outstanding.

Pro Forma Results of Operations

On a non-GAAP basis, the elimination of the effect of the non-cash impairment charges and the gain on early retirement of debt would have resulted in a net improvement of our net loss before taxes by approximately $295.8 million to net income before taxes of $4.9 million in 2008. In addition, excluding the non-cash impairment charges and the gain on early retirement of debt of $(10.10) per share in continuing operations and $(12.28) per share including discontinued operations, on a non-GAAP basis we had income of $0.15 per diluted share from continuing operations, and a loss of $(0.34) per diluted share including discontinued operations. The loss recorded under GAAP was $(9.95) per diluted share from continuing operations and $(12.62) per diluted share including discontinued operations. For a reconciliation of the non-GAAP financial data, see “Pro Forma Reconciliations,” below. The financial tables contain certain non-GAAP financial measures as defined under SEC rules, such as net income and diluted earnings per share from continuing operations, adjusted in each case to exclude certain disclosed items. As required by SEC rules, we have provided reconciliations of these measures to the most directly comparable GAAP measures, which are set forth herein. We believe that the non-GAAP financial measures improve the transparency of our disclosure, provide a meaningful presentation of our results from our core business operations excluding the impact of items not related to our ongoing core business operations, and improve the period-to-period comparability of our results from our core business operations.

Outlook

We anticipate a continued weak economic environment in 2009. Despite the economic weakness, we believe the actions discussed in Restructuring and Cost-Cutting Initiatives will help mitigate its impact. As retailers, we are able to reduce many variable costs, a majority of which are personnel related, and adjust our inventories relatively quickly. In addition to these variable costs, we have cut fixed costs totaling approximately $43 million annually. We remain committed to quickly and aggressively responding to any further decline in the overall economy or the automotive retail environment and are prepared to continue to reduce costs if current conditions deteriorate.

In 2008, we believe the impact of gasoline prices on the value of trucks and SUVs and reduced industry sales resulted in below normal profit margins on vehicles. We intend to improve our vehicle margins by

 

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improving our inventory mix to meet current demand. This action has resulted in improved margins on both new and used vehicles in the fourth quarter of 2008. We believe that margins in 2009 will be consistent with the margins experienced in the fourth quarter of 2008. We also adjusted our used vehicle inventory mix throughout 2008 and believe that, going into 2009, we are better positioned with a mix of vehicles that customers are currently demanding. Also, as vehicle sales decline, we are emphasizing the more stable, higher-margin service, body and parts business, which improves our overall gross profit margins stated as a percentage of our total revenue.

Results of Continuing Operations

Certain revenue, gross profit margin and gross profit information by product line was as follows for 2008, 2007 and 2006:

 

2008

   Percent of
Total Revenues
    Gross
Profit

Margin
    Percent of Total
Gross Profit
 

New vehicle

   54.9 %   7.8 %   24.8 %

Used vehicle, retail

   22.3     11.3     14.6  

Used vehicle, wholesale

   4.6     (3.1 )   (0.8 )

Finance and insurance(1)

   3.7     100.0     21.3  

Service, body and parts

   14.3     47.9     39.7  

Fleet and other

   0.2     31.9     0.4  

2007

   Percent of
Total Revenues
    Gross
Profit

Margin
    Percent of Total
Gross Profit
 

New vehicle

   58.2 %   7.8 %   26.8 %

Used vehicle, retail

   21.1     14.1     17.4  

Used vehicle, wholesale

   5.1     2.3     0.7  

Finance and insurance(1)

   3.8     100.0     22.3  

Service, body and parts

   11.6     47.7     32.5  

Fleet and other

   0.2     27.2     0.3  

2006

   Percent of
Total Revenues
    Gross
Profit

Margin
    Percent of Total
Gross Profit
 

New vehicle

   58.6 %   7.9 %   27.0 %

Used vehicle, retail

   21.9     14.9     19.0  

Used vehicle, wholesale

   4.8     2.8     0.8  

Finance and insurance(1)

   3.9     100.0     22.8  

Service, body and parts

   10.6     48.8     30.0  

Fleet and other

   0.2     28.8     0.4  

 

(1) Commissions reported net of anticipated cancellations.

 

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

 

      Year Ended December 31, (1)  
     2008     2007     2006  

Revenues:

      

New vehicle

   54.9 %   58.2 %   58.6 %

Used vehicle

   26.9     26.2     26.7  

Finance and insurance

   3.7     3.8     3.9  

Service, body and parts

   14.3     11.6     10.6  

Fleet and other

   0.2     0.2     0.2  
                  

Total revenues

   100.0 %   100.0 %   100.0 %

Gross profit

   17.3     17.0     17.2  

Goodwill impairment

   12.7     —       —    

Other asset impairments

   1.1     —       —    

Selling, general and administrative expenses

   14.8     13.3     12.9  

Depreciation and amortization

   0.8     0.7     0.5  
                  

Operating income (loss)

   (12.2 )   3.1     3.7  

Floorplan interest expense

   (1.0 )   (0.9 )   (1.0 )

Other interest expense

   (0.8 )   (0.6 )   (0.5 )

Other income, net

   0.3     0.0     0.0  
                  

Income (loss) from continuing operations before income taxes

   (13.6 )   1.6     2.3  

Income tax benefit (expense)

   4.3     (0.6 )   (0.9 )
                  

Income (loss) from continuing operations

   (9.3 )%   0.9 %   1.4 %
                  

 

(1)

The percentages may not add due to rounding.

The following tables set forth the changes in our operating results from continuing operations in 2008 compared to 2007 and in 2007 compared to 2006:

 

      Year Ended
December 31,
    Increase
(Decrease)
    %
Increase

(Decrease)
 

(In Thousands)

   2008     2007      

Revenues:

        

New vehicle

   $ 1,172,807     $ 1,528,246     $ (355,439 )   (23.3 )%

Used vehicle

     574,373       686,728       (112,355 )   (16.4 )

Finance and insurance

     78,970       99,727       (20,757 )   (20.8 )

Service, body and parts

     306,743       304,302       2,441     0.8  

Fleet and other

     4,911       5,279       (368 )   (7.0 )
                              

Total revenues

     2,137,804       2,624,282       (486,478 )   (18.5 )

Cost of sales:

        

New vehicle

     1,081,032       1,408,496       (327,464 )   (23.2 )

Used vehicle

     523,439       605,890       (82,451 )   (13.6 )

Service, body and parts

     159,944       159,262       682     0.4  

Fleet and other

     3,345       3,845       (500 )   (13.0 )
                              

Total cost of sales

     1,767,760       2,177,493       (409,733 )   (18.8 )
                              

Gross profit

     370,044       446,789       (76,745 )   (17.2 )

Goodwill impairment

     272,503       —         272,503     n/a  

Other asset impairments

     23,402       —         23,402     n/a  

Selling, general and administrative

     316,183       349,283       (33,100 )   (9.5 )

Depreciation and amortization

     17,732       16,862       870     5.2  
                              

Operating income (loss)

     (259,776 )     80,644       (340,420 )   (422.1 )

Floorplan interest expense

     (20,398 )     (24,373 )     (3,975 )   (16.3 )

Other interest expense

     (17,350 )     (15,985 )     1,365     8.5  

Other income, net

     6,673       641       6,032     941.0  
                              

Income (loss) from continuing operations before income taxes

     (290,851 )     40,927       (331,778 )   (810.7 )

Income tax benefit (expense)

     91,703       (16,485 )     (108,188 )   (656.3 )
                              

Income (loss) from continuing operations

   $ (199,148 )   $ 24,442     $ (223,590 )   (914.8 )%
                              

 

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Table of Contents
     Year Ended
December 31,
    Increase
(Decrease)
    %
Increase

(Decrease)
 
     2008     2007      

New units sold

     40,206       52,512       (12,306 )   (23.4 )%

Average selling price per new vehicle

   $ 29,170     $ 29,103     $ 67     0.2  

Used retail units sold

     28,853       32,700       (3,847 )   (11.8 )

Average selling price per used retail vehicle

   $ 16,522     $ 16,896     $ (374 )   (2.2 )

Used wholesale units sold

     16,631       20,264       (3,633 )   (17.9 )

Average selling price per used wholesale vehicle

   $ 5,872     $ 6,625     $ (753 )   (11.4 )

Finance and insurance sales per retail unit

   $ 1,144     $ 1,170     $ (26 )   (2.2 )
     Year Ended
December 31,
    Increase
(Decrease)
    %
Increase

(Decrease)
 

(In Thousands)

   2007     2006      

Revenues:

        

New vehicle

   $ 1,528,246     $ 1,449,012     $ 79,234     5.5 %

Used vehicle

     686,728       660,588       26,140     4.0  

Finance and insurance

     99,727       97,036       2,691     2.8  

Service, body and parts

     304,302       261,949       42,353     16.2  

Fleet and other

     5,279       5,250       29     0.6  
                              

Total revenues

     2,624,282       2,473,835       150,447     6.1  

Cost of sales:

        

New vehicle

     1,408,496       1,333,906       74,590     5.6  

Used vehicle

     605,890       576,271       29,619     5.1  

Service, body and parts

     159,262       134,153       25,109     18.7  

Fleet and other

     3,845       3,740       105     2.8  
                              

Total cost of sales

     2,177,493       2,048,070       129,423     6.3  
                              

Gross profit

     446,789       425,765       21,024     4.9  

Selling, general and administrative

     349,283       319,854       29,429     9.2  

Depreciation and amortization

     16,862       13,383       3,479     26.0  
                              

Operating income

     80,644       92,528       (11,884 )   (12.8 )

Floorplan interest expense

     (24,373 )     (25,156 )     (783 )   (3.1 )

Other interest expense

     (15,985 )     (12,081 )     3,904     32.3  

Other income, net

     641       798       (157 )   (19.7 )
                              

Income from continuing operations before income taxes

     40,927       56,089       (15,162 )   (27.0 )

Income tax expense

     (16,485 )     (21,597 )     (5,112 )   (23.7 )
                              

Income from continuing operations

   $ 24,442     $ 34,492     $ (10,050 )   (29.1 )%
                              
     Year Ended
December 31,
    Increase
(Decrease)
    %
Increase

(Decrease)
 
     2007     2006      

New units sold

     52,512       52,340       172     0.3 %

Average selling price per new vehicle

   $ 29,103     $ 27,685     $ 1,418     5.1  

Used retail units sold

     32,700       33,225       (525 )   (1.6 )

Average selling price per used retail vehicle

   $ 16,896     $ 16,298     $ 598     3.7  

Used wholesale units sold

     20,264       19,244       1,020     5.3  

Average selling price per used wholesale vehicle

   $ 6,625     $ 6,187     $ 438     7.1  

Finance and insurance sales per retail unit

   $ 1,170     $ 1,134     $ 36     3.2 %

 

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Revenues

Total revenues decreased 18.5% and increased 6.1%, respectively, in 2008 compared to 2007 and in 2007 compared to 2006.

The decrease in 2008 compared to 2007 primarily resulted from reduced demand and decreased same-store sales, which were brought on by the challenging retail environment, higher fuel prices, tighter credit environment, declines in available home equity, low consumer confidence and the weak economy.

The increase in 2007 compared to 2006 was a result of acquisitions, partially offset by a 3.2% decrease in same-store sales, excluding fleet. 2007 faced a difficult comparison with 2006 when total same-store sales grew by 4.1%. The decrease in same-store sales in 2007 was also impacted by a weak retail sales environment, especially with our domestic brands.

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

 

     2008 compared to 2007     2007 compared to 2006  

New vehicle retail, excluding fleet

   (24.1 )%   (3.6 )%

Used vehicle, retail

   (15.8 )   (7.1 )

Used vehicle, wholesale

   (29.3 )   3.6  

Total vehicle sales, excluding fleet

   (22.3 )   (4.1 )

Finance and insurance

   (20.8 )   (3.1 )

Service, body and parts

   (0.3 )   4.0  

Total sales, excluding fleet

   (19.7 )   (3.2 )

Same-store sales are calculated for stores that were in operation as of December 31, 2007, and only including the months of operations for both comparable periods. For example, a store acquired in June 2007 would be included in same store operating data beginning in July 2007, after its first full complete comparable month of operation. Thus, operating results for same store comparisons would include only the periods of July through December of both comparable years.

Penetration rates for certain products were as follows:

 

     2008     2007     2006  

Finance and insurance

   75 %   77 %   76 %

Service contracts

   42     43     44  

Lifetime oil change and filter

   34     37     39  

2008 Compared to 2007

The decline in same-store total vehicle sales, excluding fleet, in 2008 compared to 2007 was primarily a result of the retail environment, but was exacerbated by our heavier domestic automaker exposure. Through the second quarter of 2008, increasing gas prices pushed consumer demand towards smaller, more fuel-efficient vehicles. However, as gas prices have decreased, demand for heavier trucks and SUVs has returned. However, this trend was more than offset by a decline in the overall macroeconomic environment, as the majority of automakers experienced double digit declines in sales when compared to the prior year. The average price of new vehicles sold in 2008 increased slightly over the average prices for 2007, but the number of vehicles sold was significantly lower. Vehicle prices increased in 2008 compared to 2007 due to a higher average invoice cost and also due to a shift away from the volume based strategy we adopted in prior years. The average price of used vehicles sold decreased in 2008 compared to 2007 as we worked through an inventory of vehicles that was not in high demand, a shift towards cars and away from trucks and as a reduction in available credit decreased the amount of financing customers could obtain, which resulted in lower average transactions.

 

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Our finance and insurance sales were down in 2008 compared to 2007, both on an overall basis and a same-store basis, primarily due to the overall decline in vehicles sold combined with a decline in the average warranty and other finance product sales per retail unit. As fewer credit challenged customers were able to receive financing, the overall mix of customers had improved credit quality. As there are more lenders for stronger credit customers, loans are more competitive and less profitable to us. Additionally, the tightening of credit markets has limited the payment to income and debt to income ratios that are required by lenders, reducing the opportunity to add insurance and warranty products as their impact on payment may exceed financing limits. However, despite the tightening of the credit markets, we were able to maintain our finance and insurance penetration rate at 75% in 2008.

Our service, body and parts business was less affected by the challenging economic environment in 2008 than our other business lines. This demonstrates the counter-cyclicality of this component of our business. We focus on customer satisfaction in an effort to keep our customers returning to our facilities for their service needs. Warranty work accounts for approximately 20% of our same-store service, body and parts sales. Same-store warranty sales in 2008 were up 2.4% compared to 2007. Our domestic brand warranty work increased by 4.7%, while import/luxury warranty work decreased by 0.2%. The customer pay service and parts business, which represented approximately 80% of the total service, body and parts business in 2008, was down 1.0% on a same-store basis compared to 2007.

2007 Compared to 2006

The decline in new vehicle same-store sales in 2007 compared to 2006 was primarily due to a slowing sales environment in 2007 and declining sales of domestic manufacturers’ vehicles that represented a large percentage of our new vehicle sales. Due to aggressive manufacturer incentive programs in 2006, which were not sustained at the same level in 2007, same-store new vehicle unit sales were down 3.6% in 2007 compared to 2006. The decrease in same-store unit sales was partially offset by a 3.4% increase in same-store average selling prices.

The decline in same-store used retail vehicle sales in 2007 compared to 2006 was primarily due to the slowing sales environment mentioned above. Same-store used retail unit sales decreased 7.1% in 2007 compared to 2006. The same-store unit decrease was partially offset by a 2.0% increase in same-store average selling prices.

The increase in used wholesale vehicle same-store sales in 2007 compared to 2006 resulted from a 3.6% increase in same-store average selling prices, partially offset by a 2.9% decrease in same-store unit sales.

Same-store finance and insurance sales were negatively affected in 2007 compared to 2006 by decreases in same-store vehicle unit sales, which lowered the overall opportunity for finance and insurance sales. This was offset by a 4.1% increase in the finance and insurance sales per unit in 2007 compared to 2006.

The increase in same-store service, body and parts sales in 2007 compared to 2006 was primarily due to a 4.0% increase in the customer-paid portion of the business. The customer-paid portion of the business excludes warranty and represented approximately 81% of total service, body and parts sales in 2007. In addition, we realized a 3.7% increase in same-store warranty sales.

 

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Table of Contents

Gross Profit

Gross profit decreased $76.7 million in 2008 compared to 2007 and increased $21.0 million in 2007 compared to 2006. The decrease in 2008 compared to 2007 primarily resulted from decreased total revenues, while the increase in 2007 compared to 2006 was primarily due to increased total revenues.

Gross profit margins achieved were as follows:

 

     Year Ended December 31,     Basis Point
Change*
 
     2008     2007    

New vehicle

   7.8 %   7.8 %   —   bp

Retail used vehicle

   11.3     14.1     (280 )

Wholesale used vehicles

   (3.1 )   2.3     (540 )

Finance and insurance

   100.0     100.0     —    

Service, body and parts

   47.9     47.7     20  

Overall

   17.3     17.0     30  
     Year Ended December 31,     Basis Point
Change*
 
     2007     2006    

New vehicle

   7.8 %   7.9 %   (10 )bp

Retail used vehicle

   14.1     14.9     (80 )

Wholesale used vehicles

   2.3     2.8     (50 )

Finance and insurance

   100.0     100.0     —    

Service, body and parts

   47.7     48.8     (110 )

Overall

   17.0     17.2     (20 )

 

*

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

2008 Compared to 2007

New vehicle margins were flat in 2008 compared to 2007 as negative effects of the challenging economic environment were offset by a shift in consumer demand to cars vs. trucks and SUVs. Our stores typically target a dollar amount of profit on each vehicle sale, rather than a percentage. As such, when the average vehicle sale price declines but the profit remains consistent, margins are positively affected. Margins were up on new cars, while they were down on trucks and SUVs as we lowered pricing on these vehicles in order to clear out older inventory. Given the reduced number of new vehicle sales transactions, we implemented training and focused our stores on maintaining the profit on each vehicle retailed. This focus helped to offset the broader impact on revenues and margins due to the declining economy.

The challenging retail environment led to the declines in gross profit margins in retail and wholesale used vehicle sales in 2008 compared to 2007. We adjusted the pricing on our used vehicle inventories due to a shift in the types of used vehicles in demand in an effort to reduce inventory levels and lower amounts outstanding on our credit facility. Also, the tightening of the credit markets affected the ability of customers to obtain financing, and reduced the overall amount of credit available to each customer. As such, customers sought out lower priced used vehicles. This shift, which improves margins as we target a specific dollar amount of profit per transaction rather than a percentage, helped to offset some of the pricing adjustments discussed above.

Service, body and parts gross margins increased in 2008 compared to 2007 due to concentration on maximizing all profit opportunities in the service drive through the sale of additional service work and fewer consumer discounts and promotions, partially offset by the continued shift to parts and accessories business and more competitive pricing on service work in order to emphasize volume. As vehicle sales decline, more expensive service work is required due to the increased average age of vehicles in service. We expect this trend to positively impact our operations until the new car market recovers.

 

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Table of Contents

2007 Compared to 2006

Gross profit margins for both new vehicle and retail used vehicle sales decreased in 2007 compared to 2006 primarily as a result of the slowing retail sales environment.

The decrease in wholesale used vehicle gross profit margin in 2007 compared to 2006 was due to wholesale market conditions and a focus on retailing more used vehicles. Our ability to provide customers with a better value for their trade-ins, offering closer to their true market value, has been improved by our use of technology. This improves our ability to retail new vehicles. However, this lowers the gross profit margin we are able to achieve on the re-sale of the trade-ins we elect to wholesale. In addition, as we focus on retailing more used vehicles, we are left with the lower-quality used vehicles for wholesaling, which also contributed to lower gross profit margins. We dispose of our wholesale used vehicles by using centralized controls, holding our own local used vehicle auctions and managing the disposal of units at larger third party auctions.

Gross profit margins in the service, body and parts business line decreased in 2007 compared to 2006 partially due to a shift in mix towards selling more parts and accessories, which carry lower margins than the service side of the business. However, due to an increase in volume, same–store gross profit increased 0.7% in 2007 compared to 2006.

Goodwill and Other Asset Impairment Charges

Pursuant to SFAS No. 142, “Goodwill and Other Intangible Assets,” we are required to test our goodwill and other indefinite lived intangible assets for impairment at least annually or more frequently if conditions indicate that an impairment may have occurred. In addition, long-lived assets held and used by us and intangible assets with determinable lives are reviewed for impairment whenever events or circumstances indicate that the carrying amount of assets may not be recoverable in accordance with SFAS No. 144 “Accounting for the Impairment or Disposal of Long-Lived Assets.”

By the second half of 2007, cracks in the credit market brought about by accelerating defaults on home mortgages had begun to appear in various forms including:

 

   

The declining availability of consumer credit at commercially viable rates reducing the breadth of our potential customer base; and

 

   

The willingness (including financial capability) of manufacturers to offer consumer incentives previously relied upon to reinvigorate car sales to sustainable levels customarily experienced by the industry.

The proliferation of these issues resulted in a rapid deterioration of business conditions throughout the second quarter of 2008. Further, rapidly escalating oil prices to unprecedented levels, and the potential for oil prices to increase even more, dramatically affected the confidence of the American consumer. Consequently, these factors diminished their willingness to purchase big-ticket items such as automobiles and, more specifically, the profitable large trucks and SUVs then being offered by many of our manufacturers.

In response to the deterioration of business conditions and the resultant decline in automobile sales, we announced a restructuring plan on June 3, 2008. That plan called for a reduction in store and support personnel, the sale of certain non-essential assets, and the deferral of non-essential expenditures including administrative centralization and operational initiatives. The most significant component of the restructuring was our decision to divest 12 locations.

As a result of our decision to dispose of approximately 10% of our stores, an adverse and rapidly changing business climate, our resultant reduced earnings and cash flow forecast and a significant decline in our market capitalization, we determined that our goodwill and other indefinite lived intangible assets, as well as our other long-lived assets, required an interim impairment test. The interim impairment test required us to update the adjusted present value (“APV”) model used in determining the fair value of our business, and by extension, the valuation of our goodwill.

 

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Table of Contents

The unexpected and unprecedented material changes in the economic and credit environment experienced in the first six months of 2008 caused us to revise certain key assumptions in our determination of the fair value of our business. Also, we determined that cost savings, particularly those associated with administrative centralization and operational initiatives could not be realized in the current environment as the dramatic shift in economic conditions caused us to defer their implementation. The total impact of the changes to key assumptions materially reduced the estimated value of our business.

Inherent difficulties existed in forecasting the extent and magnitude of the macroeconomic correction underway, and the effect such a correction would have on our business at the time we were evaluating the recoverability of our goodwill in connection with the finalization of our 2007 recoverability assessment. By the end of the second quarter of 2008, the fundamental changes in the economic landscape were obvious; however, few had the foresight to forecast the degree and speed by which deteriorating credit markets would significantly undermine the overall health of the U.S. economy.

We believe we acted prudently in concluding our goodwill was permanently impaired in the second quarter of 2008, consistent with the realization that the state of the automobile industry had suffered and the effect of the credit crisis had spread throughout the broader economy.

As a result of our analysis, the following impairment charges were recorded within continuing operations in 2008:

 

Goodwill

   $  272.5 million

Franchise value and other intangibles

     16.4 million

Real estate

     4.5 million

Equipment

     1.0 million

Terminated construction projects

     4.5 million

Other

     2.1 million
      

Total Impairment

   $ 301.0 million
      

After the charge, and the allocation of goodwill to stores classified within discontinued operations, our remaining balance in goodwill is zero. Following the $16.4 million charge related to our indefinite-lived intangible assets (franchise value), the remaining value of our indefinite-lived intangible assets was approximately $42.0 million as of December 31, 2008. See Notes 1, 5 and 6 of Notes to Consolidated Financial Statements for additional information.

Selling, General and Administrative Expense

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

SG&A decreased $33.1 million in 2008 compared to 2007 and increased $29.4 million in 2007 compared to 2006. SG&A as a percentage of revenue was 14.8%, 13.3% and 12.9%, respectively, in 2008, 2007 and 2006. The increase in SG&A as a percentage of revenue in 2008 compared to 2007 was primarily due to lower revenues in 2008 compared to 2007 as discussed above, partially offset by cost reduction measures in 2008.

 

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

 

     2008 compared to 2007

Decrease related to salaries, bonuses and benefits

   $ (19.4) million

Decrease related to sales compensation

     (9.6) million

Decrease related to employee benefits

     (4.9) million

Decrease related to travel expenses

     (3.6) million

Decrease related to workers’ compensation and other insurance

     (2.8) million

Decrease related to stock-based compensation

     (1.7) million

Increase related to write-off of construction projects and other assets

     5.1 million

Increase related to acquisitions

     3.4 million

Increase in other expenses

     0.4 million
      
   $ (33.1) million
      
     2007 compared to 2006

Increase related to acquisitions

   $ 33.4 million

Increase in employee benefits

     2.8 million

Decrease related to sales compensation

     (4.0) million

Decrease related to travel expenses

     (1.5) million

Decrease related to salaries and bonuses

     (0.8) million

Decrease in other expenses

     (0.5) million
      
   $ 29.4 million
      

SG&A as a percentage of gross profit is an industry standard for measuring performance relative to SG&A. SG&A as a percentage of gross profit was as follows:

 

Year Ended December 31,  

2008

   2007     2006  
85.4%    78.2 %   75.1 %

In 2008, SG&A expense included a $5.1 million charge related to terminated construction projects and other asset write-offs. We endeavored to reduce SG&A expense throughout 2008 as part of our restructuring and cost-cutting plans, and made significant progress based on overall expenditure amounts. However, primarily due to a sharply declining revenue base and a reduction in gross profit, SG&A as a percentage of gross profit increased by 720 basis points in 2008 compared to 2007.

As a result of expenses detailed above, as well as costs related to our investments in personnel for our centralization efforts, L2 Auto and the other initiatives in 2007, SG&A as a percentage of gross profit increased by 310 basis points in 2007 compared to 2006.

Depreciation and Amortization

Depreciation – Buildings is comprised of depreciation expense related to buildings and significant remodels or betterments. Depreciation and Amortization – Other, is comprised of depreciation expense related to furniture, tools and equipment and signage and amortization of certain intangible assets, including customer lists and non-compete agreements.

Depreciation and amortization increased $0.9 million and $3.5 million, respectively, in 2008 compared to 2007 and in 2007 compared to 2006 due to the addition of property and equipment primarily related to our acquisitions, as well as improvements to existing facilities and equipment costs related to our initiatives. The increase in depreciation and amortization has slowed as we have slowed our acquisition and improvement projects and disposed of stores during the weak economic environment.

Operating Income (Loss)

Operating margins of a negative 12.2% in 2008 were due primarily to the goodwill and other asset impairment charges discussed above. In addition, 2008 was negatively affected by increased SG&A and depreciation and amortization as a percentage of revenues as discussed above.

 

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Operating margins decreased by 60 basis points to 3.1% in 2007 compared to 3.7% in 2006 due primarily to the decrease in gross profit margins and increased SG&A and depreciation and amortization as discussed above.

Floorplan Interest Expense

Floorplan interest expense decreased $4.0 million in 2008 compared to 2007. Decreases of $7.7 million due to lower average interest rates and decreases of $0.2 million due to slightly lower average balances outstanding were partially offset by increases related to our interest rate swaps of $3.9 million.

We discontinued one cash flow hedge in the fourth quarter due to the forecasted transaction no longer being probable as expected future levels of floorplan debt will decrease related to planned divestiture activity. Subsequently, the cash flow hedge was re-designated in the fourth quarter. Additionally, we discontinued two cash flow hedges in the fourth quarter. Changes in the market value of $0.5 million related to these swaps during the undesignated periods were recognized in earnings as a component of floorplan interest expense. The remaining increase of $3.4 million related to all other interest rate swaps activity, including ineffectiveness.

Floorplan interest expense decreased $0.8 million in 2007 compared to 2006. In 2006, we recorded a $1.9 million charge to floorplan interest expense related to our interest rate swaps. In 2007, we designated our interest rate swaps as cash flow hedging instruments and, accordingly, changes in the fair value of our interest rate swaps were recorded in Accumulated Other Comprehensive Income. We realized a decrease of $0.8 million as a result of a decrease in the average outstanding balances of our floorplan facilities. In addition, we realized a decrease of $0.6 million as a result of changes in the average interest rates on our floorplan facilities and an increase of $0.6 million related to our interest rate swaps.

Other Interest Expense

Other interest expense includes interest on our senior subordinated convertible notes, debt incurred related to acquisitions, real estate mortgages and our working capital, acquisition and used vehicle line of credit.

Other interest expense increased $1.4 million in 2008 compared to 2007. Changes in the average outstanding balances resulted in an increase of approximately $1.5 million and a reduction in the amount of capitalized interest in 2008 compared to 2007 resulted in a $1.5 million increase. These increases were partially offset by a $1.6 million decrease due to the weighted average interest rate on our debt. Interest expense related to our outstanding senior subordinated convertible notes (the “Notes”) that were issued in May 2004 totaled approximately $2.7 million in 2008 compared to $3.0 million in 2007. During 2008, we repurchased a total of $42.5 million face value of the Notes on the open market. Following our repurchases, interest expense on the Notes totals approximately $386,000 per quarter, which currently consists of $305,000 of contractual interest and $81,000 of amortization of debt issuance costs. The $5.2 million gain on the early retirement of debt is classified in other income, net on the statement of operations.

Other interest expense increased $3.9 million in 2007 compared to 2006. Changes in the average outstanding balances resulted in an increase of approximately $6.9 million. A decrease in the weighted average interest rate on our debt resulted in a $1.3 million decrease in other interest expense and an increase in the amount of capitalized interest in 2007 compared to 2006 resulted in a $1.7 million decrease.

Capitalized interest on construction projects totaled $1.7 million, $3.2 million and $1.5 million, respectively, in 2008, 2007 and 2006.

 

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Other Income, net

Other income, net of $6.7 million in 2008 includes a $5.2 million gain on the early retirement of $42.5 million face value of our Notes. Additionally, a gain of approximately $1.0 million is related to the result of a binding arbitration that was completed in 2008.

Income Tax Expense

Our effective tax rate was (31.5%) in 2008, 40.3% in 2007 and 38.5% in 2006. Our federal income tax rate is 35% and our state income tax rate is currently 3.0%, which varies with the mix of states where our stores are located. We also have certain non-deductible expenses and other adjustments that impact our effective rate. In 2008, a large permanent item related to the impairment of goodwill associated with a prior corporate acquisition reduced the rate. In 2007, the effect of non-deductible expenses was magnified by a decline in income due to the slower sales environment.

Pro Forma Reconciliations

Due to the significant non-cash impairment charges and the gain on early debt retirement recorded in 2008, we are providing our results of operations excluding these items. We believe that each of the non-GAAP financial measures provided improves the transparency of our disclosure, provides a meaningful presentation of our results from core business operations excluding the impact of items not related to our ongoing core business operations, and improves the period-to-period comparability of our results from core business operations.

The following tables reconcile reported GAAP results per the statement of operations to non-GAAP results (in thousands):

 

Unaudited – Before Tax    Year Ended December 31,
     2008     2007     2006

Income (loss) from continuing operations before income taxes – as reported

   $ (290,851 )   $ 40,927     $ 56,089

Goodwill and other asset impairments

     301,000       —         —  

Gain on early retirement of debt

     (5,248 )     —         —  
                      

Pretax income from continuing operations – non GAAP

   $ 4,901     $ 40,927     $ 56,089
                      

Income (loss) from discontinued operations before income taxes – as reported

   $ (85,435 )   $ (3,295 )   $ 4,627

Goodwill and other asset impairments

     70,063       5,923       911
                      

Pretax income (loss) from discontinued operations – non GAAP

   $ (15,372 )   $ 2,628     $ 5,538
                      

Pretax income (loss) – as reported

   $ (376,286 )   $ 37,632     $ 60,716

Goodwill and other asset impairments

     371,063       5,923       911

Gain on early retirement of debt

     (5,248 )     —         —  
                      

Pretax income (loss) – non GAAP

   $ (10,471 )   $ 43,555     $ 61,627
                      

 

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Unaudited – After Tax    Year Ended December 31,
     2008     2007     2006

Income (loss) from continuing operations – as reported

   $ (199,148 )   $ 24,442     $ 34,492

Goodwill and other asset impairment, net of tax

     204,752       —         —  

Gain on early retirement of debt, net of tax

     (2,568 )     —         —  
                      

Income from continuing operations – non GAAP

   $ 3,036     $ 24,442     $ 34,492
                      

Income (loss) from discontinued operations, net of tax – as reported

   $ (53,438 )   $ (2,893 )   $ 2,812

Goodwill and other asset impairment, net of tax

     43,540       4,719       554
                      

Income (loss) from discontinued operations – non GAAP

   $ (9,898 )   $ 1,826     $ 3,366
                      

Net income (loss) – as reported

   $ (252,586 )   $ 21,549     $ 37,304

Goodwill and other asset impairment, net of tax

     248,292       4,719       554

Gain on early retirement of debt, net of tax

     (2,568 )     —         —  
                      

Net income (loss) – non GAAP

   $ (6,862 )   $ 26,268     $ 37,858
                      

The following table reconciles reported GAAP diluted earnings (loss) per share (“EPS”) to non-GAAP diluted EPS:

 

Unaudited – EPS    Year Ended December 31,
     2008     2007     2006

Income (loss) per diluted share from continuing operations – as reported

   $ (9.95 )   $ 1.19     $ 1.65

Goodwill and other asset impairment, net of tax

     10.23       —         —  

Gain on early retirement of debt, net of tax

     (0.13 )     —         —  
                      

Income (loss) per diluted share from continuing operations – non GAAP

   $ 0.15     $ 1.19     $ 1.65
                      

Income (loss) per diluted share from discontinued operations – as reported

   $ (2.67 )   $ (0.13 )   $ 0.13

Goodwill and other asset impairment, net of tax

     2.18       0.21       0.02
                      

Income (loss) per diluted share from discontinued operations – non GAAP

   $ (0.49 )   $ 0.08     $ 0.15
                      

Net income (loss) per diluted share as reported

   $ (12.62 )   $ 1.06     $ 1.78

Goodwill and other asset impairment, net of tax

     12.41       0.21       0.02

Gain on early retirement of debt, net of tax

     (0.13 )     —         —  
                      

Net income (loss) per diluted share – non GAAP

   $ (0.34 )   $ 1.27     $ 1.80
                      

Discontinued Operations

We perform an internal evaluation of our store performance, on a store-by-store basis, in the last month of each quarter. If a particular location does not meet certain return on investment criteria established by our management team, the location is targeted for potential disposition. If a store that has been identified for potential disposition does not improve its operations for an extended period of time, the decision is made to divest the location. Additional factors we consider that may result in the disposition of a location include capital commitment requirements, our estimate of local market and franchise outlook, and the geographic location of certain stores.

When the decision is made to dispose of a location, we evaluate the store to ensure that it meets the criteria to be classified as “held for sale,” as defined by paragraph 30 of SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” This evaluation includes the following considerations:

 

   

Our executive management group, possessing the necessary authority, commits to a plan to dispose the store.

 

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The store is available for immediate sale in its present condition. The sale is subject only to terms that are usual and customary.

 

   

We initiate an active program to locate buyers and take other actions that are required to sell the store.

 

   

We believe there is a market for the store and that its disposal is likely. We also expect to record the transfer of the store as a completed sale within one year.

 

   

We actively market the store for sale at a price that is reasonable in relation to current estimated fair value.

 

   

We believe it is unlikely management will make significant changes to the plan or withdraw the plan. We have not, to date, withdrawn any plan related to the disposal of store locations.

When a store has been classified as held for sale for a period exceeding one year, we evaluate whether we continue to meet the criteria of SFAS No. 144, which states that we must evaluate whether we (1) initiated actions necessary to respond to the poor market conditions during the initial one-year period, (2) continue to actively market the asset at a price that is reasonable in view of market conditions, and (3) continue to meet all of the other criteria in paragraph 30 for classifying the asset as held for sale.

In the second quarter of 2008, we had three stores classified as held for sale for a period exceeding one year. Additionally, as part of the restructuring plan announced on June 3, 2008, we performed an evaluation of our portfolio of stores, resulting in 12 underperforming stores, mostly consisting of domestic franchises, being selected for disposal. We also elected to close a facility at that time. Given these facts, we evaluated whether the classification of all stores as held for sale and presented in discontinued operations was appropriate under SFAS No. 144.

The three stores identified above represented some of the worst-performing locations in our portfolio. Their poor performance, coupled with the increasingly negative environment for automotive retailing, necessitated a longer period to complete the sale of these locations. Over the initial one-year period, we had entered into multiple preliminary asset sales agreements, confirming that prospective buyers were interested in these locations. Over the period these stores were available for sale, we continued to lower the price of the three dealerships. We recorded additional impairment charges to recognize the assets at estimated fair value based on the outlook for potential sale proceeds. We believe our response to the declining economic factors, diminishing sources of credit with financially viable terms, and overall uncertainty surrounding the future demonstrated that we took:

 

   

actions necessary to respond to a change in circumstances; and

 

   

that the assets were and continue to be actively marketed at a reasonable price given the continuing changes in circumstances.

Finally, for these three locations, we evaluated the six criteria in paragraph 30 of SFAS No. 144 and concluded that we continued to meet the required criteria. We determined that the 13 stores targeted for disposal as a result of our restructuring plan also met the criteria of paragraph 30 of SFAS No. 144. Therefore, we believe that the stores’ classification in discontinued operations is appropriate.

In addition, during the third quarter of 2008, 15 additional stores were classified as discontinued operations for a total of 28 stores in 2008. Given the significant number of stores classified as held for sale, and the fact that the sale of certain stores was not prompt, we considered additional factors prior to classifying the additional 15 stores as discontinued operations including:

 

   

the inherent difficulty in selling three of the worst-performing stores in our portfolio, and the fact that the other stores targeted for disposal in 2008 would be more desirable to potential buyers. For example, we closed on the sale of two locations in the third quarter of 2008 that were initially classified as held for sale in the second quarter of 2008;

 

   

that one of the locations classified as held for sale for a period exceeding one year had been sold in the third quarter of 2008, and another location had been closed;

 

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that three stores classified as held for sale in the second quarter of 2008 were under preliminary contract to be sold; and

 

   

that 9 of the 15 stores classified in the third quarter of 2008 have been sold or were under preliminary contract to be sold.

Therefore, we believe that a market continues to exist for the stores we have targeted for disposal, and that we met the other criteria outlined by paragraph 30 of SFAS 144. As of December 31, 2008, we have one store that has been classified as held for sale for a period exceeding one year. We believe that this store’s continued classification in discontinued operations is appropriate.

We disposed of nine stores and closed four stores classified within discontinued operations during 2008. As of December 31, 2008, 18 stores were classified as held for sale. We disposed of three additional stores classified within discontinued operations in the first quarter of 2009 through the date of the filing of this Form 10-K. See Notes 19 and 21 of Notes to Consolidated Financial Statements for additional information.

Selected Consolidated Quarterly Financial Data

The following tables set forth our unaudited quarterly financial data(1).

 

     Three Months Ended,  

2008 (in thousands, except per share data )

   March 31     June 30     September 30     December 31  

Revenues:

        

New vehicle sales

   $ 318,817     $ 339,212     $ 309,447     $ 205,331  

Used vehicle sales

     157,323       151,992       154,129       110,929  

Finance and insurance

     21,876       21,936       21,130       14,028  

Service, body and parts

     78,433       76,074       77,586       74,650  

Fleet and other

     930       1,459       867       1,655  
                                

Total revenues

     577,379       590,673       563,159       406,593  

Cost of sales

     478,812       491,363       468,844       328,741  
                                

Gross profit

     98,567       99,310       94,315       77,852  

Goodwill impairment

     —         272,503       —         —    

Other asset impairments

     —         23,402       —         —    

Selling, general and administrative

     83,746       85,173       78,152       69,112  

Depreciation and amortization

     4,569       4,526       4,358       4,279  
                                

Operating income (loss)

     10,252       (286,294 )     11,805       4,461  

Floorplan interest expense

     (5,134 )     (5,100 )     (4,637 )     (5,527 )

Other interest expense

     (4,470 )     (4,515 )     (4,318 )     (4,047 )

Other, net

     64       1,076       1,890       3,643  
                                

Income (loss) from continuing operations before income taxes

     712       (294,833 )     4,740       (1,470 )

Income tax (provision) benefit

     (404 )     93,094       (2,038 )     1,051  
                                

Income (loss) before discontinued operations

     308       (201,739 )     2,702       (419 )

Discontinued operations, net of tax

     (2,469 )     (42,045 )     (5,065 )     (3,859 )
                                

Net income (loss)

   $ (2,161 )   $ (243,784 )   $ (2,363 )   $ (4,278 )
                                

Basic income (loss) per share from continuing operations

   $ 0.02     $ (10.15 )   $ 0.13     $ (0.02 )

Basic loss per share from discontinued operations

     (0.13 )     (2.12 )     (0.25 )     (0.19 )
                                

Basic net income (loss) per share

   $ (0.11 )   $ (12.27 )   $ (0.12 )   $ (0.21 )
                                

Diluted income (loss) per share from continuing operations

   $ 0.02     $ (10.15 )   $ 0.13     $ (0.02 )

Diluted loss per share from discontinued operations

     (0.13 )     (2.12 )     (0.25 )     (0.19 )
                                

Diluted net income (loss) per share

   $ (0.11 )   $ (12.27 )   $ (0.12 )   $ (0.21 )
                                

 

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     Three Months Ended,  

2007 (in thousands, except per share data )

   March 31     June 30     September 30     December 31  

Revenues:

        

New vehicle sales

   $ 357,943     $ 426,890     $ 408,084     $ 335,329  

Used vehicle sales

     169,179       190,896       184,257       142,396  

Finance and insurance

     24,635       27,612       27,435       20,045  

Service, body and parts

     73,591       76,657       77,990       76,064  

Fleet and other

     670       1,269       2,326       1,014  
                                

Total revenues

     626,018       723,324       700,092       574,848  

Cost of sales

     516,083       601,353       580,994       479,063  
                                

Gross profit

     109,935       121,971       119,098       95,785  

Selling, general and administrative

     87,684       91,700       87,726       82,173  

Depreciation and amortization

     3,818       4,134       4,271       4,639  
                                

Operating income

     18,433       26,137       27,101       8,973  

Floorplan interest expense

     (5,797 )     (6,635 )     (6,503 )     (5,438 )

Other interest expense

     (3,808 )     (4,061 )     (3,851 )     (4,265 )

Other, net

     178       76       108       279  
                                

Income (loss) from continuing operations before income taxes

     9,006       15,517       16,855       (451 )

Income tax (provision) benefit

     (3,539 )     (6,161 )     (6,827 )     42  
                                

Income (loss) before discontinued operations

     5,467       9,356       10,028       (409 )

Discontinued operations, net of tax

     1,608       (1,413 )     1,209       (4,297 )
                                

Net income (loss)

   $ 7,075     $ 7,943     $ 11,237     $ (4,706 )
                                

Basic income (loss) per share from continuing operations

   $ 0.28     $ 0.48     $ 0.51     $ (0.02 )

Basic income (loss) per share from discontinued operations

     0.08       (0.07 )     0.07       (0.22 )
                                

Basic net income (loss) per share

   $ 0.36     $ 0.41     $ 0.58     $ (0.24 )
                                

Diluted income (loss) per share from continuing operations

   $ 0.27     $ 0.44     $ 0.48     $ (0.02 )

Diluted income (loss) per share from discontinued operations

     0.07       (0.06 )     0.05       (0.22 )
                                

Diluted net income (loss) per share

   $ 0.34     $ 0.38     $ 0.53     $ (0.24 )
                                

 

(1) Quarterly data may not add to yearly totals due to rounding.

Seasonality and Quarterly Fluctuations

Historically, our sales have been lower in the first and fourth quarters of each year due to consumer purchasing patterns during the holiday season, inclement weather in certain of our markets and the reduced number of business days during the holiday season. As a result, financial performance is expected to be lower during the first and fourth quarters than during the second and third quarters of each fiscal year. We believe that interest rates, levels of consumer debt, consumer confidence and manufacturer sales incentives, as well as general economic conditions, also contribute to fluctuations in sales and operating results. Acquisitions had also been a contributor to fluctuations in our operating results from quarter to quarter.

However, in 2008, primarily as a result of economic conditions previously described, these historical trends have not continued. The seasonal improvement typically experienced in the second and third quarters of 2008 did not occur, as sales levels remained relatively flat compared with levels experienced in the fourth quarter of 2007 and the first quarter of 2008. We also experienced a decline in sales levels in the fourth quarter of 2008 from the flat levels experienced in the first three quarters of 2008. We believe this to be the result of a combination of both seasonal trends and overall macroeconomic issues, and uncertainty remains as to the impact of both of these factors in the future.

Liquidity and Capital Resources

GMAC Reclassification

On November 30, 2006, General Motors (“GM”) completed the sale of a majority equity stake in GMAC to an investment consortium. Although GMAC continues to be the exclusive provider of GM financial products and services and continues to have the relationships with GM, GM has indicated in its public filings that it no

 

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longer controls the GMAC entity. As a result, we treat the financing of new vehicles by GMAC after the change in ownership control as a financing activity.

Repayments of floorplan debt on vehicles financed prior to this change in control continue to be classified as an operating activity, which reduced cash flows from operating activities by $85.6 million in 2007 and $25.1 million in 2006. The effect in 2008 was immaterial. On a non-GAAP basis, the elimination of the effect of the change in control would have increased cash flows from operations and decreased cash flows from financing activities as follows (in thousands):

 

     Year Ended December 31,  
     2007     2006  

Net cash provided by (used in) operating activities as reported

   $ (49,211 )   $ 37,939  

Effect of GMAC reclassification

     85,576       25,061  
                

Net cash provided by operating activities, non-GAAP

   $ 36,365     $ 63,000  
                

Net cash provided by financing activities as reported

   $ 124,908     $ 114,872  

Effect of GMAC reclassification

     (85,576 )     (25,061 )
                

Net cash used by financing activities, non-GAAP

   $ 39,332     $ 89,911  
                

We believe the reader should consider this factor when reviewing our statement of cash flows and related cash flows from operating activities. Each of the foregoing non-GAAP financial measures improves the transparency of our disclosure, provides a meaningful presentation of our results from core business operations excluding the impact of items not related to our ongoing core business operations, and improves the period-to-period comparability of our results from core business operations. We do not anticipate this condition to occur in future periods, as floorplan financing does not typically change classification categories in the statement of cash flows.

Principal Needs

Our principal needs for liquidity and capital resources are for capital expenditures, working capital and debt repayment. Historically, we have also used capital resources to fund our cash dividend payment and for acquisitions. We intend to utilize capital resources in the future to pay a dividend and to acquire locations as part of our long-term growth strategy.

We have relied primarily upon internally generated cash flows from operations, borrowings under our credit agreements, financing of real estate and the proceeds from public equity and private debt offerings to finance operations and expansion. During 2008, we generated $151 million through the sale of assets and stores and the issuance of long-term debt. We believe the continued execution of our restructuring plan will result in available cash, cash equivalents, available lines of credit, planned asset sales and cash flows from operations that will be sufficient to meet our anticipated operating expenses, debt maturities and capital requirements for at least the next 12 months from December 31, 2008. However, no assurances can be provided that our restructuring plan and our cash flows from operations will be sufficient to meet our anticipated needs.

At December 31, 2008, we had sufficient availability utilizing both unadvanced floorplan financing and our Credit Facility to refinance our remaining $42.5 million of outstanding 2.875% Notes which can be put to us in May 2009 at the option of the holders, and to accommodate our long-term growth strategy.

At December 31, 2008, we also had 18 stores held for sale, for which we estimate net proceeds upon sale to be approximately $54.4 million. We disposed of three of these stores in the first quarter of 2009 through the date of the filing of this Form 10-K, generating net proceeds of $3.5 million.

In addition to the above sources of capital, potential sources of additional liquidity include the placement of subordinated debentures or loans, additional store sales or additional other asset sales. We will evaluate all of these options and select one or more of them depending on overall capital needs and the availability and

 

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cost of capital, although no assurances can be provided that these capital sources will be available to us in sufficient amounts or with terms acceptable to us.

Summary of Outstanding Balances on Credit Facilities

Interest rates on all of our credit facilities below, excluding the effects of our interest rate swaps, ranged from 1.59% to 4.75% at December 31, 2008. Amounts outstanding on the lines at December 31, 2008, together with amounts remaining available under such lines were as follows (in thousands):

 

     Outstanding at
December 31,
2008
   Maximum Availability
at December 31,

2008
 

New and program vehicle lines

   $ 337,700    $ —   (1)

Working capital, acquisition and used vehicle credit facility

     86,000      34,747 (2)(3)
               
   $ 423,700    $ 34,747  
               

 

(1) There are no formal limits on the new and program vehicle lines with certain lenders.

 

(2) Reduced by $349 for outstanding letters of credit.

 

(3) The amount available on the line is limited based on a borrowing base calculation and fluctuates monthly.

Inventories and Flooring Notes Payable

We maintained a disciplined inventory approach throughout 2008. As a result of the challenging economic environment, during the second quarter of 2008, we repriced our entire inventory to reflect current demand and pricing in an effort to move older and less popular vehicles. Our days supply of new vehicles at December 31, 2008 was 36 days above our five-year average historical days supply and 45 days above our December 31, 2007 levels. This resulted from the dramatic drop in retail sales in the fourth quarter of 2008. We continue to reduce new inventories by ordering less vehicles in order to sell through the inventory on hand. We reduced our days supply of new vehicles by 25 days between December 31, 2008 and February 28, 2009.

Given the disruptions in the credit markets, captive finance companies have experienced increases in capital cost and decreases in availability of funds. We have not experienced any disruption in our inventory flooring arrangements. Rates have gone up by 50 to 100 basis points, with certain lending restrictions on aged inventories. No assurances can be given that we will not experience disruptions in available credit for new vehicle inventories in the future.

Our days supply of used vehicles was 9 days above our historical December 31 balances at December 31, 2008. Primarily as a result of our used vehicle repricing strategy, we reduced our days supply of used vehicles by 4 days between June 30, 2008 and December 31, 2008. We reduced our days supply of used vehicles by 15 days between December 31, 2008 and February 28, 2009. We continue to work to respond to changes in consumer demand in order to bring our used vehicle inventory in line with historical levels.

While our days supply of new and used vehicles is up, inventories are down in absolute dollars. In connection with the decreased inventories, our new vehicle flooring notes payable decreased to $337.7 million at December 31, 2008 from $451.6 million at December 31, 2007. New vehicles are financed at approximately 100% of invoice cost.

Working Capital, Acquisition and Used Vehicle Credit Facility

We have a working capital, acquisition and used vehicle credit facility (the “Credit Facility”) with U.S. Bank National Association, DaimlerChrysler Financial Services Americas LLC (“Chrysler Financial”), DCFS U.S.A. LLC (“Mercedes Financial”) and Toyota Motor Credit Corporation (“TMCC”).

In August 2008, we amended the Credit Facility, effective as of June 30, 2008. This amendment reduced our minimum net worth ratio and lowered our required covenant performance ratios through the second quarter of 2009, to allow us to operate more effectively in the current economic environment. Beginning in the third quarter of 2009, the covenant performance ratio requirements increase on a quarterly basis so that by the fourth quarter of 2009, they will return to the levels mandated in the original agreement.

 

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Due to the slowing of our acquisition plans, and in an effort to reduce the fees associated with unutilized credit, the total amount available on the line was reduced from $300 million to $150 million in connection with the fourth amendment. As part of the fourth amendment, we received approval to dispose of approximately $150 million in assets, including assets currently held for sale. The schedule of assets approved for disposal was updated in a fifth amendment to the Credit Facility in December 2008.

In addition, under the fourth amendment, cash dividends were limited to $0.05 per share in the third quarter of 2008 and are permitted, based on a formula, beyond that quarter. Although we suspended our dividend based on fourth quarter results, we would not have been allowed to pay it under the formula stipulated by the agreement. Repurchases by us of our common stock are not permitted without the prior approval of our lenders. The interest rate on the agreement increased, which resulted in additional expense of approximately $0.5 million, or $0.03 per share, in 2008. We were assessed a $0.2 million change fee on the amendment and the maturity date was revised to April 30, 2010. We believe the Credit Facility continues to be an attractive source of financing given the current cost and availability of credit alternatives.

Loans are guaranteed by all of our subsidiaries and are secured by new vehicle inventory, used vehicle and parts inventory, equipment other than fixtures, deposit accounts, accounts receivable, investment property and other intangible personal property. Capital stock and other equity interests of our subsidiary stores and certain other subsidiaries are excluded. The lenders’ security interest in new vehicle inventory is subordinated to the interests of floorplan financing lenders, including Chrysler Financial, Mercedes Financial and TMCC. The agreement for this facility provides for events of default that include nonpayment, breach of covenants, a change of control and certain cross-defaults with other indebtedness. In the event of a default, the agreement provides that the lenders may declare the entire principal balance immediately due, foreclose on collateral and increase the applicable interest rate to the revolving loan rate plus 3 percent, among other remedies.

New Vehicle Flooring

Chrysler Financial, Mercedes Financial, TMCC, Ford Motor Credit Company, GMAC LLC, VW Credit, Inc., American Honda Finance Corporation and BMW Financial Services NA, LLC have agreed to floor new vehicles for their respective brands. Chrysler Financial and TMCC serve as the primary lenders for all other brands. The new vehicle lines are secured by new vehicle inventory of the stores financed by that lender. Vehicles financed by lenders not directly associated with the manufacturer are classified as floorplan notes payable: non-trade and are included as a financing activity in our statements of cash flows. Vehicles financed by lenders directly associated with the manufacturer are classified as floorplan notes payable and are included as an operating activity.

Debt Covenants

We are subject to certain financial and restrictive covenants for all of our debt agreements. The Credit Facility agreement includes financial and restrictive covenants typical of such agreements including requirements to maintain a minimum total net worth, minimum current ratio, fixed charge coverage ratio and cash flow leverage ratio. The covenants restrict us from incurring additional indebtedness, making investments, selling or acquiring assets and granting security interests in our assets.

We utilize an internal forecast to project compliance with our covenants. Top line revenue numbers were significantly worse than our internal forecast had anticipated for the second half of 2008. Despite this negative development, we were able to improve our vehicle margins and reduce our SG&A and other costs in-line with these changes. As a result, our overall attainment to forecasted results was near expectation. We believe our 2009 forecast utilizes assumptions that are conservative.

The fourth amendment to our Credit Facility stipulates a minimum net worth of not less than $245 million, with an additional reduction of up to $30 million related to any intangible asset impairment charges. This net worth covenant is adjusted up by 75% of any net income amounts, and is not adjusted down based on net

 

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loss amounts. Our fixed charge coverage ratio cannot be less than 1.0:1, and our cash flow leverage ratio cannot be more than 3.0 to 1. Our minimum current ratio cannot be less than 1.2:1.

As of December 31, 2008, our minimum net worth was approximately $248.3 million, our fixed charge coverage ratio was 1.10 to 1, our cash flow leverage ratio was 2.45 to 1 and our minimum current ratio was 1.25 to 1. Based on this data, we were in compliance with the four financial covenants set forth in our Credit Facility.

Based on our most recent forecast for 2009, we have identified the risk of non-compliance with our minimum current ratio covenant required by our Credit Facility in the quarterly measurement period ending June 30, 2009. In the second quarter of 2009, the Credit Facility will have a remaining term of less than one year and will therefore become classified as a current obligation on our consolidated balance sheet. We are in negotiations to amend certain terms and conditions of the Credit Facility, including the minimum current ratio covenant, to ensure prospective compliance. We believe we will be successful in obtaining the amendment. However, if we are unsuccessful in obtaining the amendment, we will commence a number of initiatives to create sufficient liquidity to pay down the required outstanding balance on the Credit Facility.

As previously disclosed, we have identified for sale a number of non-strategic properties and dealerships. Several dealerships are under executed sale agreements and are expected to close prior to June 30, 2009, subject to normal terms and conditions in the industry. In addition, we are in the process of financing, or refinancing, certain real properties with other third party lenders.

In the event sales of identified properties and dealerships and the financing of properties do not result in sufficient levels of proceeds, or do not occur within the time frame necessary to enable us to comply with our June 30, 2009 minimum current ratio covenant, we intend to accelerate and expand upon additional cost-cutting and cash generating initiatives currently being implemented. The acceleration and expansion of these initiatives is expected to provide additional liquidity in sufficient levels to repay all outstanding amounts on the Credit Facility by June 30, 2009 and to continue operations without further advances on the Credit Facility through at least December 31, 2009. These initiatives include reducing the days supply of inventories of used vehicles and parts, increasing the flooring and/or refinancing of program and employee operated vehicles, reduction of employee compensation, deferring certain capital expenditures and paying vendors and service providers pursuant to their maximum stipulated terms or on revised terms. However, no assurances can be provided that we will be successful in executing these plans, including obtaining an amendment to the Credit Facility, completing the sale of dealerships and non-strategic properties, financing or refinancing certain real properties, or achieving liquidity through other initiatives.

In the event that we are unable to meet the financial and restrictive covenants, we would enter into a discussion with the lenders to remediate the condition. If we were unable to remediate or cure the condition, a breach would give rise to certain remedies under the agreement, the most severe of which is the termination of the agreement and acceleration of the amounts owed.

2.875% Senior Subordinated Convertible Notes due 2014

Following our repurchases through the filing date of this Form 10-K, which totaled $42.5 million of face amount, as of March 16, 2009, we had outstanding $42.5 million of Notes due 2014. We will also pay contingent interest on the Notes during any six-month interest period beginning May 1, 2009, in which the trading price of the notes for a specified period of time equals or exceeds 120% of the principal amount of the notes. The notes are currently convertible into shares of our Class A common stock at a price of $36.09 per share upon the satisfaction of certain conditions and upon the occurrence of certain events as follows:

 

   

if, prior to May 1, 2009, and during any calendar quarter, the closing sale price of our common stock exceeds 120% of the conversion price for at least 20 trading days in the 30 consecutive trading days ending on the last trading day of the preceding calendar quarter;

 

   

if, after May 1, 2009, the closing sale price of our common stock exceeds 120% of the conversion price;

 

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if, during the five business day period after any five consecutive trading day period in which the trading price per $1,000 principal amount of notes for each day of such period was less than 98% of the product of the closing sale price of our common stock and the number of shares issuable upon conversion of $1,000 principal amount of the notes;

 

   

if the notes have been called for redemption; or

 

   

upon certain specified corporate events.

A declaration and payment of a dividend in excess of $0.08 per share per quarter will result in additional adjustments in the conversion rate for the notes if such cumulative adjustment exceeds 1% of the current conversion rate. The January and July 2008 dividends resulted in changes in the current conversion rate per $1,000 of notes, which is currently 27.7098.

The notes are redeemable at our option beginning May 6, 2009 at the redemption price of 100% of the principal amount plus any accrued interest. The holders of the notes can require us to repurchase all or some of the notes on May 1, 2009 and upon certain events constituting a fundamental change or a termination of trading. A fundamental change is any transaction or event in which all or substantially all of our common stock is exchanged for, converted into, acquired for, or constitutes solely the right to receive, consideration that is not all, or substantially all, common stock that is listed on, or immediately after the transaction or event, will be listed on, a United States national securities exchange. A termination of trading will have occurred if our common stock is not listed for trading on a national securities exchange or the Nasdaq National Market.

The following table summarizes our repurchases to date, all of which were made on the open market:

 

Purchase

Date

   Face Amount
Purchased
   Purchase
Price
per $100
   Total Purchase
Price
   Gain on Early
Retirement of
Debt

August 2008

   $ 16.0 million    $ 89.0    $  14.4 million    $  1.6 million

October 2008

     17.4 million    $ 86.5      15.1 million      2.2 million

October 2008

     4.6 million    $ 81.0      3.7 million      0.9 million

December 2008

     4.5 million    $ 89.0      4.0 million      0.5 million
                       
   $ 42.5 million       $ 37.2 million    $ 5.2 million
                       

The gain of $5.2 million on the early retirement of the debt through December 31, 2008, is recorded as a component of other income, net on the consolidated statement of operations.

Share Repurchase and Dividends

Our Board of Directors declared dividends of $0.14 per share on our Class A and Class B common stock, which were paid in January 2008, April 2008 and July 2008 and totaled approximately $2.8 million each payment period. In addition, our Board of Directors declared a dividend of $0.05 per share on our Class A and Class B common stock related to third quarter 2008, which totaled $1.0 million and was paid on October 29, 2008. Management evaluates performance and makes a recommendation on dividend payments on a quarterly basis. Pursuant to our amended credit facility, cash dividends were limited to $0.05 per share in the third quarter of 2008 and are allowed, based on a formula, beyond that quarter. Based on our fourth quarter results and the broader economy, we suspended our dividend for the quarter. However, a dividend would not have been allowed pursuant to our Credit Facility.

In June 2000, our Board of Directors authorized the repurchase of up to 1,000,000 shares of our Class A common stock. Through December 31, 2008, we have purchased a total of 479,731 shares under this program, none of which were purchased during 2008. The fourth amendment to the credit facility requires lender approval prior to any share repurchases. We may continue to repurchase shares from time to time in the future if permitted by our credit facilities and as conditions warrant. Current tax law tends to equalize the benefits of dividends and share repurchases as a means to return capital or earnings to shareholders

 

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Contractual Payment Obligations

A summary of our contractual commitments and obligations as of December 31, 2008 was as follows (in thousands):

 

     Payments Due By Period

Contractual Obligation

   Total    2009    2010 and
2011
   2012 and
2013
   2014 and
beyond

Floorplan Notes

   $ 337,700    $ 337,700    $ —      $ —      $ —  

Lines of Credit and Long-Term Debt

     343,818      78,634      125,211      52,652      87,321

Interest on Scheduled Debt Payments

     66,414      11,658      18,560      13,918      22,278

Fixed Rate Payments on Interest Rate Swaps

     23,097      4,592      8,655      6,424      3,426

Estimated Chargebacks on Contracts

     13,497      8,059      4,936      489      13

Capital Commitments

     14,603      14,603      —        —        —  

Operating Leases

     174,879      21,567      33,780      26,065      93,467
                                  
   $ 974,008    $ 476,813    $ 191,142    $ 99,548    $ 206,505
                                  

We had capital commitments of $14.6 million at December 31, 2008 for the construction of two new facilities, both of which are replacing existing facilities. We already incurred $29.2 million for these projects and anticipate incurring the remaining $14.6 million in 2009. In the second quarter of 2008, we terminated approximately $60 million of non-essential construction projects and placed other pending capital investments on hold. As a result of these actions, we recorded an expense of approximately $4.5 million, of which $3.0 million was related to invoiced expenditures and $1.5 million was related to capitalized interest incurred on the expenditures and associated land.

We expect to pay for the construction out of existing cash balances, construction financing and borrowings on our line of credit. Upon completion of the projects, we anticipate securing long-term financing and general borrowings from third party lenders for 70% to 90% of the amounts expended, although no assurances can be provided that these financings will be available to us in sufficient amounts or with terms acceptable to us.

We anticipate approximately $16 million in non-financeable capital expenditures in the next one to three years for various new facilities and other construction projects currently under consideration. Non-financeable capital expenditures are defined as minor upgrades to existing facilities, minor leasehold improvements, the percentage of major construction typically not financed by commercial mortgage debt, and purchases of furniture and equipment. We will continue to evaluate the advisability of the expenditures given the current weak economic environment, and anticipate a prudent approach to future capital commitments.

Critical Accounting Policies and Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make certain estimates, judgments and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities and reported amounts of revenues and expenses at the date of the financial statements. Some of our accounting policies require us to make difficult and subjective judgments on matters that are inherently uncertain. The following accounting policies involve critical accounting estimates because they are particularly dependent on assumptions made by management. While we have made our best estimates based on facts and circumstances available to us at the time, different estimates could have been used in the current period. Changes in the accounting estimates we used are reasonably likely to occur from period to period, which may have a material impact on the presentation of our financial condition and results of operations.

 

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Our most critical accounting estimates include assessment of recoverability of our deferred tax asset, indefinite-lived intangible assets, recoverability of long-lived assets, estimates of expected proceeds on assets held for sale, service contract and lifetime oil contract income recognition and workers’ compensation insurance premium accrual. We also have other key accounting policies, such as our policies for valuation of accounts receivable, expense accruals and revenue recognition. However, these policies either do not meet the definition of critical accounting estimates described above or are not currently material items in our financial statements. We review our estimates, judgments and assumptions periodically and reflect the effects of revisions in the period that they are deemed to be necessary. We believe that these estimates are reasonable. However, actual results could differ from these estimates.

 

Nature of Critical

Estimate Item

  

Assumptions/

Approach Used

  

Effect of a Change in

Assumptions

Deferred Tax Asset      

Due to impairment of goodwill and franchise value, we are in a position where our future tax deductible amounts exceed our future tax payable amounts.

 

As of December 31, 2008, we have a net deferred tax asset of approximately $46.5 million.

  

Pursuant to SFAS No. 109, “Accounting for Income Taxes,” we considered whether it is more likely than not that some portion or all of the deferred tax assets will not be realized.

 

The ultimate realization of deferred tax assets is dependent upon future taxable income during the periods in which those temporary differences become deductible. We consider the scheduled reversal of deferred tax liabilities (including the impact of available carryback and carryforward periods), projected future taxable income, and tax-planning strategies in making this assessment.

 

Based upon the level of historical taxable income, projections for future taxable income over the periods in which the deferred tax assets are deductible, and available tax-planning strategies, we believe it is more likely than not that we will realize the benefits of these deductible differences.

 

At December 31, 2008, we have not recorded any valuation allowance on deferred tax assets. However, a valuation allowance could be recorded in the future if estimates of taxable income during the carryforward period are reduced.

  

If we are unable to meet the projected operational results utilized in our analysis, and depending on the nature of our operations as compared to available tax planning strategies, we might record a valuation allowance on a portion or all of our deferred tax asset.

 

In the event that the domestic manufacturers are unable to remain solvent, our operations may be impacted and we might record a valuation allowance on a portion or all of the deferred tax asset.

 

In the event that we are forced to file for bankruptcy protection, we would be forced to record a valuation allowance on all of the deferred tax asset.

 

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Nature of Critical

Estimate Item

  

Assumptions/

Approach Used

  

Effect of a Change in

Assumptions

Indefinite-lived

Intangible Assets

     

We have determined that our franchise agreements with various manufacturers represent the most significant portion of intangible assets without a definite life.

 

We review our indefinite-lived intangible assets at least annually by applying a fair-value based test using the APV method to indicate fair value. During 2008, we reviewed our indefinite-lived intangible assets in the second quarter of 2008, as discussed above. We also reviewed our indefinite-lived intangible assets at the end of the fourth quarter of 2008.

 

Additionally, we stipulate a period of time prior to testing assets that have been recently acquired in order to allow them to be integrated into our operations. As we have not recently acquired any stand-alone locations, no assets were excluded from testing in 2008.

  

Future cash flows are based on recently prepared forecasts and business plans to estimate the future economic benefits that the store will generate. We estimate the appropriate discount rate to convert the future economic benefits to their present value equivalent.

 

We have determined that only certain cash flows of the store are attributable to the Franchise Value.

 

According to Emerging Issues Task Force (“EITF”) 02-7, “Unit of Accounting for Testing Impairment of Indefinite-Lived Intangible Assets,” we have concluded that the appropriate unit of accounting for determining franchise value is on an individual store basis.

 

Growth rates are calculated for five years based on management’s forecasted sales projections. The growth rates used for periods beyond five years are calculated based on the U.S. Department of Labor, Bureau of Labor Statistics for historical consumer

price index data.

 

The discount rate applied to the future cash flows is derived from an APV Model which factors in an equity risk premium, small stock risk premium, a beta and a risk free rate.

 

We also evaluate each franchise based on Management’s judgment and have recorded impairments on certain domestic locations based on this evaluation.

 

During 2008, we recorded impairments to franchises, which totaled $16.4 million as a component of continuing operations and $5.7 million as a component of discontinued operations. There were no impairments to franchises as a component of continuing operations in 2007 or 2006. At December 31, 2008 and 2007, other indefinite-lived intangible assets were $42.0 million and $68.9 million, respectively.

  

A future decline in store performance, change in projected growth rates, other margin assumptions and changes in interest rates could result in a potential impairment of one or more of our franchises.

 

In the event that the domestic manufacturers are unable to remain solvent, we may record a partial or total impairment on the remaining franchise value. As of December 31, 2008, we had domestic franchise value totaling $19.1 million.

 

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Nature of Critical

Estimate Item

  

Assumptions/

Approach Used

  

Effect of a Change in

Assumptions

Long Lived Assets Held

and Used

     

We review our long-lived assets held and used at least annually by calculating the projected undiscounted cash flows the assets are projected to generate over the life of the major asset within the group.

 

During 2008, we reviewed our long-lived assets held and used in the second quarter of 2008, as discussed above. We also reviewed our long-lived assets held and used at the end of the fourth quarter of 2008.

  

We evaluate the current and prior two years operating results. If a store has an operating loss in the current year and one of the prior two, it is evaluated for impairment. Additionally, certain locations near breakeven are also included in the evaluation based on Management judgment.

 

We calculate the projected undiscounted cash flows for each asset group based on internally developed forecasts incorporating historical results for prior periods.

 

If the undiscounted cash flows do not exceed the carrying value of the asset, we obtain market data to determine the fair value of the asset group.

 

If the fair value of the asset is lower than the carrying value, an impairment is indicated.

 

We recorded impairment charges of $5.5 million in 2008 as a component of continuing operations where fair value was less than carrying value.

  

A future decline in store performance, change in projected growth rates, and other margin assumptions could result in a potential impairment of long-lived asset groups.

 

In the event that the domestic manufacturers are unable to remain solvent, we may record an impairment charge on the long-lived assets associated with the franchise.

 

Currently, 45.3% of our long-lived assets are associated with domestic franchises and 54.7% of our long-lived assets are associated with corporate operations or import / luxury locations.

 

A continued decline in the commercial real estate market could result in a potential impairment of certain investment properties not currently used in operations.

 

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Nature of Critical

Estimate Item

  

Assumptions/

Approach Used

  

Effect of a Change in

Assumptions

Assets Held for Sale

     

Under the requirements of SFAS 144, when assets are classified as held for sale, an estimate of the proceeds that will be received is used to determine the amount of impairment to be recorded, if any.

 

During 2008, we classified approximately 25% of our locations as held for sale. As a result, we recorded impairment charges of approximately $70.1 million based on our estimate of the proceeds that would be received.

  

We have a group of personnel who specialize in the purchase and sale of dealership operations. We also enlist the services of brokers to assist in developing leads and ensuring that our dealership properties are priced competitively. The ultimate decision on the estimated proceeds to be received is made by management.

 

We utilize historical experience, current asset purchase agreements, feedback from prospective buyers and third party estimates of value to determine the proceeds we will receive for locations. We also evaluate the gross margin of our locations and calculate the average percentage of margin used to pay rents for our operations. This evaluation is compared to the gross margin at locations we are divesting to support the carrying value of real property.

 

We utilize Manheim auction data to determine the wholesale value of our used inventories. This evaluation is updated quarterly as our used vehicle inventories change.

  

A future decline in store performance, change in market conditions for commercial real estate, or the potential insolvency of a manufacturer could reduce the proceeds that will be received for the assets.

 

Additionally, if locations are unable to be sold as operating dealerships and are closed, the remaining assets, such as real estate and equipment would need to be sold in the open market. This could reduce the proceeds that will be received for the assets.

 

Utilizing a valuation guide such as NADA or Kelly Blue Book could result in a different result in our used vehicle analysis.

 

If Manheim auction data is not accurate, or market valuations depart from the historical margins Manheim has experienced, we could experience losses not indicated in the analysis.

 

At December 31, 2008, we have approximately $9.8 million in used vehicle inventory, $93.9 million in property and equipment, and $2.0 million in intangible asset value.

 

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Nature of Critical

Estimate Item

  

Assumptions/

Approach Used

  

Effect of a Change in

Assumptions

Service Contract, Lifetime

Oil Change, and Other

Insurance Contract

Income Recognition

     

We receive fees from the sale of vehicle service contracts and lifetime oil contracts to customers. The contracts are sold through an unrelated third party, but we may be charged back for a portion of the fees in the event of early termination of the contracts by customers.

 

We may also participate in future underwriting profit pursuant to retrospective commission arrangements, which are recognized as income upon receipt.

  

We have established a reserve for estimated future charge-backs based on an analysis of historical charge-backs in conjunction with estimated lives of the applicable contracts. If future cancellations are different than expected based on historical experience, we could have additional expense or income related to the cancellations in future periods

 

At December 31, 2008 and 2007, this reserve totaled $13.5 million and $15.7 million, respectively, and is included in accrued liabilities and other long-term liabilities on our consolidated balance sheets.

   A 10% increase in cancellations would result in an additional reserve of approximately $1.4 million.

Workers’ Compensation

Insurance Premium Accrual

     

Insurance premiums are determined under a five-year retrospective cost policy, whereby premium cost depends on experience. We accrue premiums based on our historical experience rating, although the actual claims can be something greater or less than the historical experience, which could create our estimated liability to either be under or over accrued.

 

Premiums are based on actual claims plus an insurance component. We have a maximum exposure to claims in a given year, at which point additional claims are paid by the carrier.

  

As of December 31, 2008 and 2007, the reserve for workers compensation insurance premiums was $4.3 million and $5.5 million, respectively, and is included in accrued liabilities and other long-term liabilities on our consolidated balance sheets.

 

We expect that the retrospective cost policy, as opposed to a guaranteed cost with a flat premium, will be the most cost-effective over time.

   A 10% increase in claims experience would result in additional reserves of approximately $1.6 million.

 

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Recent Accounting Pronouncements

See Note 20 of Notes to Consolidated Financial Statements.

Off-Balance Sheet Arrangements

We do not have any off-balance sheet arrangements that have or are reasonably likely to have a material current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.

 

Item 7A. Quantitative and Qualitative Disclosures About Market Risk

Variable Rate Debt

We use variable-rate debt to finance our new and program vehicle inventory and certain real estate holdings. The interest rates on our variable rate debt are tied to either the one or three-month LIBOR or the prime rate. These debt obligations therefore expose us to variability in interest payments due to changes in these rates. The flooring debt is based on open-ended lines of credit tied to each individual store from the various manufacturer finance companies. If interest rates increase, interest expense increases. Conversely, if interest rates decrease, interest expense decreases.

Our variable-rate flooring notes payable, variable rate mortgage notes payable and other credit line borrowings subject us to market risk exposure. At December 31, 2008, we had $497.4 million outstanding under such agreements at interest rates ranging from 1.59% to 4.75% per annum. A 10% increase in interest rates would increase annual interest expense by approximately $0.3 million, net of tax, based on amounts outstanding at December 31, 2008.

Fixed Rate Debt

The fair market value of our long-term fixed interest rate debt is subject to interest rate risk. Generally, the fair market value of fixed interest rate debt will increase as interest rates fall because we could refinance for a lower rate. Conversely, the fair value of fixed interest rate debt will decrease as interest rates rise. The interest rate changes affect the fair market value but do not impact earnings or cash flows.

Based on open market trades, we determined that our $42.5 million of long-term convertible fixed interest rate debt outstanding had a fair market value of approximately $37.0 million at December 31, 2008. In addition, at December 31, 2008, we had $141.7 million of other long-term fixed interest rate debt outstanding with maturity dates of between January 2009 and September 2027. Based on discounted cash flows, we have determined that the fair market value of this long-term fixed interest rate debt was approximately $154.0 million at December 31, 2008.

Hedging Strategies

We believe it is prudent to limit the variability of a portion of our interest payments. Accordingly, we have entered into interest rate swaps to manage the variability of our interest rate exposure, thus leveling a portion of our interest expense in a rising or falling rate environment.

We have effectively changed the variable-rate cash flow exposure on a portion of our flooring debt to fixed-rate cash flows by entering into receive-variable, pay-fixed interest rate swaps. Under the interest rate swaps, we receive variable interest rate payments and make fixed interest rate payments, thereby creating fixed rate flooring debt.

We do not enter into derivative instruments for any purpose other than to manage interest rate exposure. That is, we do not engage in interest rate speculation using derivative instruments. Typically, we designate all interest rate swaps as cash flow hedges.

 

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As of December 31, 2008, we had outstanding the following interest rate swaps with U.S. Bank Dealer Commercial Services:

 

 

 

effective March 9, 2004 – a five year, $25 million interest rate swap at a fixed rate of 3.25% per annum, variable rate adjusted on the 1st and 16th of each month;

 

 

 

effective March 18, 2004 – a five year, $25 million interest rate swap at a fixed rate of 3.10% per annum, variable rate adjusted on the 1st and 16th of each month;

 

 

 

effective June 16, 2006 – a ten year, $25 million interest rate swap at a fixed rate of 5.587% per annum, variable rate adjusted on the 1st and 16th of each month;

 

 

 

effective January 26, 2008 – a five-year, $25 million interest rate swap at a fixed rate of 4.495% per annum, variable rate adjusted on the 26th of each month;

 

 

 

effective May 1, 2008 – a five year, $25 million interest rate swap at a fixed rate of 3.495% per annum, variable rate adjusted on the 1st and 16th of each month; and

 

 

 

effective May 1, 2008 – a five year, $25 million interest rate swap at a fixed rate of 3.495% per annum, variable rate adjusted on the 1st and 16th of each month.

We receive interest on all of the interest rate swaps at the one-month LIBOR rate. The one-month LIBOR rate at December 31, 2008 was 0.44% per annum as reported in the Wall Street Journal.

The fair value of our interest rate swap agreements represents the estimated receipts or payments that would be made to terminate the agreements. These amounts related to our cash flow hedges are recorded as deferred gains or losses in our consolidated balance sheet with the offset recorded in accumulated other comprehensive income, net of tax. Changes to the fair value of discontinued cash flow hedges are recognized into earnings as a component of floorplan interest expense. At December 31, 2008, the fair values of all of our agreements was a liability of $10.8 million. The estimated amount expected to be reclassified into earnings within the next twelve months is $4.9 million at December 31, 2008.

As inventory levels fell and future levels of floorplan debt were expected to decrease, one cash flow hedge was discontinued at the end of the third quarter of 2008 due to the forecasted transaction no longer being probable. Additionally, in response to expected decreases in debt levels, we discontinued two cash flow hedges and de-designated and re-designated certain other swaps in the fourth quarter of 2008. The change in the market value of undesignated swaps resulted in a $0.5 million loss, which was recognized in earnings as a component of floorplan interest expense in the fourth quarter of 2008. Following the discontinuation and de-designation of cash flow hedges, approximately $1.2 million remained a component of accumulated other comprehensive income (loss) at December 31, 2008, which will be recognized over the remaining life of these swaps.

Ineffectiveness occurs when the amount of change in fair market value of the swap is greater than the change in fair market value of the hypothetical derivative. Any ineffectiveness will be reflected in the floorplan interest expense in our statement of operation in the period in which it occurs. In 2008 and 2007, we recorded $363,000 and $73,000, respectively, of ineffectiveness. We did not record any ineffectiveness in 2006.

Risk Management Policies

We assess interest rate cash flow risk by continually identifying and monitoring changes in interest rate exposures that may adversely impact expected future cash flows and by evaluating hedging opportunities.

We maintain risk management control systems to monitor interest rate cash flow attributable to both our outstanding and forecasted debt obligations as well as our offsetting hedge positions. The risk management control systems involve the use of analytical techniques, including cash flow sensitivity analysis, to estimate the expected impact of changes in interest rates on our future cash flows.

 

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Item 8. Financial Statements and Supplementary Financial Data

The financial statements and notes thereto required by this item begin on page F-1 as listed in Item 15 of Part IV of this document. Quarterly financial data for each of the eight quarters in the two-year period ended December 31, 2008 is included in Item 7.

 

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

None.

 

Item 9A. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

Our management evaluated, with the participation and under the supervision of our Chief Executive Officer and Chief Financial Officer, the effectiveness of our disclosure controls and procedures as of the end of the period covered by this Annual Report on Form 10-K. Based on this evaluation, our Chief Executive Officer and our Chief Financial Officer concluded that our disclosure controls and procedures are effective to ensure that information we are required to disclose in reports that we file or submit under the Securities Exchange Act of 1934 is accumulated and communicated to our management, including our Chief Executive Officer and our Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure and that such information is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms.

Changes in Internal Control Over Financial Reporting

There was no change in our internal control over financial reporting that occurred during our last fiscal quarter that has materially affected or is reasonably likely to materially affect our internal control over financial reporting.

Management’s Report on Internal Control Over Financial Reporting

Our management is responsible for establishing and maintaining adequate internal control over financial reporting.

Our management assessed the effectiveness of our internal control over financial reporting as of December 31, 2008. In making this assessment, we used the criteria set forth in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on our assessment using those criteria, our management concluded that, as of December 31, 2008, our internal control over financial reporting was effective.

KPMG LLP, our Independent Registered Public Accounting Firm, has issued an attestation report on our internal control over financial reporting as of December 31, 2008, which is included in Item 8 of this Form 10-K.

 

Item 9B. Other Information

None.

 

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PART III

 

Item 10. Directors, Executive Officers and Corporate Governance

Information required by this item will be included under the captions Election of Directors, Meetings and Committees of the Board of Directors, Audit Committee Financial Expert, Code of Ethics, Executive Officers and Section 16(a) Beneficial Ownership Reporting Compliance in our Proxy Statement for our 2009 Annual Meeting of Shareholders and, upon filing, is incorporated herein by reference.

 

Item 11. Executive Compensation

The information required by this item will be included under the captions Compensation of Directors, Compensation Committee Report, Compensation Discussion and Analysis, Executive Compensation, Potential Payments Upon Termination or Change-in-Control, and Compensation Committee Interlocks and Insider Participation in our Proxy Statement for our 2009 Annual Meeting of Shareholders and, upon filing, is incorporated herein by reference.

 

Item 12. Security Ownership of Certain Beneficial Owners and Management

Equity Compensation Plan Information

The following table summarizes equity securities authorized for issuance as of December 31, 2008.

 

Plan Category

   Number of securities
to be issued upon
exercise of

outstanding options,
warrants and rights (a)
   Weighted average
exercise price of
outstanding options,
warrants and rights (b)
   Number of securities
remaining available for
future issuance under
equity compensation plans
(excluding securities
reflected in column (a) (c)
 

Equity compensation plans approved by shareholders

   2,007,257    $ 13.81    962,780 (1)

Equity compensation plans not approved by shareholders

   —        —      —    
                  

Total

   2,007,257    $ 13.81    962,780  
                  

 

(1) Includes 205,687 shares available pursuant to our 2003 Stock Incentive Plan and 757,093 shares available pursuant to our Employee Stock Purchase Plan.

The additional information required by this item will be included under the caption Security Ownership of Certain Beneficial Owners and Management in our Proxy Statement for our 2009 Annual Meeting of Shareholders and, upon filing, is incorporated herein by reference.

 

Item 13. Certain Relationships and Related Transactions, and Director Independence

The information required by this item will be included under the captions Certain Relationships and Related Transactions and Director Independence in our Proxy Statement for our 2009 Annual Meeting of Shareholders and, upon filing, is incorporated herein by reference.

 

Item 14. Principal Accountant Fees and Services

Information required by this item will be included under the caption Independent Registered Public Accounting Firm in our Proxy Statement for our 2009 Annual Meeting of Shareholders and, upon filing, is incorporated herein by reference.

 

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PART IV

 

Item 15. Exhibits and Financial Statement Schedules

Financial Statements and Schedules

The Consolidated Financial Statements, together with the report thereon of KPMG LLP, Independent Registered Public Accounting Firm, are included on the pages indicated below:

 

     Page

Reports of Independent Registered Public Accounting Firm

   F-1, F-2

Consolidated Balance Sheets as of December 31, 2008 and 2007

   F-3

Consolidated Statements of Operations for the years ended December 31, 2008, 2007 and 2006

   F-4

Consolidated Statements of Changes in Stockholders’ Equity and Comprehensive Income (Loss) for the years ended December 31, 2008, 2007 and 2006

   F-5

Consolidated Statements of Cash Flows for the years ended December 31, 2008, 2007 and 2006

   F-6

Notes to Consolidated Financial Statements

   F-7

There are no schedules required to be filed herewith.

Exhibits

The following exhibits are filed herewith and this list is intended to constitute the exhibit index. An asterisk (*) beside the exhibit number indicates the exhibits containing a management contract, compensatory plan or arrangement, which are required to be identified in this report.

 

Exhibit

       

Description

  3.1    (a)    Restated Articles of Incorporation of Lithia Motors, Inc., as amended May 13, 1999.
  3.2       Amended and Restated Bylaws of Lithia Motors, Inc. (Corrected)
  4.1    (b)    Specimen Common Stock certificate
  4.2    (j)    Indenture dated May 4, 2004, between Lithia Motors, Inc. and U.S. Bank National Association, as Trustee, relating to 2.875% Convertible Senior Subordinated Notes due 2014.
10.1*    (b)    1996 Stock Incentive Plan
10.2*    (c)    Amendment No. 1 to the Lithia Motors, Inc. 1996 Stock Incentive Plan
10.2.1*    (b)    Form of Incentive Stock Option Agreement (1)
10.3*    (b)    Form of Non-Qualified Stock Option Agreement (1)
10.4*    (d)    1997 Non-Discretionary Stock Option Plan for Non-Employee Directors
10.5*    (l)    1998 Employee Stock Purchase Plan, as amended
10.6*    (f)    Lithia Motors, Inc. 2001 Stock Option Plan
10.6.1*    (g)    Form of Incentive Stock Option Agreement for 2001 Stock Option Plan
10.6.2*    (g)    Form of Non-Qualified Stock Option Agreement for 2001 Stock Option Plan
10.7.1*    (k)    2003 Stock Incentive Plan, as amended and restated
10.7.2*    (k)    Form of Restricted Share Grant for 2003 Stock Incentive Plan, as amended and restated
10.8*    (o)    Summary 2008 Discretionary Support Services Bonus Program
10.9*    (o)    2008 L2 Performance Objectives and Bonus Program

 

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Exhibit

       

Description

10.10    (a)    Chrysler Corporation Sales and Service Agreement General Provisions
10.10.1    (h)    Chrysler Corporation Chrysler Sales and Service Agreement, dated September 28, 1999, between Chrysler Corporation and Lithia Chrysler Plymouth Jeep Eagle, Inc. (Additional Terms and Provisions to the Sales and Service Agreements are in Exhibit 10.9) (2)
10.11    (b)    Mercury Sales and Service Agreement General Provisions
10.11.1    (e)    Supplemental Terms and Conditions agreement between Ford Motor Company and Lithia Motors, Inc. dated June 12, 1997.
10.11.2    (e)    Mercury Sales and Service Agreement, dated June 1, 1997, between Ford Motor Company and Lithia TLM, LLC dba Lithia Lincoln Mercury (general provisions are in Exhibit 10.10) (3)
10.12    (e)    Volkswagen Dealer Agreement Standard Provisions
10.12.1    (a)    Volkswagen Dealer Agreement dated September 17, 1998, between Volkswagen of America, Inc. and Lithia HPI, Inc. dba Lithia Volkswagen. (standard provisions are in Exhibit 10.11) (4)
10.13    (b)    General Motors Dealer Sales and Service Agreement Standard Provisions
10.13.1    (a)    Supplemental Agreement to General Motors Corporation Dealer Sales and Service Agreement dated January 16, 1998.
10.13.2    (i)    Chevrolet Dealer Sales and Service Agreement dated October 13, 1998 between General Motors Corporation, Chevrolet Motor Division and Camp Automotive, Inc. (5)
10.14    (b)    Toyota Dealer Agreement Standard Provisions
10.14.1    (a)    Toyota Dealer Agreement, between Toyota Motor Sales, USA, Inc. and Lithia Motors, Inc., dba Lithia Toyota, dated February 15, 1996. (6)
10.15    (e)    Nissan Standard Provisions
10.15.1    (a)    Nissan Public Ownership Addendum dated August 30, 1999 (identical documents executed by each Nissan store).
10.15.2    (e)    Nissan Dealer Term Sales and Service Agreement between Lithia Motors, Inc., Lithia NF, Inc., and the Nissan Division of Nissan Motor Corporation In USA dated January 2, 1998. (standard provisions are in Exhibit 10.14) (7)
10.16    (a)    Lease Agreement between CAR LIT, L.L.C. and Lithia Real Estate, Inc. relating to properties in Medford, Oregon.(8)
10.17    (m)    2007 Board of Directors’ Compensation Package
10.17.1       Non-Employee Director Compensation Plan for 2008/2009 Service Year
10.18    (k)    Form of Outside Director Nonqualified Deferred Compensation Agreement
10.19    (m)    Loan Agreement and Amendments for revolving credit facility with U.S. Bank National Association, as Agent
10.19.1    (n)    Fourth Amendment to revolving credit facility with U.S. Bank National Association, as Agent
10.19.2       Fifth Amendment to revolving credit facility with U.S. Bank National Association, as Agent, Dated December 12, 2008.
10.20    (m)    Split Dollar Agreement dated November 7, 2006 with Sidney B. DeBoer
10.21    (m)    Split Dollar Insurance Agreement dated December 20, 2007 with Sidney B. DeBoer
10.22*       Terms of Amended Employment and Change in Control Agreement between Lithia Motors, Inc. and Sidney B. DeBoer dated January 15, 2009. Substantially similar agreements exist between Lithia Motors, Inc. and each of M.L. Dick Heimann, Bryan B. DeBoer and Jeffrey B. DeBoer.
21       Subsidiaries of Lithia Motors, Inc.

 

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Exhibit

  

Description

23    Consent of KPMG LLP, Independent Registered Public Accounting Firm
31.1    Certification of Chief Executive Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of 1934.
31.2    Certification of Chief Financial Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of 1934.
32.1    Certification of Chief Executive Officer pursuant to Rule 13a-14(b) or Rule 15d-14(b) of the Securities Exchange Act of 1934 and 18 U.S.C. Section 1350.
32.2    Certification of Chief Financial Officer pursuant to Rule 13a-14(b) or Rule 15d-14(b) of the Securities Exchange Act of 1934 and 18 U.S.C. Section 1350.

 

(a) Incorporated by reference from the Company’s Form 10-K for the year ended December 31, 1999 as filed with the Securities and Exchange Commission on March 30, 2000.

 

(b) Incorporated by reference from the Company’s Registration Statement on Form S-1, Registration Statement No. 333-14031, as declared effective by the Securities Exchange Commission on December 18, 1996.

 

(c) Incorporated by reference from the Company’s Form 10-Q for the quarter ended June 30, 1998 as filed with the Securities and Exchange Commission on August 13, 1998.

 

(d) Incorporated by reference from the Company’s Registration Statement on Form S-8, Registration Statement No. 333-45553, as filed with the Securities Exchange Commission on February 4, 1998.

 

(e) Incorporated by reference from the Company’s Form 10-K for the year ended December 31, 1997 as filed with the Securities and Exchange Commission on March 31, 1998.

 

(f) Incorporated by reference from Appendix B to the Company’s Proxy Statement for its 2001 Annual Meeting as filed with the Securities and Exchange Commission on May 8, 2001.

 

(g) Incorporated by reference from the Company’s Form 10-K for the year ended December 31, 2001 as filed with the Securities and Exchange Commission on February 22, 2002.

 

(h) Incorporated by reference from the Company’s Form 10-Q for the quarter ended September 30, 2001 as filed with the Securities and Exchange Commission on November 14, 2001.

 

(i) Incorporated by reference from the Company’s Form 10-K for the year ended December 31, 1998 as filed with the Securities and Exchange Commission on March 31, 1999.

 

(j) Incorporated by reference from the Company’s Form 10-Q for the quarter ended March 31, 2004 as filed with the Securities and Exchange Commission on May 10, 2004.

 

(k) Incorporated by reference from the Company’s Form 10-K for the year ended December 31, 2005 as filed with the Securities and Exchange Commission on March 8, 2006.

 

(l) Incorporated by reference from the Company’s Form 8-K filed November 15, 2007.

 

(m) Incorporated by reference from the Company’s Form 10-K for the year ended December 31, 2007 as filed with the Securities and Exchange Commission on April 11, 2008.

 

(n) Incorporated by reference from the Company’s Form 10-Q for the quarter ended June 30, 2008 as filed with the Securities and Exchange Commission on August 18, 2008.

 

(o) Incorporated by reference from the Company’s Proxy Statement for its 2008 Annual Meeting as filed with the Securities and Exchange Commission on April 29, 2008.

 

(1) The board of directors adopted the new stock option agreement forms when it adopted the 2001 Stock Option Plan; and, although no longer being used to grant new stock options, these option agreements remain in effect as there are outstanding stock options issued under these stock option agreements.

 

(2) Substantially identical agreements exist between DaimlerChrysler Motor Company, LLC and those other subsidiaries operating Dodge, Chrysler, Plymouth or Jeep dealerships.

 

(3) Substantially identical agreements exist for its Ford and Lincoln-Mercury lines between Ford Motor Company and those other subsidiaries operating Ford or Lincoln-Mercury dealerships.

 

(4) Substantially identical agreements exist between Volkswagen of America, Inc. and those subsidiaries operating Volkswagen dealerships.

 

(5) Substantially identical agreements exist between Chevrolet Motor Division, GM Corporation and those other subsidiaries operating General Motors dealerships.

 

(6) Substantially identical agreements exist (except the terms are all 2 years) between Toyota Motor Sales, USA, Inc. and those other subsidiaries operating Toyota dealerships.

 

(7) Substantially identical agreements exist between Nissan Motor Corporation and those other subsidiaries operating Nissan dealerships.

 

(8) Lithia Real Estate, Inc. leases all the property in Medford, Oregon sold to CAR LIT, LLC under substantially identical leases covering six separate blocks of property.

 

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SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

Date: March 16, 2009     LITHIA MOTORS, INC.
      By   /s/ SIDNEY B. DEBOER
      Sidney B. DeBoer
      Chairman of the Board and
      Chief Executive Officer

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities indicated on March 16, 2009:

 

Signature

  

Title

    
/s/ SIDNEY B. DEBOER    Chairman of the Board and    
Sidney B. DeBoer    Chief Executive Officer  
   (Principal Executive Officer)  
/s/ JEFFREY B. DEBOER    Senior Vice President and Chief Financial Officer    
Jeffrey B. DeBoer    (Principal Financial Officer)  
/s/ BRYAN B. DEBOER    Director    
Bryan B. DeBoer     
/s/ THOMAS BECKER    Director    
Thomas Becker     
/s/ WILLIAM L. GLICK    Director    
William L. Glick     
/s/ CHARLES R. HUGHES    Director    
Charles R. Hughes     
/s/ MARYANN KELLER    Director    
Maryann Keller     
/s/ A.J. WAGNER    Director    
A.J. Wagner     

 

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Report of Independent Registered Public Accounting Firm

The Board of Directors and Stockholders

Lithia Motors, Inc. and subsidiaries:

We have audited the accompanying consolidated balance sheets of Lithia Motors, Inc. and subsidiaries as of December 31, 2008 and 2007, and the related consolidated statements of operations, changes in stockholders’ equity and comprehensive income (loss), and cash flows for each of the years in the three-year period ended December 31, 2008. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Lithia Motors, Inc. and subsidiaries as of December 31, 2008 and 2007, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2008, in conformity with U.S. generally accepted accounting principles.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Lithia Motors, Inc. and subsidiaries’ internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 16, 2009 expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.

 

/s/ KPMG LLP
Portland, Oregon
March 16, 2009

 

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Table of Contents

Report of Independent Registered Public Accounting Firm

The Board of Directors and Stockholders

Lithia Motors, Inc. and subsidiaries:

We have audited Lithia Motors Inc. and subsidiaries’ internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Lithia Motors, Inc. and subsidiaries’ management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, Lithia Motors Inc. and subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Lithia Motors Inc. and subsidiaries as of December 31, 2008 and 2007, and the related consolidated statements of operations, changes in stockholders’ equity and comprehensive income (loss), and cash flows for each of the years in the three-year period ended December 31, 2008, and our report dated March 16, 2009 expressed an unqualified opinion on those consolidated financial statements.

 

/s/ KPMG LLP
Portland, Oregon
March 16, 2009

 

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Table of Contents

LITHIA MOTORS, INC. AND SUBSIDIARIES

Consolidated Balance Sheets

(In thousands)

 

     December 31,  
     2008     2007  

Assets

    

Current Assets:

    

Cash and cash equivalents

   $ 10,874     $ 21,665  

Contracts in transit

     27,799       48,474  

Trade receivables, net of allowance for doubtful accounts of $348 and $391

     41,816       60,913  

Inventories, net

     422,812       601,759  

Vehicles leased to others, current portion

     8,308       9,498  

Prepaid expenses and other

     20,979       10,647  

Deferred income taxes

     2,541       1,775  

Assets held for sale

     161,423       23,807  
                

Total Current Assets

     696,552       778,538  

Land and buildings, net of accumulated depreciation of $20,604 and $20,628

     284,088       363,391  

Equipment and other, net of accumulated depreciation of $47,414 and $46,126

     62,188       98,355  

Goodwill

     —         311,527  

Other intangible assets, net of accumulated amortization of $68 and $52

     42,008       68,946  

Other non-current assets

     4,616       5,978  

Deferred income taxes

     44,007       —    
                

Total Assets

   $ 1,133,459     $ 1,626,735  
                

Liabilities and Stockholders’ Equity

    

Current Liabilities:

    

Floorplan notes payable

   $ 234,181     $ 311,824  

Floorplan notes payable: non-trade

     103,519       139,766  

Current maturities of senior subordinated convertible notes

     42,500       —    

Current maturities of other long-term debt

     36,134       13,327  

Trade payables

     21,571       38,715  

Accrued liabilities

     50,951       63,602  

Liabilities held for sale

     108,172       17,857  
                

Total Current Liabilities

     597,028       585,091  

Real estate debt, less current maturities

     163,708       179,160  

Other long-term debt, less current maturities

     101,476       276,335  

Other long-term liabilities

     22,904       14,647  

Deferred income taxes

     —         63,290  
                

Total Liabilities

     885,116       1,118,523  

Stockholders’ Equity:

    

Preferred stock - no par value; authorized 15,000 shares; none outstanding

     —         —    

Class A common stock - no par value; authorized 100,000 shares; issued and outstanding 16,717 and 15,960

     234,522       229,151  

Class B common stock - no par value; authorized 25,000 shares; issued and outstanding 3,762 and 3,762

     468       468  

Additional paid-in capital

     9,275       8,112  

Accumulated other comprehensive loss

     (5,810 )     (1,437 )

Retained earnings

     9,888       271,918  
                

Total Stockholders’ Equity

     248,343       508,212  
                

Total Liabilities and Stockholders’ Equity

   $ 1,133,459     $ 1,626,735  
                

See accompanying notes to consolidated financial statements.

 

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Table of Contents

LITHIA MOTORS, INC. AND SUBSIDIARIES

Consolidated Statements of Operations

(In thousands, except per share amounts)

 

     Year Ended December 31,  
     2008     2007     2006  

Revenues:

      

New vehicle sales

   $ 1,172,807     $ 1,528,246     $ 1,449,012  

Used vehicle sales

     574,373       686,728       660,588  

Finance and insurance

     78,970       99,727       97,036  

Service, body and parts

     306,743       304,302       261,949  

Fleet and other

     4,911       5,279       5,250  
                        

Total revenues

     2,137,804       2,624,282       2,473,835  

Cost of sales:

      

New vehicle sales

     1,081,032       1,408,496       1,333,906  

Used vehicle sales

     523,439       605,890       576,271  

Service, body and parts

     159,944       159,262       134,153  

Fleet and other

     3,345       3,845       3,740  
                        

Total cost of sales

     1,767,760       2,177,493       2,048,070  
                        

Gross profit

     370,044       446,789       425,765  

Goodwill impairment

     272,503       —         —    

Other asset impairments

     23,402       —         —    

Selling, general and administrative

     316,183       349,283       319,854  

Depreciation - buildings

     4,847       4,200       3,325  

Depreciation and amortization - other

     12,885       12,662       10,058  
                        

Operating income (loss)

     (259,776 )     80,644       92,528  

Other income (expense):

      

Floorplan interest expense

     (20,398 )     (24,373 )     (25,156 )

Other interest expense

     (17,350 )     (15,985 )     (12,081 )

Other income, net

     6,673       641       798  
                        

Total other income (expense)

     (31,075 )     (39,717 )     (36,439 )
                        

Income (loss) from continuing operations before income taxes

     (290,851 )     40,927       56,089  

Income tax (provision) benefit

     91,703       (16,485 )     (21,597 )
                        

Income (loss) from continuing operations

     (199,148 )     24,442       34,492  

Discontinued operations:

      

Income (loss) from operations, net of income taxes

     (9,898 )     1,826       3,366  

Loss from disposal activities, net of income taxes

     (43,540 )     (4,719 )     (554 )
                        

Net income (loss)

   $ (252,586 )   $ 21,549     $ 37,304  
                        

Basic income (loss) per share from continuing operations

   $ (9.95 )   $ 1.25     $ 1.77  

Basic income (loss) per share from discontinued operations

     (2.67 )     (2.67 )     (2.67 )
                        

Basic net income (loss) per share

   $ (12.62 )   $ 1.10     $ 1.91  
                        

Class A shares used in basic per share calculations

     16,255       15,768       15,723  
                        

Class B shares used in basic per share calculations

     3,762       3,762       3,762  
                        

Diluted income (loss) per share from continuing operations

   $ (9.95 )   $ 1.19     $ 1.65  

Diluted income (loss) per share from discontinued operations

     (2.67 )     (0.13 )     0.12  
                        

Diluted net income (loss) per share

   $ (12.62 )   $ 1.06     $ 1.77  
                        

Class A shares used in diluted per share calculations

     16,255       18,320       18,340  
                        

Class B shares used in diluted per share calculations

     3,762       3,762       3,762  
                        

See accompanying notes to consolidated financial statements.

 

F-4


Table of Contents

LITHIA MOTORS, INC. AND SUBSIDIARIES

Consolidated Statements of Changes in Stockholders’ Equity and Comprehensive Income (Loss)

For the years ended December 31, 2005, 2006 and 2007

(In thousands)

 

     Common Stock    Additional          

Accumulated
Other
Compre-

hensive

         

Total

Stock-

 
     Class A     Class B    Paid In     Unearned     Income     Retained     holders’  
     Shares     Amount     Shares    Amount    Capital     Compensation     (Loss)     Earnings     Equity  

Balance at December 31, 2005

   15,629     $ 224,775     3,762    $ 468    $ 2,559     $ (1,132 )   $ —       $ 233,561     $ 460,231  

Net income

   —         —       —        —        —         —         —         37,304       37,304  

Issuance of stock in connection with employee stock plans

   299       6,844     —        —        —         —