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Executives

Mark O’Neil - Chairman, CEO

Robert Cox - CFO, SVP

Katherine Piscopo Stein - Investor Relations

Analysts

Aaron Schwartz - JP Morgan

David Scharf - JMP Securities

Chris Mammone - Deutsche Bank

Franco Turrinelli - William Blair

Peter Goldmacher - Cowen and Company

Chris Cowen - Thomas Weisel Partners

Gary Prestopino - Barrington Research

Mitchell Bartlett - Craig-Hallum

DealerTrack Inc (TRAK) Q3 2008 Earnings Call November 5, 2008 5:00 PM ET

Operator

Good afternoon everyone and welcome to DealerTrack’s third quarter conference call. As a reminder, today’s call is being recorded. At this time I will turn the call over to Katherine Piscopo Stein of Investor Relations at DealerTrack; please go ahead ma’am.

Katherine Piscopo Stein

Thank you, Kevin. Good afternoon and welcome to DealerTrack’s third quarter conference call. Joining me today are Mark O’Neil, Chairman and Chief Executive Officer; and Robert Cox, Chief Financial Officer and Senior Vice President.

Mark will begin today’s call with an overview of our financial results and other key metrics for the third quarter of 2008. He will then provide a quick summary of the quarter from a business and strategy prospective and discuss some of our latest accomplishments, as well as the auto lending and sales environment we have seen this year. Bob will then provide further details on our financial performance for the quarter, year to date and will discuss our outlook for the remainder of 2008. We will then be available to answer your questions.

Before I begin, I would like to remind everyone that the remarks made during this conference call will contain forward-looking statements made pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. These statements are neither promises nor guarantees, but involve risks and uncertainties that could cause actual results to differ materially from those set forth in the forward-looking statements including without limitation those risks detailed in DealerTrack’s filings with the SEC such as our 2007 annual report on Form 10-K for the fiscal year ended December 31, 2007.

We disclaim any obligation to publicly update or revise such statements to reflect any change in our expectations or in events, conditions or circumstances on which any such statements may be based or that may affect the likelihood that actual results will differ from those set forth in the forward-looking statements.

We also use non-GAAP financial measures to represent business performance. A reconciliation of GAAP to non-GAAP financial measures is included in today’s press release which is available on the Investor Relations section of the company’s website at www.dealertrak.com.

I would now like to introduce Mark O’Neil.

Mark O’Neil

Thank you, Katherine. Hello and thanks to everyone for joining us. Many of you on the call tonight are aware of the historic retrenchment of credit providers and the record low auto sales reported in the last few months. At DealerTrack we are keenly aware of events in the financial and automotive sectors and remain pleased with our third quarter results under these circumstances.

Now let me provide a high level of financial review before discussing some key business initiatives. Revenue for the quarter was $60.5 million; cash net income for the quarter was $8.8 million; EBITDA was $6.7 million which includes an impairment charge taken of $5.7 million for our auction rate securities. Adjusted EBITDA was $12.4 million, which excludes the impairment charge.

We continued to expand financing sources for our dealers on the network. We had 706 financing sources connected as of the end of the third quarter, up 43% from a year ago. The banks and credit unions that we’re signing up are smaller in origination than many of the initial lenders on the network.

While they continue to add dealer to lender relationships and financing options for our dealer customers, they cannot immediately fill the void left as large national lenders merge or exit indirect auto lending and reduce originations. We expect to continue signing these smaller financing sources for several quarters into the future. The total number of active dealers in the network was approximately 21,000 as of the end of the quarter, down 7% from a year ago.

This year we have seen a steep decline in franchise dealers industry wide. Approximately 590 have closed in the first nine months of the year and the National Automobile Dealers Association projects 700 franchise dealers will have closed by the end of this year. We expect this consolidation trend to continue through 2009 and to possibly accelerate in the event of a merger between General Motors and Chrysler.

Our subscription business again experienced strong growth this quarter. In the third quarter we increased our subscription count by over 1,600 subscriptions. Our focus remains on providing technology solutions to make our dealer customers more profitable as we integrate our products and dealers experience increases in workflow efficiency.

Cross selling to our dealer customers and reaching out to other dealers on the network has resulted in subscriptions in the network growing to over 33,000 which is up 21% from a year ago. Approximately 13,700 of our dealer customers in the US now have one of more of the subscription products we offer, which represents 65% of our active US dealers.

As we told you last quarter, we’re now reporting the average monthly spend per subscriber dealer in the US and Canada. For the third quarter this spend was approximately $557 compared to $528 in the third quarter of 2007.

The ongoing tightening of the credit market and declining auto sales numbers continue to present headwinds for our transaction business. We processed approximately 19.2 million transactions during the quarter, which is down 19% from a year ago.

The average transaction price increased to $1.72. We had just over 179,000 lender-to-dealer relationships at the end of this quarter as compared to 196,000 at the end of the second quarter, a 9% decline. This larger than anticipated decline includes the departure of HSBC, which I told you about on our last call, as well as 15 other lenders who exited indirect auto lending in the third quarter.

As I mentioned earlier, we are continuing to add financing sources, including credit unions, to our network, adding to the lender-to-dealer relationships available. However it’s difficult to fill the void left by some major national players who’ve either limited loan originations or exited the indirect auto lending space altogether.

Our DMS continues to draw attention from dealers. This quarter we announced the integration of our DMS with Hyundai enabling more seamless communication between Hyundai dealers and the car manufacturer. This will increase the appeal of our DMS system to over 860 Hyundai dealers in the US and we believe our DMS is the high value option for many dealers seeking alternatives to expensive solutions offered by our competitors and we continue to maintain a strong pipeline for installation and recognize that DMS is a key foundation for DealerTrack, increasing our share of the technology spend by dealerships.

Another strategic subscription product that has been selling well is our InventoryPro product. InventoryPro offers a new and used car managers tools to increase profit on used car sales and trade-in vehicle. This product is an expansion beyond our core products in the FNI office and is a valuable solution for dealerships that are facing increased profit pressures.

InventoryPro gives managers tools to evaluate data and trends inside and outside the dealership to make the best decisions on what cars to keep on the lot, where to source cars, and how to price those vehicles. InventoryPro is one of the only solutions in the market that applies analytical tools to internal and external information and is a fraction of the cost of the competition. We are continuing to see success in the sales of InventoryPro and we’re excited about its long-term growth potential.

I discussed our DealWatch product last quarter. In addition to identity verification and red flags compliance, dealers are also experiencing the benefits of the electronic document storage, tracking and reporting functions of DealWatch.

The regulatory deadline for dealers to have a red flags compliance product in place has now been postponed from November 1 this year until May 1, 2009. We expect that this will continue to drive sales of DealWatch into the beginning of next year as dealers continue to understand the regulations and look for a product which assists them in meeting compliance requirements while offering advanced features for reporting, tracking and storage.

I’m pleased to welcome Jim Foy to our Board of Directors. Jim is President and CEO of privately held Aspect Software. He brings to us a broad software experience and a breadth of knowledge in mergers and acquisitions. Jim will be serving on both the investment committee and the compensation committee. We’re excited to have him join our team.

Lastly, as we announced at the beginning of October, we have positive news regarding our patent infringement lawsuit against RouteOne. Judge Guilford, the Federal District Court judge in the Central District of California hearing our case issued his long awaited Markman ruling on a claim interpretation. Judge Guilford ruled that we may proceed in our case of infringement against RouteOne on the claims related to our 427 patent, one of our broadest patents.

We also saw RouteOne and Finance Express as claims of victory in the media, while we would have been pleased to have the judge rule in our favor on each of the three patents; the fact remains that in a patent infringement case violation of only one claim of one patent is needed to win. We continue to believe that our case is strong and look forward to this lawsuit being brought to trial in February.

Bob will now provide further detail on our financials.

Robert Cox

Thank you, Mark. Our revenue of $60.5 million for the quarter which is a $2.4 million decrease from the third quarter of last year breaks down as follows. Transaction revenue of $33 million was down 16% from the third quarter of 2007. Subscription revenue of $23.8 million was an increase of 17% from the same period last year and nearly 100% of the subscription revenue growth was organic. Other revenue of $3.7 million compared to $3.4 million a year ago.

For the nine months ended September 30, total revenue is $188 million, up $14.9 million or 9% from a year ago. That breaks down as follows: transactions revenue for the nine months of $107.5 million, down 4% from a year ago. Subscription revenue of $69.1 million, an increase of 29% from the same period last year and other revenue of $11.4 million compared to $7.5 million a year ago.

We have re-measured the value of our auction rate securities portfolio as of September 30, 2008. We have determined that the valuation of certain securities has declined and as a result we have recognized a $5.7 million impairment charge. As of today, the remaining balance of our auction rate securities portfolio is $5.5 million.

Our GAAP net loss for the quarter was $2.6 million, a decrease compared to $4.5 million net income a year ago. Excluding the impairment charge of $5.7 million, GAAP net income from the quarter would have been $3.1 million. GAAP net income for the nine months ended September 30 was $2.8 million compared to $15.6 million a year ago.

EBITDA for the quarter was $6.7 million compared to $17.5 million in the third quarter of 2007. Adjusted EBITDA for the quarter was $12.4 million which excludes the impairment charge of $5.7 million. EBITDA for the nine months ended September 30 was $34 million compared to $51 million a year ago. Adjusted EBITDA for the nine months was $39.6 million, which again excludes the impairment charge of $5.7 million.

Cash net income was $8.8 million for the quarter compared to $11.4 million in the third quarter of 2007 and cash net income for the first nine months of the year was $28 million compared to $32.9 million a year ago. For the quarter, diluted GAAP net loss per share was $0.07. The previously mentioned impairment charge has negatively impacted GAAP net income per share by $0.14.

Diluted cash net income per share was $0.22 based on a weighted average of 39.8 million shares outstanding. For the nine months ended September 30, diluted GAAP net income per share was $0.07 and diluted cash net income per share was $0.66 based on a weighted average of 42.2 million shares outstanding.

Detailed reconciliations of GAAP net income to our non-GAAP financial measures of EBITDA, adjusted EBITDA, and cash net income, are included as attachments to today’s press release, which is posted to our company’s website.

Cash flow from operations was $20.5 million for the quarter compared to $12.6 million in the third quarter of 2007. This is an increase of 63%. For the nine months ended September 30, cash flow from operations was $44.3 million compared to $33.1 million for the same period in 2007. We maintained a very strong balance sheet with approximately $200 million in cash and investments as of September 30, 2008.

Capital expenditures were $5.6 million for the quarter and $13.6 million for the nine months ended September 30. Our litigation expenses relating to our patent infringement case against RouteOne and Finance Express were $1 million for the third quarter. Our year to date expenditure for the lawsuit is $6.8 million. We project our total litigation expense through the end of the year will be approximately $7.1 million.

Based on a fee arrangement that has been negotiated with outside council and assuming the trial starts in February 2009 as currently scheduled, we do not expect any additional out of pocket litigation expenses beyond this $7.1 million through the end of trial other than incidental expenses. In the event that we are successful at trial or there is a favorable settlement, we may owe additional fees to our outside council.

During the third quarter, DealerTrack repurchased approximately 1.6 million shares at a cost of approximately $25.6 million. Since the end of the quarter, we purchased an additional 0.4 million shares for approximately $5.1 million, bringing our total repurchase through November 5 to 3 million shares and $49.8 million.

Now let me give you our revised guidance for 2008’s annual performance. In light of the continued and unexpectedly accelerated deterioration of the economic environment, the challenges facing the lending and automotive industries and the impact of the impairment charges relating to auction rate securities taken in this third quarter, we have revised our guidance for the full year 2008 as follows.

Expected GAAP Results: Revenue for the year is expected to be between $240 million and $243 million compared to the previous estimates of $246 million to $253 million. GAAP net income for the year is expected to be between $1.2 million and $1.7 million, compared to the previous estimate of $9.4 million to $12.8 million. Diluted GAAP net income per share for the year is expected to be between $0.03 and $0.04 per share compared to the previous estimate of between $0.22 and $0.30 per share.

EBITDA for the year is expected to be between $39.8 million and $40.6 million, compared to the previous estimate of $48.3 million to $54.3 million. Adjusted EBITDA for the year is expected to be between $45.5 million and $46.3 million.

Cash net income for the year is expected to be between $32.1 million and $32.6 million, as compared to the previous estimate given as $33.9 million to $37.3 million. Diluted cash net income per share for the year is expected to be between $0.77 and $0.78 per share as compared to the previous estimate given of $0.80 to $0.88 per share.

Included in GAAP net income and EBITDA guidance is an impairment charge of $5.7 million relating to certain auction rate securities recognized during the three months ended September 30. Our guidance for GAAP net income per diluted share was unfavorably impacted by $0.14 in the third quarter as a result of this impairment.

This guidance is based on a seasonally adjusted annualized rate of 10 million to 10.5 million new car sales for the fourth quarter and continued contraction of the auto-lending environment. Our guidance is based on an estimated average of 41.8 million shares outstanding.

That concludes our formal remarks for this call and I’ll now turn it over to the operator to take your questions.

Question-and-Answer

Operator

(Operator Instructions) Your first question comes from Aaron Schwartz – JP Morgan.

Aaron Schwartz – JP Morgan

I know a lot of the things that are going on in the environment are certainly outside of your control, but certainly a theme that we’ve been seeing is a de-linking of the auto in the financing side of captives and I’m just sort of interested in your perspective of if that continues, what opportunities does that create for you to one, pick up some share on the captive side and then also the potential impact of pricing if some other parties step in and take some of the financing from some of the captives?

Mark O’Neil

Yes, just a broad comment. Not enough of that’s happening. Obviously with the decline in car sales, the captives are pulling back, but the net number of cars being financed is dropping rapidly, so the share is shifting. I mean clearly GMAC’s announcement that they’re only writing 700 credit and above shifted volume from the captive to the independents and we benefit from that.

The offset of course is the number of vehicles being financed has declined significantly. So, what you see is from a percentage impact, but the net, net dollars we’re not seeing any positive up tick right now, but obviously we’re more well positioned as we go into next year, should sales pick up. So we view it as a net positive, it’s just not translating to the financials in the near-term.

Do we think it’ll continue? The answer is yes. I think GM announced first. Chrysler I think has been in the process steadily, not any broad sweeping announcements and we expect all of them to come under pressure in the next few months and the big banks, the Bank of Americas, the JP Morgans, the Wells pick up volume as a result of that and we’re seeing that behavior both in the US and in Canada.

Aaron Schwartz – JP Morgan

Switching gears a little bit to the DMS side, certainly a lot of pricing pressure in the industry, but you’re sort of positioned as a low cost provider; I was just wondering if you could talk about the opportunity there to take share as pricing pressure maybe has increased. Are you sort of held hostage to when some of these contracts expire at the dealers or is there something you can do there to try to win dealers to come over to your side, given that you’re a lower cost provider?

Mark O’Neil

Yes, we are the low cost provider or certainly one of the lowest costs. We are hostage to the contract renewal cycle. About 20% old contracts come up each year and very few dealers will consider switching much in advance of those contracts in part because in essence that doesn’t drive down their costs at all. They’ve got to pay the old contract and start paying on the new.

Is it an option for us to waive that potentially? Theoretically yes, but practically speaking, no. We have more than enough demand to fill out install capacity right now, so there’d be no need to make that trade off.

So, we’re very happy with that business. It is growing significantly, certainly one of our largest dollar growers and I’ll tell you; the tough times out there are only increasing the volume of dealers looking at lower cost solutions. This pressure is causing dealers to look everywhere and that’s a good thing.

That said we have seen our competitors drop price as well to try to hold onto business given the tightening environment. We are very well positioned if we get into that more aggressive activity there.

Aaron Schwartz – JP Morgan

Okay and last question for me. I know you’re not giving ‘09 guidance, but as we look to put our models together, do you have any sort of views on how you’re looking at ‘09 in terms of the car volume and then also, it does seem like the use has started to roll over where it was a little more constant. Can you walk us through maybe some of the assumptions in your guidance for the used side of the picture?

Mark O’Neil

We don’t have any different numbers than the industry has and the bulk of the industry if you look at published reports; and no one’s really put a stake in the ground here, so you see a lot of kind of preliminary qualifiers, estimate qualifiers. I would say the vast majority of the numbers we have seen suggest that next year’s volume will run at the same pace as the second half of this year, possibly more oriented to the latter part.

So, that’s probably in a $11 million to $12 million, maybe a $11 million to $13 million range if you really broaden that. So, if you look back at first quarter this year was a $15 million quarter. It’s going to be down substantially first quarter to first quarter.

Second quarter was in the I believe high 13s, low 14s, and it was only as we got into the third and now going into the fourth quarter that we see the range. The October number was the low at $10.5 million run rate and I believe the high in the third quarter was $12.8 million. So, that’s a big range and what’s going to be the right number? I think it’s all going to be dependent on what the government does on economic stimulus, what they do on an auto loan package and what the lenders do on getting back out there lending.

It’s clear we’re hearing from virtually every manufacturer that there is more demand than what they’re selling now, but they are constrained by credit and so when credit loosens up I think car sales improve. Can we give you any greater clarity at this point? No, we will not give formal guidance until early into the year where we have this full year under our belt and more perspective on some of the variables that drive it.

Aaron Schwartz – JP Morgan

Okay, and then any comment on the used side?

Mark O’Neil

Yes, so look at the extreme numbers that are dropping. Used is more insulated, it has not dropped as significantly as the new. I think the estimates, and there’s much less data on this, so let’s be a little bit careful; is that we’re running 13 or slightly under run rates, whereas we had been running last year on the 14 million rate. So 14 dropping to 13; it could be as low as somewhere in the 12s, but that is substantially less than the 16 million run rate last year, 16.1 on new, that’s going to adjust down to say 13 this year.

So, it’s holding up better. We are in talking to dealers and looking at for example the sales of our InventoryPro product, there is huge focus on used and although we don’t have the data to substantiate this, I would tell you that I think the new car franchise dealer is taking used car volume from the independent dealer and that’s part of why the numbers are not down as much from an industry perspective and I think they’ll continue to do that. They’re being very aggressive in that segment right now in every respect in terms of what they’re sourcing and how aggressively they’re pushing it in terms of sales efforts and the like.

Operator

Your next question comes from David Scharf - JMP Securities.

David Scharf - JMP Securities

Mark, can you talk a little bit more about the contraction on the dealership and lender side? Setting aside just the cyclical headwinds, obviously I think the biggest question on a lot of peoples’ minds is just how big a market you’re addressing in terms of number of dealers and number of lenders, when not only we emerge from the cycle, but we have the shake out of contraction.

Maybe starting with the dealership side, I know you quoted a few industry figures, but if GM and Chrysler were to merge, can you give us a sense for what that would mean in your best estimate of let’s say two years from now, from the franchise dealers we’re talking about?

Mark O’Neil

Yes, so let’s just recap the numbers that we know for sure. So, we know in the first nine months we lost 590 dealerships according to NADA. We know we’re on track to lose 700. By the way, we lost about 700; it was six and change in 2007. So, that number given the environment is not substantially different.

That said, there are projections out there and again, take these as a grain of salt because I think people are really trying to grapple with this one, ourselves included, that next year could be 1,000 units in a normal run rate. Normal meaning it’s a contracting environment, tough lending environment, dealers losing floor plan, dealers’ volumes, who’ve built new facilities, not supporting their fixed costs, etc. So, maybe it’s 1,000, maybe it’s 1,500.

I think in the event of a merger, I don’t think it’ll be a radical change in the first year because I don’t know what would precipitate that unless they can raise enough financing to buy out dealers, but you might see twice that, 2,000 dealers go out in a year, maybe 2,500. As we’re doing some long-term projections and we look out five years, we think it’s a reasonable probability that the industry sorts out 16,000, 17,000 dealers and you think of that from 21 today, that’s a fairly sizeable decline.

What could change that? Obviously the merger is likely to push us closer to the 16 number depending on the Chinese manufacturers. I know everyone believes they will; no one believes the cars are quite ready for this market. Hyundai has almost 900 dealers, so you look at the Korean equivalent; I believe Kia has around 600; VW Audi has around 900; Toyota has about 1,200 before you add in Lexus, maybe 1,300.

So, you could bring in a Chinese manufacturer and an Indian manufacturer and add 500 to 1,500 new dealership points from that perspective. So, a merger might accelerate the entrance of a new player who would take over some of the dealership point and we don’t have any clarity beyond some of these scenarios we’ve modeled.

I think at the end of the day, we feel like it won’t impact our transaction business and substantially speaking it won’t impact in the near-term, next two to three years our subscription business, just because we’re so under penetrated on the 21,000 that if it’s 19,000 next year or its 20 or it’s 18.5, it’s not going to change the sales opportunity substantially.

Will it change it somewhat? Yes, to the extent we develop new products though, I think that offsets it to the extent we expand some of our product offerings such as our compliance offering, our inventory offering which have road maps for significant increased functionality over the next five years, which means also increased pricing. I think we offset some of that.

So, in the near-term we think it’s healthy for the industry. We’re not really worried about it in terms of direct impact on DealerTrack, but it’s a lot of noise to navigate.

David Scharf - JMP Securities

Switching to the lender side, the 179,000 connections, that reflects HSBC dropping out right?

Mark O’Neil

Yes, it does.

David Scharf - JMP Securities

But not yet Wachovia?

Mark O’Neil

No, it doesn’t reflect Wachovia dropping out, obviously everyone’s aware it. Wells is going to take over Wachovia. Not clear who’s going to run the auto business going forward. They’re both fairly substantial and it’s not sure the timing of that transaction. We will have some fallout as a result of that.

Wachovia historically had a lot more independent dealers and a slightly different mix of new car dealers than Wells did. So, again we don’t know any thing that certainly we could share publicly on what that re-work’s going to look like and whether they’re going to expand the footprint contracted, follow the Wells model, follow the Wachovia, but maybe half of the dealers are at risk of either one of them. I don’t think we’ll end up with just the same count as one, but we will feel a decline and again, we’re expecting that to start happening in the latter part of this year and early next year.

David Scharf - JMP Securities

Are you at any liberty to give us a sense for scale? Just what percentage of connections of Wachovia or Wells stand-alone currently represent?

Robert Cox

One way to think about it David, is they’re both top 20 lenders. So, to give you a number when it would be out of place for us, that’s their proprietary information.

David Scharf - JMP Securities

A couple of other questions; one, in terms of investment spending, I know the last couple of quarters, I believe Q1 and Q2 calls, you mentioned despite the headwinds that were emerging that you didn’t see any need to curtail any R&D or head count additions based on the opportunities ahead.

Given how this credit crisis has really accelerated the pain in the sector, I’m trying to get a feel for how we ought to think about product development expenses and some overhead. Are you going to retrench a little bit in terms of your investment in the technology development budget going into ’09 or should we be looking at generally the same levels of spending?

Mark O’Neil

We are looking hard at those numbers right now. We don’t have our ‘09 budget complete. I will tell you, we did consolidate/exit, and I have to clarify that comment; the specialty business in the US, which is really RV and marine; auto has taken it on the chin and is a hurricane headwind.

In describing the headwinds, they were forced by on the RV and marine and I mean that industry has just been decimated and we have been in the process of investing and building of proprietary portal to support that type of collateral and we are now transitioning that be just an enhanced auto application and that are able to reduce nominally some of our costs there.

These times do require us to revisit our investments and we’ll continue to do that through the budget cycle here in November and December. Do I think you’ll see a material change? No. Do I think you’ll see a measurable change? Yes.

David Scharf - JMP Securities

Since GMAC announced its pullback, not writing below 700 bureau score, have you seen any impact on your business, obviously normalizing for just the overall state of demand, but is it resulting in any more transactions flowing your way that otherwise wouldn’t have come to your lenders?

Mark O’Neil

When we look at decline in car sales and look at declines in credit apps, credit apps are not declining at the same rate as car sales are and unique application. So, we know there’s some up tick. With that said you’re not able to see it in terms of strong results, just because of the huge tick downs in sales and that being magnified by still the lender behavior right now. So, yes it’s helping us; yes, volume is shifting onto our network, but it’s being offset by the other two variables right now, i.e. lenders exiting and car sales being down materially.

By the way, Bob was just feeding me a number. October’s used car sales, and I think Aaron had asked this earlier, were down 19%.

Robert Cox

That is by the way the first time we’ve seen used vehicle sales from franchise dealers, anywhere above the 5% decline. For the first nine months of the year, we were running in the high 13’s if you will, compared to about 14.1 last year I believe. So, that had been holding its own. October’s a data point; we’re obviously keeping a close eye to see how the year winds up.

David Scharf - JMP Securities

Okay and just one last question, then I’ll get back in queue. The subscription numbers you report are on a net basis. I mean any commentary on renewal rates? I mean the subscriptions come up for renewal. Is there any material change in whether or not dealers are canceling certain products?

Mark O’Neil

Yes, in the third quarter cancellation rates increased slightly and yet we still grew fairly substantially over the second quarter. So, the number would have been even more impressive I think if we weren’t in this environment. We factored that into our numbers.

We’re real pleased with the subscription business. Yes, cancellations are up, but sales are up significantly more and we’re really working with dealers right now. A dealer who is not getting the full value out of a given product because of maybe volumes, we’re being flexible and looking at other products they might trade into. So, we’re being quite creative on helping keep them in the customer fold and keep them paying and it’s working out quite well.

Robert Cox

But David to be clear, the 590 that NADA quotes as having closed their doors since the beginning of the year and the 700 that they expect for the end of the year, we on average serve 65% of dealers. So, again on average mind you, we’re going to lose two-thirds of those dealer customers. So, if you think about the one way that it’s a little bit of an uphill climb is we’ve got to replace those folks.

Now, to Mark’s point, we have been able to pretty well through the third quarter, but we’ll lose our fair share of those subscriptions because of closures.

Operator

Your next question comes from Chris Mammone - Deutwche Bank.

Chris Mammone - Deutsche Bank

Just on the guidance. I guess we were under the impression on the last revision back on the second quarter call that you did leave sufficient room I guess for downside to that guidance. I think you talked about the time sort of a 13 million to 14 million SAR for the year.

Clearly I know October results were disastrous and I guess if I plug in sort of 10 million for each November and December, I still get to that sort of 13 million for the year number. So, is there anything else that we’re missing that really caused you to lower the expectations further?

Mark O’Neil

Yes Chris, substantially; remember the two drivers of application volume. One is lender-to-dealer relationships and that is the most significant driver of volume and the second is car sales. So, whereas we’re at a low end of our guidance numbers on the sales side and probably could have absorbed the October rate, we couldn’t be at the low end there.

We effectively missed our internal number on lender-to-dealer relationships and our expectation of what will happen there is just the lenders haven’t slowed down their contraction and we just talked about the Wachovia/Wells merger. That’s the piece that again is very hard to get visibility and that is substantially challenging our number.

Robert Cox

Chris, for a little color, we were down about 9.4% from the second quarter and our internal modeling called for that more of a 9.4% or 10% decline towards the end of the year, yet we hit the full decline in Q3. So, if we missed, you’re right, we we’re at the low end of the other metrics and could have probably still hit our numbers, just this lender number that has caught us.

Chris Mammone - Deutsche Bank

Maybe just expanding on one of David’s questions there, has the exiting, the contraction of the lender side of it, has it happened, has it been more frequent as sort of the third quarter went on? I mean could you sort of talk about the pace of the lender contraction?

Mark O’Neil

It didn’t. We thought it would bottom up and as Bob said we thought it would be more level. You can certainly look at the AmeriCredit call, and in the public call, they’ve cut back originations another 50% or so. The number might be in the high 40s. Now down to $100 million a month and I believe they had been running at about $500 million a quarter, so $300 versus $500. That’s 100s of millions of dollars of origination. It just keeps happening. Again, folks who are relying on securitization aren’t able to access those markets, so they’re holding back.

Even looking at the October number, we feel comfortable with our revised number because we’ve been more conservative on what’s going to happen from a lender perspective, but it is declining still. The credit environment has not improved and has not bottomed yet. That’s all we can say and the trend has not slowed to the extent we thought it would.

Chris Mammone - Deutsche Bank

Okay, on the Markman results and the outlook there for your legal expenses, I guess what if there is a lengthy appeal process to that trial? I mean what would that do to legal spending next year?

Mark O’Neil

That, we’ve never factored in an appeal. An appeal seems an unlikely scenario. It is possible, you never rule it out. Look, an appeals process would change things and I think it’s way too early to spec that. Let’s get through the trial. Our cap is not inclusive of an appeal.

Chris Mammone - Deutsche Bank

Finally, I guess if you were an auto executive Mark, I mean what would be sort of your ideal scenario for what the government should do to help improve liquidity by the industry or just improve structurally the industry?

Mark O’Neil

Look, this is really driven more by what they need to do to stimulate the economy and the lending. Again, I think if you talk to dealers and you even talk to manufacturers, it’s not that the manufacturers directly need help. It’s that we need help and GM aside right now, I mean all the projection show, them running into a cash issue at the current burn rate by next summer. So, GM has its own singular issue.

Let’s put that aside a second and say if we could stimulate the economy now or if we could stimulate lending, we could get back at 13, 14, maybe even thinner and an optimistic scenario to 15 million units. That would change the burn rates and therefore the bailouts wouldn’t be needed. So, the question is do you approach this as let’s get the consumer stimulated and out there buying cars or let’s give cash to the manufacturers to hold on?

Our preference certainly would be let’s get the consumer going because we all win or let’s get lenders stimulated to loosen up and extend some credit here. That’s what we’d like to see and that’s what we’d be lobbying for, if we had the opportunity to knock on President-elect Obama’s door right now, that’s what we’d be petitioning.

All that said we hope that GM and Chrysler are able to work things out. We don’t want to see an auto manufacturer fail, that’s not good for anyone.

Operator

Your next question comes from Franco Turrinelli - William Blair.

Franco Turrinelli - William Blair

First of all, thanks for the attempts at predicting the future here, which is very helpful. I mean I guess to kind of keep going along that road, what in your opinion would stop this continued cut back of dealership lender pairs? What should we be looking at to kind of get a sense that that might be flattening out?

Mark O’Neil

Look, if there was a predictive measure, I think we would have really locked onto it. Whatever the measure that we could all grab that would say credit is being extended and I don’t know whether that’s looking at the big five banks as a bellwether and saying what do the loan originations look like? Many of them don’t break out auto, but what do they look like on a relative basis quarter-to-quarter? As originations grow or asset based grows, that would be a sign, “hey, the credit’s being extended.”

One behavior that we do see that’s positive and we’re trying to monetize it as quickly as possible, but then again they are just limitations. Clearly the credit unions appear to have deposit basis and are stepping in and I think picking up a few points of share over here. They’re just so many of them and they’re so small, that it’s hard to get it to impact the numbers in the near term, but there is a lot of headline suggesting that the small credit unions, community banks, are stepping in and doing more lending where the large national or super regional players have been pulling back.

Again, there’s no data that we’ve found that lets us look at a gauge to say that’s improving, but there is lots of anecdotal and lots of kind of articles in the trade presses around that behavior. So, we don’t have a lot more unfortunately that we can use as a predictor here.

Franco Turrinelli - William Blair

I mean just to kind of listening to the answer that you’ve given to many of these questions, it really seems as though at the heart of all of these problems, it’s credit, but if credit was more available, then dealerships would be able to sell more and their financial health would be better, so we wouldn’t be as worried about consolidation and they might spend more on subscriptions, kind of etc, etc. Is that really the right way for us to think about this, but it’s not so much that we need to look at car sales; it’s really that we need to look at credit.

Mark O’Neil

Credit is the predictor of car sales right now. I mean there’s no one in the industry who views this differently and credit is fear on the bank side and I think there’s also fear on the consumer side of job loss, etc and not wanting to commit to a capital purchase.

There was a stat, a quote out from GM executive, I believe it was earlier this week; on Monday when the car sale numbers came out and look we can’t substantiate it, but it says, it was something along the lines of “October’s numbers were effectively adjusting for population increases running at the post World War II era numbers.”

That it is seems an unsustainable pace to stay this low, based on demographics and the fact that cars wear out, but we know that some kind of demand is building and each quarter that goes by that the consumer doesn’t spend is a higher probability that they’ll come back in a subsequent quarter and they’ll come back strong, but it has to be supplemented with the lender being available there to finance the vehicle and we just haven’t seen it and I think you’re not going to see the captives come back in the next year or two. I think their balance sheets are impaired for years.

So, we’re relying on the big independents to come out there and participate and until we see it, we don’t know. I mean a lot of what you hear the lenders saying is we’re going to go through and we’re going to be cautious through ‘09 and that’s all we have to work with.

Franco Turrinelli - William Blair

Well, I mean the other part of it is if we could see through some of these cyclical issues, it sounds as though most of the structural changes that you’ve highlighted and talked about are ones that ultimately would put DealerTrack in a better position rather than a worse position.

Mark O’Neil

Look, we said it a number of times and I’ll reiterate it. Every quarter that goes by, we’re more strongly positioned, whether that’s because of the strength of the network, whether that’s because there’s more subscriptions wrapped around and absolutely or individually we’ve rolled out more products and built more dealer relationships.

If you look at some of the press releases in the last quarter, BMW service centers have now standardized on Arkona; Tesla, a little bit of a halo brand, certainly not a volume brand, has standardized on Arkona; the new relationship with Hyundai that we just announced; we’re working on some other OEM relationships right now.

These are all really good things. A number of OEMs are looking at some of our other subscription products beyond BMS right now and we’re quite bullish that we are steadily penetrating OEMs we’ve never penetrated before and building stronger relationships. Dealers are more frequently turning to us asking for help to cut costs and find solutions and I think this doesn’t change.

I’m thrilled with our subscription numbers given this economy. I think it says the dealer is turning to DealerTrack as a technology solutions provider and we’re meeting that need. Can we translate it into dollars? Yes, over time and if we can do it concurrent with a snap back in transactions, this model is poised for very strong results, but we’ve got to get through this malaise in the near term.

Franco Turrinelli - William Blair

Yes, I must admit we didn’t raise our numbers for the Tesla announcement, but two quick questions for you and then I’ll get back in line.

Mark O’Neil

How about one quick one, because I think we have six more, but we’ll go beyond six guys.

Franco Turrinelli - William Blair

Okay. I mean you’ve got $200 million sitting on the balance sheet. I mean are you seeing some more opportunities out there or what are you doing with that?

Mark O’Neil

We are seeing opportunities. The pipeline is absolutely rich. I can’t give you any more details on that right now. Let’s just say there’s more than one opportunity and to add to that, it’s a very uncertain time. We are going to maintain a very conservative stance on ballot sheet positioning as we think most good companies are today.

Operator

Your next question comes from Peter Goldmacher - Cowen and Company.

Peter Goldmacher - Cowen and Company

I want to ask you a quick question, if you got a chance to listen to the ADP earnings call; they claim to be taking share in the DMS business, would love to hear your thoughts on that.

Mark O’Neil

Actually, we saw a quote that went something like this, Peter. So, I didn’t listen to the call first hand, so I’m going to discount this as third hand information, but that their original guidance had projected 6% to 8% growth in the auto business and because of dealer consolidation and other challenges, they were revising that to either zero or negative.

So, the only other comment I can make is every new car franchise dealer out there has a DMS already. You can see we’re substantially growing that business; every one of those sales is a conquest. So, if ADP is saying they’re gaining share, which if they’re saying it, I would believe it, it must be coming out from another player. It’s not coming out of DealerTrack side.

Operator

Your next question comes from Tom Roderick - Thomas Weisel Partners.

Chris Cowen - Thomas Weisel Partners

Hey guys, this is actually Chris Cowen for Tom Roderick. Just a quick question and sorry if you mentioned this earlier, I joined a little late; but on the transactional side of the model, I was wondering if you could give us a better idea of like given the uncertainty surrounding where that might bottom, how quickly can you guys cut out the variable costs associated with transactional business?

I don’t know if you could put like a percentage number on it, but obviously it looks like from your implied Q4 that you’re going to lose some decent leverage there and I was just wondering how quickly you think you can react to kind of maybe right size it if things were to stay down for a while.

Mark O’Neil

Not quickly. There is not a person associated with 1,000 incremental transactions that you can readily identify and say cut them and as you’re probably aware, our sales force is substantially in place to sell subscriptions or lenders effectively do the selling for us and because we’re already connected to all dealers, they already have a natural inclination and behavior to use our network.

So, the substantive part of our costs around that transaction network are supporting the network and whether you do 3 million units or you do 5 million units, many of those costs exist. So, there isn’t a lot of variability. We would have to look at new initiatives, R&D areas, etc, if we were trying to scale back expenses.

Chris Cowen - Thomas Weisel Partners

So, it is primarily fixed costs and if this were to keep going down, then it would potentially be money losing at some point?

Mark O’Neil

Yes. We’re long ways away from that.

Chris Cowen - Thomas Weisel Partners

I was wondering if you could comment maybe on obviously the domestic cap to financing environment has changed significantly and they’re tightening up a lot; are you seeing the same from format manufacturers or is it across-the-board just bad or is like Toyota, Honda doing a little bit better versus say GM, Ford?

Mark O’Neil

We haven’t seen quite the tightening and certainly not the outright kind of cutting off a hard threshold and throwing the business to independent banks. With the import manufacturers as we have with the big three. They are very uniquely contracting and shutting down parts of credit where everyone else is still tweaking models and staying there pretty much holistically for the dealer.

Less leasing, as you can imagine by the imports, particularly the high end because of the uncertainty of residuals and no one willing to take on that risk, but they’re pretty much in the game still doing a reasonably full spectrum, near prime to prime financing.

Chris Cowen - Thomas Weisel Partners

Okay, so the cap just throwing off is just mostly the domestic guys then, right?

Mark O’Neil

Yes.

Operator

Your next question comes from Gary Prestopino - Barrington Research.

Gary Prestopino - Barrington Research

Mark, are you at liberty to just tell us what the installs on Arkona are at the end of the quarter?

Mark O’Neil

We hit in the summer 1,000 installs. We are not giving that update quarterly, more for competitive reasons. We will give it periodically, but I don’t think it’s to our advantage. Let’s just say as we said earlier, we’re maxed out on install capacity right now.

Gary Prestopino - Barrington Research

Okay, and then looking at it the same way, was there significant growth in InventoryPro installs as well?

Mark O’Neil

Yes. InventoryPro, DealWatch, and BMS all had very healthy growth in the third quarter.

Gary Prestopino - Barrington Research

Okay, great and then this whole issue with dealers consolidating, dealers are closing, dealers maybe worsening, being forced to be closed. I mean as you look at right now your base of dealers that have subscriptions, which is what about 13,700. Are you looking at that and saying there is or some of those dealers would be at risk to being closed down, consolidated or whatever?

Mark O’Neil

Yes, sure they are. I mean percentage wise, they are 65% of all dealers and we lose 2,000 dealers next year; it’s a certainly high-end number. We’re not quite projecting that, but its easy math. Would we be at risk potentially with 1,300 subscriptions? We would say mathematically yes and actually our average dealer has more than two subscriptions, so that does present risk and in fact that’s to happen this year.

If you look at the 1,600 we delivered this quarter, that’s already in the context of as Bob touched on. I’ll use round numbers, the actual number’s 590, but we call it 600 in the first nine months. So 65%, I would have said, “hey, over the year we lost 360, maybe 400 dealerships who went out of business, who would have had at least mathematically two or more subscriptions; our growth was in spite of that.” So, that’s factored into our numbers.

I will tell you, the more consolidation we see, the more dealer unrest, the more dealer concern, the more they’re looking at our alternatives, because we are positioned across-the-board in the market as a low cost player and everyone out there is saying is there another alternative available to me that does X and does it cheaper and we stand up pretty good when you ask that question.

Robert Cox

Gary, I would say anecdotally that while statistically over the last five years the dealers that have closed have been on the small dealer side of the business. If you were to say that that would be the trend that would continue, then we probably wouldn’t lose quite our fair share. Kind of the open issue on our side is does this start creeping into the mid sized dealers; maybe a little more of the urban dealers than in the past. So, at the very most, it’ll be at the median which it will lose our fair share of the dealers, a statistically fair share.

Gary Prestopino - Barrington Research

Okay, and then getting back to some of these new products and I think this is some important terms of investors, because investors are looking for you to really flip flop your revenue stream here and move it away from transactions in a way, and move it towards subscriptions. With the newer products that you’re talking about, like Arkona, Accessories, InventoryPro, all these are subscription products. I mean is it very safe to assume that the uptake growth has been more than the 20% or 21% that you got in this quarter?

Robert Cox

Because of those, because that’s a net number you mean Gary?

Gary Prestopino - Barrington Research

Yes.

Robert Cox

Yes, that’s a fair statement.

Gary Prestopino - Barrington Research

That’s fine and then Bob just real quickly, what’s your CapEx and capitalized software going to be this year?

Robert Cox

We had originally guided the $16 million to $18 million; we haven’t moved off of that, we may be at the low end.

Gary Prestopino - Barrington Research

Okay, and capitalized software?

Robert Cox

That’s included in there. I apologize, I don’t have that break out.

Operator

Your next question comes from Mitchell Bartlett - Craig-Hallum.

Mitchell Bartlett - Craig-Hallum

Yes, I don’t mean to beat a dead horse, but just to clarify, you’ve talked about losing a large lender is pretty damaging and it’s hard to make that up with all the little credit unions out there, but you are seeing some traction with them. Can you characterize what the mix shift is towards the smaller lenders? Can you give some bounds on how that’s going and in light of what is a fairly good average revenue per transaction number that you’re putting out?

Mark O’Neil

Right, well remember we price transactions on a volume basis. So, volumes drop, people drop in the higher price tiers; only add smaller volume lenders that also drive up price.

Let me phrase it this way. I think this year on a gross basis, we added close to 150 lenders by the end of the year and broadly speaking that’ll be substantially credit unions and small community banks and now we’ve indicated 40 plus will fall out. So net, that’s 100.

I think we can do that again next year and I think we can do it again the following year and I think we look at the pipeline of interested lenders. Dealers are pushing more away right now and they are clearly picking up share. All the data lags here, so we don’t know and credit unions I think we’re running in 2007, these are approximate numbers. About 17% to 18% of total auto loan originations were originated by credit unions.

To the extent we can get the majority of credit unions on our network that puts us in a good position. Will they grow their share next year to 18% to 19% or 19% to 20%? If the current behavior continues, that would be a reasonable number and we’d be well positioned.

So, again I only wish we could move faster, but it’s a very slow and steady process of bringing on 100 lenders.

Robert Cox

Well and Mitch as you know, the captives, at least the ‘07 number for the captives was about 24% of total financings and with the declining leasing and the pullbacks specifically by GMAC within the credit spectrums, you can expect that the captive percentage will be less in ‘08 as well and going forward if they don’t change the behavior. So, it’s really leaving a wider berth for the independents, for the credit unions, for the local banks. We just need some of them to step into that and take some share and we’ll be the beneficiary of it.

Mitchell Bartlett - Craig-Hallum

And also we’ve talked about some of the new products, but nobody’s brought up the accessories network, the aftermarket network. Tough market to roll out new products like that, but maybe if you could add any color.

Mark O’Neil

Very tough to roll out new products. Nothing really additionally to comment. I believe on the last call we said we couldn’t measure aftermarket until the first quarter when we had Allstate fully connected and up and running and Asco fully rolled out, but it’ll still take us to the end of this quarter to do that, so no updates there.

We are continuing to sign players and the same in the accessory business. It’s just virtually every vendor associated or distributor associated with the industry right now is pulling back on efforts; new initiatives, technology projects and that’s slowing things down there. I think if you ask at the end of Q1 and I think we’ll be able to give you color. We’re still building and positioning those, but we won’t see any material traction in the near term.

Operator

And that does conclude our question-and-answer session. I’d now like to turn the call back over to Mark O’Neil for any additional or closing remarks.

Mark O’Neil

No closing remarks other than guys, thanks a million for the questions. Thanks for your continued support and know that we just continue to position the business here for one this lending environment turns around. So, here’s to it turning around as quickly as possible. Take care, everyone. Bye, bye.

Operator

And that does conclude today’s call. We do appreciate everyone’s participation. You may disconnect at this time.

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Source: DealerTrack Q3 2008 Earnings Call Transcript
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