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Group 1 Automotive Inc. (NYSE:GPI)

Merrill Lynch & Co., Inc.'s 2013 New York Auto Summit

March 27, 2013 9:40 am ET

Executives

Earl J. Hesterberg - Chief Executive Officer, President, Executive Director and Member of Finance/Risk Management Committee

John C. Rickel - Chief Financial Officer, Chief Accounting Officer and Senior Vice President

Unknown Analyst

I'm very pleased to introduce Earl Hesterberg, President and CEO of Group 1 Automotive. Earl's been with the company since 2005 and previously served as group Vice President of North America marketing, sales and service at Ford. And with them is John Rickel, Senior Vice President and CFO, who came over with Earl from Ford, where he was controller of Ford Americas and previously CFO of Ford Europe. And I will just mention that in the last 18 months, Group 1 stock has been one of the best performers at our coverage, and Earl and John here really had a lot to do with that by generating substantial operating leverage in a foreign environment that still remains below what we would consider at trend level. So without further ado, I will turn it over to Earl, who will take you through the Group 1 story.

Earl J. Hesterberg

Thank you very much. Just in case you aren't familiar with the general history of our company, we're the fourth largest dealership group in the U.S. Last year, we retailed a little bit over 128,000 new vehicles, about 85,000 used vehicles. We're a little bit unique from some of the companies in our sector as we do not have any dominating or controlling independent shareholders, and so we truly are a public auto retailer. We're pretty well positioned for growth, most recently in Brazil, which we'll talk about a little bit, and we've had 2 years of pretty significant growth, which I will also detail for you.

Our geographic footprint, obviously, the company is U.S.-centric and has been through most of our history from 1997 with several of our founders from the Texas and Oklahoma area. We're currently up to 142 dealerships, representing over 180 franchises, we have 36 collision centers. We run our U.S. business on an east-west basis, with about 2/3 of that business coming from the West region, which includes Texas and Oklahoma. We've now got 14 dealerships in the United Kingdom around the London area, representing 6% of our sales. And we're just completing our first month of operating 18 dealerships in Brazil, primarily in São Paulo but also in the state of Parana, which is immediately Southwest and contiguous to São Paulo.

Our brand mix has always been very dominant with Toyota and Lexus, it's still about 30% of our company. And then you can see Nissan and Honda and BMW and MINI, all around 11%; and Ford, a significant part of our business at a little less than 10%. You can also see that Texas, California and Massachusetts are our primary geographies, and the U.K. showing up there at about 6%, but I expect will continue to grow.

This is our basic business model, again, if you followed companies in our sector, you'd probably have seen something like this before. It's very disproportionate in the importance of the Parts & Service business. While Only 12% of our revenue, our Parts & Service business generates 42% of our profit. Finance and Insurance business also is disproportionate in its contribution to our profit level, 4% of revenues generate 23% of our gross profit. So although a vast majority of our revenues, 57%, come from selling new vehicles, only a little more than 1/5 of our profit comes from that. Also, you can see our Parts & Service gross profit is very stable and more stable throughout the year -- economic downturn. And that, that gross profit from that part of our business covers a vast majority of our fixed cost.

Our financial results for last year indicate that we had a great growth here, keeping in mind that the U.S. new vehicle industry grew about 13.5%. We were able to grow our top line by about 23% and our bottom line by 25% or 26%. So I think that's the best summary of what we're able to accomplish last year. We got some good leverage from our cost structure, about 100 basis points. I would have to say we missed a little opportunity in the fourth quarter as we didn't get very much of that cost leverage in the fourth quarter, so we're working hard to turn that around and get another good year of leverage this year.

On a same-store basis, you can see that our new vehicle sales were up 16.3%, our total revenues up a little bit less than 14% last year. So it wasn't just our acquisition growth strategy that drove that top line growth of 23%, we outperformed the industry on a same-store basis last year as well.

I talked about cost leverage. You can see here how we began to leverage the cost structure as we came out of the downturn, particularly at the end of 2009, and we've gotten almost 5 full percentage points of leverage over the last 3 to 3.5 years.

We continue to grow cash flow as we've grown the top line and the bottom line in our company, that's grown from about $117 million of cash flow generation in 2009 to almost $160 million of operating cash flow last year. Although this is not the highest margin business in the world, it's a very good cash-generating business.

Now, some part of our cash flow obviously needs to be reinvested back into the business, in particular, into facilities. And you can see that we had to pull back quite a bit in 2009 on our cash flow and capital expenditures, or the use of our cash flow and capital expenditures, and we've started to handle some of those deferred projects here in the last year or 2. And in addition, some of the acquisitions we've made in the last couple of years require some facility work. And we spent $62 million last year, and we would expect to spend a similar level, perhaps a little bit more this year, but in any case, less than $70 million.

We are going into our third year of trying to grow the company aggressively. We believe that's still the best use of our cash, it would be our intention to continue to find acquisitions to clear our return hurdles of 15% to 20% pretax discounted cash flow. I'll show you in a minute, we've had 2 international acquisitions already this year. I'm optimistic that by the end of the year, we'll continue to find ways to grow our U.S. business as well. Our quarterly cash dividend is $0.15 per share, and that's one of our alternatives when we can't find growth opportunities externally. And in the last quarter of last year, we didn't repurchase any shares, but we did repurchase a little less than a 0.25 million shares last year at an average price of a little bit below $47 a share. We still haven't opened a repurchase authorization on the books.

I talked about external growth opportunities. You can see in 2012, the bottom line on this chart that we made a wide range of different types of acquisitions last year, and $715 million in annual revenue were acquired across the U.S. but also a fairly large Audi dealer group in the U.K. East and North East of London. You can't see, unless you look at the footnote, that we also disposed of 6 franchises with total 12-month revenues averaging about $128 million, so the net add to the company was a little less than $600 million of annualized revenue. But you can see in the first 2 months of this year, we've added another $827 million of annualized revenues through the purchase of 4 dealerships in the U.K. and 18 dealerships in Brazil, which I mentioned.

The 4 Ford dealerships in the U.K., which include one collision center, will add an extra $177 million in annualized revenue. There, southwest of London, have to be in the exact same geography where we've already owned and operated BMW dealerships. So we now have 14 dealerships in the U.K.

You can see the geographies there kind of West and Southwest of London: Bracknell; Wokingham; Farnborough; and Guildford. Now, we are the BMW dealer in Farnborough and have adjacent dealerships just south of that.

I mentioned we added 18 dealerships in Brazil. We estimated annual revenues of $650 million. Last year, those dealerships sold 16,500 new vehicles. You can see the franchise of BMW and MINI, Toyota, Renault, Nissan, Peugeot, Land Rover and Jaguar.

I expect most of you know that Brazil is one of the fastest-growing economies in the world, and also now the fourth-largest vehicle market, it's now a bigger vehicle market than Germany. And industry sales of autos have grown at a compounded annual rate of over 9% there since 2007, and we expect a little less than 4 million sales there this year. But the growth potential of the Brazilian auto market is undeniable, very low density of vehicle population, well below Mexico and Russia, for example. 150 cars per 1,000 inhabitants, that compares to something like 800 in the U.S. The market's fragmented, we believe we have an opportunity to expand but also to be one of the most sophisticated and professional dealer groups in that market.

We continue to see great potential for growth in the U.S. market in the next few years as well. However, still a lot of pent-up demand, the age of the car park is as old as it's ever been, near 11 years. The number of licensed vehicle drivers is on the rise. Financing is widely available in the market. And used vehicle prices, although they've softened recently, are still very strong, which helps consumers trade their vehicles. So there are a lot of very positive factors that lead us to believe that we have several good years at a minimum ahead of us in the U.S. market as well.

You can see the trend line we're on. Our estimate is, sales this year of 15.3 million to 15.5 million new vehicles in the U.S. We are taking some initiatives to further increase the efficiency in our company to further leverage our cost structure. To do that, we've had to make some incremental investments. We're very close now to finally having one business support center kind of more along the lines of central accounting center, although there are some other services we provide from there, and that's a major transition from having accounting in each dealership 8 years ago to having one central accounting center by the end of this year. And that along the line could save many millions of dollars, but certainly a $1 million annual savings from where we are now beginning next year.

We're going to one common computer system per customer relationship management in the U.S. Our CRM system is how we refer to it in our industry. At the end of this year, that will be across all of our dealerships and that will give us some marketing capabilities that we've never had before.

In addition, we're about halfway through the rollout of a central inbound service call handling center which should enable us to answer the phone within 20 seconds of 95% to 97% of the time, instead of 80% at the time, which is what we had when we had that service in each dealership. So these are key factors that help us not only become more efficient, but more effective. So it should help us sell more, it should help us make our people much more productive. We think over the last 3 years, we've proven that the business model works. We continue to balance our portfolio by brand and geography. We continue to develop the more nontraditional areas of the business such as Parts & Service and Collision Repair shop, finance and insurance, and that helped us get through the downturn, but it also gets us more leverage on the upside. We've got a strong balance sheet and we maintained a strong balance sheet through the downturn. We've got opportunities still to grow every area of our business, and I don't think the market conditions for our business have ever been this favorable, probably in the last decade in terms of the trend line per growth.

So with that, these are the core values of our company. In particular, professionalism is something that a large dealership group like ours should bring to the party for both the customer and the OEM. And that's kind of at the core of everything we do. With that, I think we can open it up for questions.

Question-and-Answer Session

Unknown Analyst

This is just a question about March sales. March is typically a pretty high-volume month with sales -- for sales, the weather, it's a little warmer. Are you seeing any negative impact this March just from the relatively colder weather?

Earl J. Hesterberg

I mean, the place we've seen weather issues really has been kind of more in the Northeast, and we obviously have big concentration dealerships in Boston. That's really been more over the last 3 or 4 weeks than kind of specific to March at kind of weekend after weekend, the big snowstorms up there that weren't really helpful. But -- and of other than that, if you look at kind of the public information, we obviously don't report monthly sales, but if you look at the public information, the prognostications from March look to be kind of on track with that 15.3 range that we're talking about for the industry. So based on everything that we can see that's publicly available, we look to be on track with what we're expecting.

Unknown Analyst

And this is just a quick one about Brazil and Europe. Auto sales are obviously very cyclical, and we're in an upswing in the cycle now in the U.S. Do you think the exposure to Europe and Brazil kind of helped hedge against eventual volume declines in the U.S.? Or is it more of a long term just growth strategy?

Earl J. Hesterberg

Well, it's both. I mean, it's a long-term growth strategy, but it is also the hedge. We think there are a number of years left in the U.S. recovery story. We're 15.3 to 15.5 this year. We think trend is 16.5, you're going to have to have a couple of years above trend to kind of start to bring down the age of the carpark that Earl talked about. But at some point, this is a mature market. And at some point the growth is going to slow, and when that happens, we think what we're offering investors with the investments in the U.K. and now, particularly Brazil, is someplace else to go for that growth to continue our growth story. So that's absolutely the thinking.

Unknown Analyst

Would you talk about the current trends within the Parts & Service business?

Earl J. Hesterberg

It's interesting. Looking at the Parts & Service business, first, the warranty part of the business, which maybe 20%, 25% of the business. There was a time a couple of years ago when that was clearly declining with the rationale being the improved quality from the OEMs, which is true. But since that time, it has flattened out, and the decline hasn't been quite what we might have expected, and some of that has to do with recalls. There have been a much higher frequency of recalls from virtually every manufacturer in the last 2 or 3 years in the aftermath of the Toyota issues. It appears that there's a much more sensitive hair trigger for recalls, and that business shows up as warranty in our business because the factory pays for those inspections and repairs and things like that. The customer pay business seems to be coming back nicely now. First, the shrinking carpark or units in operation from declining vehicle sales were a bit of a headwind the last couple of years, and consumers were delaying work during the downturn as well. But for example, at the end of last year, it appears that the math is starting to favor us again with a building carpark from the sales increase, I think our same-store Parts & Service business last year was up 2% for the year but up 4% in the fourth quarter. So you could kind of see what I hope, is a little better trend in that area. So we should start to pick up a little benefit from expanding units and operation, and then also, hopefully, a little more consumer confidence and financial willingness to pay for repairs. Our company has also invested in adding 2 or 3 Collision Repair shops every year. We think that is a good business that lends itself to large professional operators and a type of business where we can control our own destiny regardless of the economic environment.

Unknown Analyst

Would you comment on pricing trends within the Parts & Service business?

Earl J. Hesterberg

I'm sorry, pricing trends within Parts & Service? I would say they're stable. I would say pricing trends are stable. I will admit that because it is a priority with our company and I think others as well, is we will continue to be aggressive in pricing maintenance and very competitive types of products. So in any given quarter, that could hit us 0.5 point or 1 point in margin, but we run pretty consistently around a 52% gross margin in our Parts & Service business, mixing labor and parts, and I would expect that to hold fairly stable.

Unknown Analyst

Can you talk around a little bit about the Parts & Service environment in your Brazil acquisitions honoring -- being a big issue on the -- or a big benefit on the luxury side? Is that something that we should look for? Has it helped you?

John C. Rickel

I think over time, there is a lot of opportunity in Parts & Service in Brazil. I mean, it's one of the ones where you got to have the carpark continue to grow. And there's the development of the customer base, but we think there's certainly opportunities there as we go forward. It's one of the things that we think we can help them with, some of the focus that we bring on Parts & Service.

Earl J. Hesterberg

Yes. Warranties tend to be a bit shorter there right now, I think that will change. The volume vehicles in the market by the manufacturers, they dominate, such as Volkswagen and Fiat with 20% shares, are very simple older technology vehicles without many electronics. The brands that we're selling tend to be a little more upmarket, Japanese brands like Nissan and Toyota are probably closer to luxury than volume brands there, at least to date. As they start to manufacture local cars, I think they'll make cheaper, smaller cars. But some of the brands we operate should have a little better potential for owner service loyalty. But over time, I think that sophistication of vehicles in Brazil will increase with more technology and electronics. And I think there's a big Parts & Service growth potential over the next decade for auto dealers in Brazil, and we hope to lend our expertise to that.

Unknown Analyst

In the states, presumably new car sales rise, your dealerships will get more trade-ins that's going to affect used car values. How do you think that's going to roll out over the next 3 or 4 years with the benefits that you had on the used car margins really over the course of last 3 years? You guys think are going to see some contraction there?

Earl J. Hesterberg

Well, we actually saw contraction over the last couple of years. The issue we've been faced with is that used vehicles are actually a more stable part of the market than new. And as new vehicles trailed off during the recession, our best source of inventory, if you will, is the trade when somebody comes to buy a new vehicle and that fell off as the new vehicle sales fell. We got down to a low of about 50% of our used vehicles being sourced via trade-in, where kind of prior to the recession, we were running about 70%. That puts some downward pressure on our margins. If you look over the last couple of years, we were running prior to the recession, close to $2,000 a copy. We're right now, kind of 17, 17 50 [ph]. We think there is actually opportunity in the move that back up over the next couple of years as that flow of trade-in starts to come back. Really starting later this year and into 2014 is off-lease units start to return to the market. And we went through a couple of year period where there weren't a lot of off-lease units coming back, because leasing pretty well shut down during the recession period. As those start to come back, that'll be the first piece of it. And then as the carpark gate starts to come down, we should start to get a better flow of better quality trade-ins as well. Both of those should help. But we have to go to auction to source cars. We're paying $500 to $1,000 more kind of for a similar vehicle. You got auction fees, you got transportation cost, and you're ultimately bidding against other dealers. So it's a more expensive place to pick up inventory, so we think there's opportunities going forward there.

Unknown Analyst

What are your biggest challenges on the cost side? And what's the biggest -- what are the biggest near-term opportunities? As you mentioned the CRM system and support center, how long do you think it is until those investments really start to pay off?

Earl J. Hesterberg

I think the challenge for us in our business structure is always going to be on the human side, because 60% of our SG&A, plus or minus, is always personnel cost. So we have to find ways to make our people more productive. I was in a NADA event yesterday, I think some of you were there also. They showed, for example, that the productivity of salespeople over the last decade, or maybe it was even longer than a decade, hadn't really improved much while you're selling 8 to 10 cars per month per salesperson. And we've got to find a way to change that. And there's a similar concept with service advisors, can they write more repair orders per day, can we sell more per ticket, things like that, per person? And that's where we have to learn to leverage technology. So as I mentioned, the service call center, if we can free up our service advisors from answering the telephone, they can spend more time with the customers and the drive. If we answer every telephone call, we will get more service appointments. Each repair order is worth $150 of gross profit to us. So there are ways -- we have to become more productive. So it's on the human side that we have a lot of work to do. And I think thereby, that's our best opportunity, is how to get more out of our people.

Unknown Analyst

Great. Let me kind of squeeze in one more. What are inventories like in your U.K. stores? Because we're hearing that production isn't declining as much as it should be in Europe, and that I'm wondering if there's an inventory inflation happening on...

Earl J. Hesterberg

Well, the way the U.K. system works, we don't really stock the inventory at our dealerships. The manufacturers for most every brand hold them at the central holding center. So while I can see that pressure in the market of the overcapacity, it does it doesn't show up like it would in the U.S. with more cars on our lot and a big floor plan bill. Now, we do have some interest cost in the U.K., but it's only a fraction of what it would be in the U.S. So it's for per units that become a certain age or a demo car stock, which the manufacturer may try to get us to inflate a little bit, but it's not a significant factor for us in the U.K. John, do you?

John C. Rickel

Yes. No, I agree with that. It's just a kind of a different setup, so it's not the same sort of inventory pressures that you would see here.

Earl J. Hesterberg

I mean, outside of the U.K., I mean, the European auto market's a mess, has been a pleasant surprise how well the U.K. industry held up all last year and appears to be holding up so far this year.

Unknown Analyst

As you've gone into Brazil, are you finding that purchase multiples are similar? Or are they more advantageous to be in a foreign market? Meaning, would you see more opportunity coming to you guys in Brazil than with here in the U.S.?

John C. Rickel

That's a good question and I can't answer it yet, because we haven't looked to purchase anything other than the original company that we bought in its entirety. And I think it's hard for me to tell what the multiples are for what we purchased. I'll have to look back on that someday, but it pretty well comes out to $5 million or $6 million a dealership, which I have, I guess, $6 million a dealership, which I think will be very cheap someday. But the limited knowledge I have is that there haven't been enough meaningful buy sales to occur in Brazil for us to really know what those multiples are in the market. It appears to me that we will have many expansion opportunities in Brazil, if and when we want to take advantage of them, they will be driven by the OEMs and will not necessarily even involve necessarily purchasing businesses. And every OEM I met with, I met with all of them actually last week that we've represent, are very excited to have a well-capitalized partner down there. So I think we're going to get a lot of opportunities, but I can't yet gauge those multiples. If the multiples were any higher than the U.S. it wouldn't make sense. I just wouldn't pencil on a 15% or 20% return on investment. But it does appear that Brazil, like the U.K., the bigger challenge, particularly in São Paulo or Rio, the big metros, it will be real estate.

Unknown Executive

The one in the back?

Unknown Analyst

I think you -- just a question about your -- you mentioned in your presentation the consolidation of your accounting from the dealers to central accounting. How long -- I know you expect to finish it by end of this year, but how long will that process have taken? And how much of that was motivated by cost savings versus sort of command and control, making sure of the integrity of the information?

Earl J. Hesterberg

Well, I'll start, and John is the expert, so I'll let him finish. But I can tell you it started as control. It started with financial control being a public company and with some of the historic and inherent accounting and control weaknesses in automotive retailing, and we wanted to eliminate those, and our board and auto committee wanted to eliminate those, so that's how it started. It then had a lot of other benefits and things. I'll let John talk about it.

John C. Rickel

All right. As for when it started, I came to Group 1 in December 2005 and we started to process, really, January 2006. For the very reasons that Earl's talking about, to be able to sign off on the internal controls, the C&I have to do every quarter, it was clear that you were never really going to get the robust control environment unless you add kind of a consistent approach. When we first came to the company, we didn't have the Standard Chartered accounts. There are different ways of accounting across the dealerships, so we had a lot of fundamentals to put in place. The nice side benefit that's come from that has also been pretty significant cost savings as well. From where we started to today, probably $7 million of annualized savings that we've been able to take out from having it consolidated, we're now down to this final step, which is to put our last 2 centers together. We have 1 in Boston, 1 in Houston. And by the end of this year, it will all be located at our business support center in Houston. For 2014, that ought to reduce our accounting cost by another kind of million dollars annually going forward. But the real, real driver was to ensure that we had appropriate internal controls, which we are now very proud of our control environment and where things stand, but the nice benefit is some pretty significant cost reductions as well.

Unknown Analyst

Just to follow up on that, if you had to start from scratch today in a decentralized environment, do you think you could do it faster than 7 years? Do you think it would take you 6 or 7 years?

Earl J. Hesterberg

Well, I mean -- yes, you know what we know today...

John C. Rickel

Yes, knowing what we know today. But I mean, there were a lot of enablers that had to go in, it wasn't just the accounting, and a lot of the operational changes had to happen to be able to support that. So it was being able to move along and continue to support the business. I mean, ultimately, we're a support center and we can only move as fast as we can bring the operations along. So yes, probably could do it faster, but it still probably wouldn't be overnight if you were starting from completely decentralized.

John C. Rickel

All right. I think we're out of time.

Earl J. Hesterberg

We're out of time, perfect. Thank you.

John C. Rickel

Thank you.

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