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Executives

Roger Penske - Chairman

Robert O'Shaughnessy - Chief Financial Officer

J.D. Carlson - Controller

Tony Pordon - Senior Vice President

Analysts

Edward Yruma - J.P. Morgan

Rich Nelson - Stephens

Matt Nemer - Thomas Weisel Partners

Rich Kwas - Wachovia

John Murphy - Merrill Lynch

Scott Stember - Sidoti & Co.

Matt Fassler - Goldman Sachs

Rex Henderson - Raymond James

Tim Secanty - Northern Trust

Jonathan Steinmetz - Morgan Stanley

Penske Automotive Group (PAG) Q1 2008 Earnings Call April 29, 2008 2:00 PM ET

Operator

Good afternoon ladies and gentlemen and welcome to the Penske Automotive Group first quarter 2008 earnings conference call.

The call today is being recorded and will be available for replay approximately one hour after completion through May 6, 2008. Please refer to Penske Automotive’s press release dated April 9, 2008 for specific information about how to access the replay. I would now like to introduce Mr. Tony Pordon, Senior Vice President of Penske Automotive Group. Sir, please go ahead.

Anthony Pordon

John, thank you and welcome everyone. As John indicated, our press release detailing our first quarter results was released this morning and it is posted on our website at www.penskeautomotive.com.

Participating on the call today will be Roger Penske, our Chairman; Robert O'Shaughnessy, our Chief Financial Officer; and J.D. Carlson, our Controller. At the conclusion of our remarks, we will open the call up for questions and will be available by phone to answer any follow-up questions that you may have.

Before we begin today, I would like to remind you that statements made in this conference call may include forward-looking statements regarding Penske Automotive’s future reportable sales and earnings growth potential. We caution you that these statements are only predictions which are subject to the risks and uncertainties including those relating to general economic conditions, interest rate fluctuations, changes in consumer spending and other factors over which management has no control. Our actual results may vary materially from these predictions.

These forward-looking statements should be evaluated together with additional information about Penske Automotive Group which is contained in our filings with the Securities and Exchange Commission including our 2007 Annual Report on Form 10-K.

During this call, we would be discussing certain non-GAAP financial measures such as adjusted income from continuing operations and adjusted earnings per share from continuing operations.

Adjusted first quarter 2007 earnings exclude the $12.3 million or $0.13 per share sub debt redemption charge we recorded in the first quarter of 2007. We believe such non-GAAP disclosure improves the comparability of our financial results from period-to-period and is useful in understanding our financial performance.

At this time, I would like to introduce our Chairman, Roger Penske.

Roger Penske

Thank you Tony and good afternoon everyone and thanks for joining us this afternoon.

The first quarter was a great way to start the year as our business posted solid overall revenue and earnings growth. Like many sectors of the retail environment, the first quarter was challenging particularly as it relates to new vehicle sales here in the US. Although new vehicle market continued to struggle, our results certainly showcase the strength of our business model and the benefit provided by our brand mix and diversified revenue streams.

The recently completed registration period in the UK highlighted the strength of that market as registrations increased during the period and contributed to our success in the first quarter. During the quarter, retail sales units increased 2.6% to 72,461 units. New was up 1%, used was up 5.3%, and total revenue increased 4% to $3.2 billion.

On a same store retail revenue basis, it decreased 2.3%. We were down 4.8% in the US and internationally, we were up 1.4%. The decrease and the softness is in both the premium and value in foreign businesses here in the US particularly in Arizona, California, and Florida just were a couple of data points. Arizona and California were down between 18% to 20% on new, Florida was down 10% and we are up about 3% on used in those markets, so even though we had the deterioration on the new side we had some pick up on used.

As a result overall same-store retail revenues declined 5.5% due to an 8.9% decline in revenue in the U.S. Overall on the new vehicle market was challenging same-store used retail revenues increased 2.2% putting 3.6% growth in the U.S as we continue to implement programs to enhance our used vehicle operations. Our service and parts business holds steady generating same-store growth at 1.1%. We had a 5.5% same-store growth in F&I despite the softness in the U.S market due to the continued growth of this business overseas. Seeing the impact of exchange rates, overall retail same-store revenues declined 3.1% including a 0.4% decline in our international operations.

In total changes in exchange rates resulted in $25 million increase to revenues and less then a penny per share benefit to EPS in the first quarter. Interest in every selling prices at new and used decline with $35,900 down $100 on new for the quarter and used was down almost $700 to $29,800. Our revenue mix in the first quarter was -- internationally was 40%, U.S was 60% and that was the same as it was in 2007. On a world wide basis foreign and premium name plates represented 94% of total revenues including 65% from premium brands.

The victory contributed 6% consistent with the first quarter last year. They took the U.S alone, the victory was 8% of our revenue. Trying to look at specific brand mix as you can see our press releases as put out this morning will you give more specifics. During the quarter our operating income was 46% in the U.S and 54% internationally.

Turning to gross margin, the overall gross margin for the quarter increased 43 basis points to 15.4%. New margins in fact remain stable at 8.4% despite the slower selling environment and used margins increased from 7.8% to 8.4%. With a $76 increase per unit in F&I to $1036, the good news is our service and parts continue to perform well as our margins improve 50 basis points to 56%.

We have noted that our SG&A as a percentage of gross increased 74 basis points to 80.8% in the first quarter. This can be largely attributed to the de-leveraging of our expenses in the U.S as same-store growth profit declined 3.6% due mainly to the weakness of the new vehicle market in the United States. Our tax rate for the quarter was 35.8% compared to 34.3% last year and if we look at it for the balance year we think our annualized tax rates will be approximately 35% to 36%.

Moving on to the balance sheet, total vehicle inventory was $1.7 billion which is up $137 million compared to December and on the same-store basis vehicle inventory was up a $122 million compared to December and breaking that out it was $97 million new and $25 million used. At the end of the quarter our world wide day supply of inventory was in solid shape 51 days on new and 33 days on used if you go back and look at that at the end of the year we were at 59 days, so we have really come since 12, ’07, we are 43 days on used. If you go back to a year ago, we were up ten days at inventory on new 41 to 51 and used is really 31 for 33. So not much increase in used, so we think our inventory grew pretty decent shape. United States in our used inventory for the quarter was 30 days.

Moving onto CapEx. Gross CapEx in the quarter was approximately $49 million. Sale-lease back proceeds were $4 million for the quarter. As a result, our net CapEx for the quarter was $45 million. In 2008, we expect to complete sale-leaseback transactions as a result in net capital expenditure of approximately $50 million in 2008. However, based on the impact of the recent turmoil in the credit markets we may delay these transactions until more favorable rates become available.

Looking at our leverage, we had $844 million of non-vehicle debt consisting of $750 million of senior subordinated notes at a blended rate of 5.625%. We had $91 million drawn under our foreign credit agreements at a blended rate of 5.7%. We had no outstanding under our US credit agreement at the end of the quarter. As a result, we had approximately $375 million availability under our credit agreements and we have considerable equity in our vehicle inventory also, approximately $80 million at the end of the quarter.

As of March 31, our debt to capital ratio was 37%. We had $1.7 billion at Floorplan notes outstanding at the end of the quarter. We have slots that convert the $300 million of our Floorplan at a fixed effective rate of 4.65% through January of 2011 with the remaining $1.4 billion, approximately 50% within the US. When you include the $1.7 billion in Floorplan, 43% of our debt was fixed with an average interest rate of 5.1% and an average maturity of 4.8 years, so we are in great shape.

Looking at acquisitions, we did not complete any acquisitions during the quarter. However, in April, we completed the purchase of an Audi business in the UK and a Toyota Scion business in the US. We expect these on an annualized basis to generate about $150 million in annualized revenue and we sold off one franchise during April which will reduce that revenue to a net revenue annualized of $30 million.

Turning to our Smart distribution business; as you know, we began selling the smart fortwo in January. We also expect to have 74 Smart centers doing business in 2008. We currently project the dealership network to consist of 28 exclusive Smart centers that parts and service; 33 shop-in-shop centers inside Mercedes Benz facilities; and 13 standalone sales centers which will share MB service facilities. 68 of those dealerships are in operation today, eight of the Smart retail outlets are owned and operated by PAG.

In Q1, we delivered wholesale 4,913 units to the retail network. We continue to estimate 20,000 to 25,000 wholesale deliveries in 2008 and earnings per share contributions I think will be somewhere between $0.08 and $0.12. We certainly are excited about the Smart business. We believe our timing is right. This is another key differentiator for us to look at the Penske Automotive model.

Looking to guidance, we provided guidance in our press release this morning. We currently expect second quarter earnings from continuing operations to be in the range of $0.45 to $0.47 per share and we continue to expect earnings from continuing operations to be in the range of a $1.63 to $1.71 for the year; our guidance is based on $95 million weighted shares outstanding.

Let me just make a note on our share repurchase program. Before I close the call I want to address the share repurchase program that we announced in February. Today we have not repurchased any shares under this program, we will continue to monitor the market and we will make purchase when prices we think are appropriate certainly to our open trading windows.

In summary we had a great quarter, I was pleased with the performance of our business in a difficult operating environment. As I indicate at the beginning of the call our results continue to showcase the strength of our business model and the diversification provided by a premium luxury brand mix, international operations and our smart distribution business. Thanks for your attention and we look forward to talking to you and we’ll open the call now.

Question-and-Answer Session

Operator

(Operator Instructions) First to the line of Edward Yruma with J.P. Morgan. Please go ahead.

Edward Yruma - J.P. Morgan

Can you give us a little bit more color on the performance of in-skip intern sale? Have these ramped as quickly as you might have expected given the weakly eco environment?

Roger Penske

Well, I would say the good news is the in skip -- we have completed all of the construction, we got our management team in place and I think that we were positive in the first quarter. I think that we will see an upward trend as we go into the second, third and fourth quarter of the year. We are still under construction and chances of overwriting an Audi point -- open Audi point there and we expecting to finish that up at the end of the year and again I would say that they are still not generating the EBT that we are forecasting. Obviously as we go forward and when you think about San Diego and think Scottsdale 101, it takes a couple of years to get them in a position where we’ll produce solid results, but at this point they are surely not a drag on earnings.

Edward Yruma - J.P. Morgan

And have there been any surprises to-date in terms of the smart vehicles that you retailed, in terms of the model that people prefer and the level of accessorisation?

Roger Penske

Let me say this that we had expected the inexpensive model, that pure would be 10% to 11% of our brand mix. It’s running 3% to 4% and the interesting thing is that people can figure their car; we are looking at anywhere from a $1000 to $1100 more content, so that’s part of the -- and the average selling price for the first quarter is right around $15,000 which is positive for us and I think that it’s unique when you think about today’s new vehicle environment that we are able to sell this brand into a separate market, but I think the vehicle itself with the fuel economy that’s certainly metro favorable from the stand point of size and I think the receiving hours will be great as we go forward. We delivered -- I think I said in my comments, we wholesaled 4900 units in the first quarters.

Edward Yruma - J.P. Morgan

And one final follow up. Can you give us a little bit of color around acquisition multiples particularly in the U.K, thank you.

Roger Penske

Well, the motors in the U.K have always been less than the U.S and they continue to be the same. I can’t say today whether they are 30% or 40% less, it depends on the particular situation but typically we have not seen an increase other than if we are trying to buy something that would be up close in our own markets; you might pay a little more for that but typically the multiples are pretty much the same.

Edward Yruma - J.P. Morgan

That’s it, thank you.

Operator

And our next question is from Rick Nelson with Stephens. Please go ahead.

Rich Nelson - Stephens

The smart distribution, I have a question about the gross margin. You reported a 15.9% gross margin in the first quarter. How should we think about that as we move forward if the mix stays similar, would the impact be similar and what are the cost below that gross margin line?

Roger Penske

I think we probably got a little bit of a bump in the first quarter because of the parts that we delivered out to fill up the network that was 101 shot that we get in the first quarter. We won't get that on a continuing basis and as we get units in operation that will certainly grow over the next two or three years which will be certainly a benefit for us and for the dealers. The other question was -- yes, repeat that for me would you.

Rich Nelson - Stephens

The costs below the margin -- what are the major costs?

Roger Penske

We have normalized G&A, we have marketing costs, we have our people costs, traveling and I think that we have guided 8 to 12 and we made $0.02 in the quarter and we don’t really break out the SG&A to run this business that we showed overall.

Rich Nelson - Stephens

And there were 5,000 units?

Roger Penske

4,900 -- I think 4,913 to be exact was what we wholesaled. We would expect to be in the 6,000 range for the next -- 6,000 to 6,500 for the next three quarters. However, we have got the month of August where the plant is shutdown, we got model changeover, so I'm not sure what kind of impact that will make. So I'm pretty comfortable between 20,000 and 25,000.

Rich Nelson - Stephens

Thank you and can you comment on April trends maybe as they relate to what you saw in March? Are you seeing much change in the business?

Roger Penske

I think that we certainly saw March better than January and February because where we are located in many cases I think used car business seems to be better because we have concentrated a lot on selling the car retail rev and whole selling it but I would say the trends are probably pretty much the same as we come out of March and April.

Rich Nelson - Stephens

And the UK market has been pretty resilient. Has it seen the big declines in the US market? What does your crystal ball kind of --?

Roger Penske

I'm not sure of my crystal ball. I can say that the market in the UK was up I think 0.7% and the expectations from the auto association there, they are estimating a flat market in 2008. So we feel pretty good about that and when you think about our premium luxury, I know there has been lots of pressure on premium luxury in the US. 95% of all of our business internationally is premium luxury and we have not seen the margin pressures. Today, in fact, when you look at our new car margins, they were in good shape for the quarter.

Rich Nelson - Stephens

And just a question about the CapEx requirements that a lot of the OEMs are I think out there for the dealers and particularly the employees and some of the larger dealers, where do you stand in terms -- are those mostly behind you now at this point or --?

Roger Penske

We have as you know probably -- and I’ll have to go back and get the right number but I think acquisitions have generated $5 billion or $6 billion of our revenue over the last five or six years, so we’ve had a consistent number of acquisitions and every case as we buy a store, the OEM looks at the facility and part of our agreement as we would take it over would be to meet the current CI requirements. So we’ve made a lot of those investments. I know there is some brands which are pushing hard now specifically in our Mercedes Benz at auto house. We probably have a $7 million to $9 million estimate for what we have to do but the good news on the other side of that is we will get additional $400 per car which supports that, so I think when you are all done you are going to be -- even money, the cash flows that you will get from the cars and that will retracted back to the beginning of this year. Obviously can’t get that money until you met the criteria. The benefit will be the customer and also the environment your employees work in and well you meeting the brand standards -- we have made auto house and every single case in the U.K. So we have been building this consistently in our acquisitions in the U.K, so we were okay with it. I know a lot of the dealers I have seen -- an automotive user complaining about the cost. Obviously it’s something we have to look at and what we would do, would probably look at either on acquisition or an existing dealership and if the CapEx did not give us the returns we would expect meaning more service pays and give us the margin we want, we would probably dispose of it. Also as you start to look at margins now, there’s the front end margin and the back end margin and much of this back end margin there is a compliance requirement which requires CI; you won’t get that margin net on top of the -- so much per car in the case of Mercedes, so it’s a mixed bag and I think each one of us have to work through our own situation and it’s unfortunate that there has been many times our people have made significant investments and have to turn around and lead a new CI standard. We have gone into that, I wouldn’t say a number of times, but a few time and it’s somewhat disappointing but on the other hand I think we got to move on.

Operator

Next from the line of Matt Nemer with Thomas Weisel Partners. Please go ahead.

Matt Nemer - Thomas Weisel Partners

Hi good afternoon Roger. My first question it’s just following up on Rick’s question about the U.K retail environment. Obviously the media is painting a negative picture there and I am just wondering if you can give us more flavor on the mix of vehicles that are being sold over there and it’s just customer behavior in the U.K

Roger Penske

Well we have such a strong market share in the U.K and the premium luxury and when you think about the 15 BMW, 15 Mercedes, we have many stores with all of the BMW which obviously is a plus, with gas prices the way they are. We are largest Bentley dealer, we have 11 Audi stores, four Porsche stores, six Lexus stores, so we are in a area in markets where we really have made those brands or multiple brands in one particular geographic are and I don’t feel that on the retail side that we will expect a decline and that’s what the NADA people in the U.K are saying today. Now 2007 was the sixth highest year for the market and overall we had a good quarter and I think that it will do a lot of blocking and tackling and we really have not made our acquisitions are -- with the Audi store is we end up being in a cluster of Nottingham, Derby and Lester, so these are projects for us. So we really have the benefit of scale in a particular market and we have activated our used car businesses even greater in the UK. So I think used car business will continue to be good. We have been pushed on pre registrations by BMW and some of the other manufacturers which have given us the benefit of giving us higher margins and I think we got to look at margins there and we got to look at same store and we got to grow our parts and service and if we stay on that kind of a mission, I think that we are going to be fine for 2008. Now we are hoping there might be another reduction in the discount rate. We went 50 basis points this year which obviously helps in our lease rates and when you look at our overall business Matt, almost 70% of all of PAG’s business is either financed or leased. So obviously interest rates along residual values really tell you what your rates are going to be and I think that at the present time with lower interest rates, we might be getting some of that benefit on the car side than we seen yet on the housing side.

Matt Nemer - Thomas Weisel Partners

Great and then on the used car business, you picked up quite a bit of momentum in your central region using some software and processes. I'm just wondering how that’s going and what the timeline might be for rolling that out the nationwide.

Roger Penske

There is a number of products out there. We have -- first look has been our favorite and I think with Lamborghini in the central region has really jumped on that program and when you look at our used to new ratio, a year ago, we were at roughly 0.5, 0.55 and we are almost at 0.8 now during the first quarter and the returns if you take, used vehicle revenue or gross profits you take F&I less wholesale, we are probably up 100 basis points of profitability and I think that when you look at the increase year-over-year, we have had a substantial, 15% or 16% increase in unit sales and at the end of the day, one thing that we have been following is that we have been able to sell cars at a lower price point and we are down probably $1,000 in the central region from $1,500 to $1,400. So we are really selling everything that we trade. We are doing safety checks and then reconditioning which one thing you get in the software markets where maybe your new car customers are coming in. That internal gross profit goes a long way covering some of your fixed costs.

Matt Nemer - Thomas Weisel Partners

And then this is more of a housekeeping question but do you have the SG&A to gross profit excluding any changes in the rent expense, just trying to get a sense for how much that may have changed the ratio?

Roger Penske

I think if you take red out, we were roughly 72.2 in the last year and we were up about 40 basis points this year.

Matt Nemer - Thomas Weisel Partners

And then last question on Smart; can you give us an update on what you are seeing from churn rates as these cars are actually hitting dealerships and the sales professionals are calling customers -- what type of churn are you seeing?

Roger Penske

Well, I think the great news is that we are seeing today with about a 19% cancellation rate from the point till we make the $99 reservation and I think that’s key when we are sitting today with 52,000. Now we went out to the market about a month ago and indicated to all reservation order that they could go online and check the availability when they might expect to be able to receive their car within a nine day period, we didn’t see a big disconnect of people drop out. Quiet honestly, today we got 37,000 people who have an idea when their car is going to be delivered and with a 19% drop out, I said we’ll be doing a great job if we held half of them. When you think we had no sales people, we had no dealers, so it just shows you the power of the internet. To date 5% of the orders as I said earlier are the Pure, that’s a smaller version of the Coupe; 62% is the Coupe that has more equipment on it, the higher value and of course the balance would be the convertible 32%, so again I think this is in a situation where people are concerned about the price. At the end of the day I think people want the car and want as much content as they can get, in fact leather seats, etc. We have reservations in all 50 states at the moment.

Operator

And next with the line of Rich Kwas with Wachovia. Please go ahead.

Rich Kwas - Wachovia

Hey good afternoon Roger. Just following up on Smart, what are the number of reservations you have right now. What is the number?

Roger Penske

52,000 plus as of -- we ran it this morning. 52,757 to be exact and that’s net of what we delivered already too and net of anything that is falling out at least prior to deliver. We get some fall out obviously in the cars ahead of hitting the ground but that’s part of the 19%.

Rich Kwas - Wachovia

Okay and then in terms of gross profit, gross margin for new vehicles you were flat year-over-year, you said there hasn’t been really any deterioration internationally. What are your expectations given that a fair number of dealers have pretty high inventory levels on the luxury side; do you expect gross to hang in there here in the U.S going forward over the next couple of quarters?

Roger Penske

Well if you look at the first quarter on our new margins, we were in at 7.7% and that was down 20 basis points, so we saw some of the same pressure downward that the other dealers, the publics have seen in the quarter. On the other hand in the U.K -- and I think this shows you the strength of our business model, we don’t have the competitive pressure; at least we don’t have it as I sit here today. We were up about 30 basis points and when you combine the two year rate which was flat year-over-year which was a real benefit to us and the average transaction price went down about $700 in the U.S from $32,000 to $31,000 and quiet honestly we are seeing here because of our mix there is so much premium luxury. We are up about $1300 in average transaction price in the U.K. If you look that overall we were down a $100 and then on a gross basis, we held our grosses nicely; up 300 in the U.K, down 100 in the U.S and basically flat, so I can’t tell you that we are smarter than anybody else, but I think it’s the diversification because a big piece of our premium luxury -- 65%, a big piece of that’s overseas that’s given us the benefit.

Matt Nemer - Thomas Weisel Partners

Rich Kwas - Wachovia

Okay, that’s helpful and then on the used front I know your focus on shifting down gear in terms of the mix of vehicles particularly in the central region, are you seeing -- aside from that are you seeing any shift any shift within used vehicles where somebody comes in and maybe thought they could afford a $20,000 used vehicle and maybe had to settle for something less than that, anything along those lines?

Roger Penske

I think today, that’s all about getting the person financed and you have a sub-prime customer which really is 10% of our business and we have people to take that client on a non-recourse basis, the balance we are doing with a captives. Probably 70% of our business both non-dues as with captives is the best, the rest is with our preferred lenders and we really have not seen any pressure. If someone has credit, we are able to get him finance through the traditional source of good OEM, captive in OR, or a preferred lender. I don’t see a shift -- I'm not on the line that close, so I don’t want to give you a bad fact here, but I think that what we are focusing on -- when you look at the used car prices in the US, the average selling price is roughly $20,000 and the average selling price in the UK is $46,000 and that’s because we have sold so much more weighted to premium luxury. On the other hand, our margins because of I think the commitment to use and we are not being pushed to pre-register a lot of demonstrators, we have been able to sell used cars and our margins are up in the UK about 100 basis points and we were down 40 here in the US, but overall up 60. So, I think at the end of the day, we are in pretty good shape. Advance rates, probably the amount they will advance -- the finance might put some pressure on people to put more down payment but when you think about 70% of our business is financed and a big portion of that is leased and when you look at BMW, Audi, Lexus, Mercedes most of those are on leases and they have -- today you really have to put your initial down payment down, they don’t give any 0% on those unfortunately but I think we are seeing maybe some same pressure as the consumer is seeing with commodity prices, the day-to-day stuff they buy, you got sticker shot with the fuel prices and we are loosing about $500 million I guess, but it will go through the adjustment rate mortgage portfolio which will always downward pressure. The big problem that we face potentially in the US is that if these rates are not reduced and these adjustment rate mortgages, it might take the equity values down at homes and toady I guess we got maybe one or two out of ten are under water and that could hurt us because in many cases, the credit rating is based on the value of that equity you have in your home, so all of that plays into the consumer wallet today, so lots of leverage.

Operator

Our next question is from John Murphy with Merrill Lynch. Please go ahead.

John Murphy - Merrill Lynch

On the parts and service business, there’s a little bit of a slowing in the same store sales. I mean there was clearly a tough comp. I was just wondering if there is anything going on there and also on the margin, you said some expansion to margin, you had slowdown there. Just wondering how we should about or how you think about the capacity utilization there and if we need that growth to keep ramping up that margin?

Roger Penske

We are about 70% utilization today and that would be with a number of bank, we are 3,800 base and we have got plenty of room and plus you can go to second shifts, we can go to six and seven day shifts from the standpoint. I think you are saying people today if it’s under a warranty they don’t bring it in, but warranty is a percentage of the total sales that is coming down and may be sell it to larger tickets we are not seeing, but what we’ve done, all of our service people obviously want the up sell, so we are getting into some of that repair, the wheel repair -- we usually inform that out, we are bringing that in house and that’s given us some more margins, so lots of e-mail blasts going on and I think we had a fewer service dates with Easter, Good Friday; I think that had a little bump, I don’t know what the other public retailer saw but we saw some softness in the markets a fewer days in the U.K so we got a little bit of both.

John Murphy - Merrill Lynch

Okay and then thinking about just the pricing environment and what you are seeing from the auto makers and it sounds like even beyond just the choice three that there is getting a little bit -- I mean there is a little bit more pricing competition going on or incentives I should say from the auto makers. Just wondering what you are seeing there particularly on the Japanese and even some on the luxury brands.

Roger Penske

I think pressure is always being driven by too much inventory. When I looked at our inventory before the call and we are up $30 million from the end of March. Now March 31 and to April 20 is obviously -- we delivered a lot of the cars in the last couple of days and when you look at that increase Lexus is up $7 million, Honda is up 12, BMW Mini is up 12 so out of $31 million, there it is and you got some ins and outs there. Mercedes only have $3 million bucks, so I think that the pressure on gross is -- I don’t think there is anybody out there who want to give these cars away but the OEM’s we are going to have get rationale and realize that too much stock, nobody makes money and what happens is now we get into some distressed advertising. All that does is lower price and ultimately we will get lower residual values our self. I think the lever is in the OEM’s hand to help us on this growth side.

John Murphy - Merrill Lynch

Then just glancing on SG&A, was up a little bit year-over-year. Just wondering if there is any opportunity there in the short run or if there was anything that happened in the quarter that was sort of making it inflate that in anyway abnormally.

Roger Penske

I don’t think so. I think that when you look at -- and I was kind of looking at SG&A because that’s a hot topic across the people that cover our stock and when you look at us at 12.5% we are in good shape and certainly when you look at us as a percentage to gross profit, it’s a little bit higher but when you look at the mix of business we are already running parts and service about 11% of our total revenue and that’s the high margin business, so I am looking at 12.5%, do I want it to be less? We do, we got lots of programs, but you got to be careful. We are in a variable comp mode today and when business gets a little tighter, I think you got to look at some of your paid plans and there might be -- and when margins are down and people are used to being paid on margin, you might support some of your sales team in order to be sure that they take enough money home so there could be a little bit of cost there, but I don’t have anything that I think -- our rents are descent, we are up obviously $4 million quarter-over-quarter, some of that’s due to acquisition, some to CPI and some to fair-leaseback, but in overall I feel we are in good shape.

Operator

Your next question from Scott Stember with Sidoti. Please go ahead.

Scott Stember – Sidoti & Co.

Do you think we can dig into the customer pay -- the parts and service a little bit better, what was customer pay versus the one’s you worked in the quarter?

Roger Penske

That’s been running somewhere about I think 35% warranty and the balance in customer pay and customer pay in the quarter was up 3% to 5%. I can't tell you what was international and what was domestically and we see warranty continuing to come down, but one component of the warranty we got to remember is on these full circle programs where the OEMs providing some of the maintenance items, you pay that back through warranty claims. So I'm not sure how the accounting is being done on that at the moment but we see coming down much better quality from the standpoint of all OEMs but domestic and foreign nameplate.

Scott Stember – Sidoti & Co.

Would that higher customer pay work be responsible for the parts and service gross margin being up?

Roger Penske

You would get more on the -- exactly, that’s a good point. We would expect to get more margin on parts on a customer versus a warranty.

Scott Stember – Sidoti & Co.

All right and just for the interest expense line in aggregate it’s been quarter-over-quarter or year-over-year, it’s down about 15%. Could you talk about how much maybe lower rates contributed to that?

Roger Penske

Obviously, we are getting the benefit of the convert 3.5% which we didn’t have in the previous year, that was probably the biggest factor.

Operator

And we’ll go to the line of Darren Kennedy with Goldman Sachs. Please go ahead.

Matt Fassler - Goldman Sachs

My questions actually are on Smart and the first one is about I guess the cancellations. I'm really not that worried about it considering the manufacturing constraints or the amount that you having shipped this year. You don’t really seem that concerned about being in the fall through of that, correct?

Roger Penske

Well, when we are saying -- when I'm saying cancellations that’s from the original of someone putting a $99 deposit, that’s the original reservation we take and we take that all the way down to delivering those cars, people that have dropped out is only 19%, so we are saying there is now roughly 75% to 80% stick rate on people who want the car and I think it’s about wait time, because they got to15 months to get one, we might loose some of those but we went out in the market and told all of the customers that they can go and take their reservation number into our Smart One system and would them with the 90 days when they would get the car and we didn’t see a big dropout at that point.

Matt Fassler - Goldman Sachs

Okay, because I think someone in the pressure you decided that you thought you could use more smart cars from manufacturer but I didn’t know if there was really any possibility there. Are they all manufactured in one plant currently?

Roger Penske

Well, just to put in perspective, they are all built in Humbug, France, it’s a Mercedes Benz plant. They have a capacity of somewhere between 130,000 and 140,000 vehicles and they are at max production, so we are in competition with the other parts of the world. There is no question with this new model, the smart fortwo has been well received and I think that we are going to work on trying to get more allocation in next year but --

Matt Fassler - Goldman Sachs

But next year, you are going to be facing the introduction in China as well, I just want to make sure I have it straight, right?

Roger Penske

Well -- there are certainly from our discussions that they are going to look at getting more efficiency out of the plant, they have not run at these levels in the past and I think that we will get some benefit out of the increased production and they will give us a number that we will negotiate with them as we get further into the third quarter.

Matt Fassler - Goldman Sachs

Okay, great and the final question around this because I am just trying to understand the growth trajectory as well as any lumpiness. I think at one point I look at Canada and the roll out of Smart there and then I saw some numbers that really dipped and I think it was a model transition period, is that something that’s in your are -- looking at projections I don’t know if I have that right or if something is going to be different in U.S in the way that they roll that out?

Roger Penske

Well they had the original Smart with a diesel in it and the vehicles that are selling today does not have a diesel. I think they waited about four months from the time they shut down the old model until they ramped it up. So they were really sure of the product. What’s my understanding of their bid is that it’s way up and Canada also on the current quarter. I wish I had that exact number, I will get Tony may be to get it for you, but I know that smart year-over-year is up substantially and if you -- now take out this down what they did to conversion, but we will have a month out of production in August when they take vacations and there will be a model change over. It will impact us probably in the October, November time frame, but if you take our numbers and what we expect to wholesale, over 6,000 this quarter and you take another 6,000 in the third quarter less they impact I think we are – 20,000 to 25,000 is realistic, but we will keep you posted.

Operator

And we’ll go to the line of Rex Henderson with Raymond James. Please go ahead.

Rex Henderson - Raymond James

Hello Roger. I wanted to drill down a second on the parts and service margin again. I saw that you are getting pretty consistent and pretty good growth in that margin line. I am wondering as you grow the used car business how much of that improvement in the parts and service margins is attributable to reconditioning profit that are booked in parts and service and how much of that margin improvement is native to the customer pay business or the warranty business?

Roger Penske

Let me talk about used cars. Obviously it was a real benefit. We don’t have a discounted internal rate today in our shops. If our sale rate is $95 per hour that’s what we charge on the reconditioning of the used car and we get the appropriate price mark up, so the more we can do that’s going to drive more overall gross profit and there won’t be a decreased. I think what’s happening with the new shops and the ability from the logistics perspective getting vehicles in and out, they were getting productivity which gives us a higher margin from our technicians. I can see today where we have shops that are 130%, 140% efficiency and that’s going to help drive that margin.

Rex Henderson - Raymond James

Okay, so what are you saying is then is you think it is needed to the core business and not just a portion of the -- or an asset of the used car business.

Roger Penske

Well I think the used car business is helping us build a total gross profit I think in the Central Europe $300,000 and in the quarter just on internal gross profit but I think that the units in operation which we’ve been able to generate because of our same-store growth over the last six years is driving a bigger customer base and that base today is coming into the dealership for their service and I said earlier in the call we had a dent doctor come in and take dents, but we are doing that internally. They had just set up a significant piece in the shop in Scottsdale 101. We are doing wheels -- a lot of these wheels, these fancy aluminum wheels get damaged, so we are doing a lot of wheel repairs, so those have margins that are obviously a lot higher than you would have on a normal coverage when you have the time study of service that’s generated by the technician. So I think a lot of that is helping the mix but we have got to grow this business in parts and service and the good news is that with the complexity in the cars today, they have got to come back to the OEM dealer. I don’t care if it’s GM, Ford, Chrysler or any of the foreign nameplates. Unless we throw the customer out the door which we are not doing, there is a lot more CSI, a lot more follow-up today, e-mail blasts, we are using the Internet excessively to bring these customers back and we are following up on service. So basically, everywhere we can get some revenue -- we do oil changes, that was always done by the Pennzoil guy or someone around the corner. That’s a huge factor today and there is real good margin in that when you think about someone comes in for an oil change, maybe a $25 oil change than you can up sell and that gives us the tire business; we have never been in the tire business and today, it’s a big focus throughout all of our stores and in fact, we pay the service writer on the drive-through a commission for tire sales.

Rex Henderson - Raymond James

Okay. One other thing on the parts and service business, your same store sales in parts and service this quarter was 1.1% which is -- I think it’s the lowest number I have seen since I have been covering the Company in several years back. I'm just wondering what your outlook is for the rest of this year. Do you think that number is good for the rest of this year or do you think you can get back to more historic numbers?

Roger Penske

If you break it out, maybe we haven’t broken out, we are up 2.5% in the US and down 1.5% internationally and there were fewer days that we were open due to holidays, etc in the UK. Now I’ll give you a better feel for that after we get through this quarter, but I don’t see any deterioration. We had some big comps, I think it was double-digit comps last year and obviously we will see how it plays out during Q2.

Operator

And we go to Jonathan Steinmetz with Morgan Stanley. Please go ahead.

Jonathan Steinmetz - Morgan Stanley

A lot of them have been asked, but let me just follow up. I think you said something on CapEx projects that if the rates don’t become more favorable, that there may be a few things that you defer. If that’s true, you could just elaborate on the dollar amount that’s sort of in question here, maybe what some of those types of projects might be?

Roger Penske

I think -- maybe I wouldn’t -- I’m sorry I wasn’t very clear. What we meant was that we were looking at the rates. I think that there is activity out there but there is not quite a competitive environment to give us maybe the rates we want. We then would look at having our lender provide us with a real estate line of credit for mortgage and so we have not done that in the past. As you know, we make our money on selling cars. I know there is lots of Companies owning their own real estate but when you are looking at 5.5% cap rates internationally and we are at a 8% range today, you think about depreciation, interest rates, it’s off our balance sheet, it gives us some flexibility. If you got a five or a seven or a ten year initial lease, it gives you the benefit of some flexibility versus owning it yourself. So there are pluses and minuses and we have used our capital in the past. We have a debt to capital of 37% and I think you got to take everything into consideration. Where we think we are position is in the right direction, I think we will still be in this $50 million, maybe slightly higher depending on what happens with rates as far as the next CapEx for the year.

Jonathan Steinmetz - Morgan Stanley

Okay, and then on this parts and service side, so I guess you did a 2.5% Comp in the U.S. Do you have any data on things like either number of pay orders year-over-year or traffic counter or anything like that and I am just trying to get a feel as to whether increases in commodity prices are actually beneficial and any real magnitudes to this line item given that everything from the price of motor oil to any steel on hard parts, it’s all going up, is that at all a factor in growing?

Roger Penske

I looked at some data before the conference call. I think I might -- we are up about in the East and the West -- they don’t have the information in the center but we were up about 10% in numbers of RO’s for the first quarter, we are down about 7% in RO’s, so again there is a slight increase. The big question is hours per RO, that’s a huge incentive to the service writer because he gets paid on that and obviously we get more scale and more dollars per RO and we get more efficient in the shops, so I take overall total RO’s is probably a year up slightly but there is a shift now between warranty and then customer pays.

Jonathan Steinmetz - Morgan Stanley

Okay and lastly I guess you had a 1036 on F&I per vehicle; just your thoughts going forward on that. Do you think there is a lot of latitude to drive that line item higher over the next couple of years and if so where would that come from?

Roger Penske

I would say that in a $1000 we are -- probably I would look for a big route there for a couple of reasons. The ability for us on leash now is to sell a lot of these extra products. When someone leashes their car for three years, they don’t want an extended service contract. A lot of these extras because of the lease rates, people are being probably a little more prudent and especially in the premium luxury we want to be sure that we are competitive as people look at different mix of cars. One good thing has happened in the U.K. They have a personal contract that purchase a PCP which is like a lease but it’s a finance contract with a guaranteed reschedule and we have really grown the business from 39% in 2006 to 53% in over this last quarter and that’s given us some nice reserve and we see that to be pretty consistent, but in overall at the end of the day we’ve got to be careful with what we do -- so and I have to add that this is definitely a good charge back to us if the car is sold or traded into someone else. So overall I think that you are going to see finance penetration continuing to go up. We are up about three points this past quarter in U.K.

Operator

Your final question is from the line of [Tim Secanty] with Northern Trust. Please go ahead.

Tim Secanty - Northern Trust

I just have one question, it’s on the used business. I would say first of all it’s definitely in process with the margin expansion because it’s just because I have been hearing a lot of negative news about residual values and I just kind of wanted to get your thoughts on is that a trend that’s going to continue during the next couple of quarters or is that pretty much going to be stay steady or is there going to be any impact in U.S, I am guessing on these lower auction rates --?

Roger Penske

Well, I think what you got look at is types of vehicle. I think you’ve got some vehicles that are off the charts as far as maintaining their residuals and the other thing is you take the BMW Full Circle program, we take a lot of those vehicles back and with all these going into the same type of marketing and I'm not sure today whether Mercedes has -- they have a minimum number of vehicles you have to purchase now to get some backend money. So that’s getting the dealers more involved. I think there is many more initiatives whether it’s a public dealership or private to keep the used cars and get in the used car business -- the CPO. 38% of our business was CPO for the quarter and I think that’s going to help residuals. If you got trucks and you got big SUVs, I'm not sure there is anybody who can turn those around at the moment because of the fuel prices but we have got a concept called ‘retail first’. So we are trying to give our sales the ability to sell these cars. First of all, maybe won't make them certified pre-owned, in fact, we will do a safety check and maybe provide the customer a six-month warranty he doesn’t even pay for, so if anything that pops up that’s unexpected, the customer is covered. So I think you got to look at residual values by model type and certainly some of the smaller cars, better fuel economy cars are going to hold residuals but the trucks and some of the higher horsepower engine might lose it and I think it’s a mixed bag personally.

Tim Secanty - Northern Trust

Okay, see it’s reasonable then for me to say that the luxury mix that you have and some more retailer focus is what would drive this in the future?

Roger Penske

Well, I would think that not only ours but the people who are in a similar business because we have to become good used car operators. There has been a -- probably for the last ten years because it was so easy to sell a new car on the foreign nameplate side, there really wasn’t a big supply of used because people kept these cars. We are now having to get into the used business and get this ratio from 0.4, 0.5 to 1 up into 0.6, 0.7 and in the UK in many of our stores, we sell more used than we do new. We have got to understand how to do that here. We are just not really focused on that and I think that the margins are less over there on used than they are here, but I think the competition with the customer to get him in a vehicle and our ability to get all the margin front and back from the manufacturer is going to include a major focus on our used car products and that’s what we are trying to do. It’s a little different OEM by OEM but I think all of them are focused on that and that could only help us because higher residuals will take the cost down for the consumer, whether it’s a financed or a leased product.

Operator

Now Mr. Penske, I will turn it back to you for any closing comments.

Roger Penske

One other item we were talking about at the end of the -- talking about acquisitions and we had $85 million, we’ll have net in revenue annualized. I said we had $115 million gross left of 30 from the store we had exited from here in the quarter, so I just want to make a note that I give you a wrong fact there, but thank you for joining us today and we will talk to you next quarter. Thanks.

Operator

Ladies and gentlemen, that does conclude your conference for today. Thank you for your participation. You may now disconnect.

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Source: Penske Automotive Group Q1 2008 Earnings Call Transcript
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