Summary of LITHIA MOTORS INC

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

Forward Looking Statements and Risk Factors

Some of the statements in this Form 10-Q constitute forward-looking statements. In some cases, you can identify forward-looking statements by terms such as "may," "will," "should," "expect," "plan," "intend," "forecast," "anticipate," "believe," "estimate," "predict," "potential," and "continue" or the negative of these terms or other comparable terminology. The forward-looking statements contained in this Form 10-Q involve known and unknown risks, uncertainties and situations that may cause our actual results, level of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by these statements. Some of the important factors that could cause actual results to differ from our expectations are discussed in Item 1A of this Form 10-Q.

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

Overview

We are a leading operator of automotive franchises and retailer of new and used vehicles and services. As of October 30, 2009, we offered 27 brands of new vehicles and all brands of used vehicles in 87 stores in the United States and over the Internet. We sell new and used cars and light trucks, sell replacement parts, provide vehicle maintenance, warranty, paint and repair services and arrange related financing, service contracts, protection products and credit insurance for our automotive customers. Our dealerships are geographically diverse and are primarily located in small and mid-size regional markets in the Western and Midwestern regions of the United States. The majority of our franchises are in "single-point" locations, meaning that these locations do not have competing dealerships offering the same brand as our dealerships offer.

As compared to automobile manufacturers, we believe that Lithia, like other automotive retailers, has a higher ratio of variable and discretionary costs to fixed costs. These variable and discretionary costs include sales commissions, personnel, advertising and inventory financing expenses, which can be adjusted to more closely match vehicle sales demand. In addition to adjusting costs, we seek to diversify our sources of revenue to mitigate the cyclicality of new vehicle sales. For example, our Service, Body and Parts business line generates substantially higher gross margins than vehicle sales and, historically, has been less affected by economic cycles. Similarly, through our used vehicle sales business line, we seek to utilize our existing dealership footprint to generate incremental sales free of any manufacturer restrictions.

To reduce our exposure to any one manufacturer and to changing consumer preferences, we offer a wide variety of both import and domestic new vehicle brands and models, including economy, luxury, sports utility vehicles, crossovers, minivans and light trucks. We believe our brand mix is well-suited to consumer preferences in the small and mid-size geographic markets we serve. We continuously evaluate our portfolio of franchises, divesting dealerships that are not expected to meet our financial return requirements while selectively acquiring attractive dealerships in our target markets.

We believe that the reorganization of Chrysler and General Motors did not materially impact our sales levels relative to the overall market sales environment. Overall, while the new vehicle market remains weak, our Chrysler and General Motors locations are not experiencing materially different results than our other franchise locations.

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Our operating philosophy is based on an integrated, centralized operating structure. Through our management information system, our emphasis on standardized operating practices and the centralized processing of administrative and office functions, we seek to gain economies of scale from our dealership network. For example, accounts payable, accounts receivable, credit and collections, accounting and taxes, information technology, legal, human resources, human development, treasury, cash management, advertising and marketing functions are centralized at our corporate headquarters. These efficiencies have allowed us to reduce overall administrative personnel from 6.4 people per dealership in 2007 to 3.2 people per dealership as of August 31, 2009. The reduction of administrative functions at our dealerships allows our local store managers to focus on customer-facing opportunities in order to generate incremental revenues and gross profit. Our operations are supported by our formalized training and personal development program, which shares best practices across our dealership network and seeks to develop our store management talent.

We have restructured our operations to align our cost base with current industry vehicle sales levels. Through various cost cuts and personnel reductions, initiated in the second quarter of 2008, we have achieved $65 million of annualized permanent cost reductions. Since the second quarter of 2008 through September 30, 2009, we also generated $71 million in cash by divesting stores that were non-core or that did not meet our financial return expectations. We believe that we are well positioned to benefit from an increase in new vehicle sales above current levels.

We believe the actions we have taken over the past nine months demonstrate the resiliency of our company. However, no assurances can be given that industry sales will not experience a further decline, or that our restructuring plan will be of sufficient magnitude to meet our operating objectives in a declining market.

We continue to believe that the fragmented nature of the automotive dealership sector provides us with the opportunity to drive growth through consolidation. We have completed over 100 acquisitions since our initial public offering in 1996. Our acquisition strategy has been to acquire underperforming dealerships and, through the application of our centralized operating structure, improve store profitability. We believe the current economic environment provides us with attractive acquisition opportunities. Additionally, our management team possesses substantial experience, with our key management executives having an average of over 25 years experience in automotive retailing, and has demonstrated the ability to profitably operate stores and successfully integrate acquisitions.

Outlook

The overall macroeconomic issues that affected us in 2008 continued in the first nine months of 2009 and have reduced consumers' desire and ability to purchase automobiles. An additional factor negatively impacting auto sales has been a reduction in available options for consumer auto loans. The manufacturers' captive financing companies have suffered additional pressure as the financial crisis has raised their cost of funds and reduced their access to capital. This has prevented them from offering as many incentives designed to drive sales, such as subsidized interest rates, and reduced the amount of loan to value they are willing to advance on vehicles.

The magnitude of the seasonal improvement we have typically experienced in March did not occur in the first quarter of 2009. This is similar to our experience in 2008, where the seasonally strong second and third quarters of the year were relatively flat compared with the first quarter of 2008. The third quarter of 2009 experienced an incremental improvement in new vehicle sales as a result of the Car Allowance Rebate System ("CARS") program. Our current operational plan assumes vehicle sales do not decline as dramatically in the fourth quarter of 2009 as they did in 2008 given the already historically low sales levels. However, given the incremental improvement in the third quarter results, new vehicle sales in subsequent quarters may trend lower than sales levels in the comparable prior year periods. No assurances can be provided that our plan will be achieved, or that a further deterioration in the economic environment will not occur.

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Results of Continuing Operations

Certain revenue, gross margin and gross profit information by product line was
as follows:



                                          Percent of        Gross       Percent of Total
Three Months Ended September 30, 2009   Total Revenues      Margin        Gross Profit
New vehicle                                       52.7 %       8.8 %                24.9 %
Used vehicle, retail                              25.7        15.3                  21.0
Used vehicle, wholesale                            4.0         0.4                   0.1
Finance and insurance(1)                           3.2       100.0                  17.1
Service, body and parts                           14.2        48.4                  36.6
Fleet and other                                    0.2        34.2                   0.3

                                          Percent of        Gross       Percent of Total
Three Months Ended September 30, 2008   Total Revenues      Margin        Gross Profit
New vehicle                                       55.8 %       7.7 %                25.5 %
Used vehicle, retail                              22.5        10.4                  13.9
Used vehicle, wholesale                            4.5        (4.7 )                (1.2 )
Finance and insurance(1)                           3.8       100.0                  22.8
Service, body and parts                           13.2        49.3                  38.6
Fleet and other                                    0.2        43.0                   0.4

                                          Percent of        Gross       Percent of Total
Nine Months Ended September 30, 2009    Total Revenues      Margin        Gross Profit
New vehicle                                       49.9 %       8.6 %                22.3 %
Used vehicle, retail                              27.1        14.3                  20.2
Used vehicle, wholesale                            3.9         0.9                   0.2
Finance and insurance(1)                           3.4       100.0                  17.6
Service, body and parts                           15.5        48.6                  39.3
Fleet and other                                    0.2        47.9                   0.4

                                          Percent of        Gross       Percent of Total
Nine Months Ended September 30, 2008    Total Revenues      Margin        Gross Profit
New vehicle                                       56.6 %       7.8 %                26.0 %
Used vehicle, retail                              21.7        11.5                  14.8
Used vehicle, wholesale                            4.9        (2.8 )                (0.7 )
Finance and insurance(1)                           3.8       100.0                  22.7
Service, body and parts                           12.8        48.5                  36.8
Fleet and other                                    0.2        36.9                   0.4

(1) Commissions reported net of anticipated cancellations.

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

                                                 Three Months Ended           Nine Months Ended
                                                   September 30,                September 30,
                                               2009(1)        2008(1)       2009(1)       2008(1)
Revenues:
New vehicle                                        52.7 %        55.8 %        49.9 %        56.6 %
Used vehicle retail                                25.7          22.5          27.1          21.7
Used vehicle wholesale                              4.0           4.5           3.9           4.9
Finance and insurance                               3.2           3.8           3.4           3.8
Service, body and parts                            14.2          13.2          15.5          12.8
Fleet and other                                     0.2           0.2           0.2           0.2

Total revenues                                    100.0 %       100.0 %       100.0 %       100.0 %
Gross profit                                       18.7          16.8          19.1          16.9
Goodwill and other asset impairment charges          -             -             -           18.9
Selling, general and administrative
expenses                                           14.1          13.8          15.3          14.3
Depreciation and amortization                       0.9           0.8           1.0           0.8

Operating income (loss)                             3.8           2.1           2.8         (17.1 )
Floorplan interest expense                          0.6           0.8           0.7           0.9
Other interest expense                              0.6           0.8           0.8           0.8
Other, net                                           -           (0.4 )        (0.1 )        (0.2 )

Income (loss) from continuing operations
before taxes                                        2.5           0.9           1.5         (18.6 )
Income tax (expense) benefit                       (1.0 )        (0.4 )        (0.6 )         5.8

Income (loss) from continuing operations            1.5 %         0.5 %         0.9 %       (12.8 )%

(1) The percentages may not add due to rounding.

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The following tables set forth the changes in our operating results from continuing operations in the three and nine-month periods ended September 30, 2009 compared to the three and nine-month periods ended September 30, 2008:

                                              Three Months Ended                               %
(Dollars in thousands)                          September 30,              Increase         Increase
                                             2009           2008          (Decrease)       (Decrease)
Revenues:
New vehicle                                $ 241,577      $ 282,669      $    (41,092 )         (14.5 )%
Used vehicle retail                          117,678        114,118             3,560             3.1
Used vehicle wholesale                        18,486         23,112            (4,626 )         (20.0 )
Finance and insurance                         14,685         19,400            (4,715 )         (24.3 )
Service, body and parts                       64,960         66,728            (1,768 )          (2.6 )
Fleet and other                                  814            846               (32 )          (3.8 )

Total revenues                               458,200        506,873           (48,673 )          (9.6 )
Cost of sales:
New vehicle                                  220,247        261,016           (40,769 )         (15.6 )
Used vehicle retail                           99,654        102,274            (2,620 )          (2.6 )
Used vehicle wholesale                        18,419         24,198            (5,779 )         (23.9 )
Service, body and parts                       33,511         33,864              (353 )          (1.0 )
Fleet and other                                  536            482                54            11.2

Total cost of sales                          372,367        421,834           (49,467 )         (11.7 )

Gross profit                                  85,833         85,039               794             0.9
Selling, general and administrative           64,492         70,079            (5,587 )          (8.0 )
Depreciation and amortization                  3,923          4,073              (150 )          (3.7 )

Operating income                              17,418         10,887             6,531            60.0
Floorplan interest expense                    (2,886 )       (4,300 )          (1,414 )         (32.9 )
Other interest expense                        (2,943 )       (4,070 )          (1,127 )         (27.7 )
Other income, net                                 24          1,881            (1,857 )         (98.7 )

Income from continuing operations before
taxes                                         11,613          4,398             7,215           164.1
Income tax expense                            (4,631 )       (1,911 )           2,720           142.3

Income from continuing operations          $   6,982      $   2,487      $      4,495           180.7 %


                                              Three Months Ended                               %
                                                September 30,              Increase         Increase
                                             2009           2008          (Decrease)       (Decrease)
New units sold                                 8,364          9,450            (1,086 )         (11.5 )%
Average selling price per new vehicle      $  28,883      $  29,912      $     (1,029 )          (3.4 )

Used retail units sold                         7,156          7,059                97             1.4
Average selling price per used retail
vehicle                                    $  16,445      $  16,166      $        279             1.7

Used wholesale units sold                      3,817          3,884               (67 )          (1.7 )
Average selling price per used wholesale
vehicle                                    $   4,843      $   5,951      $     (1,108 )         (18.6 )

Finance and insurance sales per retail
unit                                       $     946      $   1,175      $       (229 )         (19.5 )

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                                               Nine Months Ended                                 %
(Dollars in thousands)                           September 30,               Increase         Increase
                                             2009             2008          (Decrease)       (Decrease)
Revenues:
New vehicle                               $   612,138      $   881,116      $  (268,978 )         (30.5 )%
Used vehicle retail                           332,082          338,509           (6,427 )          (1.9 )
Used vehicle wholesale                         50,160           74,654          (24,494 )         (32.8 )
Finance and insurance                          41,255           59,735          (18,480 )         (30.9 )
Service, body and parts                       190,051          199,349           (9,298 )          (4.7 )
Fleet and other                                 1,947            3,188           (1,241 )         (38.9 )

Total revenues                              1,227,633        1,556,551         (328,918 )         (21.1 )
Cost of sales:
New vehicle                                   559,795          812,762         (252,967 )         (31.1 )
Used vehicle retail                           284,568          299,595          (15,027 )          (5.0 )
Used vehicle wholesale                         49,697           76,760          (27,063 )         (35.3 )
Service, body and parts                        97,633          102,625           (4,992 )          (4.9 )
Fleet and other                                 1,015            2,013             (998 )         (49.6 )

Total cost of sales                           992,708        1,293,755         (301,047 )         (23.3 )

Gross profit                                  234,925          262,796          (27,871 )         (10.6 )
Asset impairment charges                           -           294,075         (294,075 )        (100.0 )
Selling, general and administrative           188,286          222,381          (34,095 )         (15.3 )
Depreciation and amortization                  11,988           12,632             (644 )          (5.1 )

Operating income (loss)                        34,651         (266,292 )        300,943          (113.0 )
Floorplan interest expense                     (8,008 )        (13,758 )         (5,750 )         (41.8 )
Other interest expense                         (9,545 )        (12,490 )         (2,945 )         (23.6 )
Other income, net                               1,447            3,004           (1,557 )         (51.8 )

Income (loss) from continuing
operations before taxes                        18,545         (289,536 )        308,081           106.4
Income tax (expense) benefit                   (7,429 )         90,720           98,149           108.2

Income (loss) from continuing
operations                                $    11,116      $  (198,816 )    $   209,932           105.6 %


                                               Nine Months Ended                                 %
                                                 September 30,               Increase         Increase
                                             2009             2008          (Decrease)       (Decrease)
New units sold                                 20,746           30,167           (9,421 )         (31.2 )%
Average selling price per new vehicle     $    29,506      $    29,208      $       298             1.0

Used retail units sold                         20,568           19,970              598             3.0
Average selling price per used retail
vehicle                                   $    16,146      $    16,951      $      (805 )          (4.7 )

Used wholesale units sold                       9,557           12,153           (2,596 )         (21.4 )
Average selling price per used
wholesale vehicle                         $     5,249      $     6,143      $      (894 )         (14.6 )

Finance and insurance sales per retail
unit                                      $       999      $     1,191      $      (192 )         (16.1 )

Revenues

Total revenues decreased 9.6% and 21.1%, respectively, in the three and nine-month periods ended September 30, 2009 compared to the same periods of 2008, primarily as a result of a 9.2% and a 20.8% decrease, respectively, in same-store sales, excluding fleet. The decreases in same-store sales reflected the continuing challenging retail environment, led by declining credit availability and deteriorating consumer confidence. In the third quarter of 2009, some of the macroeconomic pressures were temporarily counteracted through the CARS program, which provided government sponsored rebates for consumers who elected to purchase a new vehicle with improved fuel economy. In the fourth quarter of 2009, the revenue declines on a year-over-year basis are expected to slow. This is a result of less drastic prior year comparisons due to the lower sales in the recessionary environment experienced in the second half of 2008.

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

                                           Three months ended                    Nine months ended
                                         September 30, 2009 vs.                September 30, 2009 vs.
                                           three months ended                    nine months ended
                                           September 30, 2008                    September 30, 2008
New vehicle retail, excluding
fleet                                                     (14.3 )%                              (30.3 )%
Used vehicle retail                                         3.9                                  (1.6 )
Used vehicle wholesale                                    (19.1 )                               (33.2 )
Total vehicle sales,
excluding fleet                                            (9.6 )                               (23.0 )
Finance and insurance                                     (23.3 )                               (30.2 )
Service, body and parts                                    (2.8 )                                (4.6 )
Total sales, excluding fleet                               (9.2 )                               (20.8 )

Same-store sales are calculated for stores that were in operation as of September 30, 2009, and only including the months of operations for both comparable periods. For example, a store acquired in July 2008 would be included in same-store operating data beginning in August 2008, after its first full complete comparable month of operation. Thus, operating results for same-store comparisons would include only the periods of August through September of both comparable years.

Within our business lines, vehicle sales have been impacted most severely by the current recessionary environment. Weak consumer confidence and a lack of available credit have reduced demand for vehicles. The third quarter of 2009 experienced incremental improvement as a result of the CARS program, which provided government sponsored rebates for consumers who elected to purchase a new vehicle with improved fuel economy.

While same-store new vehicle unit sales have declined, same-store used vehicle retail unit sales have increased as consumers seek out lower-priced vehicles when making a purchase, and as we have focused on increasing higher-margin used car sales. We have focused our store personnel on maximizing retail used vehicle sales and reducing the number of used vehicles acquired via trade-in that have historically been wholesaled. As a result of the shift in mix to more used vehicles and fewer new vehicles sold, our used to new vehicle sales ratio has improved from 0.7:1 in the first nine months of 2008 to 1.0:1 in the first nine months of 2009.

The declines in finance and insurance same-store sales were primarily due to fewer vehicles sold in the 2009 periods compared to the 2008 periods, as well as a decline in our penetration rate for finance and insurance products, and the impact of restrictions on the overall loan amount to vehicle invoice cost which can impact the financing of ancillary products. Additionally, customers participating in the CARS program elected to pay cash for their vehicle at a higher rate and purchased fewer extended warranties and other ancillary products than our traditional customers.

Additionally, in the first quarter of 2009, we discontinued the transfer of the obligation related to our lifetime lube, oil and filter insurance product to a third party. As a result, beginning March 1, 2009, we no longer recognize revenue related to earned commissions at the inception of the contract but, instead, defer the full sale price of the contract and recognize the revenue over the expected life of the contract as services are provided. This change improves our cash position as we retain 100% of the contract sales price, but decreased our finance and insurance revenues by approximately $91 and $70 per vehicle, respectively, in the three and nine-months periods ended September 30, 2009 compared to the same periods of 2008.

Penetration rates for certain products were as follows:

                                      Three Months Ended          Nine Months Ended
                                         September 30,              September 30,
                                     2009            2008         2009           2008
   Finance and insurance                 68 %            72 %         69 %         74 %
   Service contracts                     42              42           42           43
   Lifetime oil change and filter        37              34           36           36

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