ITEM 1. BUSINESS
OVERVIEW
United Auto Group, Inc. ("UAG" or the "Company") is a leading acquirer, consolidator and operator of franchised automobile and light truck dealerships and related businesses. The Company is the second largest publicly-traded retailer of new motor vehicles in the United States. At the end of 1998, the Company operated franchises located in Arizona, Arkansas, California, Connecticut, Florida, Georgia, Illinois, Indiana, Louisiana, Nevada, New Jersey, New York, North Carolina, South Carolina, Tennessee, Texas and Puerto Rico. As an integral part of its dealership operations, UAG also sells used vehicles. All of UAG's franchised dealerships include integrated service and parts operations, which are an important source of recurring revenues. In addition, UAG dealerships market a complete line of aftermarket automotive products and services through its wholly owned subsidiaries United Auto Care, Inc. ("UAC") and United Auto Care Products, Inc. ("UAC Products").
UAG was incorporated in the State of Delaware in December 1990 and commenced dealership operations in October 1992. Unless the context otherwise requires, references herein to "Common Stock" refers to the Company's Voting Common Stock, par value $0.0001 per share.
The Company was formed to capitalize on consolidation opportunities within the highly fragmented automotive retailing industry by acquiring, consolidating, and operating large automobile retailers and related businesses. As capital requirements to operate dealerships continue to increase and many owners who were granted franchises in the 1950s and 1960s approach retirement age, many individual dealers are seeking exit opportunities. These conditions present attractive consolidation opportunities for larger automobile retailers such as UAG.
The following table sets forth information with respect to dealerships acquired by the Company during 1998:
UAG purchases substantially all new car inventories directly from manufacturers. Each of the Company's dealerships operates pursuant to a franchise agreement between the applicable manufacturer and the subsidiary of the Company that operates such dealership. In accordance with the individual franchise agreements, each dealership is subject to certain rights and restrictions typical of the industry. The ability of manufacturers to influence the operations of a dealership, or the loss of a franchise agreement, could have a negative impact on the Company's operating results.
Manufacturers allocate inventory based on the size and location of dealerships, but actual shipments result from negotiations with individual dealers. The Company believes that larger dealers, such as UAG, are better positioned to secure favorable inventory shipments and optimize manufacturers' allocations. UAG finances its inventory purchases through revolving credit arrangements known in the industry as floor plan facilities.
BUSINESS STRATEGY
UAG seeks to be a leader in the consolidation of the automotive retailing industry and to increase stockholder value through a business strategy that includes the following principal elements:
Acquire and Integrate Profitable Dealership Operations
UAG seeks to capitalize on continuing consolidation in the U.S. automotive retailing industry by selectively acquiring profitable dealerships. The Company targets dealerships or dealership groups with established records of profitability as well as with experienced management willing to remain in place. The Company focuses on opportunities in geographic markets with above-average projected population and job growth. The Company attempts to create regional hubs of dealerships that will be able to share administrative and other operations to reduce costs.
The Company's acquisition program has been specifically tailored to address dealers' desire to retain a management role in their businesses while achieving personal liquidity. Owners of acquired dealerships typically continue as dealership managers and some also participate in overall Company operations through UAG's Chairman's Committee. The Company believes it provides dealership managers additional management tools, as its economies of scale, marketing expertise and corporate resources act as catalysts for continual dealership growth. In addition, the dealer may retain an equity interest in the business through the ownership of capital stock and/or stock options of UAG.
Grow Higher-Margin Operating Businesses
UAG is focusing on higher-margin businesses such as the retail sale of used vehicles, aftermarket products and service and parts.
Used Vehicles. Used vehicle sales by franchised dealers, with average prices approximating 60% of new vehicle prices, typically generate higher gross margins as a percentage of sales value than new car sales because of limited comparability among them and the somewhat subjective nature of their valuation. Consumer acceptance of used vehicle purchasing has grown, due principally to (i) an increase in the availability of late-model, low-mileage used vehicles due in part to the large supply of vehicles coming off short-term leases, (ii) improvements in the quality of motor vehicles and (iii) increases in the prices of new vehicles.
UAG believes that through its new vehicle franchises, it enjoys significant advantages over both independent and chain used-vehicle companies in sourcing used vehicles. Specifically, the Company has access to (i) a steady supply of used vehicles accepted as trade-ins for new vehicle purchases, (ii) off-lease vehicles that were originally leased through the new vehicle franchise and (iii) used vehicle auctions open only to new vehicle dealers. In addition, only new vehicle franchises are able to sell used vehicles certified by the manufacturer under recently introduced programs in which the manufacturer supports specific high-quality used cars with extended warranties and attractive financing options.
Aftermarket Products. Each sale of a new or used vehicle provides the opportunity for the Company to sell aftermarket products. Aftermarket products include accessories such as radios, cellular phones, alarms, custom wheels, paint sealants and fabric protectors, as well as agency services such as extended service contracts, credit insurance policies and financing and lease contracts. In addition, the Company receives fees for placing financing and lease contracts. In order to meet customers' needs and help create a "one-stop" shopping experience, management continues to expand aftermarket product offerings through UAC and UAC Products.
Service and Parts. Each of UAG's new vehicle dealerships offers a fully integrated service and parts department. The service and parts business provides an important recurring revenue stream to the Company's dealerships, which may help to mitigate the effects of downturns in the automobile sales cycle. Unlike independent service shops or used car dealerships with service operations, UAG is qualified to perform work covered by manufacturer warranties. Since warranty service work is paid for by the manufacturer, consumers are motivated to service their vehicles at a dealership for the warranty period. In recent years, manufacturers have generally lengthened standard warranty coverage on new cars and introduced warranty coverage on used cars, further enhancing customer retention opportunities in the service area. To grow their service and parts businesses, UAG dealerships have implemented programs to track maintenance records of customers and contact them regarding dealership promotions and maintenance schedules. In addition, the Company is actively marketing warranty-covered services to potential customers such as municipalities and corporations with large fleets of automobiles located near certain of its dealerships. The Company is able to offer repair services to such customers on a more efficient and less costly basis than such customers generally can perform themselves. The Company also believes that its market share will grow at the expense of independent mechanics' shops, which may be unable to address the increased mechanical and electronic sophistication of today's motor vehicles and the increased expenses of compliance with more stringent environmental regulations.
Implement "Best Practices"
The Chairman's Committee, comprised of senior executives and key managers, meets periodically to review the operating performance of individual dealerships, as well as to examine important industry trends and, where appropriate, recommend specific operating improvements. This facilitates implementation of successful strategies throughout the organization so that each dealership can benefit from the successes of the others, as well as from the knowledge and experience of UAG's senior management. Management also attends various industry sponsored leadership and management seminars and receives continuing education in products, marketing strategies and management information systems. The Company shares training techniques across its dealership base and has made improving service absorption and aftermarket revenues a Company-wide focus.
Emphasize Customer Service
Central to UAG's overall philosophy is customer-oriented service designed to meet the needs of an increasingly sophisticated and demanding automotive consumer through "one-stop" shopping convenience, competitive pricing and a sales staff that is knowledgeable about product offerings and responsive to a customer's particular needs. The Company's goal is to establish lasting relationships with its customers, which enhance its reputation in the community and create the opportunity for significant repeat and referral business.
The quality of customer service provided by dealerships' sales and service departments is measured by customer satisfaction index ("CSI") scores, which are derived from data accumulated by manufacturers through individual customer surveys. UAG relies on this data to track the performance of dealership operations and uses it as a factor in determining the compensation of general managers and sales and service personnel in its dealerships. The Company's most recent CSI scores indicate that a majority of its dealerships' CSI scores were at or above the average CSI scores for the applicable regions.
COMPETITION
Automobile Dealerships
The automotive retailing industry is extremely competitive. In large metropolitan areas, consumers have a number of choices in deciding where to purchase a new or used vehicle and where to have such a vehicle serviced.
For new vehicle sales, the Company competes with other franchised dealers in each of its marketing areas. The Company does not have any cost advantage in purchasing new vehicles from the manufacturer, and typically relies on advertising and merchandising, sales expertise, service reputation and location of its dealerships to sell new vehicles. In recent years, automobile dealers have also faced increased competition in the sale of new vehicles from independent leasing companies and on-line purchasing services and warehouse clubs. Due to lower overhead and sales costs, these companies may be capable of operating on smaller gross margins and offering lower sales prices than franchised dealers. In addition, the Company may face competition in the future from partnerships between manufacturers and dealers.
For used vehicle sales, the Company competes with other franchised dealers, independent used vehicle dealers, automobile rental agencies, private parties and used vehicle "superstores" for supply and resale of used vehicles.
The Company believes that the principal competitive factors in vehicle sales are the marketing campaigns conducted by manufacturers, the ability of dealerships to offer a wide selection of the most popular vehicles, the location of dealerships and the quality of customer service. Other competitive factors include customer preference for particular brands of automobiles, pricing (including manufacturer rebates and other special offers) and warranties. The Company believes that its dealerships are competitive in all of these areas.
The Company competes against other franchised dealers to perform warranty repairs and against other automobile dealers, franchised and unfranchised service center chains, and independent garages for non-warranty repair and routine maintenance business. The Company competes with other automobile dealers, service stores and auto parts retailers in its parts operations. The Company believes that the principal competitive factors in parts and service sales are price, the use of factory-approved replacement parts, the familiarity with a manufacturer's brands and models and the quality of customer service. A number of regional or national chains offer selected parts and services at prices that may be lower than the Company's prices.
EMPLOYEES AND LABOR RELATIONS
As of December 31, 1998, UAG employed approximately 5,500 people, approximately 590 of whom are covered by collective bargaining agreements with labor unions. Relations with employees are considered by the Company to be satisfactory. The Company's policy is to motivate its key managers through, among other things, grants of stock options.
ENVIRONMENTAL MATTERS
As with automobile dealerships generally, and service parts and body shop operations in particular, the Company's business involves the use, handling and contracting for recycling or disposal of hazardous or toxic substances or wastes, including environmentally sensitive materials such as motor oil, waste motor oil and filters, transmission fluid, antifreeze, refrigerant, waste paint and lacquer thinner, batteries, solvents, lubricants, degreasing agents, gasoline and diesel fuels. The Company's business also involves the past and current operation and/or removal of aboveground and underground storage tanks containing such substances or wastes. Accordingly, the Company is subject to regulation by federal, state and local authorities that establish health and environmental quality standards and impose penalties for violations of those standards. The Company is also subject to laws, ordinances and regulations governing remediation of contamination at facilities it operates or to which it sends hazardous or toxic substances or wastes for treatment, recycling or disposal.
The Company believes that it does not have any material environmental liabilities and that compliance with environmental laws, ordinances and regulations will not, individually or in the aggregate, have a material adverse effect on the Company's results of operations or financial condition. However, soil and groundwater contamination has been known to exist at certain properties leased by the Company. Furthermore, environmental laws and regulations are complex and subject to frequent change. There can be no assurance that compliance with amended, new or more stringent laws or regulations, stricter interpretations of existing laws or the future discovery of environmental conditions will not require additional expenditures by the Company, or that such expenditures would not be material.
ITEM 2.
ITEM 2. PROPERTIES
The Company seeks to structure its operations so as to avoid the ownership of real property. As a result, the Company leases or subleases substantially all of its facilities, including dealerships and office space used for corporate activities. As of December 31, 1998, the Company has leases at the majority of its dealerships, which can include facilities for (i) new and used vehicle sales, (ii) vehicle service operations, (iii) retail and wholesale parts operations, (iv) body shop operations, (v) storage and (vi) general office use. Such leases are generally for a period of between five and twenty years and typically include renewal options for an additional five to ten years in favor of the Company. In addition, the Company leases office space in New York, NY, Purchase, NY and Rochester, NY for the Company's corporate headquarters and other corporate related activities.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
The Company and its subsidiaries are involved in litigation that has arisen in the ordinary course of business. None of these matters, either individually or in the aggregate, are expected to have a material adverse effect on the Company's results of operations or financial condition.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY-HOLDERS
There were no matters submitted to a vote of security holders during the fourth quarter of 1998.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Common Stock is listed on the New York Stock Exchange ("NYSE") under the symbol "UAG." There were 114 holders of record of the Common Stock and one holder of record of the Non-voting Common Stock as of March 24, 1998. There is no established market for the Company's Non-voting Common Stock, but such stock is convertible into an equal number of shares of Voting Common Stock at any time, subject to certain conditions, for no cost at the option of the holder thereof.
The following table sets forth the high and low sales prices as reported on the NYSE during each fiscal quarter during 1998 and 1997.
The Company has not declared or paid dividends on its Common Stock during 1998 or 1997. The Company intends to retain future earnings, if any, to finance the development and expansion of its business and, therefore, does not anticipate paying any cash dividends on its Common Stock in the foreseeable future. The decision whether to pay dividends will be made by the Board of Directors of the Company in light of conditions then existing, including the Company's results of operations, financial condition and requirements, business conditions and other factors.
The Credit Agreement (as hereinafter defined) restricts the Company from paying dividends in excess of $5.0 million in the aggregate. In addition, the indentures governing the Notes (as hereinafter defined) limit the Company's ability to pay dividends based on a formula which takes into account, among other things, the Company's consolidated net income. The Company is a holding company whose assets consist primarily of the indirect ownership of the capital stock of its operating subsidiaries. Consequently, the Company's ability to pay dividends is dependent upon the earnings of its subsidiaries and their ability to distribute earnings to the Company and other advances and payments by such subsidiaries to the Company.
Pursuant to the automobile franchise agreements to which the Company's dealerships are subject, all dealerships are required to maintain a certain minimum working capital, and some dealerships are also required to maintain a certain minimum net worth. These requirements may restrict the ability of the Company's operating subsidiaries to make dividend payments, which in turn may restrict the Company's ability to make dividend payments.
ITEM 6.
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
The following table sets forth selected historical consolidated financial and other data of the Company as of and for the five years in the period ended December 31, 1998. Such financial information has been derived from the Company's consolidated financial statements. During the five year period, the Company made a number of acquisitions, each of which has been accounted for using the purchase method of accounting. Accordingly, the Company's financial statements include the results of operations of the acquired dealerships only from the date of acquisition. As a result, the Company's period to period results of operations vary depending on the dates of such acquisitions. The selected consolidated financial data should be read in conjunction with the Company's consolidated financial statements and related footnotes included elsewhere herein.
SELECTED CONSOLIDATED FINANCIAL DATA (1) (2)
- - ------------------------------------ (1) The Company made a decision to discontinue the auto finance business of its wholly owned subsidiary, United Auto Finance, Inc. ("UAF"). As a result, UAF will no longer engage in the purchase or sale of automotive loans; however, it will continue to service its securitized portfolios in accordance with contractual commitments. Consequently, UAF has been reported as a discontinued operation in the accompanying consolidated statements of operations. The Company has restated its prior financial statements to present the results of UAF as a discontinued operation for all periods presented. (2) During 1997, the Company changed its method of accounting for new vehicle inventory from LIFO to the specific identification method. The effect of the change in accounting for new vehicle inventories was to increase net income and income before extraordinary item by $573 ($0.05 per diluted share) in 1996, decrease net income and income before extraordinary item by $188 ($0.03 per diluted share) in 1995 and increase net income and income before extraordinary item by $1,446 ($0.38 per diluted share) in 1994. (3) Includes a $12.6 million pre-tax charge for estimated future repair costs under the terms of approximately 51,000 warranty and extended service contracts sold by UAC from January 1, 1997 to October 31, 1998. See footnotes to consolidated financial statements. (4) Includes the results of the Skelton Group, the Young Group, the Classic Group, Graceland Dodge, Pioneer Ford, the San Diego dealerships and Citrus Dodge from their respective dates of acquisition. (5) Includes a $31.7 million charge recorded during 1997 to realign certain elements of the Company's business. See footnotes to consolidated financial statements. (6) Includes the results of Crown Automotive, Hanna Nissan, the Staluppi Automotive Group, the Gene Reed Automotive Group, the Lance Landers dealerships, Stone Mountain Jeep Eagle, Shreveport Dodge, Central Ford, Covington Pike Dodge and the Triangle Group from their respective dates of acquisition (7) Includes the results of Atlanta Toyota, United Nissan (GA), Peachtree Nissan, the Sun Automotive Group, the Evans Group and United Nissan (TN) from their respective dates of acquisition. (8) Includes the results of Landers Auto from its date of acquisition.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
GENERAL
The Company retails new and used automobiles and light trucks, operates service and parts departments and sells various aftermarket products, including finance and insurance contracts.
New vehicle revenues include sales to retail customers and to leasing companies providing consumer automobile leasing. Used vehicle revenues include amounts received for used vehicles sold to retail customers, leasing companies providing consumer leasing, other dealers and wholesalers. Finance and insurance revenues are generated from sales of accessories such as radios, cellular phones, alarms, custom wheels, paint sealants and fabric protectors, as well as amounts received as fees for placing extended service contracts, credit insurance policies, and financing and lease contracts. UAG dealerships market a complete line of aftermarket automotive products and services through UAC. Service and parts revenues include fees paid for repair and maintenance service and the sale of replacement parts. The Company also derives revenue from fees paid by financial institutions which purchase installment contracts from customers at the Company's dealerships.
The Company's selling expenses consist of advertising and compensation for sales department personnel, including commissions and related bonuses. General and administrative expenses include compensation for administration, finance and general management personnel, depreciation, amortization, rent, insurance, utilities and other outside services. Interest expense consists of interest charges on all of the Company's interest-bearing debt, other than interest relating to floor plan inventory financing which is included in cost of sales.
The Company has been informed by Trace International Holdings, Inc. ("Trace") and its subsidiary Alpha Automotive, Inc. ("Alpha") that they are in the process of evaluating their ability to meet their obligations with respect to the cost of future repairs under the terms of approximately 51,000 warranty and extended service contracts sold by UAC between January 1, 1997 and October 31, 1998. The repair obligations for these contracts had been contractually assumed by Trace and Alpha. As a result of the uncertainty about Trace and Alpha's ability to perform their contractual obligations, the Company has entered into an insurance agreement with Virginia Surety Company, Inc. ("Virginia Surety") and certain of its affiliates. Virginia Surety is a subsidiary of Aon Corporation, an insurance services holding company. Under the terms of the agreement, affiliates of Virginia Surety have agreed to assume the repair obligations on the 51,000 warranty and extended service contracts in exchange for a fixed premium payable over time. The Company has recorded a $12.6 million pre-tax charge (the "Alpha Charge"), which represents the estimated present value of those premium payments. Such charge has been reflected in cost of goods sold in the accompanying financial statements. The Company has no further financial obligations related to these contracts other than to make the specified premium payments.
The Company has terminated the contract with Trace and Alpha with respect to warranty or extended service contracts sold by UAC subsequent to October 31, 1998, and has entered into an agreement with affiliates of Virginia Surety pursuant to which these affiliates will assume the repair obligations on all warranty and extended service contracts sold and to be sold by UAC subsequent to October 31, 1998 in exchange for specified insurance premiums. Trace and Alpha will remain liable with respect to warranty or extended service contracts sold prior to November 1, 1998. Future recoveries from Trace and Alpha will reduce the cost of the Virginia Surety insurance agreement.
The Company made a decision to discontinue its auto finance business. As a result, UAF will no longer engage in the purchase or sale of automotive loans; however, it will continue to service its securitized portfolios in accordance with contractual commitments. Consequently, UAF has been reported as a discontinued operation in the accompanying consolidated statements of operations. The Company has restated its prior financial statements to present the results of UAF as a discontinued operation for all periods presented. Based on its most recent Schedule 13-D filed with the Securities and Exchange Commission, Trace is the beneficial owner of 4,016,110 shares of common stock of the Company, which represents approximately 20.5% of the Company's outstanding common stock. Marshall S. Cogan, Chairman and Chief Executive Officer of the Company, is also Chairman and Chief Executive Officer of Trace.
During 1997, the Company recorded a pre-tax charge of $31.7 million (the "1997 Charge"). The charge included costs associated with (i) the divestiture of automotive franchises, (ii) the closure of three stand-alone used vehicle satellite locations in Arkansas and the disposal of related inventory, (iii) the implementation of a new policy to more efficiently manage the Company's working capital invested in retail inventory, (iv) excess real estate, (v) the write-off of non-performing assets and (vi) certain corporate consulting agreements. Costs associated with the 1997 Charge amounting to $9.8 million and $20.9 million have been reflected in cost of goods sold and selling, general and administrative expenses, respectively, in the accompanying financial statements. In addition, $1.0 million has been reflected in discontinued operations.
Also, the Company changed its method of accounting for new vehicle inventory from LIFO to the specific identification method during 1997. All results of operations and related comparisons in this Management's Discussion and Analysis of Financial Condition and Results of Operations have been restated to reflect such change in accounting principle.
Also, the Company made a number of dealership acquisitions in 1998, 1997 and 1996. Each of these acquisitions has been accounted for using the purchase method of accounting and as a result, the Company's financial statements include the results of operations of the acquired dealerships only from the date of acquisition.
RESULTS OF OPERATIONS
YEAR ENDED DECEMBER 31, 1998 COMPARED TO YEAR ENDED DECEMBER 31, 1997
Revenues. Revenues increased by $1.3 billion, or 59.8%, from $2.1 billion to $3.3 billion. The overall increase in revenues is due primarily to (i) dealership acquisitions made subsequent to January 1, 1997 and (ii) an overall 5.2% increase in retail revenues at dealerships owned prior to January 1, 1997, partially offset by (i) a decrease in retail vehicle sales revenues and finance and insurance revenues at dealerships in the Atlanta marketplace and (ii) a decrease in revenues at dealerships which were divested during 1998. The overall increase in retail revenues at dealerships owned prior to January 1, 1997 reflects 4.4%, 19.5% and 7.7% increases in retail vehicle sales, finance and insurance and service and parts revenues, respectively.
Sales of new and used vehicles increased by $1.1 billion, or 57.8%, from $1.8 billion to $2.9 billion. The increase is due primarily to (i) acquisitions made subsequent to January 1, 1997 and (ii) the net increase at dealerships owned prior to January 1, 1997, offset by (i) the decrease in the Atlanta marketplace and (ii) a decrease at dealerships which were divested during 1998. The increase at dealerships owned prior to January 1, 1997 is due to an increase in the comparative average selling price per vehicle, partially offset by a 2.7% decrease in retail unit sales. Aggregate unit retail sales of new and used vehicles increased by 51.8% and 49.5%, respectively, due principally to acquisitions, offset by (i) the net decrease at dealerships owned prior to January 1, 1997 and (ii) the decrease at dealerships which were divested during 1998. The Company sold 77,403 new vehicles (62.4% of total vehicle sales) and 46,724 used vehicles (37.6% of total vehicle sales) during the year ended December 31, 1998, compared with 50,985 new vehicles (62.0% of total vehicle sales) and 31,253 used vehicles (38.0% of total vehicle sales) during the year ended December 31, 1997.
Finance and insurance revenues increased by $53.2 million, or 71.7%, from $74.2 million to $127.4 million. The increase is due primarily to (i) acquisitions made subsequent to January 1, 1997, (ii) the net increase at dealerships owned prior to January 1, 1997 and (iii) an increase in revenues at UAC, offset by (i) the decrease in the Atlanta marketplace and (ii) a decrease at dealerships which were divested during 1998.
Service and parts revenues increased by $143.3 million, or 75.1%, from $190.8 million to $334.1 million. The increase is due primarily to (i) acquisitions made subsequent to January 1, 1997 and (ii) the net increase at dealerships owned prior to January 1, 1997, offset by a decrease at dealerships which were divested during 1998.
Gross Profit. Gross profit increased by $169.8 million, or 66.1%, from $257.1 million to $426.9 million. The increase in gross profit is due to (i) acquisitions made subsequent to January 1, 1997, (ii) a net increase in total gross profit generated at stores owned prior to January 1, 1997 (iii) the increase in revenues at UAC and (iv) the impact of the 1997 Charge on gross profit in 1997, offset by (i) the impact of the Alpha Charge on gross profit in 1998 and (ii) a decrease at dealerships which were divested during 1998. Gross profit as a percentage of revenues increased from 12.3% to 12.8%. The increase in gross profit as a percentage of revenues is primarily attributable to (i) the increase in higher margin finance and insurance and service and parts revenues as a percentage of total revenues, (ii) improved gross profit margins on retail vehicle sales revenues, (iii) improved gross profit margins on finance and insurance revenues and (iv) improved gross profit margins on service and parts revenues.
Selling, General and Administrative Expenses. Selling, general and administrative expenses increased by $120.0 million, or 47.0%, from $255.1 million to $375.0 million. The increase in selling, general and administrative expense is due principally to (i) acquisitions made subsequent to January 1, 1997, (ii) an increase at stores owned prior to January 1, 1997, offset in part by the impact of the 1997 Charge on selling general and administrative expense in 1997. Such expenses as a percentage of revenue decreased from 12.2% to 11.2%.
Other Interest Expense. Other interest expense increased by $17.4 million, from $14.1 million to $31.5 million. The increase is due to (i) the issuance of the Company's Senior Subordinated Notes due 2007 in July and September 1997 and (ii) the incurrence of acquisition-related debt.
Other Income (Expense), Net. Other income (expense), net increased by $4.5 million, due primarily to $4.8 million of income earned pursuant to dealership management agreements during 1998.
Income Tax Provision. The 1998 income tax provision increased $15.5 million from a benefit of $4.0 million to a provision of $11.6 million. The increase is due to an increase in pre-tax income in 1998 compared with 1997, coupled with an increase in the Company's estimated annual effective income tax rate during 1998.
Loss from Discontinued Operations. Loss from discontinued operations increased by $10.7 million from $2.2 million to $12.9 million. The increase in loss from discontinued operations is due primarily to (i) an increase in UAF's 1998 operating loss and (ii) the recording of a $14.4 million loss on disposal, offset by the impact of the 1997 Charge on loss from discontinued operations in 1997. The increase in UAF's 1998 operating loss was due primarily to (i) losses incurred on the sale of loans in private non-securitized transactions, (ii) losses in connection with exiting interest rate management transactions and (iii) asset impairment relating to finance assets. The loss on disposal consists of (i) $5.9 million relating to contractual commitments, the write-off of certain fixed assets, severance and other administrative expenses, (ii) $3.8 million of asset impairment and losses incurred on the sale of loans in private non-securitized transactions, (iii) $3.9 million of estimated future costs associated with servicing its securitized portfolio of retail automotive loans and (iv) $0.8 million relating to the write-off of deferred financing fees in connection with the closure of UAF's warehouse lines.
Extraordinary Item. The extraordinary item of $1.2 million, net of taxes of $0.9 million, represents a loss resulting from the first quarter write-off of unamortized deferred financing costs relating to the Company's previous credit facility.
YEAR ENDED DECEMBER 31, 1997 COMPARED TO YEAR ENDED DECEMBER 31, 1996
Revenues. Revenues increased by $790.6 million, or 60.7%, from $1.3 billion to $2.1 billion. The overall increase in revenues is due principally to dealership acquisitions made in 1997 and the inclusion of a full year's revenues for dealerships acquired in 1996, offset by a net decrease in sales at dealerships owned prior to January 1, 1996. The net decrease in revenues at dealerships owned prior to January 1, 1996 is due primarily to (i) a reduction in revenues at Atlanta Toyota, impacted by shortages of inventory of certain models and weakness in the Atlanta market, and (ii) a decrease in sales volume at the Company's DiFeo division, resulting principally from the closure of unprofitable dealerships.
Sales of new and used vehicles increased by $663.0 million, or 56.9%, from $1.2 billion to $1.8 billion. The overall increase in vehicle sales is due principally to dealership acquisitions made in 1997 and the inclusion of a full year's revenues for dealerships acquired in 1996, offset by the net decrease in new and used vehicle sales at dealerships owned prior to January 1, 1996 noted above. Aggregate unit retail sales of new and used vehicles increased by 38.5% and 70.4%, respectively, due principally to acquisitions, offset by the sales declines noted above. For the year ended December 31, 1997, the Company sold 50,985 new vehicles (62.0% of total vehicle sales) and 31,253 used vehicles (38.0% of total vehicle sales). For the year ended December 31, 1996, the Company sold 36,802 new vehicles (66.7% of total vehicle sales) and 18,344 used vehicles (33.3% of total vehicle sales). The increase in the relative proportion of used vehicle sales to total vehicle sales was due primarily to the expansion of used car operations in response to the popularity of used cars. New vehicle selling prices increased by an average of 11.4% due primarily to changes in the mix of models sold and changes in manufacturer pricing. Used vehicle selling prices increased by an average of 9.2% due to changes in market conditions which resulted in a change in the mix of used vehicles sold and the increase in sales of recent model year off-lease vehicles.
Finance and insurance revenues (aftermarket product sales) increased by $30.6 million, or 70.3%, from $43.6 million to $74.2 million. The increase is due primarily to (i) dealership acquisitions made in 1997, (ii) the inclusion of a full year's revenues for dealerships acquired in 1996 and (iii) the establishment of UAC, partially offset by a net decrease in finance and insurance revenues in the DiFeo Group. The decrease in the DiFeo Group is due principally to the closure of certain franchises.
Service and parts revenues increased by $96.9 million, or 103.2%, from $93.9 million to $190.8 million. The increase is due primarily to dealership acquisitions made in 1997 and the inclusion of a full year's revenues for dealerships acquired in 1996, partially offset by a net decrease in service and parts revenues in the DiFeo Group. The decrease in the DiFeo Group is due to the closure of certain franchises.
Gross Profit. Gross profit increased by $111.5 million, or 76.6%, from $145.6 million to $257.1 million. Gross profit as a percentage of revenues increased from 11.2% to 12.3%. The increase in gross profit and in gross profit as a percentage of revenues is due to (i) dealership acquisitions made in 1997 and the inclusion of a full year's operations for dealerships acquired in 1996, (ii) increased dealership finance and insurance and service and parts revenues, which yield higher margins, as a percentage of total revenues, (iii) improved gross profit margins on vehicle sales revenues, (iv) improved gross profit margins on finance and insurance revenues, (v) improved gross profit margins on service and parts revenues and (vi) the establishment of UAC, offset by the 1997 Charge.
Selling, General and Administrative Expenses. Selling, general and administrative expenses increased by $130.8 million, or 105.3%, from $124.2 million to $255.1 million due principally to (i) dealership acquisitions made in 1997 and the inclusion of a full year's operations for dealerships acquired in 1996, (ii) an increase in the infrastructure required to manage the substantial increase in the Company's operations and planned expansion of its business in the future and (iii) the 1997 Charge. Selling, general and administrative expenses as a percentage of revenue increased to 12.2% from 9.5%.
Other Interest Expense. Other interest expense increased by $9.7 million, from $4.4 million to $14.1 million. The increase is due to interest expense arising from (i) borrowings under the Senior Credit Facility, (ii) the issuance of the Company's Senior Subordinated Notes due 2007 and (iii) the issuance of acquisition-related debt, offset by a reduction in interest expense due to the retirement of the Company's Senior Notes in October 1996.
Other Income (Expense), Net. Other income (expense), net decreased by $2.3 million, from $2.6 million to $0.3 million, due principally to a reduction in related party interest income resulting from the disposition of the minority interests in certain dealerships in October 1996.
Income Tax Provision. During 1997, the Company recorded an income tax benefit in the amount of $4.0 million, compared with income tax expense of $7.2 million in the prior year. The change is due to the Company's experiencing a net operating loss in 1997 compared with net income in 1996.
Loss from Discontinued Operations. Loss from discontinued operations increased by $1.3 million from $0.9 million to $2.2 million. The increase in loss from discontinued operations is due primarily to (i) an increase in infrastructure spending by UAF in 1997, (ii) charges relating to revised loan loss estimates during 1997 and (iii) the impact of the 1997 Charge.
LIQUIDITY AND CAPITAL RESOURCES
CASH AND LIQUIDITY REQUIREMENTS
The cash requirements of the Company are primarily for the acquisition of new dealerships, working capital and the expansion of existing facilities. Historically, these cash requirements have been met through issuances of equity and debt instruments and cash flow from operations. At December 31, 1998, the Company had working capital of $85.2 million.
During 1998, dealership activities resulted in net cash provided by operations of $55.0 million. Net cash used by dealerships in investing activities during the year ended December 31, 1998 totaled $150.2 million, relating primarily to dealership acquisitions, funding provided to UAF and capital expenditures. Dealership financing activities provided $50.6 million of cash during the year ended December 31, 1998, principally relating to net proceeds from the issuance of long-term debt.
The Company finances substantially all of its new and used vehicle inventory under revolving floor plan financing arrangements with various lenders. The floor plan lenders pay the manufacturer directly with respect to new vehicles. The Company makes monthly interest payments on the amount financed, but is not required to make loan principal repayments prior to the sale of new and used vehicles. Substantially all of the assets of the Company's dealerships are subject to security interests granted to their floor plan lending sources.
At December 31, 1998, the Company had approximately $38.5 million of cash available to fund operations and future acquisitions. In addition, the Company is party to a $75.0 million Credit Agreement, dated February 27, 1998 (as amended) (the "Credit Agreement"), with a group of banks, which was to be used principally for acquisitions. As of March 24, 1999, $4.6 million is available for borrowing under the Credit Agreement.
The Credit Agreement restricts the Company from paying dividends in excess of $5.0 million in the aggregate. In addition, the indentures governing the Notes limit the Company's ability to pay dividends based on a formula which takes into account, among other things, the Company's consolidated net income. The Company is a holding company whose assets consist primarily of the indirect ownership of the capital stock of its operating subsidiaries. Consequently, the Company's ability to pay dividends is dependent upon the earnings of its subsidiaries and their ability to distribute earnings to the Company and other advances and payments by such subsidiaries to the Company. The Notes are fully and unconditionally guaranteed on a joint and several basis by the Company's auto dealership subsidiaries.
The Company was in compliance with the financial covenants in its Credit Agreement at year end. Nevertheless, the Company anticipates that it may not meet the more stringent first quarter 1999 net worth covenants contained therein primarily as a result of the charges described above. The Company has commenced discussions with its lenders to amend or waive such covenants if necessary; however, there can be no assurance that if such amendments or waivers are necessary, they will be obtained.
The Company's principal source of growth has come from acquisitions of automobile dealerships. The Company believes that its existing capital resources will be sufficient to fund its current operations and commitments relating to extended warranty contracts previously assumed by Trace and Alpha. To the extent the Company pursues additional significant acquisitions, it may need to raise additional capital either through the public or private issuance of equity or debt securities or through additional bank borrowings. A public equity offering would require the prior approval of certain automobile manufacturers.
CYCLICALITY
Unit sales of motor vehicles, particularly new vehicles, historically have been cyclical, fluctuating with general economic cycles. During economic downturns, the automotive retailing industry tends to experience similar periods of decline and recession as the general economy. The Company believes that the industry is influenced by general economic conditions and particularly by consumer confidence, the level of personal discretionary spending, interest rates and credit availability.
SEASONALITY
The Company's combined business is modestly seasonal overall. The greatest seasonalities exist with the dealerships in the northeast United States, for which the second and third quarters are the strongest with respect to vehicle related sales. The service and parts business at all dealerships experiences relatively modest seasonal fluctuations.
EFFECTS OF INFLATION
The Company believes that the relatively moderate rates of inflation over the last few years have not had a significant impact on revenue or profitability. The Company does not expect inflation to have any near-term material effects on the sale of its products and services. However, there can be no assurance that there will be no such effect in the future.
The Company finances substantially all of its inventory through various revolving floor plan arrangements with interest rates that vary based on the prime rate or LIBOR. Such rates have historically increased during periods of increasing inflation. The Company does not believe that it would be placed at a competitive disadvantage should interest rates increase due to increased inflation since most other automobile dealers have similar floating rate borrowing arrangements.
IMPACT OF YEAR 2000
Many existing computer systems and related applications use only two digits to identify a year in the date field. As the year 2000 approaches, such programs may be unable to distinguish years beginning with 20 from years beginning with 19. As a result, date sensitive systems and related applications may fail to process data accurately, before, during or after the year 2000. The Company is currently analyzing the potential for year 2000 issues to impact the operations and management of its auto dealerships.
The Company's auto dealerships rely heavily upon two mission critical systems: Dealer Management Systems ("DMS") and Dealer Communication Systems ("DCS"). The DMS is a leased computer system that supports critical day-to-day operations of the dealership, including vehicle sales, inventory, service and parts operations and accounting functions. The DCS is a communication system through which the dealerships exchange information with the manufacturer for processes such as ordering vehicles and parts, submitting warranty claims, reporting financial information and receiving technical information for vehicle service activities. The Company has received assurances from each of the providers of these systems that year 2000 compliant versions of the systems have been developed and are available to the Company as part of the recurring maintenance of such systems. To date, the installation of the year 2000 compliant DMS and DCS systems has been completed at more than ninety percent of the Company's dealerships. The remaining dealerships are expected to have installed the year 2000 compliant systems by April 30, 1999. In order to test the ability of the Company's recently upgraded mission critical systems to process date related information correctly, the Company has established a redundant computer platform which is being used to evaluate the reliability of such systems. The majority of such testing is expected to be completed by May 31, 1999. While the testing of the mission critical systems is still pending, the Company has received assurances that the vendors supplying such systems have made all corrections necessary to the systems to ensure date related information is processed correctly. The cost of the upgraded mission critical systems is included in the recurring fees paid by the Company to the system providers. As a result, the implementation of such systems has not resulted in incremental cost to the Company.
The Company is also attempting to verify that the critical services provided by external service providers, such as vehicle and parts manufacturers and suppliers, public utilities and financial institutions with which the Company conducts business, will be available without interruption during the transition to the year 2000. Financial institutions with which the auto dealerships conduct critical business activities include floorplan lending sources and retail lending institutions. In the event such service providers are unable to verify their ability to address year 2000 issues, the Company will explore alternative sources for such services. If the Company's current service providers fail to address year 2000 issues, and if the Company is unable to secure such services from an alternative service provider, then such failure could result in a material adverse effect on the Company.
In addition to the mission critical systems and critical services noted above, the dealerships utilize a variety of non-critical devices and systems containing embedded systems which may fail to process data accurately, before, during or after the year 2000. Such non-critical devices and systems include personal computers, software applications, service lifts and certain other equipment used by service technicians, phone systems and alarms. The Company has developed a summary list of potential year 2000 issues for its dealerships, which is based on an industry guide designed to help dealerships address year 2000 issues, as well as on information obtained through in-depth reviews of the potential impact of year 2000 issues at certain Company dealerships. Each of the Company's dealerships is scheduled to have completed a thorough review designed to identify such non-mission critical systems and devices by April 30, 1999. In addition, each dealership is expected to have addressed these non-mission critical systems by December 31, 1999. The cost of correcting the non-mission critical systems and devices is not expected to cost in excess of $2.0 million, which will be paid for from the cash flow from operations of the individual dealerships.
Despite the Company's efforts and testing, there is a risk that not all possible problems associated with the year 2000 issue will be corrected. Further, despite assurances that the Company has received or will receive, there can be no guarantee that the systems and services provided by vendors, or that the systems of other companies with which the Company does business, will be year 2000 compliant. Any such non-compliance could result in the reduction or shutdown of the retail sale of automobiles and ancillary products, which could have a material adverse effect on the Company.
FORWARD LOOKING STATEMENTS
Certain portions of this Annual Report contain "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. All statements, other than statements of historical facts, included in this Annual Report or incorporated herein by reference regarding the Company's financial position and business strategy may constitute forward-looking statements. Although the Company believes that the expectations reflected in such forward-looking statements are reasonable, it can give no assurance that such expectations will prove to have been correct. Important factors that could cause actual results to differ materially from the Company's expectations, some of which are described in greater detail elsewhere in this Annual Report, include the following: (i) the Company is subject to the influence of various manufacturers whose franchises it holds; (ii) the Company is leveraged and subject to restrictions imposed by the terms of its indebtedness; (iii) the Company's growth depends in large part on the Company's ability to manage expansion, control costs in its operations and consummate and consolidate dealership acquisitions; (iv) many of the Company's franchise agreements impose restrictions on the transferability of the Company's Common Stock; (v) the Company will require substantial additional capital to acquire automobile dealerships and purchase inventory; (vi) unit sales of motor vehicles historically have been cyclical; (vii) the automotive retailing industry is highly competitive; (viii) the automotive retailing industry is a mature industry; (ix) the Company's success depends to a significant extent on key members of its management; and (x) the Company's business is seasonal. In light of the foregoing, readers of this Annual Report are cautioned not to place undue reliance on the forward-looking statements contained herein.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Foreign Currency Exchange Rates. The Company's business is conducted in the United States and its revenues and expenses are transacted solely in U.S. dollars. As a result, the Company's results of operations are not subject to foreign exchange rate fluctuations and, accordingly, the Company does not hedge against such fluctuations. In common with other automobile retailers, the Company purchases certain of its new car inventories from foreign manufacturers. The Company's business in this regard is subject to certain risks, including, but not limited to, differing economic conditions, changes in political climate, differing tax structures, other regulations and restrictions and foreign exchange rate volatility. The Company's future results could be materially and adversely impacted by changes in these or other factors.
Interest Rates. The Company is exposed to market risk from changes in the interest rates on certain of its outstanding indebtedness. The outstanding balance under the Credit Agreement bears interest at a variable rate based on a margin over the prevailing London Interbank Offered Rate ("LIBOR"). Based on the amount outstanding as of March 24, 1999, a 100 basis point change in interest rates would result in an approximate $0.7 million change to the Company's annual interest expense. Similarly, amounts owing under the revolving floor plan financing arrangements, pursuant to which the Company finances substantially all of its vehicle inventory, bear interest at a variable rate based on a margin over LIBOR. Based on the average aggregate outstanding amounts under such financing arrangements for the year ended December 31, 1998, a 100 basis point change in interest rates would result in an approximate $3.8 million change to the Company's annual floor plan interest expense. For fixed rate debt such as the Notes, certain seller financed promissory notes and obligations under certain capital leases, interest rate changes effect the fair market value thereof, but do not impact earnings or cash flows.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
See the consolidated financial statements listed in the accompanying Index to Consolidated Financial Statements for the information required by this item.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Not applicable.
PART III
The information required by Items 10 through 13 is included in the Company's definitive proxy statement under the captions "The Board of Directors and its Committees," "Election of Directors," "Executive Officers," "Security Ownership of Certain Beneficial Owners and Management" and "Certain Relationships and Related Transactions." Such information is incorporated herein by reference, pursuant to General Instruction G(3).
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) Financial Statements
The consolidated financial statements listed in the accompanying Index to Consolidated Financial Statements are filed as part of this Annual Report on Form 10-K.
(b) Reports on Form 8-K.
The Company did not file any Current Reports on Form 8-K during the three month period ended December 31, 1998.
(c) Exhibits
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in New York, New York on March 31, 1999.
UNITED AUTO GROUP, INC.
By: /s/ Marshall S. Cogan ------------------------ Marshall S. Cogan Chairman of the Board and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on its behalf by the registrant and in the capacities and on the dates indicated:
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
REPORT OF INDEPENDENT ACCOUNTANTS
To the Stockholders of United Auto Group, Inc.:
In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of United Auto Group, Inc. (the "Company") at December 31, 1998 and 1997, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1998, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above.
/s/ PricewaterhouseCoopers LLP
Princeton, New Jersey March 29, 1999
UNITED AUTO GROUP, INC. CONSOLIDATED BALANCE SHEETS (Dollars in Thousands)
See Notes to Consolidated Financial Statements.
UNITED AUTO GROUP, INC. CONSOLIDATED STATEMENTS OF OPERATIONS (In Thousands, Except Per Share Amounts)
See Notes to Consolidated Financial Statements.
UNITED AUTO GROUP, INC. CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (Dollars in Thousands)
See Notes to Consolidated Financial Statements.
UNITED AUTO GROUP, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (Dollars in Thousands)
See Notes to Consolidated Financial Statements.
UNITED AUTO GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in thousands, Except Per Share Amounts)
1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
United Auto Group, Inc. ("UAG" or the "Company") is engaged in the sale of new and used motor vehicles and related products and services, including vehicle service and parts, finance and insurance products and other aftermarket products. The Company operates dealerships under franchise agreements with a number of automotive manufacturers. In accordance with the individual franchise agreements, each dealership is subject to certain rights and restrictions typical of the industry. The ability of the manufacturers to influence the operations of the dealerships, or the loss of a franchise agreement, could have a negative impact on the Company's operating results.
As discussed in Note 4, the Company has discontinued its auto finance business. As a result, the Company's wholly owned subsidiary, United Auto Finance, Inc. ("UAF"), is presented as a discontinued operation in the accompanying financial statements. Also, as discussed in Note 5, the Company completed a number of acquisitions during the three years in the period ended December 31, 1998. Each of these acquisitions has been accounted for using the purchase method of accounting. As a result, the Company's financial statements include the results of operations of the acquired dealerships only from the date of acquisition.
In October 1996, The Company consummated an initial public offering of 6,250,000 shares of its common stock (the "IPO"). Net proceeds from the IPO amounted to $170,410, which were used to prepay outstanding indebtedness, fund certain acquisitions, fund operations of UAF and for working capital purposes.
Principles of Consolidation
The consolidated financial statements include all significant majority-owned subsidiaries. All material intercompany accounts and transactions among the consolidated subsidiaries have been eliminated. Affiliated companies that are 20% to 50% owned are accounted for using the equity method of accounting.
Cash and Cash Equivalents
Cash and cash equivalents include all highly-liquid investments that have an original maturity of three months or less at the date of purchase.
Fair Value of Financial Instruments
Financial instruments consist of cash and cash equivalents, accounts receivable, accounts payable and debt, including floor plan notes payable. The carrying amount of financial instruments approximates fair value due either to length of maturity or the existence of variable interest rates that approximate prevailing market rates.
UNITED AUTO GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (Dollars in thousands, Except Per Share Amounts)
Revenue Recognition
Revenue is generally recognized when vehicles are delivered to consumers, when motor vehicle service work is performed, or when parts are delivered. Finance and insurance revenues are recognized upon the sale of the finance or insurance contract or other aftermarket products. An allowance for chargebacks against revenue relating to the sale of customer finance contracts or other aftermarket products is established when the related revenue is recognized.
Inventory Valuation
Inventories are stated at the lower of cost or market. Cost for new and used vehicle inventories is determined using the specific identification method. Cost for parts, accessories and other inventories is based on factory list prices.
Property and Equipment
Property and equipment are recorded at cost and depreciated over estimated useful lives, primarily using the straight-line method. Useful lives for purposes of computing depreciation for assets other than equipment under capital lease and leasehold improvements are between 5 and 10 years. Equipment under capital lease and leasehold improvements are depreciated over the term of the lease or the estimated useful life of the asset, whichever is shorter.
Expenditures relating to recurring repair and maintenance are expensed as incurred. Expenditures that increase the useful life or substantially increase the serviceability of an existing asset are capitalized. When equipment is sold or otherwise disposed of, the cost and related accumulated depreciation are removed from the accounts, and any resulting gain or loss is reflected in income.
Income Taxes
Income taxes are provided in accordance with Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes ("SFAS 109") which requires an asset and liability approach to accounting for income taxes. Deferred tax assets or liabilities are computed based upon the difference between financial reporting and tax bases of assets and liabilities using enacted tax rates. A valuation allowance is provided when it is more likely than not that taxable income will not be sufficient to fully realize deferred tax assets.
Intangible Assets
Intangible assets of $482,049, consisting primarily of excess of cost over the fair value of net assets acquired in purchase business combinations, are being amortized on a straight-line basis over periods not exceeding 40 years. Accumulated amortization at December 31, 1998 amounted to $21,758. Amortization expense for the years ended December 31, 1998, 1997 and 1996 was $11,560, $6,300 and $1,712, respectively.
Segment Reporting
Effective January 1, 1998, the Company adopted Statement of Financial Accounting Standards ("FAS") No. 131, "Disclosures about Segments of an Enterprise and Related Information". Under FAS No. 131, the Company's operations are considered one reportable segment. The Company does not allocate goodwill amortization, interest on corporate indebtedness or general corporate expenses to its operating subsidiaries. Such items totaled approximately $53,840, $18,772 and $5,873 during 1998, 1997 and 1996, respectively. In addition, corporate assets, primarily relating to cash and cash equivalents, deferred tax assets and intangible assets, totaled approximately $522,183 and $462,293 as of December 31, 1998 and 1997, respectively.
UNITED AUTO GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (Dollars in thousands, Except Per Share Amounts)
Impairment of Long-Lived Assets
The carrying value of long-lived assets, including intangibles, is reviewed if the facts and circumstances, such as significant declines in revenues, earnings or cash flows or material adverse changes in the business climate, indicate that it may be impaired. The Company performs its review by comparing the carrying amounts of long-lived assets to the estimated undiscounted cash flows relating to such assets. If any impairment in the value of the long-lived assets is indicated, the carrying value of the long-lived assets is adjusted to reflect such impairment calculated based on the discounted cash flows or the fair value of the impaired assets.
Estimates
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. The accounts which require the use of significant estimates are accounts receivable, inventories, income taxes, intangible assets, and accrued expenses.
Advertising
Advertising costs are expensed as incurred. The Company incurred advertising costs of $37,318, $25,075 and $14,217 during the years ended December 31, 1998, 1997 and 1996, respectively.
Net Income (Loss) Per Common Share
Basic earnings per share data was computed based on the weighted average number of common shares outstanding. Diluted earnings per share data was computed based on the weighted average number of shares of common stock outstanding, adjusted for the dilutive effect of stock options, warrants, preferred stock and the dilutive effect of the minimum share price guarantee on the 1,040,039 shares of common stock issued in connection with the acquisition of the Young Automotive Group in 1998 (see Note 5).
Reclassifications
In order to maintain consistency and comparability of financial information between periods presented, certain reclassifications have been made to the Company's December 31, 1997 financial statements to conform to the current year presentation.
UNITED AUTO GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (Dollars in thousands, Except Per Share Amounts)
2. CHANGE IN ACCOUNTING PRINCIPLE
In 1997, the Company changed its method of accounting for new vehicle inventory from LIFO to the specific identification method. This change in accounting principle has been applied by retroactively restating the Company's financial statements for prior years. The effect of the change in accounting principle was to increase income before extraordinary item and net income by $573 ($0.05 per diluted share) in 1996.
3. UNUSUAL ITEMS
The Company has been informed by Trace International Holdings, Inc. ("Trace") and its subsidiary Alpha Automotive, Inc. ("Alpha") that they are in the process of evaluating their ability to meet their obligations with respect to the cost of future repairs under the terms of approximately 51,000 warranty and extended service contracts sold by United Auto Care, Inc. ("UAC") between January 1, 1997 and October 31, 1998. The repair obligations for these contracts had been contractually assumed by Trace and Alpha. As a result of the uncertainty about Trace and Alpha's ability to perform their contractual obligations, the Company has entered into an insurance agreement with Virginia Surety Company, Inc. ("Virginia Surety") and certain of its affiliates. Virginia Surety is a subsidiary of Aon Corporation, an insurance services holding company. Under the terms of the agreement, affiliates of Virginia Surety have agreed to assume the repair obligations on the 51,000 warranty and extended service contracts in exchange for a fixed premium payable over time. The Company has recorded a $12,550 pre-tax charge, which represents the estimated present value of those premium payments. Such charge has been reflected in cost of goods sold in the accompanying consolidated statement of operations. The Company has no further financial obligations related to these contracts other than to make the specified premium payments.
The Company has terminated the contract with Trace and Alpha with respect to warranty or extended service contracts sold by UAC subsequent to October 31, 1998, and has entered into an agreement with affiliates of Virginia Surety pursuant to which these affiliates will assume the repair obligations on all warranty and extended service contracts sold and to be sold by UAC subsequent to October 31, 1998 in exchange for specified insurance premiums. Trace and Alpha will remain liable with respect to warranty or extended service contracts sold prior to November 1, 1998. Future recoveries from Trace and Alpha will reduce the cost to the Company of the Virginia Surety insurance agreement.
During the fourth quarter of 1997, the Company recorded a $31,660 pre-tax charge. The charge included costs associated with (i) the divestiture of automotive franchises, (ii) the closure of three stand-alone used vehicle satellite locations in Arkansas and the disposal of related inventory, (iii) the implementation of a new policy to more efficiently manage the Company's working capital invested in retail inventory, (iv) excess real estate, (v) the write-off of non-performing assets and (vi) certain corporate consulting agreements. Costs associated with the pre-tax charge amounting to $9,757 and $20,903 have been reflected in cost of goods sold and selling, general and administrative expenses, respectively, in the consolidated statements of operations. In addition, $1,000 has been reflected in discontinued operations.
UNITED AUTO GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (Dollars in thousands, Except Per Share Amounts)
4. DISCONTINUED OPERATIONS
The Company made a decision to discontinue its auto finance business. As a result, UAF will no longer engage in the purchase or sale of automotive loans; however, it will continue to service its securitized portfolios in accordance with contractual commitments. Consequently, UAF has been reported as a discontinued operation in the accompanying consolidated statements of operations. In addition, the remaining assets and liabilities of UAF have been presented as a separate line item in non-current assets on the consolidated balance sheets. The Company has restated its prior financial statements to present the results of UAF as a discontinued operation for all periods presented.
Summarized financial information of UAF follows:
The loss on disposal consists of (i) $5,888 relating to contractual commitments, the write-off of certain fixed assets, severance and other administrative expenses, (ii) $3,803 of asset impairment and losses incurred on the sale of loans in private non-securitized transactions, (iii) $3,912 of estimated future costs associated with servicing its securitized portfolio of retail automotive loans and (iv) $812 relating to the write-off of deferred financing fees in connection with the closure of UAF's warehouse lines.
5. BUSINESS COMBINATIONS
During 1998 and 1997, the Company completed a number of acquisitions. Each of these acquisitions has been accounted for using the purchase method of accounting. As a result, the Company's financial statements include the results of operations of the acquired dealerships only from the date of acquisition.
In January 1998, the Company acquired the Skelton Automotive Group, located in Memphis Tennessee. Consideration for the purchase amounted to $16,500, including $14,700 in cash and $1,800 of seller financed promissory notes.
UNITED AUTO GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (Dollars in thousands, Except Per Share Amounts)
In February 1998, the Company acquired the Young Automotive Group, with operations in Indiana, Illinois, North Carolina, South Carolina and Florida. The aggregate consideration for the acquisition amounted to $84,000, consisting of $50,000 in cash, 1,040,039 shares of UAG common stock and $7,000 of seller financed promissory notes. The Company agreed to make a contingent payment in cash or stock to the extent the shares issued in connection with this transaction have an aggregate market value of less than $27,000 on the dates they become freely tradable. In February 1999, the Company settled a portion of this obligation with respect to 444,987 shares by issuing 1,156,689 additional shares of common stock. The remaining 595,052 shares become freely tradable in June 1999.
In February 1998, the Company acquired the Classic Automotive Group in New Jersey. The aggregate consideration for the acquisition was $28,700, consisting of $28,000 in cash and $700 of UAG common stock. The Company agreed to make a contingent payment in cash or stock to the extent the shares issued in connection with this transaction have an aggregate market value of less than $759 on the date they become freely tradable. In March 1999, the Company settled its obligation with respect to the share price guarantee by paying $306 in cash.
During the year ended December 31, 1998, the Company also acquired (i) Graceland Dodge, located in Memphis Tennessee, (ii) Pioneer Ford, located in Phoenix Arizona, (iii) a group of dealerships which operate Toyota, Lexus, Dodge and Mazda franchises in San Diego California (the "San Diego dealerships") and (iv) a 70% interest in Citrus Dodge, located in Dade City Florida. The aggregate consideration for such acquisitions amounted to $50,859, consisting of $39,059 in cash, $8,400 of UAG common stock and $3,400 of seller financed promissory notes. The Company has agreed to make contingent payments in cash to the extent the shares issued in connection with these transactions have an aggregate market value of less than $8,400 in July 1999.
In December 1997, the Company acquired the Triangle Group, located in Puerto Rico, for $12,800 in cash. In addition, if the Triangle Group achieves certain levels of annual pre-tax earnings during any of the next ten years, the Company will be required to make additional payments. No payments were required based on 1998 earnings.
In May 1997, the Company acquired the Gene Reed Automotive Group, located in North and South Carolina, for $34,000, consisting of $17,000 in cash, $4,000 of promissory notes and $13,000 of UAG common stock.
In April 1997, the Company acquired the Staluppi Automotive Group (the "Staluppi Group"), located in New York and Florida, for $49,614, consisting of $25,450 in cash, $21,864 of promissory notes and $2,300 of UAG common stock. In addition, if the Staluppi Group achieves certain levels of annual pre-tax earnings during any of the next three years, the Company will be required to make additional payments. In the Company's opinion, it is unlikely that any additional payments will be required.
UNITED AUTO GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (Dollars in thousands, Except Per Share Amounts)
In April 1997, the Company acquired Gary Hanna Nissan, Inc., located in Las Vegas Nevada, for $13,740, consisting of $7,000 in cash, $1,240 of promissory notes and $5,500 of UAG common stock.
In February 1997, the Company acquired Shannon Automotive Limited, located in the Houston area, for $7,000 in cash and 335,329 shares of UAG common stock.
During the year ended December 31, 1997, the Company also acquired (i) Covington Pike Dodge, located in Memphis Tennessee, (ii) Central Ford, located in Little Rock Arkansas, (iii) Shreveport Dodge, located in Shreveport Louisiana, (iv) Stone Mountain Chyrsler-Plymouth Jeep-Eagle, located in Stone Mountain Georgia and (v) the Lance Landers dealerships, located in Benton Arkansas. The Company paid $15,500 in cash in consideration for such acquisitions.
In addition, the Company has agreed to make a contingent payment in cash to the extent that 375,404 shares of common stock issued in connection with an acquisition that took place prior to 1997 have an aggregate market value of less than $9,400 in December 1999.
Pro Forma Results of Operations
The following unaudited consolidated pro forma results of operations of the Company for the years ended December 31, 1998 and 1997 give effect to (i) acquisitions consummated during 1998 and 1997, (ii) the divestiture of certain dealerships during 1998, (iii) the discontinuation of the Company's auto finance operations and (iv) the offering of the Company's Senior Subordinated Notes due 2007 as if they had occurred on January 1, 1997.
6. INVENTORIES
Inventories consisted of the following:
UNITED AUTO GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (Dollars in thousands, Except Per Share Amounts)
7. PROPERTY AND EQUIPMENT
Property and equipment consisted of the following:
Depreciation and amortization expense for the years ended December 31, 1998, 1997 and 1996 was $4,904, $2,800 and $1,888, respectively. Accumulated amortization at December 31, 1998 and 1997 on equipment under capital lease, included in accumulated depreciation and amortization above, amounted to $1,614 and $830, respectively.
8. FLOOR PLAN NOTES PAYABLE
The Company's automobile dealerships have "floor plan" agreements with several finance companies to finance the purchase of their automobile inventory. Floor plan notes payable consisted of the following:
The floor plan agreements grant a security interest in substantially all assets of the dealerships and require the repayment of debt after a vehicle's sale. Interest rates on the floor plan agreements are variable and increase or decrease based on movements in prime or LIBOR borrowing rates. Floor plan interest expense for the years ended December 31, 1998, 1997 and 1996 was $28,719, $19,296 and $12,578, respectively. The weighted average interest rate on floor plan borrowings was 7.6%, 8.2% and 8.3% for the years ended December 31, 1998, 1997 and 1996, respectively.
UNITED AUTO GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (Dollars in thousands, Except Per Share Amounts)
9. LONG-TERM DEBT
Long-term debt consisted of the following:
Scheduled maturities of long-term debt for each of the next five years and thereafter are as follows:
In February 1998, the Company entered into a credit agreement with a group of banks which provides for up to $75,000 in term loans, revolving loans and letters of credit, to be used principally for acquisitions (as amended, the "Credit Agreement"). The Credit Agreement bears interest at LIBOR plus 3.75% and matures in February 2001. Pursuant to the terms of the Credit Agreement, the Company is required to pay certain fees relating to outstanding letters of credit and unused commitments. Outstanding borrowings under the Credit Agreement as of December 31, 1998 amounted to $68,400. In addition, a $1,600 letter of credit was outstanding as of December 31, 1998.
The Credit Agreement contains a number of significant covenants that, among other things, restrict the ability of the Company to dispose of assets, incur additional indebtedness, repay other indebtedness, pay dividends, create liens on assets, make investments or acquisitions and engage in mergers or consolidations. In addition, the Company is required to comply with specified ratios and tests, including cash interest expense coverage, debt service coverage, debt to earnings ratios and a minimum net worth covenant. The Credit Agreement also contains typical events of defaults including change of control, material adverse change and non-payment of obligations. The Company was in compliance with the financial covenants in its Credit Agreement at year end. Nevertheless, the Company anticipates that it may not meet the more stringent first quarter 1999 net worth covenants contained therein primarily as a result of the charges described in Note 3. The Company has commenced discussions with its lenders to amend or waive such covenants if necessary; however, there can be no assurance that if such amendments or waivers are necessary, they will be obtained. The Credit Agreement replaced the Company's previous credit facility, which was terminated upon the effective date of the Credit Agreement. The Company incurred an extraordinary charge of $1,235 ($0.06 per diluted share), net of income taxes of $859, resulting from the write-off of unamortized deferred financing costs relating to the Company's previous credit facility.
UNITED AUTO GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (Dollars in thousands, Except Per Share Amounts)
On July 23, 1997, the Company completed the sale of $150,000 aggregate principal amount of 11% Senior Subordinated Notes due 2007 (the "Series A Notes"). On September 16, 1997, the Company completed the sale of an additional $50,000 aggregate principal amount of 11% Senior Subordinated Notes due 2007, Series B (together with the Series A Notes the "Notes"). The sale of the Notes were exempt from registration under the Securities Act of 1933 pursuant to Rule 144A thereunder. Proceeds from the offering of the Notes after issue discount, discount to initial purchasers and transaction costs amounted to approximately $189,469.
The Notes are fully and unconditionally guaranteed on a joint and several basis by the Company's auto dealership subsidiaries (the "Note Guarantors"). Separate financial information of the Note Guarantors has been omitted because (i) the Company is a holding company with no independent operations and (ii) financial information for the Note Guarantors is presented on the face of the Company's consolidated financial statements.
During 1996, the Company redeemed certain indebtedness with a portion of the proceeds from the IPO. The redemption of such indebtedness resulted in an extraordinary pre-tax loss of $7,672. The redeemed indebtedness contained detachable warrants that granted holders the option to purchase UAG Common Stock at $0.01 per share. Upon the consummation of the IPO, 1,109,491 shares of UAG Common Stock were issued in a cash-less exchange for all of the then outstanding warrants. The settlement of the warrants resulted in a $2,769 increase to the Company's stockholders' equity.
10. OPERATING LEASE OBLIGATIONS
The Company leases its dealership facilities and corporate office under non-cancelable operating lease agreements with expiration dates through 2036, including all option periods available to the Company. Minimum future rental payments required under non-cancelable operating leases in effect as of December 31, 1998 follow:
Rent expense for the years ended December 31, 1998, 1997, and 1996 amounted to $26,917, $17,674 and $8,729, respectively. A number of the dealership leases are with former owners who continue to operate the dealerships as employees of the Company. Of the total rental payments, $11,140, $10,911 and $5,240, respectively, were made to related parties during 1998, 1997, and 1996, respectively.
UNITED AUTO GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (Dollars in thousands, Except Per Share Amounts)
11. RELATED PARTY TRANSACTIONS
As noted above, the Company is the tenant under a number of non-cancelable lease agreements with employees of the Company, all of whom are former owners of dealerships purchased by the Company. The Company believes all such leases are on terms no less favorable to the Company than would be obtained through arm's-length negotiations with unaffiliated third parties.
The Company has entered into management agreements at certain dealerships for which the closing of the acquisition of such dealerships is pending final manufacturer approval. Pursuant to such management agreements, the Company is paid a monthly fee for managing all aspects of the dealerships' operations. During 1998, management fee income amounting to $4,800 has been included in other income (expense), net in the accompanying consolidated statements of operations.
As discussed in Note 3, the Company was party to an agreement whereby the Company's exposures with respect to the majority of the extended service contracts sold by UAC during the period from January 1, 1997 through October 31, 1998 were assumed by Trace and Alpha in exchange for certain fees. During the period covered by the agreement, the Company remitted approximately $7,729 to Alpha. Such remittances reflect approximately $10,111 in fees for the assumption of obligations with respect to the 51,000 warranty and extended service contracts, offset by approximately $2,383 of claims payments relating such contracts. As noted, the contract with Trace and Alpha was terminated effective October 31, 1998.
From time to time, the Company has paid and/or received fees from Trace and its affiliates for services rendered in the normal course of business. These transactions reflect the providers' cost or an amount mutually agreed upon by both parties. It is the Company's belief that the payments relating to these transactions are on terms at least as favorable as those which could be obtained from an unrelated third party. Aggregate (income) expense relating to such transactions of $260, $(2,118) and $225 for the years ending December 31, 1998, 1997 and 1996, respectively, has been reflected in selling, general and administrative expenses in the accompanying financial statements. As of December 31, 1998 and 1997, the Company owes $200 and $616, respectively, for such services.
During 1996, the Company recognized $2,580 of income relating to interest on advances made to minority or former minority shareholders and certain of their related entities for certain business acquisitions and interest on working capital advances to dealerships owned by those shareholders in which the Company had no ownership. Such income has been reflected in other income (expense), net in the accompanying financial statements.
UNITED AUTO GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (Dollars in thousands, Except Per Share Amounts)
12. STOCK COMPENSATION PLANS
During 1996, the Company's Board of Directors and stockholders adopted a Stock Option Plan. Under the Stock Option Plan, all full-time employees of the Company and its subsidiaries and affiliates are eligible to participate. During 1998, the Company granted options to purchase 492,390 shares at the fair market value of the Company's stock on the date of the grant. Options granted under the Stock Option Plan have a ten year life and typically vest on a pro-rata basis over five years. As of December 31, 1998, the aggregate number of shares of Common Stock for which stock options may be granted under the Stock Option Plan may not exceed 2,000,838. As of December 31, 1998, 488,023 shares of Common Stock were available for the grant of options under the Stock Option Plan. Presented below is a summary of the status of stock options held by eligible employees during 1998 and 1997:
The following table summarizes the status of UAG's employee stock options outstanding and exercisable at January 1, 1999:
The Company has adopted the disclosure only provisions of Financial Accounting Standards Board Statement of Financial Accounting Standards No. 123, Accounting for Stock Based Compensation ("SFAS 123"). Had the Company elected to recognize compensation expense for stock options based on the fair value at the grant dates of awards, net income and earnings per share would have been as follows:
The weighted average fair value of the Company's stock options was calculated using the Black-Scholes option-pricing model with the following weighted-average assumptions used for grants in 1998 and 1997: no dividend yield; expected volatility of 30%; a risk-free interest rate of 7% and expected lives of five years. The weighted average fair value of options granted during the years ended December 31, 1998, 1997 and 1996 is $6.99, $4.74 and 4.23 per share, respectively.
13. STOCKHOLDERS' EQUITY
At December 31, 1998 and 1997, the following classes of stock are authorized, issued or outstanding (share amounts in thousands):
14. INCOME TAXES
The income tax (provision) benefit relating to income (loss) from continuing operations consisted of the following:
UNITED AUTO GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (Dollars in thousands, Except Per Share Amounts)
The income tax (provision) benefit relating to income (loss) from continuing operations varied from the U.S. federal statutory income tax rate due to the following:
The Company accounts for income taxes in accordance with Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes ("SFAS 109"). Under SFAS 109, deferred income taxes reflect the estimated tax effect of temporary differences between assets and liabilities for financial accounting purposes and those amounts as measured by tax laws and regulations. The components of deferred tax assets and liabilities at December 31, 1998 and 1997 were as follows:
At December 31, 1998, the Company has $6,974 of federal net operating loss carryforwards that expire through 2012. In addition, at December 31, 1998, the Company also has $23,825 of state net operating loss carryforwards that expire at various dates through 2013.
UNITED AUTO GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (Dollars in thousands, Except Per Share Amounts)
15. SUPPLEMENTAL CASH FLOW INFORMATION
The following table presents supplementary cash flow information:
16. SUMMARY OF QUARTERLY FINANCIAL DATA (UNAUDITED)
(1) As discussed in Note 2, the Company changed its method of accounting for new vehicle inventory from LIFO to the specific identification method. (2) As discussed in Note 4, the results of UAF have been recorded as discontinued operations. (3) As discussed in Note 9, the Company recorded an extraordinary loss of $1,235 during the first quarter of 1998. (4) As discussed in Note 3, the Company recorded $12.7 million and $31.7 million charges during the fourth quarters of 1998 and 1997, respectively. (5) Includes the results of the Skelton Group, the Young Group, the Classic Group, Graceland Dodge, Pioneer Ford, the San Diego dealerships and Citrus Dodge from their respective dates of acquisition. (6) Includes the results of Crown Automotive, Hanna Nissan, the Staluppi Automotive Group, the Gene Reed Automotive Group, the Lance Landers dealerships, Stone Mountain Jeep Eagle, Shreveport Dodge, Central Ford, Covington Pike Dodge and the Triangle Group from their respective dates of acquisition.
The net income (loss) per common share amounts are calculated independently for each of the quarters presented. The sum of the quarters may not equal the full year net income (loss) per common share amounts.