Research Challenge-economic headwind

Highlights

We initiate coverage on Lithia Motors, Inc. (LAD) with a BUY

recommendation based on cautious optimism and a 12-month

price target of $89.50, offering 17% upside from its closing

price of $76.42 on February 1, 2016. Our recommendation is

driven primarily by the following factors:

– A record of consistently meeting or beating revenue and

earnings estimates. Lithia has beaten earnings estimates 10 of

the last 12 quarters (Bloomberg).

– Steady revenue and income growth through increased sales

and acquisitions. The revenue growth rate has been

consistent for five years. With the exception of the rise related

to the purchase of DCH, revenues are expected to continue

growing at a similar rate.

– Significant opportunity to pursue growth through

acquisition. As noted in Lithia’s third quarter 2015 investor

report; there are over 18,800 dealerships in the United States

of which the 10 largest only control 7%.

– In a strong financial position to endure potential macro-

economic headwinds and pursue growth.

– Analyzing the interrelationship between forecasted growth,

the credit facility and overall valuation. Specifically, how

changes in working capital affect valuation relative to debt

ratios specified in the credit facility covenants.

Recent News

– Lithia’s floor plan credit line was extended from $1.7 to

1.85B in December 2015.

– DCH announced the acquisition of Ira Toyota / Scion in

Milford, MA and Riverside Subaru in Riverside, CA. Ira Toyota

is Lithia’s first in the state of Massachusetts. The acquisitions

are estimated to generate $110 million in annual revenue.

Market Profile 52-Week High/Low $126.56/$72.30

Average Volume 0.394M

Shares Outstanding 23.7M

Market Cap 2076.3M

Dividend Yield 1.00%

Beta 1.71

EV / Revenue 1.83

EV / EBITDA 45.83

Price to Cash Flow 45.1

Institutional

Holdings 123.22%

Insider Holdings 2.99%

Lithia Motors, Inc.

This report is published for educational purposes only by students competing in the

CFA Institute Research Challenge.

Source: Bloomberg

Source: Bloomberg

Source: Bloomberg and Team Calculations

February 22, 2016 2

Business Description

Lithia Motors Inc. (Lithia) operates as a retailer and franchisee

of automotive vehicles in the United States. Lithia offers 31

brands through 135 dealerships in 14 U.S. states (Figure 1).

Historically, Lithia’s focus has been on secondary markets

throughout the western states. A more recent “metropolitan”

strategy led to the acquisition of DCH in 2014, which

established Lithia in the major markets of New York/New

Jersey, Florida, Texas and California.

Lithia’s core business is divided into four components.

– New Vehicles – Used Vehicles – Parts and Service – Financing and Insurance

Revenue and profit as a percent of total for each of the core

business components are provided in Table 1. The multiple

productive cash streams have historically made Lithia appear

recession resistant.

Lithia operates under the mission: “Driven by our employees

and preferred by our customers, Lithia is the leading

automotive retailer in each of our markets.” Furthermore,

they strive to offer their customers personal, convenient,

and flexible personalized service, complimented by

advantages associated with being a large company, those

including: selection, vehicle pricing, and broad access to

financing, and warranties. Lithia intends to continue

expanding through evaluation and acquisition of dealerships

throughout the United States (Lithia Motors, 2014).

Management and Governance

Lithia has an experienced management team, many of

whom have significant tenure with the company. They are

committed to a growth strategy through acquisition, and

have helped Lithia consistently perform over the last 20

years. A more detailed analysis of the management is

provided in Appendix A.

Management provides shareholders with the expected

disclosures. In addition to the required SEC filings, an

annual meeting and quarterly earnings calls provides

shareholders with updates on business strategy and current

performance.

Lithia Class A shareholders are entitled to one vote per

share owned. Lithia Class B shareholders are entitled to ten

votes per share owned. Lithia Holdings, managed by Sidney

B. Deboer, controls 52% of the aggregate vote (Lithia,

2014), limiting shareholder rights in company decisions.

Figure 1: Revenue By State (source: company data)

Figure 2: Institutional Owners (source: Bloomberg)

Figure 3: Historical and Forecast Revenue

Table 1: Core Business Elements as a Percent of Revenue

(source: company data)

Figure 4: Annual Growth of US Car and Truck Sales

Compared to US Real GDP (source: Bloomberg)

February 22, 2016 3

Senior management owns approximately 3.0% of the outstanding stock. While not an overwhelming

percentage, the stake is sufficient to align company and management interests.

Industry Overview and Competitive Advantage

Lithia is one of 12 companies comprising the automotive retail sector (Bloomberg). The industry is

unconsolidated and remains dominated by small and independent dealers. The ten largest dealers control

only 7% of the countries’ dealerships. Many of the larger dealerships are regionally based and are subjected

to trends in regional economies as well as national. As shown in Figure 4, US car and truck sales have

recently been growing at twice the rate of GDP. By expanding its regional base and target market, Lithia is

hoping to capitalize on increasing sales and reduce its exposure to regional volatility. Key statistics for Lithia,

the automotive retail sector, and several of its main competitors are in included in Table 2. In general Lithia

compares favorably to its national peers, however the bulk of Lithia’s competition comes from independent

dealerships in the communities it serves.

Porter’s Five Forces: Porter’s Five Forces were used to analyze Lithia’s position within the

industry. The results are presented in Figure 6 and

are discussed below.

Bargaining Power of Buyers – MODERATE: There is

intense competition between dealerships for

buyers. The resulting competition drives down

prices and increases the consumer’s ability to

bargain for better deals. Furthermore, the growing

popularity of direct purchasing through internet

sites gives the customers further flexibility and

options when choosing where they want to

purchase their vehicles from. Through the use of

Internet resources buyers are now able to educate

themselves on the comparative pricing of vehicles

that they intend to buy, which may affect Lithia’s profit margin.

Supplier Bargaining Power – SIGNIFICANT: Lithia’s performance is dependent upon their ability to maintain

healthy relationships with the manufacturers/suppliers whom provide new vehicles, parts, and financing.

Disruption or change to Lithia’s relationship with any major manufacturer exposes them to significant

downside. Lithia is reliant on new vehicle sales as the company’s largest revenue stream. In-demand new

vehicles are consistently in short supply, and therefore maintaining relationships with vehicle manufacturers

is necessary for Lithia to meet growing demands with consistent supply.

Threat of New Entrants – MODERATE: Manufacturers have policies specifying how many dealerships can operate in a given area or region. Lithia does not suffer from significant threat of entry adversely effecting

their new car revenue stream. However, in the used car arena, there is no limitation on the number of

Figure 5: Illustration of Porter’s Five Forces (source: team calculation)

Table 2: Comparison of Key Statistics for Lithia, national peers, and sector averages (2015 Actual; source: Bloomberg).

February 22, 2016 4

dealerships, or individuals, of whom can sell any given brand of car within any given region. Therefore, it is

difficult for Lithia to counter new entrants in the used vehicle markets.

Competition in the Industry – SIGNIFICANT: Automobile Retail is a competitive industry. Lithia competes

against both private and publicly owned firms, many of whom sell the same makes and models of cars.

These companies are often highly adept at sales and marketing, making it difficult for Lithia to differentiate

themselves amongst their customer base. Lithia does not have significant cost advantages relative to their

competitors in most of their business lines. Lithia’s primary advantage come from the smaller markets they

have historically occupied.

Threat of Substitutes: – MODERATE: Lithia is able to reduce the threat of customers buying from or going to

other automobile retailers by operating in secondary markets. Lithia is able to limit the number of

dealerships that they compete directly against in a given area, however this advantage also limits the

number of potential consumers available. The acquisition of DCH has gained Lithia more exposure to larger

metropolitan areas, partially alleviating the affects of operating in smaller markets elsewhere. The threat of

substitutes is higher in the used vehicle and parts market.

Investment Summary

We issue a “buy” rating with a target price of $89.50. The target price is based on the output from our

discounted cash flow model. The model is based on historical data and cautious optimism that Lithia can

execute its business strategy and grow into the future.

Industry Consolidation: Automotive retail is an unconsolidated industry. Of the estimated 17,800 dealerships in the United States only 7% are controlled by the 10 largest dealers. Significant opportunity for

growth remains by opportunistically acquiring independent dealerships. Lithia currently has 2,660

dealerships identified for potential acquisition. Lithia has historically acquired between three to five

dealerships per year, with DCH being the exception. Once the affects of DCH are fully realized, growth

should continue at historically observed rates (Figure 3).

Operational Improvements: There is room for organic growth in each of the four components of Lithia’s core business. Since 2009 new vehicle sales have increased dramatically. This growth has out paced US real GDP growth by over a factor of two, and is estimated to increase by 5% in 2016 (Bloomberg). In the United

States, used vehicle sales represent a three times larger market than new vehicle sales. Currently 37% the

used vehicle market is controlled by franchised dealers (Lithia, 2014) leaving significant market share

available to acquire. Lithia’s per unit financing and insurance earnings lag compared to the industry average

(Lithia 2014), yet remains the most profitable component of Lithia’s business. The sales and service

correlates highly to the number of new and used vehicles sold. Increasing sales in both categories should

increase parts and service revenue. While each section of Lithia’s business is profitable, there is internal

room for improvement.

Figure 6: Long-term performance of LAD shares relative to the Russell 2000 (source: Bloomberg)

February 22, 2016 5

Credit Facility: Covenants in Lithia’s credit facility mandate the company maintain a current ratio greater than 1.2. In 2014 the current ratio dropped to 1.16 requiring Lithia to obtain a waiver from the credit

syndicate. Forecasts of Lithia’s financials (Table 4) suggest the ratio could drop to 0.97 by 2020 if observed

linear trends continue. Maintaining the mandated ratio will require an additional $600 million in Net

Working Capital in 2020, substantially reducing the companies free cash flow. In order to prevent this

decrease, Lithia will either have to renegotiate the terms of the credit facility or find away to not only

maintain the observed linear growth rates, but increase them. Recession Resistant: Lithia’s performance through the recession of 2008 indicates the company tracks large economic shifts, but is relatively resistant to much of the short-term volatility (Figure 7). The apparent

“resistance” is likely attributable to the mix of cash flow sand conservative financial management.

Financial Analysis

Historical Forecasting of Financial Statements without DCH acquisition

The fundamental assumption underpinning our forecast of performance is that Lithia will continue to grow

and improve their operation at the same rate (on a cash basis) as prior to the DCH acquisition on October 1 st

2014. Based on the statements made by Lithia’s management during the CFA orientation call, and made to

the public we expect them to maintain their current acquisition rate while targeting a 20% ROE

requirements for acquisitions (Autonews 2014, Lithia 3Q 2015, Marketrealist, 2015). Furthermore, Lithia’s

historical rate of growth in a variety of key financial parameters has been extremely stable. Figure 8, show

the linearity of various key financial parameters as well as the coefficient of determination (R 2 ). By utilizing

the pre-DCH data and applying a mixture of forecasting techniques, we prepared a non-DCH financial

forecast (See appendix D). This maintained the linearity of the past into the future. It is our strong opinion

that Lithia’s fundamental management and growth strategy is clearly revealed in the historical financial

statements—IE: this level of linearity does not happen by chance—and is likely to continue into the future

until proven otherwise.

Figure 8: Linearity of Historical Balance Sheet and Income Statement Components and Forecasted Effect of the DCH

Acquisition

February 22, 2016 6

Preparing and applying DCH acquisition adjustment to forecasts

Through the utilization of the 2015 3 rd quarter filings, the impact of the DCH acquisition on the income

statement and balance sheet categories were estimated by calculating the difference between the projected

2015 3 rd Quarter non-DCH forecast and the actual 10Q from the 3

rd quarter of 2015 (see appendix E for a

detailed discussion). We used this estimated impact of DCH on a cash basis to correct the non-DCH financial

forecast and prepared our final projections provided in appendix B.

This created expected deviations in 2014 through 2020 between the DCH corrected forecast and the non-

DCH forecast as seen in figures 8. The deviation is clearly visible between 2014 through 2020 for the two

calculated variables of Net Income and Retained Earnings. Note these variables are ‘calculated’ because they

are not forecasted directly, they are calculated each year based on the forecasting of other fundamental

financial values.

In order to build support for our method

we compared the estimated impact of

DCH against published values in

connection to the DCH acquisition.

Specifically, we found repeatable the

published value of $2.3billion increase in

revenue provided by DCH (StreetInsider

2014, Marketrealist 2015). Overall, we found the difference between our estimated annual impact of DCH

and the published values to be small, adding support to our method.

Based on our forecasted financial statements we notice the continuation of interesting trends. First, the

return on assets rebounds nicely after the DCH acquisition in 2014 and is on pace to reach 2013 levels by the

end of 2020. Second, the return on equity continues to increase, indicating acquisitions Lithia has made in

the past have returned over the 20% ROE requirement and that economics of scale has helped increase the

ROE of new acquisitions.

A concerning trend is that the current ratio is projected to decrease further below their debt covenant

requirement of 1.20 (Lithia obtained a waiver for the 2014 calendar year). We expect Lithia to make

significant adjustments to either their debt covenants or to change their debt structure to increase current

assets to maintain t a current ratio above 1.2.

Table 3: Calculated Error for Incorporating DCH

Table 4: Historical and forecast Key Ratios (source: team calculations)

February 22, 2016 7

Valuation

Price Target: $90 Recommendation: Buy Discounted Cash Flow Model A three stage discounted cash flow model was constructed

to estimate Lithia’s enterprise value and share price. The

model was constructed using the forecasted financial

statements in Appendix C. A three stage model was chosen

to allow for the full incorporation of DCH into the 2015

estimates, followed by four years of consistent growth and

a perpetuity. Parameters and assumption used in the

model are included in Appendices H (Beta), I (Re and

Rwacc) and J (DCF Model). Results of the model are shown

in Table 5. Sensitivity analysis indicated the model is

extremely sensitive to the perpetuity. As shown in Table 7,

varying the perpetuity growth rate and Rwacc by the

calculated and assumed standard deviation has a

significant impact on the share price. Increasing Rwacc by

one standard deviation (1.14%) results in a 35% decrease

in the calculated share price.

Monte Carlo Simulation To further analyze the model’s sensitivity a monte carlo

simulation was run. The model used calculated and

assumed volatilities to randomly vary the free cash flow

growth rate, cost of equity, cost of debt, and the

perpetuity growth rate. Result of the simulation are

presented in Table 6 and Figure 8. A summary of the

models parameters and assumption are included in

Appendix K.

Dividend Discount Model The model estimated the value of Lithia’s future dividends.

The model estimated a price of $49.12. The current value of

Lithia is their growth therefore this estimate was not

factored into the final price target. Details on the

calculations and assumptions are provided in Appendix L.

Table 5: Results from the Discounted Free Cash Flow

Model. Prices in $1,000s, except, hare price.

Figure 9: Share Price Distribution from the Monte Carlo

Simulation. (source: team calculations)

Table 7: Model Sensitivity to Shifts in Perpetuity Calculation (source: team calculations)

Table 6: Monte Carlo Simulation Results. 95% Confidence

Interval of simulation means

February 22, 2016 8

Price Target and Range The discounted cash flow model estimated an intrinsic share price of $89.50. The mean price from the

Monte Carlo Simulation was $90.84 with a 95% confidence interval of +/- $0.37 resulting in a range of $90.42

and $91.15. The static output of the model falls slightly outside of the values predicted by the simulation,

however the high confidence in the mean implies a certain validity to the model. As a result of the model

and simulation, a target share price of $89.50 was set.

Investment Risks

Regulatory Risk: Environmental, health or safety regulation may have an adverse effect upon the performance of Lithia. Market Risk: Lithia’s historic areas of operation are secondary markets across the rural western United States. While the sole focus has changed with the acquisition of DCH, the higher percentage of sub-prime

costumers in these secondary markets may result in more sensitivity to economic downturn. Lithia’s revenue

is highly concentrated in a small number of states (Figure 1). Sales in Texas, Oregon and California,

accounted for approximately 55% of all total vehicle sales in 2014. This concentration exposes Lithia to

potential risk from local and regional economic slowdowns. Credit Risk: Lithia’s business model is predicated on the availability of credit for itself and its customers. Lithia, as well as its competitors finance their inventory with a syndicated credit facility with a floating rate

tied to the one month Libor rate. Covenants for the floor plan credit line dictate Lithia must maintain

minimum debt ratios (Table 8) or receive a waiver. Failure to maintain these ratios could result in less

favorable loan terms or loss of the credit facility. The floating rate on the credit facility exposes Lithia to

interest rate risk. A rise in the Libor Rate without a corresponding rise in sales could significantly affect

Lithia’s profitability. A decline in the availability of credit in the lending market could have an adverse effect

on Lithia. Many of Lithia’s costumers finance their vehicle purchases, including a not insignificant portion

whose financing comes from sub-prime lenders. In the event of credit standards tightening or credit

becoming less available, some consumers will be limited in their ability to purchase vehicles.

Operational Risk: Lithia is exposed to operational risk due to its dependence on the supply chain of its manufactures and distributors. A large portion of their business is dependent upon a consistent supply of

new vehicles and parts. A disruption to the supply chain could adversely impact Lithia’s ability to conduct

business as usual.

Franchise Risk: Vehicle manufactures can exert significant pressure on their franchised dealerships, exposing Lithia to significant risk if their interests are not aligned. Manufacturers can exert significant control over the

Lithia’s franchises of which they are the franchisee, and as a result there are standards of which each

franchise must meet. If these standards are not met it may jeopardize the Lithia’s relationship with the

manufacturers, and resulting in disruptions to new vehicle supply. Other Risk: Lithia is exposed to risk from local and regional tax initiatives. For instance, Oregon Initiative 2016-23, likely to be put in front of voters in November 2016, would place a 2.5% tax on all sales and service

income over $25 million earned in the state. Passage of the initiative could substantially increase Lithia’s tax

burden and decrease earnings.

Table 8: Credit Facility Debt Covenants

February 22, 2016 9

References

Bloomberg L.P. “Stock Description LAD.”. Bloomberg database. University of Portland, Portland, OR. 6

February, 2016.

Lithia Motors, Inc. (2014). Form 10-K 2010. Retrieved from SEC EDGAR website

http://www.sec.gov/edgar.shtml

http://www.lithia.com/dealership/about.htm

Lithia Motors, Inc. (2015) 3 rd Quarter Investor Call Slides

http://www.autonews.com/article/20141030/RETAIL07/141039995/lithia-will-continue-rapid-acquisition-pace-after-

dch

http://marketrealist.com/2015/01/glenview-capital-builds-position-lithia-motors/

http://www.streetinsider.com/Hot+Corp.+News/Lithia+Motors+%28LAD%29+to+Acquire+DCH+Auto+Group+in+%2436

3M+Deal/9583874.html

February 22, 2016 10

Appendix A: Corporate Governance

In order to analyze Lithia’s corporate governance risk we utilized the standards adopted by the Institutional Share Holder Service. The table below exhibits Lithia’s corporate governance rating, as determined by the ISS. The rating scale is 1-10, with low numbers indicating low levels of corporate governance risk. The ISS has rated Lithia’s Corporate Score as a 6, indicating Lithia to have moderate corporate governance risk.

Source: Institutional Shareholder Service Board of Directors – Lithia’s Board of directors consists of seven members. Lithia’s board members have a range of experience, and it is unclear how long some of them have served on the board for Lithia. Two of the seven members of Lithia’s board are reported insiders. However, certain members of the board may not be considered official insiders, yet they have worked directly with Lithia before their appointment to the board, giving rise to potential corporate governance risk. The significant number of insiders on Lithia’s board could exhibit substantial risk due to conflicts of interests that may influence the board to take action in a way not in the best interest of shareholders. Furthermore, the Board of Directors reserves the right to issue shares of preferred stock without shareholder approval. This issuance may give preferred shareholders preference in dividend payments as well as voting powers, causing the rights of shareholders and the price of Class A common stock to be adversely effected. Executive Management – Lithia has an experienced executive management team, many of whom have been with the company for periods of over ten years. They are united in their growth strategy through acquisition and have helped Lithia consistently perform and grow over the last 20 years. Disclosure and Transparency – Management provides shareholders with quarterly earnings calls and provides yearly meetings to update shareholders on the current performance and goals of the company. They also provide shareholders a website to use as a resource to keep track of company news and performance. Shareholder Rights – Lithia’s Class A shareholders are entitled to one vote per share. Each Class B shareholder is entitled to ten votes per share. On most matters, Class A and Class B shareholders will vote together. Lithia Holdings, managed solely by Sidney B. Deboer, controls 52% of the aggregate vote. As a result, Mr. Deboer’s controlling interest limits shareholder ability to influence company decisions and policy.

Appendix B: Historic and Forecasted Financial Statements Balance Sheet

Below is the historic balance sheet for the last 4 years, and the projected balance sheet for the next six years. The historical data was taken from the annual 10k filings with the SEC (CIK#: 0001023128). The projected data was created through the use of historical forecasting (using the data from 2011-2014 or a subset), simplifying assumptions, and the estimated impact of the acquisition of DCH Auto Group that was completed 10/1/2014. A detailed discussion is included in Appendix D & Appendix E.

Appendix B: Historic and Forecasted Financial Statements Income Statement

Below is the historic income statement tracking the last 5 years, and the projected income statement for the next six years. The historical data was taken from the annual 10k filings with the SEC (CIK#: 0001023128). The projected data was created through the use of historical forecasting (using the data from 2011-2014 or a subset), simplifying assumptions, and the estimated impact of the acquisition of DCH Auto Group that was completed 10/1/2014. A detailed discussion is included in Appendix D & Appendix E.

Appendix C: Historic and Forecasted Common Sized Financial Statements

Balance Sheet

Common sized balance sheet prepared by dividing each balance sheet item by the Total Assets for that year.

Appendix C: Historic and Forecasted Common Sized Financial Statements Income Statement

Common sized Income Statement was prepared by dividing each balance sheet item by the Total revenues for that year.

Appendix D: Simplifying Assumptions, & Historical Forecasting

Overall Strategy

With the acquisition of DCH in the 4th quarter of 2014, LAD’s financial performance became significantly harder to forecast considering that this is the first significant acquisition for LAD, (DCH increases LAD’s revenue by approximately 50%) and since the acquisition was recent there isn’t an abundance of data showing how LAD management and techniques would impact DCH’s performance or how DCH would aid in the growth of LAD. We tackled this problem by using the pre-DCH data to project a non-DCH forecast of the financial statements then corrected these forecasts with a DCH correction. The DCH correction was estimated through the utilization of the 3rd Quarter 2015 filings with the SEC and the projected 3rd quarter filings based on our non-DCH projection (see appendix E). Below we describe the specific assumptions and forecasting methods we used to project LAD’s performance without DCH.

Balance Sheet

Simplifying Assumptions

1. Cash levels remain at 1% of total assets for 2015 – 2020

2. Small non-impactful categories are assumed to be zero moving forward a. Non-impactful is defined as less than or equal to 1.2% common sized average in the

historical data and has no strong indication that it will grow to a point of significance soon i. This includes “Other current assets”, “Deferred Income Taxes”, “Assets held for

sale”, “liabilities related to assets held for sale” & “Accumulated other comprehensive loss”

b. The two categories that we believe will grow into being significant are “Current Maturities of long-term debt” & “Additional paid-in capital”

Historical Forecasting

For all categories not simplified by assumptions, we looked at the historical data trends and made one of two forecasts on an individual category basis—Linear growth based on 2011-2013 historical values, or a naïve projection of maintaining the common sized % based on the 2014 10k. The choice of forecasting method was based on the past data, the knowledge of LAD’s business model and the information provided in the CFA challenge orientation call.

Appendix D: Simplifying Assumptions, & Historical Forecasting

Based on the historical data and the company 10k filings, we forecasted two current liabilities to be maintained at a fixed % of total assets. These are “floor plan notes payable” and “Current maturities of long-term debt”. This is because we think these represent logically planned investments and the spending on these categories will be maintained moving forward. For example, “floor plan notes payable” refers to investment in dealerships (appearance, amenities, ect.) themselves and can easily be controlled by corporate budgeting.

In order to insure the balance sheet was internally consistent, the retained earnings for each year was calculated to set total assets equal to total liabilities and stockholders’ equity. This is a reasonable choice and by looking at the resulting long term trend of retained earnings we can see if our total forecast makes logical sense. For example, if retained earnings jumped drastically from one year to the next it would be an indication that our forecasting was not consistent. As you can see from the Figure below, retained earnings without the DCH correction is nearly linear (as indicated by the coefficient of determination) for the historical and forecasted data, indicating the assumptions above produce a reasonable forecast of retained earnings.

All other categories where forecasted using cash basis linear projections using data from 2011 through 2013. Key balance sheet categories show clear linear trends over the last 4 years as shown in the figure to the bottom right. 2014 data was excluded due to the large impact of the acquisition of DCH on these categories.

We expect the observed cash growth rate between 2011 and 2013 (driven by acquisitions and operational improvement) to continue in the future at a similar rate due to the following facts. First off, DCH is the largest acquisition by LAD. 2ndly LAD management communicated in the CFA orientation meeting that DCH is a unique acquisition and they are planning on maintaining their earlier growth rate.

Appendix D: Simplifying assumptions, & Historical Forecasting

Income Statement

Simplifying Assumptions

1. Small non-impactful categories are assumed to maintain their 2013 performance percentage wise based on their common sized income statement value.

a. Specifically, “Asset Impairments”, “Depreciation and Amortization”, “Floor Plan interest expense”, “Other interest expense”, “Other income, net”, and “income from discontinued operations, net of income tax” all are assumed to maintain their performance in 2013 into the future.

b. These values are not drastically impactful for the overall performance of LAD being all 0.50% or less of total revenue.

2. Income tax provision was projected in the future by using the average implied tax rate for 2010- 2013. The implied tax rate was determined by taking the ratio of the income tax provision and the income from continuing operations before income taxes. The average value was determined to be 37.75%.

Historical Forecasting

For all remaining independent categories, projected values where estimated by using a cash basis linear forecast determined by the performance in 2010 until 2013. Key categories show in the figure to the right clearly show linear trends over the last four years. This projection was then adjusted to account for the impact of DCH on the income statement. This process is described in detail in appendix E.

In figure X below, you can see that the projected net income without the DCH correction is extremely linear as determined by looking at the coefficient of determination (r^2 = .9899). With the DCH correction you can see a significant jump in 2015, as well as an increase in 2014 (two months of DCH).

Appendix F: Estimation of DCH’s Impact on Financial Statements

Balance Sheet Impact of DCH estimated

Appendix F: Estimation of DCH’s Impact on Financial Statements

In order to get an estimate of the impact of the DCH acquisition on the Balance sheet, the difference was calculated between the 3rd quarter Q10 filings in 2015 and the estimated 3rd quarter filings based on 2011-2013 forecast built using the assumptions in Appendix D. If these differences where significant and impacted categories we did not make simplifying assumptions on, we used these differences to correct the projected balance sheet values produced using the rules in Appendix D without DCH (data not shown) to prepare our net projections shown in Appendix B. This created the jumps in retained earnings, total assets, total liabilities associated with the DCH acquisition as seen in the figures for the 2015 year.

Appendix F: Estimation of DCH’s Impact on Financial Statements

Income Statement Impact of DCH estimated

In order to get an estimate of the impact of the DCH acquisition on the income statement, the difference was calculated between the 3rd quarter Q10 filings in 2015 and the estimated 3rd quarter filings based on 2011-2014 forecast built using the assumptions in Appendix E. We used these differences to correct the projected income statement values produced using the rules in Appendix E without DCH (data not shown) to prepare our net projections shown in Appendix C. Note that we used the assumption that 4th quarters typically account for 25% of annual totals seen on the income statement in order to prepare annual differences (9 month difference times 4/3rds). This created the jumps in revenues, costs of sales, and net income associated with the DCH acquisition as seen in the figures for the 2015 year.

Appendix F: Calculation of Free Cash Flows and Associated Values

Appendix G: Calculation of Free Cash Flows and Associated Values

Capital Expenditures Historical and projected values

Based on the Historical data of capital expenditures, we used a cash basis linear forecast to project the capital expenditures through 2020. This projection implies that the common size of capital expenditures are expected to grow faster than related total revenue. As a gauge on whether this projection was reasonable, we used the 2015 10Q filings by LAD to estimate the year on year growth rate from 2014 until 2015 and compared that growth rate versus or projected growth rate. This is shown in the figure below. The 10Q data shows a 19.7% year on year growth rate for capital expenditure through 9 months of 2015 vs. 9 months of 2014. The projected data predicts a 22.5% growth rate. This is reasonable close and lends support that our projection is not grossly off base.

Free Cash Flow with DCH correction

Based on the projected financial statements and capital expenditures we obtain the following results for LAD’s Free Cash Flow projected until 2020. The results are clear that LAD’s year on year free cash flow growth rate will decline quickly to about 5%. In order to maintain a higher growth rate in the future, LAD will need to increase its rate of acquisitions or push its operating efficiency even higher.

Note: due to our assumptions underlying the balance sheet and the components of current assets and current liabilities, working capital changes course twice (from decreasing to increasing) and this is a large enough effect to result in free cash flow shrinking in 2015 and 2017. From a practical point of view, this effect can be eliminated by purposeful

Appendix F: Calculation of Free Cash Flows and Associated Values

planning by LAD management if desired. For example, if LAD decided to hold a higher level of current liabilities without changing current assets (only 2.3% change required) it could remove the shrinking free cash flow in 2015.

Another implication our method of financial forecasting produces is that the year on year growth rate of the free cash flow will continue to decrease in the near future and will level out near 5% around 2020. This relationship is similar to exponential decay and is expected based on the linearity we built into our model on a cash basis. Essentially if LAD does not increase their acquisition rate on a cash basis their % growth will level out. As seen in the figure below.

SUMMARY OUTPUT

Regression Statistics Multiple R 0.6975 R Square 0.4865 Adjusted R Square 0.4778 Standard Error 0.0835 Observations 61

ANOVA df SS MS F Significance F

Regression 1 0.3901 0.3901 55.8986 4.21462E-10 Residual 59 0.4117 0.0070 Total 60 0.8018

Coefficients Std Error t Stat P-value Lower 95% Upper 95% Intercept 0.0255 0.0108 2.3639 0.0214 0.0039 0.0470 Russell 2000 1.7142 0.2293 7.4765 4.2146E-10 1.2554 2.1730

Appendix G: Beta Calculation

y = 1.7142x + 0.0255

-30.00%

-20.00%

-10.00%

0.00%

10.00%

20.00%

30.00%

40.00%

50.00%

-15.00% -10.00% -5.00% 0.00% 5.00% 10.00% 15.00% 20.00%

-0.4 -0.2

0 0.2 0.4 0.6

0 20 40 60 80 100 120

Y

Sample Percentile

Normal Probability Plot

Inputs Weighted Average Cost of Capital (Rwacc) 11.43% Rwacc = [Re x E%] + [Rd x ( 1-Tc) x D%] 8.98% 1.97% Total Equity $1,810 7.50% Total Debt $630 5.53% Percent Equity (E%) 74.18% 1.71 Cost of Equity (Re) 11.43%

Percent Debt (D%) 25.82% Cost of Debt (Rd) 3.00% Corporate Tax Rate (Tc) 35.60%

Risk Free Rate (Rf) Expected Return (Rmkt) Beta

Total Equit

Total Debt

Percent Equity (E%) Cost of Equity (Re) Percent Debt (D%) Cost of Debt (Rd) Corportate Tax Rate (Tc)

CAPM Assumptions

Rwacc Assumptions

Caculated using CAPM (above) Total debt divided by total equity plus total debt Calucalated cost of long term debt from third quarter 2015 10Q Estimated from Income tax expense as a percentage of operating income (2014 10K)

Yield of 10 Year United States Treasury Note at market close: February 1, 2016 Long Term Average of US Stock Markets Calculated using trailing 60 month returns relative to the Russell 2000; See appendix I)

Market Captialization as of February 1, 2016 Total long term debt including current portion from third quarter 2015 10Q. Floor plan credit line treated as working capital. Total Equity divided by Total Equity plus Total Debt

Appendix H: Re and Rwacc

Beta

Capital Asset Pricing Model (CAPM) Required Rate (Re) = (Rf) + Beta x [(Rmkt)-Rf] Risk Free Rate (Rf) Expected Return (Rmkt) Risk Premium = Expected Return – Risk Free Rate

Year 2009 2010 2011 2012 2013 2014 Revenue 1,749,315$ 1,038,321$ 1,426,888$ 3,316,487$ 4,005,749$ 5,390,326$

EBIT 34,150$ 46,470$ 110,818$ 151,861$ 187,297$ 238,278$ Taxes 4,639$ 8,625$ 33,060$ 57,996$ 68,438$ 84,851$

Depreciation 18,248$ 17,154$ 16,626$ 17,314$ 20,035$ 26,363$ Current Assets 418,063$ 508,544$ 648,191$ 933,209$ 1,081,549$ 1,615,509$

Current Liabilities 321,177$ 345,869$ 456,584$ 721,304$ 872,511$ 1,442,600$ Net Working Capital 96,886$ 162,675$ 191,607$ 211,905$ 209,038$ 172,909$

Delta NWC -$ 65,789$ 28,932$ 20,298$ (2,867)$ (36,129)$ Capital Expenditures 21,131$ 7,589$ 31,673$ 64,584$ 50,025$ 85,983$

Free Cash Flow 26,628$ (18,379)$ 33,779$ 26,297$ 91,736$ 129,936$

Forecasted Free Cash Flow Year 2015 2016 2017 2018 2019 2020

Revenue $ 7,827,960 $ 8,487,071 $ 9,146,183 $ 9,805,294 $10,464,406 $ 11,123,517 EBIT 301,446$ 339,873$ 378,299$ 416,726$ 455,152$ 493,579$

Taxes $ 113,796 $ 128,302 $ 142,808 $ 157,314 $ 171,820 $ 186,326 Depreciation 40,725$ 44,021$ 47,316$ 50,612$ 53,908$ 57,203$

Current Assets $ 1,789,189 $ 1,972,413 $ 2,187,208 $ 2,402,003 $ 2,616,798 $ 2,831,593 Current Liabilities 1,607,415$ 1,868,226$ 2,129,036$ 2,389,847$ 2,650,657$ 2,911,467$

Net Working Capital 181,774$ 104,187$ 58,172$ 12,156$ (33,859)$ (79,874)$ Delta NWC 8,865$ (77,587)$ (46,015)$ (46,015)$ (46,015)$ (46,015)$

Capital Expenditures 100,513$ 118,027$ 135,541$ 153,055$ 170,569$ 188,083$ Free Cash Flow 118,998$ 215,152$ 193,282$ 202,984$ 212,686$ 222,389$

Discounted Free Cash Flow Year 2015 2016 2017 2018 2019 Perpetuity

Forecast Free Cash Flow 118,998$ 215,152$ 193,282$ 202,984$ 212,686$ 5,594,410$ Discounted FCF 106,796$ 173,288$ 139,710$ 131,678$ 123,823$ 3,256,985$

Share Valuation Implied FCF Growth (2015) -8.4%

Implied FCF Growth (2016-2020) 11.0% Discount Rate (Re) 11.4%

Rwacc 9.0% Long Term Growth 5.0%

Enterprise Value (Vo) 3,932,280$ Cash 32,707$ Debt 1,844,770$

Shares Oustanding 23,690$ Predicted Share Price 89.50$ Rwacc Perpetuity

Current Share Price (Feb. 1, 2016) 76.42$ Standard Deviation 1.1% 0.5%

Appendix I: Discounted Free Cash Flow Model

Historical Free Cash Flow

Note: Values in 1,000s with the exception of predicted and current share price

6.70% 7.84% 8.98% 10.12% 11.26% 4.00% $154.79 $94.52 $61.86 $41.39 $27.34 4.50% $200.98 $115.88 $74.14 $49.34 $32.92 5.00% $274.41 $144.78 $89.50 $58.86 $39.39 5.50% $409.28 $186.05 $109.28 $70.43 $46.98 6.00% $738.16 $249.82 $135.71 $84.82 $56.01

Historical Free Cash Flow

Forecasted Free Cash Flow

Implied Free Cash Flow Growth Discount Rate (Re) Rwacc Long Term Growth Enterprise Value (Vo) Cash Debt Shares Outstanding Predicted Share Price Standard Deviations

Pe rp et ui ty

Gr ow

th R at e

Model Assumptions

As of Septemeber 30, 2015 As of September 30, 2015

Appendix I: Discounted Free Cash Flow Model

In 1000s; September 30, 2015

Calculated from historical data (Rwacc) or designated as 10% of rate Vo + Cash – Debt / Shares Outstanding

Implied growth rate calculated from forecasted free cash flows Calculated in Appendix H Calculated in Appendix H Growth at maturity (Bloomberg, February 1, 2016) Sum of discounted free cash flows and perpetuity

(EBIT – Taxes) + Depreciation – Changes in Net Working Capital – Capital Expenditures; From forecasted financials (Appendix B)

(EBIT – Taxes) + Depreciation – Changes in Net Working Capital – Capital Expenditures

Share Valuation Sensitivity Rwacc

Variable Model Inputs

32,707$ 74.18% 1,844,770$ 25.82%

Std Dev 1.10% 1.9500% 0.2600% 0.50% 23,690$ 35.60% Std Dev of Std Dev 0.00% 0.0000% 0.0000% 0.00%

Modeled Random FCF Random Random Random Long Term Rwacc Stock Variable Growth Variable Variable Variable Growth Price

1 0.32 11.34% -0.39 10.67% 0.34 3.09% -0.43 4.78% 8.43% $107,528 $120,442 $121,171 $121,904 $122,641 $3,747,755 106.77 2 0.12 11.11% -0.28 10.89% 0.93 3.24% -0.19 4.90% 8.62% $107,315 $119,481 $119,723 $119,966 $120,209 $3,599,298 100.21 3 -0.13 10.84% -0.97 9.54% 1.11 3.29% 0.29 5.15% 7.62% $108,637 $121,841 $123,288 $124,752 $126,234 $5,651,317 187.59 4 0.69 11.74% 0.82 13.02% 1.69 3.44% -0.13 4.93% 10.23% $105,290 $116,312 $114,992 $113,687 $112,396 $2,371,261 47.36 5 -0.02 10.96% -0.72 10.02% -1.44 2.63% 0.76 5.38% 7.87% $108,161 $121,044 $122,080 $123,124 $124,178 $5,530,667 182.24 6 1.65 12.79% 0.64 12.68% 0.71 3.18% -1.17 4.42% 9.93% $105,612 $119,249 $119,374 $119,500 $119,626 $2,446,104 51.39 7 0.63 11.68% 1.24 13.85% 1.22 3.32% -0.46 4.77% 10.83% $104,520 $114,491 $112,301 $110,153 $108,047 $1,991,863 30.79 8 -0.52 10.41% -0.50 10.44% -1.14 2.70% 0.83 5.41% 8.20% $107,747 $118,938 $118,908 $118,877 $118,847 $4,717,787 147.28 9 -1.08 9.80% 0.97 13.31% 0.46 3.12% 0.39 5.20% 10.40% $105,016 $111,725 $108,257 $104,897 $101,641 $2,146,190 36.54 10 -0.08 10.89% -0.08 11.27% -0.71 2.82% -1.33 4.33% 8.83% $106,946 $118,191 $117,789 $117,389 $116,990 $2,886,210 69.71 11 0.94 12.01% 1.05 13.47% 2.07 3.54% -0.94 4.53% 10.58% $104,867 $115,955 $114,463 $112,990 $111,536 $2,063,500 34.24 12 0.59 11.63% 0.84 13.07% 0.22 3.06% 0.36 5.18% 10.20% $105,246 $115,994 $114,521 $113,066 $111,630 $2,482,368 51.95 13 -1.33 9.52% -0.06 11.30% 1.58 3.41% 0.29 5.15% 8.95% $106,914 $115,220 $113,376 $111,562 $109,777 $3,160,417 80.42 14 -1.13 9.74% -2.12 7.28% -0.24 2.94% -0.91 4.55% 5.89% $110,920 $124,506 $127,354 $130,268 $133,248 $10,870,447 408.81 15 -1.38 9.47% 1.94 15.21% -0.26 2.93% 0.02 5.01% 11.77% $103,285 $107,422 $102,063 $96,972 $92,134 $1,491,149 7.64 16 0.51 11.55% -0.74 9.98% -0.30 2.92% -0.32 4.84% 7.89% $108,205 $122,426 $124,176 $125,952 $127,752 $4,679,278 146.72 17 2.05 13.23% -0.71 10.04% 0.56 3.15% -1.21 4.40% 7.97% $108,142 $126,002 $129,657 $133,417 $137,287 $4,350,592 133.94 18 1.06 12.15% 0.61 12.61% -0.36 2.91% 1.70 5.85% 9.84% $105,675 $118,024 $117,539 $117,057 $116,576 $3,279,901 86.23 19 -0.85 10.05% -0.64 10.17% 0.34 3.09% -1.41 4.30% 8.06% $108,009 $118,734 $118,601 $118,469 $118,338 $3,459,896 94.13 20 -1.32 9.53% 1.01 13.40% 1.98 3.51% -0.54 4.73% 10.52% $104,941 $111,032 $107,252 $103,600 $100,072 $1,892,119 25.62 21 0.64 11.69% 0.72 12.84% -0.62 2.84% 0.58 5.29% 10.00% $105,458 $116,585 $115,398 $114,222 $113,058 $2,683,618 60.63 22 0.79 11.86% 0.02 11.47% -1.03 2.73% 1.04 5.52% 8.96% $106,753 $119,822 $120,236 $120,652 $121,069 $3,929,780 114.24 23 -0.81 10.09% -0.86 9.75% 0.13 3.03% 0.96 5.48% 7.73% $108,431 $119,754 $120,134 $120,515 $120,898 $5,904,576 197.65 24 -0.69 10.22% 0.15 11.71% 1.07 3.28% 0.43 5.21% 9.23% $106,522 $115,848 $114,304 $112,781 $111,278 $3,050,195 75.93 25 -0.33 10.62% -1.44 8.62% -1.55 2.60% 0.47 5.23% 6.83% $109,551 $123,418 $125,689 $128,002 $130,357 $9,032,773 330.85 26 -0.18 10.79% -0.06 11.32% -0.08 2.98% -1.09 4.45% 8.89% $106,899 $117,874 $117,316 $116,760 $116,207 $2,901,210 70.25 27 -1.54 9.29% 1.03 13.43% 0.77 3.20% -1.02 4.49% 10.50% $104,907 $110,476 $106,447 $102,564 $98,823 $1,798,289 21.50 28 0.54 11.58% -0.87 9.72% 1.51 3.39% -1.25 4.38% 7.78% $108,454 $123,067 $125,153 $127,275 $129,432 $4,247,864 128.71 29 1.49 12.62% -0.69 10.09% -0.21 2.94% 0.26 5.13% 7.97% $108,094 $124,527 $127,388 $130,314 $133,307 $5,277,962 172.63 30 0.42 11.45% 0.39 12.19% 0.98 3.26% 0.85 5.42% 9.58% $106,069 $117,438 $116,665 $115,898 $115,135 $3,084,491 77.82 31 -0.50 10.43% 0.18 11.79% -0.21 2.94% 1.97 5.99% 9.23% $106,453 $116,136 $114,731 $113,343 $111,971 $3,809,590 108.07 32 -0.10 10.87% -0.54 10.37% -1.28 2.67% 0.76 5.38% 8.14% $107,818 $120,085 $120,633 $121,182 $121,735 $4,899,392 155.29 33 -2.07 8.71% 0.68 12.74% -0.76 2.80% 0.82 5.41% 9.92% $105,548 $110,634 $106,676 $102,859 $99,178 $2,392,165 46.64 34 -0.39 10.56% -0.58 10.30% -0.39 2.90% 0.41 5.21% 8.12% $107,887 $119,554 $119,833 $120,113 $120,393 $4,563,235 140.94 35 -1.04 9.84% 1.41 14.17% 0.07 3.02% 1.01 5.50% 11.01% $104,231 $110,148 $105,973 $101,957 $98,092 $1,956,004 28.04 36 1.26 12.37% -1.55 8.41% -0.47 2.88% 0.93 5.46% 6.71% $109,771 $127,869 $132,550 $137,401 $142,431 $12,797,786 491.17 37 0.20 11.20% -0.65 10.16% 0.09 3.02% 1.03 5.52% 8.04% $108,020 $121,254 $122,397 $123,551 $124,717 $5,490,170 180.58 38 -0.41 10.54% -1.75 8.01% -0.27 2.93% 0.07 5.03% 6.43% $110,171 $124,628 $127,543 $130,525 $133,577 $10,564,117 395.88 39 1.01 12.10% 0.27 11.95% -0.30 2.92% 1.01 5.50% 9.35% $106,300 $119,320 $119,481 $119,643 $119,804 $3,494,648 95.70 40 0.44 11.46% -1.64 8.23% -0.76 2.80% -1.12 4.44% 6.57% $109,952 $126,222 $129,996 $133,884 $137,888 $7,209,835 254.78 41 0.40 11.42% -0.65 10.16% -0.13 2.97% 0.26 5.13% 8.03% $108,027 $121,749 $123,149 $124,564 $125,996 $4,843,758 153.45 42 0.97 12.05% -0.12 11.18% 0.72 3.19% -0.73 4.64% 8.83% $107,030 $120,866 $121,811 $122,763 $123,723 $3,308,703 88.34 43 0.97 12.05% -0.54 10.37% 0.84 3.22% -0.04 4.98% 8.23% $107,821 $122,665 $124,541 $126,445 $128,378 $4,429,895 136.25 44 -0.43 10.51% 1.61 14.57% -1.18 2.69% -1.42 4.29% 11.25% $103,867 $110,725 $106,806 $103,027 $99,381 $1,577,335 12.20

Modeled Discounted Cash FlowsPerpetuity Growth Rate

2018 2019 Perpetuity2017Re Rd

Shares Oustanding (x1000)

Trial

Variable Implied FCF Growth

10.98% Re

Cost of Equity (Re) Cost of Debt (Rd)

2015 2016

11.43%

Free Cash Flow Growth

Appendix J: MONTE CARLO SIMULATION

Percent Equity Percent Debt

Tax Rate

Rd 3.00% Perpetuity Growth

5.00% Cash (Dec. 31, 2014) Debt (Dec. 31, 2014)

Fixed Model Inputs

Mean $90.84 Mean of Means $90.95 Standard Deviation $58.85 Standard Deviation of Means $0.20

95% CI Lower $90.42 95% CI Lower $90.87 95% CI Upper $91.15 95% CI Upper $91.03

1/2 Range $0.37 1/2 Range $0.08

Single Run 25 Runs

Appendix J: Monte Carlo Simulation

0 500

1000 1500 2000 2500 3000 3500 4000 4500 5000 5500 6000 6500 7000 7500 8000

$(10) $10 $30 $50 $70 $90 $110 $130 $150 $170 $190 $210 $230 $250 $270 $290

Fr eq ue nc y

Target Price

Lithia Motors Stock Price Frequency

2014 2015F 2016F 2017F 2018F 2019F 2020F

Dividend Growth 34.0% 0.80$ 1.07$ 1.44$ 1.92$ 2.58$ 3.45$ 4.63$

Perpetuity Growth 5.0% – – – – – – 72.02$ Discount Rate 11.4% – 0.96 1.16 1.39 1.67 2.01 41.93$

Share Price 49.12$

4-Nov-15 0.20$ 5-Aug-15 0.20$

13-May-15 0.20$ 11-Mar-15 0.16$ 19-Nov-14 0.16$ 6-Aug-14 0.16$ 7-May-14 0.16$ 5-Mar-14 0.13$ 6-Nov-13 0.13$ 7-Aug-13 0.13$ 8-May-13 0.13$ 13-Dec-12 0.10$ 7-Nov-12 0.10$ 8-Aug-12 0.10$ Annual Dividend Gowth Yield 9-May-12 0.10$ 2010 — 1.48% 7-Mar-12 0.07$ 2011 40.00% 1.26% 8-Nov-11 0.07$ 2012 42.86% 0.92% 9-Aug-11 0.07$ 2013 30.00% 0.92% 9-May-11 0.07$ 2014 23.08% 0.76% 9-Mar-11 0.05$ Average 33.98% 1.07%

Assumptions Dividend Growth Average 5 year growth rate Perpetuity Growth Assumed long term growth rate Discount Rate Required Rate (Re) from Appendix

Appendix L: Dividend Discount Model

$0.64

Dividend Discount Model

Dividend History

$0.20 $0.28 $0.40 $0.52

y = 9E-05x – 3.4117 R² = 0.95697

$-

$0.05

$0.10

$0.15

$0.20

$0.25

18-Nov-10 1-Apr-12 14-Aug-13 27-Dec-14 10-May-16

Dividend Trend