Tuesday, April 11, 2006
Sonic Automotive--Bear Stearns Says Buy.
Sonic Automotive, Inc. (SAH-$26.86) is one of the largest automotive retailers in the United States. As of March 1, 2006, SAH operated 175 dealership franchises at 152 dealership locations, representing 37 different brands of cars and light trucks, and 38 collision repair centers in 15 states. Each of the Company’s dealerships provides comprehensive services including (1) sales of both new and used cars and light trucks; (2) sales of replacement parts and performance of vehicle maintenance; warranty, paint and repair services; and (3) arrangement of extended service contracts, financing and insurance and other aftermarket products for its automotive customers.
On April 5, 2005, Bear Stearns, Inc. initiated coverage on SAH with an outperform rating. The nominal definition employed by Bear Stearns is as follows: "Stock is projected to outperform analyst's industry coverage universe over the next 12 months [i.e. auto retailing industry index which includes the likes of AutoNation (AN-$22.44), Group 1 Automotive (GPI-$50.31), and United Auto Group (UAG-$41.10)]."
The brokerage firm argued that four factors exist that should act as valuation catalysts: 1) a recent focus on improving core operations of existing stores and successful new store integration, combined with 2) continued growth through acquisitions at a manageable pace; 3) strong growth and margin opportunities associated with the company’s over-weighting of foreign and luxury franchises; and, 4) a de-leveraging story.
The 10Q Detective respectfully disagrees with Bear Stearns’ investment thesis.
Historically, SAH has grown through acquisitions. In 2005, however, the Company acquired only five dealerships, representing five franchises, disposed of 13 dealerships, representing 20 franchises, and terminated two franchises. Going forward, corporate expects to continue to limit its acquisition activity to approximately 10% of annual revenues each year. Management [and Bear Stearns] believe that this strategy will allow SAH to continue to reduce its financial leverage, maintain liquidity for its dividend and share repurchase activities, and also allow management infrastructure to focus on improving operating performance and integrating acquired dealerships.
Prior to 2004, SAH maintained a long-term debt to total capital ratio of approximately 48% to 52%, depending on the timing of its acquisitions. Corporate believes that the current acquisition pace will allow SAH to reduce its long-term debt to total capital ratio to 40% over the next few years. At December 31, 2005, the long-term debt to total capital ratio net of cash and cash equivalents was 46.0 percent.
According to Bear Stearns: “Our sense is that investors will be more comfortable with the less aggressive capital structure.”
As a potential investor, we agree with that statement. What Bear Stearns has failed to mention, however, is that O. Bruton Smith, chairman and chief executive officer, and his affiliates have previously assisted SAH with obtaining most of the Company’s financing. Our readers will recall that Mr. Smith is also the Chairman & CEO of Speedway Motorsports, Inc. (TRAK-$22.42), a publicly traded owner and operator of automobile racing facilities.
SAH’s obligations under its New Credit Facility were secured with a pledge of shares of common stock of Speedway Motorsports, Inc. Sonic Financial Corporation (SFC), an entity controlled by Mr. Smith, beneficially owns these shares of Speedway Motorsports common stock. Presently, the $350.0 million borrowing limit of the Revolving Credit Sub-Facility of the New Credit Facility is subject to a borrowing base calculation that is based, in part, on the value of the Speedway Motorsports shares pledged by SFC. Consequently, a withdrawal of this pledge by SFC or a significant decrease in the value of Speedway Motorsports common stock could reduce the amount that SAH can borrow under the Revolving Credit Sub-Facility of the New Credit Facility.
Mr. Smith has also guaranteed additional indebtedness incurred to complete certain dealership acquisitions. Mr. Smith may not be willing or able to provide similar guarantees or credit support in the future.
The 10Q Detective is not comfortable with this disclosure.
Bear Stearns is “comfortable that Sonic’s earnings performance has turned the corner." The analyst then went on to say: "We view late 2003 as the point at which management identified the problems associated with its prior growth profile, 2004 as the transition year when many of the company’s initiatives to fix the business went into place, and 2005 as the year that Sonic delivered operational and financial improvements. Moreover, the portfolio enrichment strategy Sonic is following should serve as a platform for solid organic growth, while the company continues to build its business with acquisitions, albeit at a moderate, more conservative pace than seen in the past."
Indulge us as we translate. Gross Profit, Operating Income, and Income from Continuing Operations [as a percentage of net revenue] have remained flat the past three fiscal years, at 15.4%, 3.2%, and 1.3% as a percentage of net revenue [within a variance of twenty basis points], respectively.
The aforementioned “portfolio enrichment” strategy refers to the higher, margin import auto markets. “Sonic Automotive has been actively managing its brand portfolio toward luxury and import brands,” said Bear Stearns. “Industry market share gains of brands falling into these categories drive multiple benefits for operators, including higher organic growth and leaner inventory levels.”
For the year ended December 31, 2005, 79.4% of SAH’s total new vehicle revenue was generated by import and luxury dealerships compared to 76.7% for 2004. The import dealerships experienced an increase of same store new vehicle volume of 6,826 units, or 7.4%, while domestic dealerships experienced a slight decrease of 379 units, or 0.7 percent.
The top performing import brands for 2005 were Honda, BMW and Lexus, which posted increases of 3,512 units, or 13.0%, 997 units, or 7.4%, and 1,006 units, or 16.1%, respectively. These increases were attributed to the introduction of new models, in addition to new body styling and design on existing models. In addition, management stability at the Company’s Honda dealerships contributed to the improvement in new vehicle sales volume.
As expected, domestic dealerships continued to experience market share declines and continued to show a decline in sales volume during the current year. The majority of the domestic dealership declines were from Cadillac dealerships (down 499 units, or 4.4%), which was mainly the result of declining SUV sales. GM (excluding Cadillac) and Ford dealerships also experienced considerable declines in new retail unit volume, but were offset somewhat by strong fleet sales.
In total, SAH’s sales price per unit increased by $168, or 0.6%, during 2005. This can be mainly attributed to the fact that the higher priced luxury vehicles generated a larger percentage of sales. Many of SAH’s import dealerships experienced price per unit increases, most notably being Honda, BMW and Lexus (up 5.8%, 3.4% and 3.0%, respectively). GM and Cadillac dealerships experienced the most significant decreases in sales price per unit (down 4.9% and 4.1%, respectively). The decreases at these dealerships were attributed to both the various pricing strategies put in place by GM during 2005 and a shift from truck and SUV sales to car sales during the year.
Despite the Company’s shift in product mix, approximately 28.5% of new vehicle revenue was derived from the sale of new vehicles manufactured by General Motors (including Cadillac) and Ford in 2005.
As of December 31, 2005, SAH owned 25 Ford franchises (including Volvo, Land Rover, Lincoln and Mercury) and 41 General Motor’s (including Cadillac, Saab, Saturn, Chevrolet, Buick, GMC, Hummer and Pontiac) franchises, respectively. Should the financial condition and operating results of either Ford or General Motors continue to significantly deteriorate, it is possible that an interruption in the flow of inventory to SAH could have a material adverse effect on the Company’s future results of operation, financial condition or cash flows.
Rising interest rates, gas prices, and an economic downturn—all are known material risks that could adversely affect the profitability of SAH in the coming quarters. The 10Q Detective would like investors to consider one other factor before making a buy purchase: the weather. SAH owns 20 dealerships in North/South Carolina & Georgia, 15 dealerships in Florida, and 17 dealerships in Houston, each geographic area contributing 11.2%, 9.6%, and 14.9%, respectively, to total 2005 revenues—and each a part of the U.S. landscape predicted to be buffeted severely by Grade Level 4 & Grade Level 5 Hurricanes come June 01, 2006.
One potential soft spot on SAH’s books that we wanted to bring to our readers’ attention is the Company’s tax tinkering. Management has done a decent job in squeezing a little extra out of its bottom line—taxes owed to the IRS. Despite the Company’s effective tax rate hovering around 38.0% the last two reporting years, SAH has seen its net deferred tax liability rising approximately $(31.5) million to $(116.9) million from 2004 to year end 2005. Much of this deferment was attributable to a basis valuation difference in goodwill. To date, the IRS has not raised any objections….
“Multiple Expansion is Likely to Bring Valuation in Line with Better Peers,” said Bear Stearns. “The key to our investment thesis on Sonic Automotive is understanding that, while not currently the “best” at any one thing in particular, Sonic is a balanced, solid performer that is undervalued by the market. Our sense is that the company’s valuation discount reflects Sonic not standing out in any one area, and that this discount should recede as the market recognizes the company’s all-around strength.”
Bear Stearns has set a 2006 year-end price target of $33 per share. “Our target is based on a 2007 EPS estimate of $2.74 and a 12-month forward P/E ratio of 12.0x. This represents an 10% expansion from Sonic’s current multiple of 10.9x, but would still value the company at a 19%, 19%, and 28% discount to the peer group average multiple and those of AutoNation and UnitedAuto, respectively — the other peer group companies to which we feel comparisons with Sonic are most appropriate. Our price target represents upside of 17% from current levels.”
Technically, the stock price is at the key pivot point on a “cup-and-handle-chart pattern.” This pivot point, $27.00 per share, is also the 50-day moving average. First Support is $24.00 per share (100-day moving average). Trading volume has averaged 369,000 shares over the last three-months. It will take more than an auto analysts’ positive comments to drive the stock to a new closing high.
Contrary to Bear Stearns conclusions, the 10Q Detective believes that the current price of Sonic Automotive has already discounted any potential top-line sales gains to be had by over-weighting its brand portfolio toward luxury and foreign imports. Further, we believe that rising interest rates, competitive pressure on auto margins from Internet retailers, and a continued deterioration in the financial condition of domestic auto manufacturers will negatively influence the operating performance and future profitability of Sonic Automotive—and its peers. SELL.