Description

Sonic Automotive owns a chain of approximately 150 auto dealerships with 166 franchises.  They sell new, used, and fleet cars, and have both foreign and domestic franchises.  They also have a repair business and a financing business.

 

The benefits and drawbacks of chains of automotive dealerships have been debated and discussed on multiple stocks for many years on this website, and we don’t feel like I have much to add to that discussion.  Intellectually, we understand the argument for shared financing, shared information, shared inventory, and economies of scale for these businesses, but we don’t think these things are going to be enough to help Sonic.  For those who disagree, there is plenty of support for your position in other VIC writeups.  Anyone reading this writeup will also be aware that the stock is down a lot due to concerns about the economy.  We still think the stock is a short, but will limit the scope of the discussion to specific points about Sonic’s business and why we think there are reasons to expect poor performance in addition to just expecting a bad economy.

 

The crux of the argument is that Sonic is using their balance sheet to cheat in the way that many retail businesses do.  They have spent too much money adding inventory, and are not marking it down.  Essentially, they have lots full of cars which allows them to offer a wide selection.  While this makes it easier for them to sell cars, the inventory they have to carry to make these sales has financing charges attached to it, and the cars depreciate each month.  They have also “made” EBIT estimates by making acquisitions where the financing cost comes below the EBIT line.

 

Looking at the big picture, over the past two quarters, sales per store have been up 1.3% and down 3.0% while inventory per store has been up 15.1% and 5.0%.  Gross margin was up .3% and .1% during that time.  This is unsustainable as Sonic clearly needs to carry more inventory to make the same number of sales.  Going to the specific business segments further illustrates the problem.  Over the past two quarters, new vehicle same store sales have been down 8.2% and 11.7% while gross margin has only dropped .3% and .2%.  Pricing hasn’t really dropped over this time, but overall sales have.  Part of this is obviously driven by the economy, but part of the issue was caused by SAH carrying too much inventory of SUVs at a time when people didn’t want them.  This has still been an issue into 2008, and it’s hard to believe that the management team couldn’t predict the lack of interest in these vehicles several quarters ago.

 

The used vehicle business has performed better over this time as people have switched to cheaper options.  Used vehicle same store sales are up 11.5% and 2.7% over the last two quarters with gross margins down .4% in each of those quarters.  The wholesale business has been shrinking, but as that business hasn’t been profitable in over two years, it’s hard to view this as much of a negative.

 

Last quarter, EBIT came in slightly above estimates including floor plan interest of $12MM which was in line with expectations.  Right below the EBIT line was other interest which was 25% higher than had been expected.  At the same time, the number of dealerships went from 144 to 150.  Sonic has been acquiring dealerships which allows them to acquire vehicles without increasing the financing that affects EBIT.  With their large inventory position that we believe they would need to mark down to sell, we believe their earnings are inflated due to a mismarked balance sheet.  Analysts are projecting an increase in gross margin both this year and next.  We are skeptical.

 

Sonic does have repair and financing businesses that do provide the majority of their gross profit.  There is a sensible argument that could be made that as people stop buying new cars, they will need more repair work done on their older cars.  What we have been reading is that people have been putting off non-essential expensive repair work.  While we’re not certain how long repairs can be avoided, right now, we’re more comfortable betting that less gets done than more.  As for the financing business, it’s hard to see how that business is not going to shrink significantly over the next couple of years.  Based on the latest quarterly reports, this hasn’t actually happened yet, but given that the financing business has 100% gross margins, any contraction here will affect the bottom line significantly, and make the analyst expectations of improving gross margins more inaccurate.

Catalyst

- Continued decline in new car sales.
- Continued decrease in profitability of car sales.
- A mismarked balance sheet that is making the business appear more profitable than it is.
- Too much inventory being financed below the EBIT line.
- Analyst estimates are too optimistic.