TEXT-S&P raises Penske Automotive Group to 'BB-'
June 21 - Overview -- Bloomfield Hills, Mich.-based Penske Automotive Group Inc. has improved credit measures in the past year and continues to generate good discretionary cash flow. -- We are raising our corporate credit rating on Penske to 'BB-' from 'B+' because we believe its credit measures can remain at or better than recently attained levels. We are also raising our issue rating on the subordinated notes to 'B' from 'B-'. -- The outlook is stable, reflecting our belief that Penske's business model, prudent financial policy, and operating track record will enable it to sustain its improved credit measures. Rating Action On June 21, 2012, Standard & Poor's Ratings Services revised its corporate credit rating on Bloomfield Hills, Mich.-based Penske Automotive Group Inc. to 'BB-' from 'B+'. The outlook is stable. In addition, we raised our issue ratings on the company's 7.75% senior subordinated notes and 3.5% subordinated convertible notes to 'B' (two notches lower than the corporate credit rating) from 'B-'. The '6' recovery rating on the notes remains unchanged and indicates our expectation that lenders would receive negligible (0-10%) recovery in the event of a payment default. Rationale We continue to assess Penske Automotive Group's business risk profile as "fair" and its financial risk profile as "aggressive." Our fair business risk profile assessment mitigates the company's high leverage and aggressive financial risk profile, in our view. Penske has a resilient business model, with a diverse revenue stream (including its foreign operations) and flexible cost basis. Also supporting our assessment of Penske's business profile is its relatively low volatility of revenues and EBITDA over the past several years, including during the 2008-2009 economic recession. We believe Penske can sustain, and possibly improve, its financial credit measures in the currently favorable climate for the retailers. Tight new and used vehicle supply is likely to keep vehicle pricing strong for now and automaker incentives at or below historical levels in the year ahead. In addition, consumers have shown renewed willingness to spend on new or nearly new vehicles despite continuing high unemployment, and credit availability for auto purchases appears to be unconstrained. Penske is the second-largest of several large consolidators in the highly competitive U.S. auto retailing industry. With 166 franchises in the U.S. and 154 abroad, primarily in the U.K., as of Dec. 31, 2011, Penske is more geographically diverse than its peers. We estimate it earns about 40% of its EBITDA in the U.K. and Germany, where the company sells premium and luxury brands. We believe that light vehicle sales will be lower in Europe in 2012, and while luxury may hold up better than the overall market, a significant downturn in Penske's foreign operations would pressure improvements in credit quality. We expect only modest changes to this geographic diversity and brand mix in the next few years. Although publicly traded, the company is controlled by founder Roger S. Penske Sr. Penske's revenues comprise sales from vehicle units, parts and service (P&S) work, and finance and insurance. The company's P&S operations provide relatively stable revenue and higher margins than new- and used-vehicle margins, which fluctuate and have slim margins in our view. P&S operations accounted for 43.7% of Penske's total gross profit for 2011, and gross profit from P&S covered 51% of the company's sales, general, and administrative expenses. Penske's revenue stream consisted of new-vehicle retail sales (49% for the first quarter of 2012), used-vehicle sales (30%), P&S (11%), fleet and wholesale sales (8%), and finance and insurance (F&I; 2%), broadly consistent with our expectation for this year and beyond. Same-store gross profit margin by operation for the first quarter was 8.3% for new-vehicle sales, 8.2% for used-vehicle sales, 58% for P&S, and 100% for F&I. In the first quarter of 2012, Penske sold 1.1 new vehicles for each used vehicle it sold; margins on new exceeded the margin on used-vehicle sales and new vehicles remain more profitable on a cash basis because of the higher price. Penske's credit measures have improved in the past year, with lease-adjusted debt to EBITDA of 5.4x for the 12 months ended March 31, 2012, compared with 6.1x for the prior 12 months. The leverage decline resulted from higher EBITDA, since debt remained relatively flat. Reported EBITDA, per our calculation, rose 18% period over period to $500.8 million for the 12 months ended March 31, 2012. Adjusted debt to total capital stood at a high 69.4% as of March 31, 2012, down from 70.3% as of March 31, 2011. The rated auto retailer group faces business challenges that differ somewhat from those of the automaker supplier segment, including: -- Ongoing structural evolution (evolving recovery in sales and changing vehicle mix) to the domestic new light-vehicle market; -- Recent auto sales declines deeper than in historical cycles and a slow recovery; -- Continuing poor consumer confidence and high unemployment, which we expect will persist for the foreseeable future; -- Tough competition for retail sales fostered by excess production capacity, product proliferation, and auto retailers' difficulty in differentiating products; -- Thin profit margins, typical of retail businesses, that require high revenue turnover; and -- Retailers' weak bargaining power with automakers because of the industry's fragmented nature and retailers' heavy dependence on a few large manufacturers. The retailers have benefited from stabilization of new light-vehicle sales in the U.S. We estimate new-vehicle sales will improve to 14 million units in 2012, a 10% year-over-year increase, and to 14.7 million units in 2013, despite the continuing weak economy, because the current SAAR remains near the high end of our scrappage rate estimate of about 13 million units. Liquidity Penske's liquidity is "adequate" under our criteria. We believe the company has adequate sources of liquidity to cover near-term needs, even in the event of an unforeseen EBITDA decline. Our assessment of Penske's liquidity profile incorporates the following expectations and assumptions: -- We expect sources of liquidity, including cash and credit facility availability, to exceed uses by 1.2x or more over the next 12 to 18 months. -- We expect net sources of liquidity to remain positive, even if EBITDA declines more than 15%. -- In our opinion, Penske could absorb a low-probability, high-impact market or operating shock, given its good conversion of EBITDA to cash flow. As of March 31, 2012, Penske had $261.1 million and GBP70 million ($111.7 million) available for borrowing under its $375 million U.S. credit agreement (due Sept. 30, 2014) and its GBP100 million U.K. credit agreement, respectively. The U.S. credit agreement, part of a credit agreement with lenders Mercedes-Benz Financial Services USA LLC and Toyota Motor Credit Corp., funds working capital, acquisitions, capital expenditures, investments, and other general corporate purposes. The agreement provides for an additional $10 million available for letters of credit, and a non-amortizing term loan with a balance of $127 million as of March 31, 2012. As of March 31, 2012, Penske had outstanding loans under its U.K. credit agreement of GBP40 million ($63.8 million). This facility with the Royal Bank of Scotland PLC and BMW Financial Services (GB) Ltd. expires November 2015, as does a demand overdraft line of credit for up to GBP10 million. The company had balance-sheet cash of $31.8 million as of March 31, 2012, and generated $288 million of free operating cash for the 12 months up to that date. We expect free operating cash flow (FOCF) to remain positive--about $100 million--in 2012 and 2013. For the March-ended trailing 12 months, we calculate that Penske's capital expenditures were $138.5 million; we expect about $100 million in capital spending for each of the next two years. The company pays a quarterly common dividend that equates to about $40 million annually; we expect the dividend to be raised in line with earnings growth. Penske is also using cash to buy back stock; as of March 31, 2012, $98 million of authorization remained available. We expect the company to spend in the range of $50 million to $100 million each year for targeted acquisitions; in the first quarter of 2012, the company acquired properties for $60 million. Debt maturities are manageable. Penske recently called for redemption the $63.3 million outstanding, as of March 31, 2012, of its 3.5% convertible notes; it will fund the redemption with cash and the U.S. revolver. The company's $375 million of 7.75% senior subordinated notes are due in 2016. As of March 31, 2012, the company also had long-term obligations of $75 million of principal under various mortgage facilities, although the majority of Penske's property is held under operating leases (which we view as debt for purposes of calculating our credit ratios). Auto retailers make heavy use of floorplan loans to finance vehicle inventory. We consider the floorplan borrowings of auto retailers analytically akin to trade payables rather than to debt because of the borrowings' indefinite maturities (other than facility expiration), high loan-to-value ratios, and widespread availability and also because long-established manufacturer subsidies largely offset borrowing costs. Penske's floorplan borrowings totaled $1.8 billion as of March 31, 2012. In the U.S., the company is required to repay floorplan borrowings when it sells the vehicles; in the U.K., it must repay principal balances outstanding for 90 days. Penske finance substantially all of its new and a portion of its used vehicle inventories under revolving floorplan arrangements with various lenders, including a majority through captive finance companies associated with automotive manufacturers. The availability on these facilities is a function of the amount of inventory required. The company derives some financial flexibility from its many dealerships, which it could sell with lender approval, although we expect market transactions--including acquisitions and new dealership openings--to occur at a measured pace. Recovery analysis For the complete recovery analysis, please see Standard & Poor's recovery report on Penske, to be published following this report, on RatingsDirect. Outlook Our stable rating outlook on Penske reflects our belief that its financial policy and operating expertise will enable it to sustain its improved credit measures. Specifically, we assume Penske will pursue a financial policy that will balance business expansion and shareholder returns with lease-adjusted leverage trending toward 4.5x-5x in the next two years. The company's adjusted leverage decreased to 5.4x for the 12 months ended March 31, 2012, with EBITDA of $500.8 million. For the rating we also expect free operating cash flow (FOCF) to adjusted total debt of 4% or greater; the company's FOCF to debt was 10.9% for the 12 months ended March 31. We could lower the rating if aggressive financial policies lead to higher leverage and we believe that the company cannot sustain 4.5x-5x leverage. This could occur if the U.S. economy falls into another recession, causing demand for vehicles and maintenance to decline rather than expand as we project, or if Penske's European operations become much less profitable given the weak economy in the U.K. This could cause Penske to generate adjusted EBITDA well below our expectation of about $525 million and cause leverage to exceed 5x, assuming debt remains at current levels. We could also lower the rating if we believe higher-than-expected capital spending on dealer upgrades will hinder free cash flow and reduce the company's FOCF to debt ratio. We do not expect an upgrade in the year ahead. However, we could raise the rating if we assessed the financial risk profile as significant (stronger than our current assessment). This could occur if Penske adopted a less aggressive financial policy, reducing adjusted leverage to near 3x and raising FOCF to total debt to about 10.5%, and we believed it would sustain this improvement in credit measures. Related Criteria And Research -- Pause Or Warning? The May U.S. Auto Sales Annual Rate Fell Below Standard & Poor's 2012 Full-Year Expectations, June 5, 2012 -- U.S. Auto Retailers Are Ready To Brave Today's Economy With Improved Credit Measures And More Focused Strategies, June 16, 2011 -- Criteria Methodology: Business Risk/Financial Risk Matrix Expanded, May 27, 2009 -- Key Credit Factors: Business And Financial Risks In The Auto Component Suppliers Industry, Jan. 28, 2009 -- 2008 Corporate Criteria: Ratios And Adjustments, April 15, 2008 Ratings List Upgraded To From Penske Automotive Group Inc. Corporate credit rating BB-/Stable/-- B+/Positive/-- Subordinated B B- Recovery rating 6 6 Complete ratings information is available to subscribers of RatingsDirect on the Global Credit Portal at www.globalcreditportal.com. All ratings affected by this rating action can be found on Standard & Poor's public Web site at www.standardandpoors.com. Use the Ratings search box located in the left column.
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