TEXT-S&P summary: Sonic Automotive Inc.
We believe U.S. sales of new light vehicles could improve to 14.4 million units in 2012, a 12% increase year over year, despite continuing high unemployment and unsettled consumer sentiment. We assume this positive demand trend will continue through 2013, with new vehicle sales increasing about 7% because sales are only now beginning to exceed our estimate of replacement levels.
Still, the auto retailer group faces continuing business risks, including:
-- A likely return to volatile sales in the future;
-- Evolving consumer purchasing habits (gas price impacts and vehicles per household);
-- Tough competition for retail sales, exacerbated by product proliferation and auto retailers' difficulty in differentiating products;
-- Thin profit margins, typical of retail businesses; and
-- Retailers' weak bargaining power with automakers because of the industry's fragmented nature and retailers' heavy dependence on a few large manufacturers.
We expect the company's geographic and brand focus to remain largely unchanged in the near term. Sonic operates dealership franchises predominately in the Southeast, West, and Southwest. In 2011, 21% of its revenues were concentrated at dealerships in the Houston market and 57% in Texas and California combined. In 2011, 83% of Sonic's total new-vehicle revenue was from mid-line import and luxury vehicles, which tend to have a fairly loyal customer base for vehicle maintenance. For the year, the company's top new-vehicle unit sales were from BMW AG (19%), Honda Motor Co. Ltd. (14%, including Acura), Toyota Motor Corp. (14%, including Lexus), Daimler AG (9%), Ford Motor Co. (9%), and GM (13%, including Cadillac).
New vehicle revenues for the first nine months of 2012 improved 15.5% year over year compared with the 13.5% increase in SAAR, and new vehicle unit sales increased 15.7%. Sonic's EBITDA (by our calculation) increased 4.2% year over year to $225 million for the nine months. This is consistent with our assumption of generally improving financial performance. Dealerships for Honda, Toyota, and Lexus, in aggregate, accounted for 78% of the nine month year-over-year increase as 2012 inventory returned to normal levels following the prior-year Japanese earthquake that led to inventory shortfalls but higher retail pricing for units in short supply. In part for this reason, gross profit per new unit decreased 9.1% during the nine-month period. In addition, gross margin was hurt by inventory shortages of BMW vehicles, the company's largest brand exposure. Still, Sonic's total new vehicle gross profit increased 5% for the nine months. Used-vehicle revenues for the nine months increased 6.2% year over year, and gross profit rose 3.3%. Parts and service revenues increased 3.3% for the nine months, with gross profit as a percent of revenue declining slightly to 48.9% from 49.1% for the prior period. Sonic's ratio of sales, general, and administrative expenses to gross profit--a continuing focus for the company--stood at 77.6% as of Sept. 30, 2012, for the nine months.
Liquidity is "adequate" under our criteria. Our assessment of Sonic's liquidity incorporates the following expectations and assumptions:
-- We expect Sonic's sources of liquidity, including cash and facility availability, to exceed uses by 1.2x or more over the next 12 to 18 months.
-- We also expect net sources to remain positive, even if EBITDA declines more than 15%.
-- We believe Sonic could absorb low-probability, high-impact shocks because of its good conversion of EBITDA to discretionary cash flow.
We calculate Sonic generated $78.2 million in adjusted free operating cash flow (FOCF), before dividends, for the 12 months ended Sept. 30, 2012, and had $62.5 million of cash on hand as of Sept. 30.
Liquidity sources include Sonic's amended and restated credit agreement, expiring Aug. 15, 2016, that provides for the following resources, subject to compliance with a borrowing base:
-- $175 million revolver for working capital and general corporate purposes;
-- $500 million for new vehicle borrowing; and
-- $80 million for used-vehicle borrowing.
As of Sept. 30, 2012, Sonic had availability of $126.3 million under the borrowing base revolver. The facility provides latitude for restricted payments, allowing the company to repurchase certain outstanding debt with existing cash without violating the fixed-charge coverage covenant. The size of the revolver can be increased to $225 million upon satisfaction of specified conditions.
In July 2012, Sonic issued $200 million principal amount of 7.0% senior subordinated notes, which mature on July 15, 2022. The net proceeds from the issuance, combined with 4 million shares of class A common stock, were used to repurchase all of Sonic's outstanding 5.0%convertible notes in an exchange offer.
Sonic has dual-class common stock that places voting control with O. Bruton Smith and B. Scott Smith, the founders and holders of the class B common stock. The borrowing base used to determine availability under Sonic's revolver is calculated on certain eligible assets plus 50% of the fair market value of 5 million shares of common stock of Speedway Motorsports Inc. pledged as collateral. Speedway is controlled by O. Bruton Smith.
In addition to the credit facility, the company has a floorplan agreement with other lenders--mostly automakers--for new- and used-vehicle financing. Auto retailers make heavy use of floorplan loans to finance vehicle inventory. We consider these borrowings like trade payables, rather than debt, because of the borrowings' indefinite maturities, high loan-to-value ratios, and widespread availability. Manufacturer subsidies often offset some borrowing costs. During the downturn, certain domestic automakers tightened floorplan financing availability to retailers, but automakers depend heavily on continuing relationships with dealers, including available floorplan financing at a reasonable cost to support vehicle sales.
Sonic was in compliance with the covenants under its credit facilities as of Sept. 30, 2012, and we expect it to remain in compliance through 2012 and into 2013. The liquidity ratio was relaxed because of an amendment executed on April 19, 2012; the required liquidity ratio is 1.05x or greater through the remainder of the term of the facilities. Additional ratios are fixed-charge coverage of greater than or equal to 1.2x and total lease-adjusted leverage of less than or equal to 5.5x.Cash used for capital spending is estimated by the company to reach about $90 million in 2012, including real estate acquisitions net of mortgage funding of about $26 million. We expect Sonic to continue the process of shifting existing leases to property ownership on an opportunistic basis. We do not view these mortgages as incremental debt when they replace operating leases because for our credit measure calculations, we view operating leases as debt-like.
Sonic pays a quarterly dividend to common shareholders of somewhat more than $5 million per year; we expect the dividend to increase in the future as earnings and cash flow expand. The company had $116 million of share repurchase authorization as of Sept. 30, 2012. Given Sonic's focus on improving operational efficiencies, we do not expect the company to undertake large acquisitions in the near term, although the business model incorporates acquisitions for expansion. During the nine months ended Sept. 30, the company repurchased $16.4 million of Class A common stock on the open market.
Debt maturities are limited in the near term. $210 million 9% senior subordinated notes are due in 2018, and its $200 million 7% subordinated notes are due in 2022.
Sonic participates in a multiemployer pension plan in California, but we do not believe this contingent liability affects the rating. In addition toongoing contributions to the plan for its own employees, this participation exposes Sonic to potentially higher liability if a major contributing employer were to become insolvent or if several other participants exit at once. We believe that Sonic's potential liability associated with this plan is relatively small and that it could be managed within the company's normal cash flow and revolving facility if the company were required to fund the liabilities for all participants in the plan.
Our rating on Sonic's subordinate debt is 'B+' with a '5' recovery rating, indicating our expectation that lenders would receive modest (10% to 30%) recovery in the event of a payment default. (For the complete recovery analysis, see the recovery report on Sonic Automotive, dated June 25, 2012, on RatingsDirect.)
Our rating outlook on Sonic is stable, reflecting our assumption that its improved performance through operating efficiencies, in combination with its diverse revenue stream and brand mix, will enable the company to generate discretionary free cash flow after common dividends. We assume EBITDA will expand into 2013, even if the U.S. economy has remains lackluster. We assume Sonic will pursue a financial policy that will balance business expansion and shareholder returns against the need to achieve and maintain leverage of 4.5x or better for the rating.
We could raise the rating if we believed Sonic could achieve and sustain improved credit measures at a level that would cause us to raise the financial profile risk score to "significant," or if our view of the business risk profile improved. For an upgrade based on a better financial risk score, we would look for sustainable lease-adjusted total debt to EBITDA of less than 4x and reported free cash flow of about $100 million. The company reached our leverage target for the 12 months ended Sept. 30, 2012, and we will monitor this ratio for sustainability. Free cash flow, by our calculation, totaled $78 million for the 12 months ended Sept. 30.
We could lower the rating if aggressive financial policies lead to leverage exceeding 4.5x for an extended period or if we believe the company could not report free cash flow of at least $45 million in the year ahead. This could occur if aggressive debt-financed acquisitions or investment in dealer upgrades leads to higher debt and adjusted EBITDA declined to about $250 million. We could also lower the rating if the slow economic recovery reverses course and EBITDA declines because the company can't offset revenue declines with cost controls.
Related Criteria And Research
-- September U.S. Auto Sales Still Higher Than Standard & Poor's Full-Year Expectation For 2012, Oct. 4, 2012
-- Liquidity Descriptors For Global Corporate Issuers, Sept. 28, 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