Sonic Automotive

Moat: 2/5

Understandability: 2/5

Balance Sheet Health: 3/5

Sonic Automotive, Inc. is one of the largest automotive retailers in the United States, operating franchised dealerships across several states and marketing various services such as maintenance and parts, F&I, and collision repair.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Sonic Automotive (SAH) operates primarily through franchised dealerships, offering both new and used vehicles, and also includes parts and service, collision repair, and finance and insurance (F&I) products.

Business Overview:

Sonic Automotive operates through a network of franchised dealerships across the United States, focusing on:

  • New Vehicle Sales: A core part of their revenue, they sell new cars and light trucks from various manufacturers.
  • Used Vehicle Sales: Offering a wide selection of used vehicles, providing an alternative to new cars.
  • Parts and Service: Providing vehicle maintenance, repair, and parts sales, a consistent source of revenue.
  • Finance and Insurance (F&I): Offers financing options, insurance products, and extended warranties.
  • Collision Repair: Provides repair services for damaged vehicles.

Industry Trends:

  • The automotive retail industry is characterized by intense competition, fluctuating customer preferences, and macroeconomic uncertainties.
  • A shift towards online sales platforms and digital consumer interactions is influencing how dealerships operate. The move towards hybrid and electric vehicles is creating a need for new training methods and product knowledge for sales personnel.
  • The auto sector is also experiencing supply disruptions caused by geopolitical events and chip shortages, making inventory levels volatile.

Inventory management remains a key challenge, balancing the need for a wide range of vehicle models with the risk of holding slow-moving models.

Competitive Landscape:

  • The industry is fiercely competitive. Car dealerships compete not only for customers but also for manufacturer’s allocations for popular models.
  • Key competitors include other large publicly traded dealership groups as well as local and regional auto retailers. There’s no differentiation in price or product quality, and all retailers sell the same product.
  • Emerging trends include online and direct-to-customer models, adding to the competitive pressures.
  • The industry is fragmented because of various geographies, and because it is more difficult to expand into new territories.

Given the commodity nature of the auto retail business, scale is one of the only forms of competitive advantage.

What Makes Sonic Automotive Different?

  • Brand Power They have a large, established network of locations that could provide a distribution advantage over smaller players. However, other large players in the industry have large networks as well and there are no network effects.
  • Growth through acquisitions Sonic Automotive has been growing by acquisitions, and is a serial acquirer. By doing this they have become one of the largest auto retailers in the US. This has given them scale advantage which other players are yet to achieve.

“They believe in making acquisitions where they can utilize our expertise to improve the operations of acquired businesses.”

Financials:

Revenue Distribution

  • Sonic Automotive’s revenue mix is primarily composed of new and used vehicle retail sales. They also generate revenues from parts, service, F&I, and collision repair services. The franchised dealerships account for a significant portion of the revenue.

Used-vehicle gross profit has significantly decreased YoY, while revenue from new vehicles saw a slight decrease in the latest report. This trend needs to be monitored closely.

Margins

  • Gross profit margins are relatively stable at 15% of revenue. It is typical for this type of business that has no differentiation in products, and where price is a key aspect of a customer’s decision-making process.
  • Operating margins are tight and have varied in the recent years. This highlights the competitive pressures.

For franchised dealerships, F&I and service margins tend to make up for razor-thin new and used vehicle margins.

Balance Sheet Health:

  • Debt has risen, which is concerning. The company has a high debt load. However, the company has enough debt capacity with the revolving credit facility.
  • The company’s ability to refinance their debt obligations over the next few years will be key.
  • The company’s debt-to-equity ratio is less than 1, which is not too high for this type of industry.

Latest News and Concerns:

  • Macroeconomic conditions, such as interest rate changes and the strength of the economy will be key determinants of the company’s performance going forward. High interest rates are eating into profitability.
  • Used vehicle prices are highly volatile and have decreased sharply. With increasing inventory in the sector, this may cause further pressure on margins in the short-term.
  • The company is focused on using technology to improve efficiency, which is something the management is emphasizing on recent earnings calls.
  • The company’s operating earnings have dropped due to many factors, as seen in the recent earnings reports.
  • The company is now also heavily reliant on its finance business, and has significant exposure to the credit cycle.
  • The company is also looking at new ways to capture revenue and increase efficiency by streamlining operations.

Moat Rating: 2/5

  • Limited Moat: Sonic Automotive has a narrow economic moat. They are in a tough industry that is very competitive. Scale of operation is one of the few sources of competitive advantage in the auto retail industry, but there is nothing unique about their operations. Moreover, they are not differentiated on product, price or customer experience.
  • They have a large network of locations that can translate to economies of scale, but their network is easily replicable.
  • Switching costs are extremely low, as customers can go to any other retailer or even buy directly from manufacturers.
  • Their operations and sales processes can be easily replicated by competition.
  • There are no network effects and they don’t have a unique technology that gives them an advantage.
  • They rely on their financial performance for growth, and do not benefit from patents, contracts, or regulations.

Legitimate Risks to the Moat and Business Resilience:

  • Economic Downturn: Reduced consumer spending and demand for vehicles. This may be their biggest headwind as their sales correlate to a certain extent with economic activity.
  • High Interest Rates: Will make vehicle sales slow down and will cause the company to have increased borrowing expenses. High interest rates can also lead to an increase in defaults for the credit subsidiary, further worsening their financials.
  • Increased Competition: New competitors entering the market, especially in online sales, could erode their market share. Manufacturers opening their own stores will also be a threat.
  • Changing Consumer Preferences: The shift towards electric or hybrid vehicles could affect their traditional sales channels.
  • Technological Disruption: New sales platforms or business models could undermine traditional dealerships.
  • Inventory Risk High inventory levels of specific models could lead to price reductions, as market demands changes.
  • Manufacturer Influence Relying on manufacturer’s inventory, and allocations makes the business very vulnerable. Any reduction in allocations will hurt their revenue drastically.

Business Resilience:

  • While the auto sector is highly cyclical, diversification across geographies, F&I services, and used vehicles can cushion them against a drop in new car sales.
  • Their service segment can act as a good buffer, as people need to maintain their existing vehicles even if new car sales drop.
  • They have the ability to sell assets to reduce debt.

Understandability: 2/5

  • The basic mechanics of the business are easy to understand.
  • Analyzing their financials and understanding how they create value is difficult.
  • They operate in a complex industry that is exposed to various trends and factors.
  • There are a lot of hidden factors that are often missed by investors in auto-retail business.

Balance Sheet Health: 3/5

  • The company is highly leveraged and has lots of debt. While their debt levels are not excessive for this type of company, an economic downturn would increase the risk of defaults.
  • The company’s total asset amount is larger than its liabilities but cash and working capital are just a fraction of their total assets.
  • The company needs to watch out for the leverage and maturity of debt.

References

*The Intelligent Investor by Benjamin Graham

  • The Little Book That Builds Wealth by Pat Dorsey
  • Valuation by Tim Koller, Marc Goedhart, and David Wessels
  • Morgan Stanley - Measuring the Moat, Assessing the Magnitude and Sustainability of Value Creation
  • Sonic Automotive’s latest 10-Q and 10-K documents
  • Sonic Automotive’s latest earnings calls
  • Various other sources.