2023-08-07 14:55:01 ET
Summary
- Sonic Automotive seems to be overly cautious when it comes to capital allocation, as the company is focused on conserving cash and paying down debt.
- SAH has recently maintained its Q1 2024 breakeven guidance for EchoPark, its pre-owned vehicle business segment.
- I have made the decision to stick with a Hold rating for Sonic Automotive, after assessing its capital allocation strategy and its used car business' profitability outlook.
Elevator Pitch
I continue to assign a Hold investment rating to Sonic Automotive, Inc. ( SAH ) stock.
With my earlier update for SAH published on May 29, 2023, I previewed Sonic Automotive's second quarter financial results and highlighted the company's balance sheet strength.
I have chosen to leave my Hold rating for Sonic Automotive unchanged, after evaluating Sonic Automotive's capital allocation approach and its used car business segment's profitability outlook with this latest article. I am disappointed that SAH doesn't seem to be as aggressive on buybacks and acquisitions as what I would have hoped for. But I am encouraged by the fact that SAH has stuck to its Q1 2024 breakeven guidance for EchoPark.
Capital Allocation
In tough economic times like these, companies have the opportunity to enhance shareholder value by allocating capital in a value-accretive manner, such as repurchasing their own undervalued shares or buying other businesses at a bargain. In that respect, I am of the opinion that Sonic Automotive's capital allocation approach is way too conservative.
At the company's Q2 2023 earnings call on July 27, SAH acknowledged that it has "a fantastic balance sheet" with "a lot of cash." But Sonic Automotive stressed at its most recent quarterly results briefing that "cash is king when you have uncertainty with economic conditions", and it noted that it has "a strategic initiative to bring our debt down."
SAH's management comments suggest that the company might potentially allocate much less capital to share buybacks and M&A in the near term.
In the first quarter of this year, Sonic Automotive spent around $91 million buying back 1.6 million shares, or approximately 5% of its outstanding shares. But SAH didn't execute on any share repurchases in Q2, 2023, which it referred to as a "strategic decision" at its second quarter earnings briefing. Notably, Sonic Automotive highlighted at the company's Q2 results call that it "will return capital to shareholders, primarily through our dividends and opportunistically do share repurchases."
Sonic Automotive disclosed in its July 2023 investor presentation that the company has reduced its number of shares outstanding by 18% since 2019. However, it appears that SAH's pace of share buybacks is likely to slow in the short term, taking into account the company's current capital allocation strategy focused on conserving cash as a buffer and deleveraging.
The market currently values SAH at 7.9 times consensus forward next twelve months' EV/EBITDA (source: S&P Capital IQ ), which is below its 10-year average forward EV/EBITDA metric of 9.9 times. As such, it makes sense for Sonic Automotive to step up its level of share buybacks now in view of its shares' undervaluation, rather than repurchase shares "opportunistically" as per its current approach.
Separately, Sonic Automotive doesn't seem to be very keen on engaging in new acquisitions anytime soon.
The company had emphasized at its second quarter earnings call that it doesn't "have anything that is pressing" from "an M&A perspective in the near term." I would have preferred that SAH build an acquisition pipeline now in anticipation of potential M&A opportunities that could emerge in due course. As the economy weakens, there will be more players in the cyclical automotive industry struggling to stay afloat, and this is typically the best time for financially strong businesses like SAH to buy distressed companies that are putting themselves up for sale.
As of the end of June 2023, Sonic Automotive's net debt-to-EBITDA was a very healthy 2.01 times and the company had liquidity of roughly $869 million as indicated in its July 2023 investor presentation. Considering these financial metrics, it doesn't seem to be reasonable for SAH to be prioritizing debt paydown over mergers and acquisitions.
In a nutshell, SAH appears to be a tad too prudent when it comes to allocating excess capital. Sonic Automotive has value enhancement levers such as share buybacks and accretive acquisitions that it can utilize, but the company seems to be too focused on cash conservation and debt repayment.
EchoPark Breakeven
The turnaround of Sonic Automotive's pre-owned vehicle business, EchoPark, is a key potential re-rating catalyst for the stock.
SAH announced that the company was maintaining its "previously issued guidance of an expected return to breakeven EchoPark Segment adjusted EBITDA" for Q1 2024, when it disclosed its Q2 2023 financial results in late July. Sonic Automotive has confidence in EchoPark realizing breakeven in the first quarter next year because of its restructuring proposal and its inventory sourcing diversification efforts, as detailed below.
Earlier on June 22, 2023, Sonic Automotive revealed that it has "suspended operations at eight EchoPark locations" as part of the company's restructuring plans for its used car segment. I have a positive opinion of this move, as EchoPark's costs are reduced with a smaller distribution network, while the re-allocation of inventories is expected to boost EchoPark's sales at other locations.
Another driver for EchoPark's profitability, apart from the recent restructuring plan, is the increase in the proportion of its inventories that don't come from auctions. In its July 2023 investor presentation, SAH mentioned that the percentage of EchoPark's inventories taken from channels (excluding auctions) went up significantly from under 10% in the past to almost a quarter for Q2 2023. A reduction in EchoPark's inventory acquisition expenses over time will naturally translate into better margins for Sonic Automotive's pre-owned vehicle business.
Concluding Thoughts
I think that the market will be impressed with Sonic Automotive if EchoPark can achieve breakeven in Q1 2024 as planned, which I think is highly probable. But investors might be disappointed by SAH's conservative capital allocation approach, in my view. Therefore, I think that a Hold or Neutral rating for Sonic Automotive is still appropriate.
For further details see:
Sonic Automotive: Capital Allocation And EchoPark Breakeven In The Limelight