2023-03-16 08:19:21 ET
Summary
- New vehicle demand remains robust but availability may be limited due to supply chain issues.
- Used vehicle demand may face affordability headwinds, but management's focus on inventory discipline and increasing used vehicle GPUs may increase total gross profit.
- Management's focus on permanent cost reductions, increased productivity, and structural improvements in F&I and new vehicle GPUs should propel margins higher in the long run.
Thesis
Overall, I would say that things are looking up for Sonic Automotive ( SAH ) in terms of demand, pricing, EchoPark improvements, and margin after 2023. However, I agree with bears that FY23 is very uncertain, which is why the current valuation is 7x forward earnings. I would advise investors to wait until 2H23 to re-evaluate the situation, as visibility into FY24 will be improved by then.
Results review
Stronger new and used volumes, resilient P&S strength, and stronger new and used car GPUs all contributed to SAH's 4Q22 results , which included a significant beat on EPS and EBITDA. Year-over-year comparable sales for brand-new units were up 5%, while sales for franchised-used units were up 6%. Once again, the Parts & Services division delivered outstanding results, with same-store sales up by 12% to further fortify the earnings resilience of the franchise dealer business model. Again, efficient cost management was a driving factor in the beat, and SG&A costs as a percentage of revenue came in at 65.2%. EchoPark lost around $25 million in EBITDA, but the management anticipates things will get better from here through 2023.
New vehicle demand
As far as I can tell, the demand for new vehicles shows no significant signs of slowing down. SAAR for 2023 is still robust in February, coming in at 14.4 million units . However, given that we are still in the process of restoring the supply chain, I anticipate that availability will remain low for the vast majority of SAH's brands for the foreseeable future, thereby having some impacts on growth. On the other hand, I anticipate a return to pre-covid levels for GPUs, but this moderation will occur at a pace determined by the OEMs' ability to keep up with demand. Consequently, investors need to keep an eye on the rate of moderation, which is likely to be volatile and might impact performance optically from a q/q perspective. Assuming OEMs maintain inventory discipline and industry supply tracks in the 40-45 days range, I believe things will become much more stable after 2023. Naturally, these are predicated on the assumption that demand will continue in the foreseeable future.
Used vehicle demand
I don't think the recent rise in wholesale prices for used cars can be maintained, as it seems to be largely attributable to increased bidding from rental company at auctions. I foresee two endings to this:
- Dealers can keep their profit margins stable by passing on higher costs to customers.
- In the face of waning demand, dealers find themselves unable to pass on the full cost of acquisition to customers. Gross margins would inevitably decrease as a result. I would refer investors to KMX 1Q24 results in June given that its 1Q24 covers the entire spring selling season in order to get a more accurate picture of industry demand.
When it comes to the resurgence of the used-vehicle market, affordability remains the most important factor for consumers to consider. Given the time it takes for prices to percolate through markets and for bid/ask spreads to level off, I anticipate that price will take a longer time to moderate. Aside from these non-controllable factors, I anticipate that management will keep its attention fixed on the maintenance of strict inventory discipline, and they may seize the opportunity to place a higher focus on used vehicle GPUs in 1Q23 in order to increase total gross profit.
Margin
SG&A as a percentage of gross profit is a crucial indicator, and I anticipate it will continue improving in the future. To be more specific, I anticipate that initiatives aimed at permanent cost reductions, increased productivity, higher F&I, and new vehicle GPUs will propel margins higher. In my opinion, management has done a decent job up to this point of cutting costs. They've improved vehicle sales per employee while simultaneously reducing staffing levels in their same-store franchises to pre-covid levels. Assuming the increased productivity is here to stay, the cost servings seem to have settled into a permanent pattern. Investments in omni-channel strategies and information technology also play an important role in boosting leverage alongside increases in labor productivity. When it comes to saving money, robotic process automation is one area where investing in technology can really pay off. On the other hand, in the long run, EchoPark should also allow for significantly increased volume throughput, which should aid in operating leverage as well.
EchoPark
I anticipate that EchoPark expansion will continue to be management's long-term focus, despite 2023 being a challenging year (given the price point of used cars) and investors need to look past FY23 to better value this asset. Once markets stabilize and affordability headwinds ease (which should be in FY24), in my opinion, management will resume expansion.
Capital allocation
Since EchoPark's growth is expected to decelerate in the near future, I anticipate that SAH's capital allocation strategy will put a premium on buybacks while still leaving a healthy amount of financial buffer to withstand any potential recessionary headwinds. About 25% of SAH's market cap can be funded by the roughly $450 million still available under the company's current authorization. However, given the covenants in bonds and credit facilities, it is highly unlikely that SAH will spend the full $450. million Even after making that adjustment—assuming SAH can only use half of it—the buyback opportunity is still around 12%.
Conclusion
While the future of SAH remains uncertain in the near term, there are many positive signs for the company's growth and profitability in the long run. Strong sales, improved margins, and the success of the EchoPark brand all point towards a bright future for SAH beyond 2023. However, investors should remain cautious and wait until the second half of 2023 before making any significant investment decisions, as visibility into FY24 will be improved by then.
For further details see:
Sonic Automotive: Wait For H2 2023 To Re-Evaluate The Stock