Sonic Automotive: Bear Stearns Says Buy, But Sell Is More Like It (SAH)

Includes: SAH, TRK
by: 10Q Detective

Sonic Automotive, Inc. (NYSE:SAH) is one of the largest automotive retailers in the United States. As of March 1, 2006, SAH operated 175 dealership franchises at 152 dealership locations, representing 37 different brands of cars and light trucks, and 38 collision repair centers in 15 states.

Each of the Company’s dealerships provides comprehensive services including (1) sales of both new and used cars and light trucks; (2) sales of replacement parts and performance of vehicle maintenance; warranty, paint and repair services; and (3) arrangement of extended service contracts, financing and insurance and other aftermarket products for its automotive customers.

On April 5, 2005, Bear Stearns, Inc. initiated coverage on SAH with an outperform rating. The nominal definition employed by Bear Stearns is as follows: "Stock is projected to outperform analyst's industry coverage universe over the next 12 months [i.e. auto retailing industry index which includes the likes of AutoNation (NYSE:AN), Group 1 Automotive (NYSE:GPI), and United Auto Group (NYSEARCA:UAG)]."

The brokerage firm argued that four factors exist that should act as valuation catalysts: 1) a recent focus on improving core operations of existing stores and successful new store integration, combined with 2) continued growth through acquisitions at a manageable pace; 3) strong growth and margin opportunities associated with the company’s over-weighting of foreign and luxury franchises; and, 4) a de-leveraging story.

The 10Q Detective respectfully disagrees with Bear Stearns’ investment thesis.

Historically, SAH has grown through acquisitions. In 2005, however, the Company acquired only five dealerships, representing five franchises, disposed of 13 dealerships, representing 20 franchises, and terminated two franchises. Going forward, corporate expects to continue to limit its acquisition activity to approximately 10% of annual revenues each year.

Management [and Bear Stearns] believe that this strategy will allow SAH to continue to reduce its financial leverage, maintain liquidity for its dividend and share repurchase activities, and also allow management infrastructure to focus on improving operating performance and integrating acquired dealerships.

Prior to 2004, SAH maintained a long-term debt to total capital ratio of approximately 48% to 52%, depending on the timing of its acquisitions. Corporate believes that the current acquisition pace will allow SAH to reduce its long-term debt to total capital ratio to 40% over the next few years. At December 31, 2005, the long-term debt to total capital ratio net of cash and cash equivalents was 46.0%.

According to Bear Stearns: “Our sense is that investors will be more comfortable with the less aggressive capital structure.