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Stock Strategist

Sonic Automotive Has Momentum

The narrow-moat car dealership has a bold strategy for both new and used car sales, but shares are pricey today.

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 Sonic Automotive (SAH) is undergoing many changes. It has resumed acquisitions, increased its product mix toward the more lucrative luxury and import brands, is installing a dealer-management system across all its stores, and has a bold strategy for new and used vehicles. 

The firm reported results that hit record fourth-quarter levels for several metrics, including used unit volume and gross profit in the service and finance segments. Adjusted diluted EPS rose 8.2% year over year to $0.66, easily beating consensus of $0.62, while revenue grew 3.5% to roughly match consensus. We are keeping our narrow moat rating but increasing our fair value estimate to $20 for a time value of money adjustment in our model. Even after the increase, we see Sonic's shares as overvalued today.

Management did a good job balancing profitability with volume in the quarter, and it appears a flattening out in the Houston market in December after a poor first two months of the quarter helped. Management was not ready to say Houston’s economy has improved, but even a sign that it's not falling as it had for most of 2016 is helpful. Texas made up 25% of total company revenue in 2016, the second-largest market for Sonic behind California’s 30%. Overall company new vehicle volume fell by only 0.8%, but gross profit per unit rose by 0.4%. Used vehicle volume rose by 5% while gross profit per unit increased by 1.9%. These metrics suggest that Sonic did not overly discount inventory.

For 2017, management guided to adjusted EPS of $2.00-$2.10, below consensus of $2.17. Guidance is based on U.S. industry new vehicle sales of 17.0 million-17.5 million, which is in line with our expectation of 17.0 million-17.2 million, and includes a projected loss for the stand-alone used vehicle EchoPark stores of $0.23 to $0.27 per share. EchoPark lost $0.17 in 2016, but we are encouraged by the numbers coming out of its five Colorado stores. Fourth-quarter year-over-year operating loss improved by 48% and retail unit volume rose by 74%. The brand will not be covering its overhead until at least the end of 2018 per management, as it needs more stores. Expansion will come this year with one more Colorado store and three to six stores in a new market, San Antonio.

Can Sonic Take on CarMax?
In October 2013, Sonic announced its intention to effectively take on  CarMax (KMX) in used vehicles. The used-vehicle market in the U.S. is highly fragmented at about 40 million units a year, with late-model used vehicles as old as six years often making up at least 15 million units, so there is certainly room for both firms to pursue their strategies. Sonic guided for these stores, called EchoPark, to be coast to coast, with 100 stores just the beginning. Openings started in late 2014 in the Denver area and in 2017 Sonic plans to open a sixth store in Colorado and three to six in San Antonio, Texas. It will be a long time before EchoPark has the scale to compete with CarMax's over 170 stores. Management does not expect the concept to be profitable until 2018. The stores will not have a big-box retail format and are not as capital-intensive as investors may think, according to management. The company wants a large hub store in a city serving smaller satellite stores in the area. Sonic does not plan to initially have a captive finance arm like CarMax but does plan to several years from now.

Sonic is the fourth-largest public dealer in the U.S., so it will have scale relative to a small dealer, but its used-vehicle throughput of about 100 units per store each month is nowhere near CarMax's 350. We also are intrigued as to how Sonic will open these stores without adding substantial capital intensity, as it currently values owning its real estate rather than leasing it.

Warranty Work Gives Sonic an Intangible Asset
We give Sonic a narrow-moat rating, as the firm's size continues to generate economies of scale and working capital efficiencies while the service segment's warranty work gives the company an intangible advantage over garages. We think the dealer sector is the best business in the automotive supply chain. The public dealers can centralize back-office operations and generate far more volume than small dealers, which brings scale. Dealers have no burdensome retiree expenses, and the large public dealers don't depend on the health of one brand. 

The dealers also enjoy mid- to high-single-digit gross margins on new vehicles and 100% gross margins on financing and insurance. We think the best source of competitive advantage is the parts and service operations. Many customers bring their vehicle to the dealer for servicing because either the vehicle is under warranty or the dealer is close to home and has the factory parts and expertise to service the vehicle. Once vehicle owners know a dealer, we think they are likely to keep going back to the dealer for service. The dealer knows the vehicle, and comparison-shopping for repair work is very time-consuming since the customer has to take the vehicle to each shop to get a quote. These cost advantages and intangible advantages from service give dealers a moat.

David Whiston does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.