Sonic Automotive

Sonic Automotive reported second-quarter adjusted diluted EPS and revenue above the LSEG consensus for both metrics, but the stock still closed down 10.9% on July 30. Management increased the low end of its 2026 guidance for new vehicle gross profit per unit to $2,850 from $2,700.

Why it matters: Although there was soft US GDP news the same day as Sonic's earnings, we don't believe the results merited the stock falling so much. The narrowing new-vehicle profit guidance range suggests some stability coming to the market as it normalizes after the chip shortage. The market may not have liked adjusted overhead cost as a percent of gross profit rising year over year by 280 basis points to 72%; however, this metric decreased from the first quarter by 80 basis points. This pattern is not different from other auto dealers who have reported this week. It's also worth noting that the prior year's quarter was abnormally strong due to people buying vehicles to avoid tariffs. If the US economy does not contract sharply this year, we expect Sonic to have a good second half, especially in the fourth quarter, which is a strong premium-brand quarter.

The bottom line: We maintain our narrow moat rating for Sonic and are increasing our fair value estimate to $98 from $96 on the time value of money. We see the prospects for good momentum in all of Sonic's businesses, and the nascent EchoPark and powersports segments are growing. The powersports group acquired five more Harley-Davidson dealers in April, which brings in another $100 million of annualized revenue. Management said there is no shortage of acquisition candidates in powersports or franchise auto dealerships. We think concern over higher overhead spending, including advertising, is short-sighted, as we believe you have to spend money to make money; that is, educate the consumer on EchoPark and on the fact that franchise dealers do service. Sonic may be cutting its service prices to get more traffic.

We are increasing our Sonic fair value estimate to $98 per share from $96. The change is from the time value of money. Our weighted average cost of capital is 7.9%. We see several growth runways for Sonic across the consolidating franchise dealer space, EchoPark expansion, and scaling the powersports segment. Our midcycle operating margin, including floor plan interest, is approximately 3%. We have historically increased this metric to reflect our expectation of better overhead cost leveraging in the long term, due to possible lower inventories following the chip shortage. This would enable better long-term pricing power, as automakers may permanently maintain new-vehicle inventories at lower levels than before the pandemic.

We model EchoPark revenue in 2030, exceeding $6 billion, as management is unsure how many one- to four-year-old vehicles it can obtain to sell following the chip shortage, reducing the supply of these vehicles due to fewer trade-ins. Still, it's possible that EchoPark's one-time $14 billion target will be reinstated, but for what year is uncertain. Sonic also permanently reduced its selling, general, and administrative expense in 2020 by about 7%. For dealers, in our view, the pandemic accelerated digital changes and related expense reductions that would have taken place over several years into just a few months. Upside potential to our valuation exists if EchoPark’s growth can move total company operating margin to a level where we think a low-3% midcycle is too low. The US used-vehicle market is large at normally 40 million annual units (slightly less currently due to the chip shortage and pandemic), and no player has a double-digit market share, so there’s ample growth runway for EchoPark if it executes correctly.

We don’t model aggressive acquisitions beyond $1.2 billion acquired annual revenue in two of the five years of our explicit forecast period due to management's emphasis on EchoPark over franchise stores and their frustration with continued demands from automakers for expensive store imaging projects with returns that Sonic feels do not justify the investment. However, we do model acquisitions occurring every year. Management prefers the used-vehicle model of EchoPark due to higher return on investment in used vehicles over new vehicles, higher used volume, and because Sonic has sole control over EchoPark, whereas new-vehicle operations and store appearance at franchised stores are mostly under the control of an automaker. We model annual acquired revenue between $800 million and $1.2 billion each year of our five-year explicit forecast period. We expect the powersports segment will see more acquisitions as that space is fragmented, offers gross margins in the area of 30% instead of 15%-17% in the auto space, and paying up to buy a powersports store can cost an extra $1 million instead of an extra $15 million in autos.

Our assumptions include revenue increasing about 7.5% on a five-year compound annual basis. We forecast the operating margin, including floor plan interest expense, to average slightly below 3% during our five-year explicit forecast period. We anticipate capital expenditures to be approximately 2% of revenue annually.

We give Sonic a Narrow Morningstar Economic Moat Rating, as its 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 and more opportunities to grow via acquisitions funded by the public's deep pockets or be awarded an open point (a brand new store) by an automaker. Dealers have no burdensome retiree expenses, and the large public dealers don't depend on the health of one brand. The dealers 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 narrow moat.

These logistics create inelasticity of demand, which creates pricing power for the dealer and is a source of excellent profit in good times and bad. In fact, during a downturn in new-vehicle sales, dealers generally report higher gross margins due to a favorable mix shift, but then report lower operating margins because of SG&A deleveraging. Excluding large impairment and restructuring charges, dealers can still report positive EBIT even in a severe recession. Although most dealerships are good businesses, we think the large publicly traded dealers are best positioned for growth since they can be the most flexible in changing brand mix. Many small business owners are choosing to exit or sell because they cannot get the scale on a variety of expenses compared with large dealer groups. Sonic is one of the largest dealers in the US, yet has under 1% new-vehicle market share. About 91% of dealer owners own between one and five stores per the National Automobile Dealers Association, so we see a long growth runway for consolidators such as Sonic. Sonic is now doing the gradual roll-up strategy in powersports, mostly via Harley-Davidson store acquisitions.

Auto dealerships are well-diversified businesses that have lucrative parts and servicing operations, which help them be profitable in almost any environment.

EchoPark could prove to be a very lucrative business long term if it can scale up.

Sonic has the potential to generate significant economies of scale as vehicle demand rebounds and if EchoPark grows. Powersports may be a lucrative new business as well, given that it does not have many large roll-up players in it like auto dealerships do.

Dealerships are prone to macroeconomic cycles, and used-vehicle profitability is under huge pressure following the chip shortage. Used profitability will improve but it will take time.

EchoPark is a major investment and may not succeed if execution stumbles.

The Smith family has over 85% voting power, so other shareholders are effectively just along for the ride.