Fitch Affirms Sonic Automotive's IDR at 'BB'; Outlook Stable

Fitch Ratings has affirmed Sonic Automotive, Inc.'s Long-Term Issuer Default Rating (IDR) at 'BB'.

The Rating Outlook is Stable.

Sonic's Automotive, Inc.'s 'BB' rating reflects its position as one of the leading players in the U.S. new and used auto dealership industry. The rating also reflects expected medium-term revenue and EBITDA of around $15 billion and around $500 million, respectively, following strong organic growth in 2021 and 2022, as well as the late 2021 acquisition of RFJ Auto Partners, Inc. The rating is supported by the balanced gross profit mix across segments, which helps limit financial sensitivity to the cyclical new and used vehicle market, a strong liquidity position underpinned by expected positive free cash flow (FCF), and Fitch's expectation that EBITDAR leverage (capitalizing leases at 8x) will be around 4x, in line with the company's EBITDAR leverage in 2023.

Key Rating Drivers

Recent Moderation in Performance: Sonic's operating results in 2020-2022 benefited from a strong vehicle pricing environment and used car volume growth at its franchised dealerships. EBITDA in 2022 was $700 million, more than twice the $300 million in 2019 despite new vehicle supply challenges, demonstrating Sonic's business model resilience to the inherently cyclical auto retail industry. The industry tailwinds in recent years are starting to reverse as interest rates rise, consumer health moderates and OEMs increase new car production, driving lower pricing and vehicle gross profit. As a result, Sonic's EBITDA fell to about $530 million in 2023. However, EBITDA margins of 3.7% in 2023 remained above the 2019 level of 2.8%.

Supply and Demand Reversal Expected: The combination of a somewhat softening consumer and improving new vehicle supply could pressure selling prices and, consequently, industry-wide margins. However, Fitch expects EBITDA could stabilize around $500 million as near-term pressure on new car margins are offset by profitability improvements at EchoPark, Sonic's used car superstore segment, as it moves from EBITDA of negative $80 million in 2023 to breakeven or slightly positive. Fitch believes Sonic could sustain EBITDA margins in the mid 3% range over the medium term, above the high 2% range prior to 2020, but below the 5% reported in 2022. Structurally higher margin forecasts are largely due to expectations that the new vehicle industry could retain some of the recent pricing strength through tighter supply.

Leading Player in Fragmented Industry: Sonic benefits from its scale as one of the largest U.S. automotive dealership groups with good OEM relationships. It operates 108 franchises and 18 EchoPark used car superstores, with most in the southeastern region of the U.S., California and Texas. The company has broad vehicle brand exposure and healthy ancillary businesses, including parts and service and finance and insurance, which generate around 40% and 30% of franchised dealership gross profits, respectively. Sonic's scale and cash flow generation allow it to navigate complex industry dynamics, as well as invest in its core businesses, M&A and newer initiatives like EchoPark.

High Barriers to Entry: Industry incumbents, such as Sonic, benefit from high barriers to entry due to protected franchise agreements that are regulated at both the state and federal levels. Additionally, dealerships require a significant upfront capital investment for initial construction and working capital. Success in the industry is also predicated on good relationships with financing partners, including automotive captive-finance entities, to achieve favorable floorplan financing terms.

EchoPark Longer-Term Opportunity: While Sonic sees growth opportunities in its core dealership business, its primary longer-term expansion channel is the EchoPark segment, which is focused on simplified, no-haggle sales of high-quality, one- to four-year old vehicles priced up to $3,000 below competitors. While revenue for this segment has grown from around $250 million in 2017 to $2.4 billion in 2023, overall EBITDA generation was negligible prior to 2020 and has weakened to a deficit of approximately $80 million in 2023 due to inventory sourcing challenges and negative customer response to rising used car prices.

Echopark has growth potential in the fragmented used auto market and has made near-term efforts to improve profitability, including store closures, expense reductions and initiatives to improve customer affordability, like sourcing older vehicles. However, given recent operating challenges, Fitch expects EchoPark's contribution to Sonic's EBITDA over the next two to three years to be negligible at best.

Strong Medium-Term FCF; Reasonable Leverage: FCF was a deficit of approximately $280 million in 2023 following a nearly $400 million negative working capital swing. Fitch expects FCF of around $100 million annually beginning in 2024 from improved working capital, despite some EBITDA moderation in 2024. Sonic's good cash flow generation provides financial flexibility through cycles and allows the company to invest in strategic initiatives, including M&A to help grow and diversify its business.

EBITDAR leverage, which was in the low-3x range between 2020 and 2022, increased to 3.9x in 2023. Fitch expects EBITDAR leverage of around 4x beginning 2024. This assumes debt levels of around $1.7 billion, in line with outstanding debt at the end of 2023. The company does not have a public leverage target, and its 'BB' rating assumes it operates with EBITDAR leverage below 4.25x.

Derivation Summary

Sonic's peers include dealership groups Asbury Automotive, Inc. (BB/Stable) and AutoNation, Inc. (BBB-/Stable), and auto parts retailer AutoZone Inc. (BBB/Stable).

Asbury's 'BB' rating reflects its top five position in the new and used auto dealership industry following recent acquisitions, with projected 2024 revenue and EBITDA around $18 billion and $1 billion, respectively. The rating is supported by good cash flow and balanced gross profit mix across segments that limit sensitivity to the cyclical new and used vehicle markets, and Fitch's expectation for EBITDAR leverage (capitalizing leases at 8x) to trend in the high-3x range, slightly higher than the company's historical EBITDAR leverage range of around 3x.

AutoNation, whose business model is similar to that of Asbury and Sonic, holds a leading position in the auto retail segment and has a history of good cash flows, which allows it to invest in growth initiatives while effectively managing through an inherently cyclical automotive industry. AutoNation's 'BBB-' rating considers the company's financial policy yielding expectations of EBITDAR leverage at or below 3.25x over time.

Unlike Sonic, AutoZone competes in the retail auto parts and accessories aftermarket. AutoZone's 'BBB' rating reflects its leading position in auto parts retail, steady operating results, high profitability margins and steady credit metrics, with EBITDAR leverage expected to trend in the high 2x range longer term. AutoZone's operating trajectory is supported by generally benign competition from direct peers and the industry's resilience to discount and e-commerce competition due to inventory investment requirements, a heavy service component and purchase immediacy requirements. The ratings consider AutoZone's financial policy and the expectation that debt balances could grow over time to support the company's share buyback program, in line with the company's publicly articulated financial policy.

Key Assumptions

Fitch's Key Assumptions Within the Rating Case for the Issuer

Revenue in 2024 could be close to flat given continued weakening in the vehicle pricing environment after several strong years, somewhat mitigated by improved new vehicle supply and a return to sales growth at EchoPark after optimizing its store footprint. Longer term, organic revenue growth could be around 2% assuming a normalization in vehicle supply and modest growth at Sonic's existing dealerships, including EchoPark;

Fitch expects EBITDA margins in 2024 to trend in the mid 3% range (lower than the 5% in 2022 but above the high 2% range in pre-pandemic 2019) given expectations of structurally tighter new vehicle supply in the medium term and some scale benefits post the RFJ acquisition. Fitch expects EchoPark's EBITDA to turn positive in 2024 but to remain negligible over the next two to three years;

Fitch expects FCF to be around $100 million annually beginning in 2024 given Fitch's EBITDA forecast and assuming neutral working capital. Fitch expects FCF to be used for strategic initiatives, including M&A and share repurchases;

Fitch projects EBITDAR leverage could trend near 4x in the medium term given Fitch's EBITDA projections and assuming debt of around $1.7 billion;

Sonic's credit facilities have a floating interest rate structure and Fitch assumes around 3.5% to 5% SOFR base rates over the forecast horizon, given the higher interest rate environment. Sonic's non-mortgage related notes have a fixed interest rate structure.

Recovery Analysis

Fitch does not employ a waterfall recovery analysis for issuers' assigned ratings in the 'BB' category. The further up the speculative-grade continuum a rating moves, the more compressed the notching between the specific classes of issuances becomes. Fitch rates Sonic's secured ABL facility at 'BBB-'/'RR1', indicating outstanding recovery prospects. Sonic's $1.15 billion unsecured notes are rated 'BB'/'RR4', indicating average recovery prospects.

RATING SENSITIVITIES

Factors that could, individually or collectively, lead to positive rating action/upgrade:

Increased confidence in Sonic maintaining EBITDAR leverage (capitalizing leases at 8x) below 3.75x, either through a publicly articulated or demonstrated financial policy, alongside operating performance in line with Fitch's current expectations.

Factors that could, individually or collectively, lead to negative rating action/downgrade:

Financial policy decisions, including debt financed M&A or share repurchases, that result in EBITDAR leverage (capitalizing leases at 8x) sustained above 4.25x;

Weaker than expected operating results due to market share loss and/or execution missteps, evidenced by EBITDA trending below $500 million, would also lead to negative action.

Liquidity and Debt Structure

Good Liquidity: Total liquidity as of Dec. 31, 2023 was $501 million comprised of $29 million in cash on hand and $472 million in available liquidity resources under its various lines of credit. Total liquidity includes $299 million available (net of LOCs) under the company's $350 million asset-based loan (ABL) revolver maturing in 2029 and $173 million available under a $500 million mortgage facility maturing in November 2027. Sonic also has $345 million in floorplan deposit balances that can be used towards liquidity.

Total debt as of Dec. 31, 2023 was $1.7 billion, consisting of $311 million in borrowings under the mortgage facility, $239 million in mortgage debt with various maturities through 2033, and $1.15 billion in unsecured notes due 2029 and 2031.

Floorplan Facilities: Automotive retailers, including Sonic, finance their inventories with floorplan facilities, which have characteristics of both payables and debt. Companies primarily use the facilities for new car inventory and the source of these facilities is typically from either financing arms of various automotive manufacturers or lending institutions. The accounting treatment of these payables is similar to that of accounts payables. For example, floorplan financing is categorized as a floorplan payable, shown as short-term liabilities on the balance sheet, with the change in floorplan payables treated as a working capital change (trade payable) of financing activity (non-trade payable) on the statement of cash flows.

Additionally, these facilities lack a fixed maturity date (loans due on demand) and a duration that is generally paid within days after a car is sold. These loans are often tied to manufacturer subsidies, which offset a portion, if not all, of the borrowing costs. These facilities are provided on a vehicle-by-vehicle basis.

Floorplan financing also incurs an interest expense (distinct from debt interest) and in a liquidation scenario, floorplan payables are secured by the collateral of the vehicle, gaining priority over unsecured debt. Fitch excludes floorplan financing from its primary leverage ratio calculation in deriving its rating for Sonic. Fitch also adjusts EBITDA by moving floorplan-related interest expense to cost of goods sold (COGS). In 2023, this adjustment increased COGS and reduced EBITDA by $67 million. These floorplan facilities are secured and would receive priority over unsecured claims in a bankruptcy.

Issuer Profile

Sonic Automotive, Inc. is a new and used automotive retailer that provides additional services including parts & repair services and finance & insurance through lending institutions.

Summary of Financial Adjustments

In addition to treating floorplan interest expense as an operating cost within cost of goods sold, Fitch adjusts for stock-based compensation expense, impairment charges and loss or gains on asset disposals.

REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING

The principal sources of information used in the analysis are described in the Applicable Criteria.

ESG Considerations

The highest level of ESG credit relevance is a score of '3', unless otherwise disclosed in this section. A score of '3' means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. Fitch's ESG Relevance Scores are not inputs in the rating process; they are an observation on the relevance and materiality of ESG factors in the rating decision. For more information on Fitch's ESG Relevance Scores, visit https://www.fitchratings.com/topics/esg/products#esg-relevance-scores.