SONIC AUTOMOTIVE INC annual report, FY2012

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Sonic Automotive, Inc. — 2012 Form 10-K

Business context and reporting period. This annual filing covers the fiscal year ended December 31, 2012; the filing also reports fourth-quarter results. Sonic operated 111 dealerships in 14 states, representing 25 vehicle brands, and 21 collision repair centers. Its revenue comes from new and used vehicle sales, fixed operations, and finance, insurance and other products.

Financial performance and liquidity

  • Full-year revenue: $8.365 billion, up 11.2% from $7.521 billion in 2011. New vehicle revenue was $4.716 billion; used vehicles $2.053 billion; parts, service and collision repair $1.162 billion; and finance, insurance and other $250.4 million.
  • Profit: Gross profit was $1.235 billion versus $1.159 billion. Operating income was $240.4 million versus $219.5 million. Continuing-operations income was $91.3 million versus $81.5 million; net income, including discontinued operations, was $89.1 million versus $76.3 million. Diluted EPS was $1.53 versus $1.29; diluted continuing-operations EPS was $1.56 versus $1.37.
  • Margins: Gross margin was 14.8%, down from 15.4%; operating margin was 2.9%, unchanged; continuing-operations net margin was 1.1%, unchanged. SG&A fell to 76.8% of gross profit from 77.6%.
  • Fourth quarter: Continuing-operations revenue was $2.189 billion and gross profit was $314.1 million. Net income was $30.4 million; basic and diluted EPS were each $0.55. In fourth-quarter 2011, revenue was $1.983 billion, gross profit $293.7 million and net income $20.5 million.
  • Cash flow: Operating activities used $67.4 million, compared with $153.6 million provided in 2011, primarily reflecting inventory growth. Investing activities used $21.7 million and financing activities provided $90.5 million. Management notes that floor-plan financing classification affects reported operating cash flow; including trade and non-trade floor-plan changes, operating cash flow would have been $57.3 million provided.
  • Balance sheet and debt: Cash was $3.4 million, total assets $2.777 billion and stockholders’ equity $526.5 million at year-end. Floor-plan notes totaled $1.179 billion; long-term debt, including current maturities, totaled $629.4 million. Total indebtedness was approximately $1.8 billion, including floor-plan, short-term and long-term debt. A $60 million lender deposit was included in other current assets and subject to withdrawal restrictions.
  • Liquidity and covenants: Year-end availability under the revolving facility was $134 million, based on the then-existing borrowing base. Sonic reported compliance with debt and lease covenants; actual liquidity, fixed-charge coverage and lease-adjusted leverage ratios were 1.15, 1.69 and 3.94, respectively, against minimums of 1.05 and 1.20 and a maximum of 5.50. A subsequent credit-facility amendment removed the pledged SMI shares, which may reduce borrowing availability.

Material changes versus 2011

  • New vehicle sales volume rose 14.9%, while gross profit per new vehicle fell 7.3% to $2,069; total new vehicle gross profit increased 6.5%. Used vehicle volume rose 6.4%, but gross profit per unit fell 3.6%.
  • F&I revenue increased 19.8%, supported by retail unit growth and improved product penetration. Fixed-operations revenue rose 3.3%, while its gross margin slipped to 48.9% from 49.2%.
  • Ten dealerships were disposed of, with no acquisitions in 2012. Discontinued operations recorded a $10.3 million disposal gain but an after-tax loss of $2.2 million for the year.
  • Sonic issued $200 million of 7.0% subordinated notes due 2022 and repurchased its remaining 5.0% convertible notes using cash and approximately 4.1 million newly issued Class A shares. The transactions generated a $19.7 million debt-extinguishment loss.
  • Share repurchases totaled approximately $82.9 million, or 4.4 million shares. Dividends declared were $0.10 per share, unchanged from 2011.

Outlook, risks and unusual items

  • Management cited industry expectations of 15.0–15.5 million U.S. new-vehicle sales in 2013, versus 14.5 million in 2012, and said its capital structure and expected operating results should support 2013 liquidity needs. This is an industry forecast, not company earnings guidance. Management expected a 38%–40% effective tax rate before unusual tax items.
  • Key risks include vehicle-market cyclicality, local economic conditions, competition and vehicle pricing, consumer credit availability, reliance on manufacturers and their incentives, and the cost and availability of floor-plan financing. Debt and lease covenants, refinancing needs, interest-rate exposure, and large lease obligations also constrain flexibility.
  • Operating lease commitments, net of sublease rentals, totaled approximately $649 million. Sonic remained responsible for certain leases associated with sold dealerships; subtenant or assignee defaults could increase costs. Legal proceedings were ongoing; reserves were approximately $3.4 million, and the company could not estimate reasonably possible losses beyond accrued amounts.
  • Six Northern California dealership subsidiaries contributed to a multi-employer pension plan in critical status. Employer contributions were scheduled to increase for seven years beginning in 2013; a future withdrawal or plan termination could result in material liability.
  • Controls issue: Management concluded disclosure controls and internal control over financial reporting were ineffective at year-end. A material weakness involved controls over new and used vehicle revenue, related receivables, and vehicle inventory valuation. The auditor issued an adverse opinion on internal control, while giving an unqualified opinion on the financial statements. Management was developing remediation measures and had not estimated when they would be implemented.
  • Other notable items include a litigation settlement that reduced legal reserves, a $3.6 million tax benefit from settlement of a state tax examination, and $0.4 million of continuing-operations impairment charges. The goodwill impairment test found fair value more than $1 billion above carrying value; no goodwill impairment was recorded.

Investor verification priorities

  • Track remediation of the material weakness, especially the design and operating effectiveness of vehicle revenue, receivables and inventory controls.
  • Verify the post-amendment revolving borrowing base and availability after removal of the SMI share pledge.
  • Assess cash conversion and inventory growth alongside floor-plan borrowings; distinguish reported operating cash flow from cash flow including all floor-plan changes.
  • Monitor vehicle gross profit per unit, fixed-operations margins and F&I penetration for sustainability as sales volumes and industry conditions change.
  • Review covenant headroom, debt maturities, lease obligations and exposure to interest-rate swaps, as well as pension, litigation and dealership-sublease contingencies.