OREANDA-NEWS. S&P Global Ratings said today that it lowered its corporate credit rating on Charlotte, N. C.-based auto retailer Sonic Automotive Inc. to 'BB-' from 'BB'. The outlook is stable. At the same time, we lowered our issue-level rating on the company's senior subordinated notes to 'B+' from 'BB-' and maintained the '5' recovery rating The '5' recovery rating reflects our expectations that lenders would receive a modest (10%-30%) recovery of principal in the event of a default. We lowered the ratings because Sonic is not generating a level of free operating cash flow (FOCF) in line with our expectations for a 'BB' rating. The weaker-than-expected FOCF generation is in part related to Sonic's investment in EchoPark, a stand-alone retail business that allows customers to search, buy, service, finance, and sell used vehicles. For the first six months of 2016, EchoPark contributed 1.2% of Sonic's business compared with about 0.8% the first six months of 2015. Sonic has opened five locations in the Denver area: Thornton Hub, Centennial, Highlands Ranch, Dakota Ridge, and Stapleton. The company is acquiring property in Texas and the Carolinas and expects to open 14 more stores in 2017 and an additional 17 in 2018. Consequently, we revised our assessment of Sonic's financial risk profile to aggressive. While we expect Sonic to maintain debt leverage of 3.0x-4.0x, we do not believe it will be able to achieve a ratio of FOCF to debt of at least 10% over the next two years due to the elevated level of capex required to build out its EchoPark stores in Texas and the Carolinas. As of June 30, 2016, Sonic's debt leverage was 3.2x and its FOCF-to-debt ratio was below 10%. The company generates almost all of its sales from its franchised dealerships. In 2015, new vehicles constituted 55% of the company's sales, used vehicles 26%, wholesales vehicle 2%, parts and services 14%, and the finance and insurance (F&I) and other segments the remaining 3%. Nevertheless, the revenue from Sonic's parts and service (P&S) operations is stable compared with its revenue from vehicle sales and contributed 47% of its gross profit in 2015. By contrast, new and used vehicle sales made up only 19% and 11%, respectively, of the company's gross profit. We expect that Sonic's geographic and brand focus will remain largely unchanged over the next year. We expect that the dealerships the company has acquired will enhance its existing geographic position so that it can further benefit from its economies of scale. In 2015, Sonic experienced a buildup in its inventory of luxury brand vehicles, such as BMW, Mercedes, and Audi. We expect continuing pressure on new vehicle gross margins during 2016 due to higher-than-normal inventory levels and increased dealer competition. In addition, there has been an ongoing shift in the sales mix of the U. S. auto market toward crossovers and sport utility vehicles (SUVs) and away from small and mid-size cars, as depressed gasoline prices have lowered the cost of ownership for larger vehicles. For 2015, 57% of Sonic's new vehicle revenue was from luxury brands, 31% came from imports, and 12% was from domestics. The company's highest-revenue new-vehicle brands were BMW AG (22%), Honda Motor Co. Ltd. (16%), and Toyota Motor Corp. (11%). Sonic has dual-class common stock that places voting control with O. Bruton Smith and B. Scott Smith, the company's founders and the holders of its class B common stock. At this time, Sonic's board of directors retains control of the company and has the final decision-making authority with respect to key enterprise risks, compensation, and conflicts of interest. If we came to believe that Sonic's board was unable to maintain sufficient independence from management to provide effective oversight of the company, we could lower our management and government modifier on the entity, which could unfavorably affect the rating. Sonic has $1800 million in inventory floorplan financing facilities for new and used vehicles with automakers' captive finance companies and commercial banks. Auto retailers make heavy use of floorplan loans to finance their vehicle inventory. We treat these borrowings like trade payables rather than debt because of the borrowings' indefinite maturities, high loan-to-value ratios, and widespread availability. Manufacturer subsidies also often offset some borrowing costs. During the U. S. economic downturn, certain domestic automakers tightened the availability of their floorplan financing to retailers. However, automakers depend heavily on their continuing relationships with dealers to support their vehicle sales.

S&P GLOBAL RATINGS BASE-CASE SCENARIOAssumptions:U. S. sales of new light vehicles will move up to 17.5 million units in 2016 (a year-over-year increase of about 4%) and 17.8 million units in 2017 (about 2%) because the average age of the typical car on the road is more than 11 years old, credit availability is high, interest rates are at historical lows, and there are some cash rebates available for purchases. The U. S. economy should continue its slow and steady recovery, with a baseline forecast for GDP growth of 2.0% in 2016 and 2.4% in 2017.European light vehicle production will rise year-over-year to 2.3% in 2016.Revenue will grow at a compound annual rate of about to 2% through fiscal-2017. Sonic was in compliance with the covenants under its credit facilities as of June 30, 2016, and we expect that it will remain in compliance through 2016 and into 2017. The covenants on the company's credit facilities include a required liquidity ratio of at least 1.05x through the remainder of the term of the facilities, a fixed-charge coverage ratio of at least 1.2x, and a total lease-adjusted leverage ratio of no more than 5.5x. Sonic participates in a multi-employer pension plan in California, but this contingent liability does not affect our rating on the company. In addition to ongoing contributions for its own employees, Sonic's participation potentially exposes it to increased liability if a major contributing employer were to become insolvent or if several other participants exit the plan at once. We believe that Sonic's potential liability associated with this plan is relatively small and that it could be managed with the company's normal cash flow and borrowings from its revolving facilities if it were required to fund the liabilities for all of the participants in the plan. The stable outlook reflects our assumption that Sonic will maintain credit measures that are in line with our expectations for the current rating, particularly debt leverage below 5.0x and an FOCF-to-debt ratio of at least 5% on a sustained basis. We assume that Sonic will pursue a financial policy that focuses on the building out of its EchoPark business. Downside scenarioWe could lower the ratings if aggressive financial policies cause Sonic's leverage metric to exceed 5.0x for an extended period or if we believe that the company will be unable to maintain an FOCF-to-debt ratio of 5%. This could occur if, for example, aggressive investment in dealer upgrades, acquisitions, or stand-alone used vehicle stores leads to increased debt or if the company's operating efficiencies erode and cause its FOCF to decline. We could also lower the ratings if the slow U. S. economic recovery reverses course, causing the company's EBITDA to decline because it is unable to offset the decrease in its revenue with cost controls. Upside scenarioAlthough not likely over the next year, we could raise the ratings if the company is able to achieve an FOCF-to-debt ratio of at least 10% on a sustained basis. We would also need to believe that Sonic could generate a sufficient level of FOCF as it expands its business by investing in stand-alone used vehicle stores and new vehicle dealerships.