Bryan Scott Smith - Sonic Automotive, Inc. Jeff Dyke - Sonic Automotive, Inc. Heath R. Byrd - Sonic Automotive, Inc..

Rick Nelson - Stephens, Inc. Bret Jordan - Jefferies LLC John Murphy - Bank of America Merrill Lynch William R. Armstrong - C.L. King & Associates, Inc. Colin Langan - UBS Securities LLC.

Good morning and welcome to the Sonic Automotive Second Quarter 2017 Earnings Conference Call. This conference is being recorded today, Friday, July 28, 2017.

Presentation materials which management will be reviewing on the conference call can be accessed at the company's website at www.sonicautomotive.com by clicking on Our Company, then Investor Relations, then Webcasts & Presentations.

At this time, I would like to refer to the Safe Harbor statement under the Private Securities and Litigation Reform Act of 1995. During this conference call, management may discuss financial projections, information or expectations about the company's products or market or otherwise make statements about the future.

Such statements are forward-looking and subject to a number of risk and uncertainties that could cause actual results to differ materially from the statements made. These risk and uncertainties are detailed in the company's filings with the Securities and Exchange Commission. I would now like to introduce Mr.

Scott Smith, Co-Founder and CEO of Sonic Automotive. Mr. Smith, you may begin your conference..

Thank you and good morning and welcome to Sonic Automotive's second quarter 2017 earnings call. I'm Scott Smith, company's Chief Executive Officer and Co-Founder. Joining me today on the call are David Smith, our Vice Chairman; Heath Byrd, our CFO; Jeff Dyke, our Executive Vice President of Operations; and CG Saffer, our Chief Accounting Officer.

I trust that everyone has read the documents released earlier this morning. I will provide some brief comments and then turn the call over for questions. For the quarter, we generated $0.27 from continuing operations on a GAAP basis and $0.40 per share on an adjusted basis.

Our GAAP results were lower as a result of impairment charges, weather-related physical damage costs, legal matters and costs associated with closing and relocating stores. Consistent with our first quarter, the first two months of the second quarter started off slowly, and there was much better performance in the month of June.

We continued to see strength and growth in used vehicle, fixed-ops and F&I areas of our business. But new vehicles remain under pressure as dealers compete for volume while trying not to erode GPU. Some brands and regional themes tell the story of our second quarter.

Northern Cal performed well during the quarter as did operations in the Colorado market. Our operations in Alabama were negatively impacted by the effects of storm damage experienced in the beginning of the quarter. And Texas is still challenged as a result of the region's dependence on a healthy energy market.

From a brand perspective, new vehicle volumes lagged the prior year for BMW, Ford, and GM stores, while Honda and Toyota experienced healthy volume gains without eroding GPU.

We remain committed to returning capital to our shareholders and again announced a dividend of $0.05 per share for shareholders of record as of September 15 with the payment occurring on October 13. Our stock repurchases were fairly robust during the quarter at a level of $22 million as we continue to remain opportunistic in our repurchase strategy.

We ended the quarter with a remaining repurchase authorization of approximately $119.1 million. Roll-out of OSOE technology continued in Birmingham, Chattanooga and LA markets, and the roll-out to our first BMW store in Greenville, South Carolina, is progressing.

EchoPark results were in line with expectations as we have accelerated our expansion plans for the Texas and Carolina markets. Current plans include the additions of 15 new stores by the end of 2018. We can provide more color on this during the Q&A.

As mentioned in our press release this morning, we have updated our earnings guidance to reflect year-to-date results, regional market conditions, and the acceleration of our expansion plans for EchoPark. At this point, I'd like to open the call for questions..

Your first question comes from Rick Nelson of Stephens..

Hi. Good morning..

Hi, Rick..

Hi..

I'd like to follow up on Scott's comment about the improvement in June.

Does that include Texas? And is that carrying into July?.

Hey, Rick. It's Jeff Dyke. Yeah, I did include Texas. It was a better month overall in June for us across the board. But we saw that in March as well. July was a little bit back to – or so far – it was a little bit back to what we've seen sort of April, May and it's just not as robust. The margins are tougher.

The incentives are a little different, in particular, with our big brands in BMW or lack there of incentives. And then Texas is kind of the same. It's not getting any worse. It's just not getting any better. We said in our notes, we expect that to continue for the remainder of the year. We're hopeful that the energy sector gets better.

The housing market is still good there. So, still plenty of positiveness about Texas, but Houston is continuing to struggle..

How do you adjust for that more challenging environment? I think the release made reference to expense initiatives, if you could elaborate there..

Yeah. We can. So that's been a big goal of ours the first six months of the year and we pulled a bunch of expense both in head count, we've adjusted some compensation plans. We've slowed some projects down and we're making adjustments. We're making those adjustments across the board, but we've been fairly aggressive there.

Obviously, you don't need as many people if you're not selling as many cars or driving as much gross, and so we've done that, and we're not through looking at it. We're going to continue to stay aggressive in that area for the remainder of the year and we'll see how things go. We still got some opportunity to cut expense there.

So, we're also working with our manufacturer partners on facilities and do we really need to build some of the bigger facilities we've been building, how can we par that back. So there's several different areas that we're looking at. We've received some nice expense cuts these last 90 days and we expect more over the next 90..

Got you. And it's full speed ahead with EchoPark. There were some changes in the guidance. If you could provide some color around that.

And then those 15 stores, is that a change in your expansion plan?.

Yeah, full speed ahead. We're very excited. EchoPark was up 80% year-over-year in terms of volume. Cash flow positive. So, in the Denver market where we started everything, our big store there, Thornton is making really nice return profit wise. So, we're full speed ahead.

And it's taking a long time to get all the properties that we wanted to come together. And they've all nicely come together here over the last couple of months. So, we're making it through all the rules and regs that you have dealing with the different counties and cities. And so we're very excited. A lot of really good things happening at EchoPark.

We couldn't be more excited. So, hopefully, we'll see another 15, maybe even a little more, between now and the end of next year open up. We've got a lot of projects that are getting ready to kick off covering Texas, in Austin, Dallas, Houston; the Carolinas, both North and South; Savannah, Georgia; and in Florida..

And just to follow up, I know Scott mentioned that earnings performance was in line with expectations at EchoPark. The guide now incorporates a bigger loss there.

Can you kind of bridge that together?.

Yeah. Sure. I mean, it's just the – at the end of the day, we have a ramp-up period. It takes about a year to get the store where we want it to from a cash flow perspective. So, it's just more stores opening, and we're incorporating that into our forecast for the reminder of the year..

Okay.

So, that's a change in the number of stores?.

Yes, it is..

Okay. All right, thanks a lot..

Yes, sir..

And your next question comes from Bret Jordan of Jefferies..

Good morning, guys..

Hey, Bret..

Good morning..

Hey, on that Thornton store, I mean, I'm just trying to understand what the EchoPark unit economics look like when they mature. But how much customer pay service business is that doing? I think we've asked this question before, and you said most of the capacity was going to vehicle refurbishment for sale.

But when you think about fixed overhead absorption, are you seeing traction in service?.

We haven't even tried, to be honest with you. Still just full capacity, recounting cars to get them out, that's a big topic of discussion around here. We are going to begin this quarter. We're going to put our toe in the water with a few of the neighborhood stores, trying to drive a more customer pay business into the stores.

We know we can do it, but I've needed every bit of capacity we've had just to keep up with the volume. And we have really been pressing hard to open up the Colorado Springs store. That was an incremental 400 cars I had to have on the ground on day one, so I've got enough inventory now.

I think we got our recon processes down where we're comfortable, and we can start beginning to drive some customer pay. So in future quarters, ask me that question again, and I'll do a better job of giving you some numbers, but right now, the customer pay numbers are zero.

I mean they were really doing – no upside there at all for the last couple of quarters. So there is a ton of upside, it's just there's not any the last few quarters, we have done no customer pay..

Okay.

Is the used buyer profile at EchoPark any different than your franchise stores? Is it either more prime or less prime?.

I would tell you that it might be a little more prime. In EchoPark, we price in the 104%, 103%, 105% of the market. And at Sonic, we're priced in the 92%, 93%, 94% of the market, so a little more aggressive pricing strategy at Sonic than we have at EchoPark, but a vastly different experience when you go on into the store.

And if you just go online and read our Reputation.com scores from Yelp or Google, and you see the feedback that we get on the EchoPark stores. It's just amazing. The guest experience is just different in there. They're showing us they're willing to pay a little bit more for the experience that we provide them..

Okay.

And then, last question, I guess as you expand the EchoPark, does your sourcing inventory change much? Do you wind up buying more at auction as opposed to being able to source out of your local stores, I mean, take trade-ins and transfer them across?.

We have done absolutely no vehicle sharing between the two companies. EchoPark is standing on its own two feet. We're buying about – I'd say 23%, 24%, 25% of our sales are now purchases off the street. The rest of it are purchased from auction. But we do no transfer of inventory from one entity to the other.

Are there economies of scale there down the road? Possibly. But we felt like early on, EchoPark needs to stand on its own two feet and that was the goal of ours from the very beginning..

Okay. Thank you..

Your next question comes from John Murphy from Bank of America..

Good morning, guys..

Good morning, John..

Unsurprisingly, I've a question about EchoPark here. So, as we look at this, I mean you're building the store count pretty aggressively.

I'm just curious if there's a point or a tipping point where you think you hit critical mass on the store counts where it starts to fund itself and the older stores, or they're not that old, but the older stores mature to some degree and it can start funding itself. I'm just curious when you think that kind of tipping point hits..

Yeah. We think that's going to be somewhere in the 25 to 30 store range at one-year average age. So if you can sort of calculate that out, we'll be at close to 20 stores by the end of next year. So, it's somewhere in that ballpark.

Along the way, as stores mature and we get better at operating them and we adjust our model as we grow, those original stores are making money, and then the new stores are losing and so forth and so on as we run through it. And obviously we're trying to shorten the window. I don't want it to take a year to get profitable. I want it to take 90 days.

We're working on that, but we're not there yet. And a lot of that just has to do with getting the right people, getting the training done, getting your inventory lined up, getting your pricing for those zip codes, what's the competition doing. We moved into Denver and CarMax dropped their pricing down to 95% of market and opened three more stores.

So, that's great. That's good respect and it gives us the opportunity to compete. So, we'll see as we move forward..

Okay. Then, also on recon, I mean, I know there's been some discussion about doing some of this reconditioning at Manheim or maybe even ADESA auctions before you get the vehicles.

Are you finding that reconditioning is not worth the money there and that you need to do it yourself anyway? Or is there something else going on there?.

No, it's not the money. It's just they're ramping up too, and they're learning how to go through this. We are not getting as many cars out of them as we'd like. If I could get all the inventory I wanted out of them, I'd switch over tomorrow because I don't have to build the plants.

We don't have to deal with the people, the overhead costs that go with it. But there's a ramp-up period that's taking longer than we'd like with Manheim. We're working with them on it, but that's not something that's going to be resolved in the next six months..

Okay. And then just last thing on EchoPark. I mean, any thought about starting a Captive FinCo and writing paper? I mean, it's worked fairly well for CarMax.

Would that be something that could accelerate your earnings maturation in that business and maybe drive the business going forward?.

So I'll start and everybody wants to add in here. I mean, it's obviously a big topic of conversation that we've had around the company, something that we've looked at hard. We did not build the business model to be able to survive by having that entity, right. We built it to survive without it and to grow and mature without it.

It's certainly something that we can look at down the road. But from my perspective, short term here, that's not part of the plan.

Heath? Scott?.

Yeah. This is Scott. I think from a strategic look, there's a tremendous upside opportunity for us to get into that arena just with the portfolio of paper that we get out of EchoPark and out of the stores. Our loss ratios are really exceptional, I think, when you look at them relative to the industry, mainly because of brand mix and franchise business.

So, I do believe that there's a tremendous of upside down the road for us. Right now, we're really focusing on getting everything up and running and sticking to what we do best. I would not foresee us doing a startup.

We would probably end up having to acquire or partner with an existing organization that's in the origination business that has depth and knowledge. But it's something that we definitely have on the radar and have noodled over..

Okay..

This is Heath, just the last piece of that is from a capital allocation standpoint, as you know, it takes a lot of capital to start that kind of business.

And depending on your credit profiles, your return on assets are anywhere from 2% to 4%, so it'll be part of our capital allocation plan as we compare that to repurchases, acquisitions, and all other strategic options as well..

That's very helpful. And then just one last one on the core new vehicle business because it does matter, as we think about this, I mean, obviously there's a lot of risk with the rise in leasing and we've kind of talked about this last quarter.

I'm just curious what your experience has been on originations and returns as you look at this increase in leasing.

And then also maybe if you could add on what kind of incentives the automakers are helping you out with as maybe you're getting some people back upside-down on leases effectively with resids coming under pressure or actual, you think the price is under pressure..

This is Jeff again. They can't help enough. We got cars coming back all over everywhere in particular with BMW. And it's an issue. It might be an outlet at some point for EchoPark in a different market than Denver. But right now, we're fighting a good battle.

There is a lot of off-lease cars coming in and they need to do more quite honestly from an off-lease perspective and we got to find spots to put them all. But there's a lot of cars coming off-lease and I don't foresee that slowing down over the next six months to eight months.

I mean that's something that you got to be really good at dealing with because the manufacturer makes you take all of them or a big chunk of them. And so, great supply of used car inventory certainly coming off is going to put pressure on margins and we know the game. This has been going on up and down for years.

We just got a bigger sled coming than normal and we're dealing with it appropriately. We're lucky and blessed because our inventory systems to me are so good they kind of keep us out of trouble. Margins may go down a little bit.

But we're still able to do the big volume per store especially in our BMW stores that helps us offset the off-lease cars that are coming in..

I'm sorry.

But is BMW or the other automakers making you take these cars back at the residual or market level? And are you able to get these consumers into new similar leases or are they trading out to these high-quality used vehicles that you now have to offer them?.

Yeah. If you take BMW in particular, it's certainly below residual, but we're losing I would say somewhere around $900 a car if I had to take that car direct to auction without retailing it. So, we need more and more help. There's no question. And they've got their hands full, look, and we understand it. A lot of cars were leased.

They're pushing not to lease as many cars because there are so many off-lease cars coming. So it's a jigsaw puzzle that we're managing, and with their partnership, we'll figure our way through it. But it's certainly creating margin pressure. And anytime you have a nearly new car, it puts pressure on new car sales, puts margin pressure on new car sales.

When you combine all that and you put it in the market like Houston, it's kind of a perfect storm, right, because you've got the pressure from the energy sector. We've got a lot of BMW stores in Houston. That's a big, big issue with our quarterly EPS this quarter. And we're going to continue to fight it, and it'll blow through.

The market will turn around a little bit. We'll get through all the off-lease cars and be done with it..

And, John, I think it's important for everybody, just as a reminder – this is Scott – we don't have a financial obligation to take all these cars. Once we're full, if we need to say stop, we can say stop.

But kind of the way that I view this is, the manufacturers, it's in their best interest to clear the pipe and make sure that these inventories are flowing. And they've set the residuals way back when. And so far they're working very hard and we're working very closely with all of our manufacturers to make sure that the pipe is clear.

But there's obvious clear pressure that the number of leases coming in is tremendous and they are upside down if you just take them to the wholesale market..

I'm sorry, just to follow up, where are these consumers landing? Are they landing in new vehicles more or are they landing in used vehicles more often than they have historically when they come back?.

Some of them were trying to get back in their leases, but they're landing in new vehicles. I mean, they're coming back and landing in new vehicles. We got some brand-to-brand depending on what the offers are that are out there.

You might have someone from BMW going to Audi or vice versa, but they're more than likely coming back and landing in a new vehicle..

Very helpful. Thank you..

Yes, sir..

And your next question comes from Bill Armstrong of C.L. King & Associates..

Good morning, everyone. Just another question on EchoPark. So on the guidance where you have a larger loss from EchoPark than previously, I understand that involves the accelerated expansion of the new stores and the ramp-up costs.

Does it also incorporate any larger losses from the existing stores in the Denver market, or is that pretty much going along as you thought?.

No, it's kind of going along as planned. We've got one store there that doesn't hold enough inventory that we're not quite sure what we're going to do with it. We just sort of missed it. It only holds 100 cars on the lot, and we like the location. But if I could take that one back, I'd take it back. But we're going to make mistakes.

Starbucks makes mistakes when they open stores and they close them. So that's going to happen. The other ones are coming along nicely. In the Colorado Springs store, which we expanded the inventory holding capacity for that location, it's ramping up faster than any store we've had so far.

So we're really excited that that one store, I'm hoping that it'll be cash flow positive this quarter, which is its first full quarter of operation. We'll see if that happens, but it's certainly ramping up a lot faster than the other stores have and it's because of its holding capacity.

We just found that having 150 to 200 cars in the lot is not quite as appetizing as having 400, and that's kind of our number right now, and that's beginning to pay off for us. So it gives us a lot of confidence as we move forward..

Okay. Thanks for that. And then on the One Sonic-One Experience, in Scott's opening comments, I missed it. I think you mentioned a rollout into some other new markets.

I was wondering if you could just repeat those markets and maybe give us an overall update on how the One Sonic-One Experience initiative is going?.

Yeah. Sure. We rolled it out in the Pensacola market with our Audi and Honda stores. We've got a new Audi point and rebuilt a Honda store there. We've got Century BMW that's the South Carolina market. Of course, all of our markets in Charlotte. We've got some of the technology in Birmingham and Southern California.

And we're just taking our time in rolling that. It is a disruptive process, new CRM tool, a whole new process going into a store. So we have a lot of different focus items going on within the company, and we're taking our time. As a store matures and it rolls out and it produces more profit, then we take another bite of the apple.

It's not something that we're really speeding towards rolling out the rest of all the markets this year. And we'll continue to slowly mature One Sonic-One Experience as the profitability matures in each of those locations..

Okay, great. Thank you..

Your next question comes from Colin Langan of UBS..

Great. Thanks for taking my question. I do want to, more on the core business. I think we've covered EchoPark quite a bit. The same-store revenue in parts and services is up 1.5%, and when I look at the pieces, it looks like customer pay was down about 7% and warranty was up quite substantially.

How should we think about the outlook for overall parts and services going forward? And then what is the issue in customer pay this quarter and why is warranty so extremely strong? And is that just pure recall work?.

Yeah. Great question, Colin. So we've got a standardization project going on here and it's making customer pay and warranty look funny. And we announced this the last call or maybe in the call before that. But we're going to be dealing with this for the next few quarters. I think we've got two more quarters' worth of this, Heath said.

So look, overall we were up. We weren't up as much as the rest of the peer group. So we have an opportunity there. A lot of that's coming from our body shop business where we are just simply at capacity. And so we have got some opportunities to expand there, and that's a project that we'll work on in the second half of the year.

But that's what's causing that and causing the reflection in the numbers that you're seeing..

Got it. And how should we think about F&I per unit, up about 2%. Some of your peers seem to be seeing slowing growth there.

I mean do you still see a lot upside or is that opportunity getting smaller?.

Yeah. If you look at the peer group, you've got some stores that are in our range and then some stores, Group 1, I think, and AutoNation are up in the $1,600 range. So there's upside. We have an internal goal sort of this year of being at $1,400. We think that number can be $1,500. The brand mixes play a role in all this and obviously so does geography.

But we certainly think that there's plenty of upside from an F&I perspective..

Okay. And lastly, on sort of new GPU, it seems to be down again year-over-year.

I mean, at what point do you expect some stability on margins on the new side? And any color on the dynamics of the market? Are the OEMs still pushing stair-step incentives, putting pressure there?.

Yeah. If I can answer that question, I wouldn't need a job anymore. Look, at the end of the day, the margins have been all over the board. But I'll tell you what, we just had our board meeting. And when you look at it, if you look at kind of Q2 back to 2014, we were like $2,100 a copy, but $1,800 in 2015, $1,978 Q2 of 2016, $1,950 this year.

It's kind of flattening out, and I think there's going to be plenty of margin pressure going forward. And so the manufacturers work out some of the leasing issues they have, some of the inventory, which they're working hard on, some of the inventory issues. I continue to expect to have margin pressure from comparisons to years past.

But I don't think it's going to get any worse than it is at this point in time. It's leveling out. It's been about the same number for the last couple of quarters. So we know where it's at, we know where it's going to be, and unless something just tragic happens, I think the margins are going to kind of be in this ballpark for the next few quarters..

Got it. All right. Thank you for taking the question..

Yes, sir..

There are no further questions in queue. This does conclude today's conference call. Thank you for your participation. You may now disconnect..