Despite car sales fall, dealership convertibles still have worthwhile plays, Lehman Brothers report says

By Evan Weinberger

New York, Oct. 3 - Despite the downturn auto retailers have faced, convertible bonds issued by five of the six car dealership groups are worth a look, according to a Lehman Brothers report released Wednesday.

Each of the convertibles have their own attraction and could serve different investor needs, the report by Lehman Brothers convertibles research analyst Manoj Shivdasani said. But even though the collective median of the five auto retailer stocks that have issued convertibles is down 14% since July 19 - compared to the Standard & Poor's 500 0.4% loss since that period and a 2.3% loss in the Russell 2000 - investors looking for volatility trades, credit trades and view trades will find something in the six outstanding auto retailer convertibles.

Lehman Brothers estimates that 16 million cars and trucks will move off the lots in 2007, significantly lower than the 17 million average. Lehman expects 16.2 million cars and trucks to be sold in 2008.

Because around 40% of car dealership revenues come from high-margin parts and service, and the historical precedent of people buying cars after interest rate cuts, Lehman Brothers wrote that the dealership groups should be able to weather the credit crunch. Car sales have been hurt by the crisis in mortgages.

Investors looking for volatility would do well to look at Charlotte, N.C.-based Sonic Automotive, Inc.'s 5.25% convertible senior subordinated notes due May 12, 2009 and Bloomfield Hills, Mich.-based Penske Auto Group's 3.5% convertibles due April 1, 2026. According to the report, these convertibles are attractive volatility plays because of their durations - 3.2 and 3.5 years to put, respectively - and reasonably manageable rhos - 1.5 and 1.7, respectively. They also have decent deltas of 70% and 65%, respectively, relatively low implied vols of 28.8 for the Sonic convertibles and 28.4 for the Penske convertibles. Both have high gammas of 0.64%.

For investors trading on credit, Medford, Ore.-based Lithia Motors Inc.'s 2.875% convertible senior subordinated notes due Nov. 30, 2015 and Sonic's 5.25% convertible senior subordinated notes are the way to play, the Lehman report said. Both convertibles have an attractive 1.6 years to put with yields of 9.76% and 7.04%, respectively. Sonic has a better leverage profile, the report said, so Lehman Brothers cautiously recommended it. Investors willing to take on more leverage risk should look to Lithia, because 271 basis point incremental yield its convertibles carry.

Lehman recommends a light delta hedge on the car dealership convertibles because of the unsettled macroeconomic environment. New York-based Asbury Automotive Group Inc.'s 3% convertible senior subordinated notes due Sept. 15, 2012 provide a very attractive risk/reward profile of 44%/13%. They have a risk premium of 12.7%, a current yield of 3.41%, yield to put of 5.87% a 45.2% premium and a 48.3% delta. They're trading at 87.75.

Penske's 3.5% convertibles are trading at 106.75 and are putable in 3.5 years. The convertibles have a 3.27% yield, a 24.2% risk premium, a 65% delta and an implied vol of 28.4. Plus, Penske gets 32% of its revenue outside the United States - mostly in the United Kingdom - which diversifies its revenue and shields it from some of the problems facing the U.S. market.

Outright investors considering a long play on auto retailer stocks, the report said, should consider convertibles instead because of higher income and lower potential downside risk exposure.

Of the six convertibles in the small universe, the Lehman Brothers report said two are fairly equity sensitive - Sonic's 4.25% convertible senior subordinated notes due Nov. 30, 2015 and Penske's 3.5% convertibles.

Two are somewhat equity sensitive - Asbury's 3% convertible senior subordinated notes due Sept. 15, 2012 and Houston-based Group 1 Automotive Inc.'s 2.25% convertible senior notes due June 15, 2036. Sonic's 5.25% convertibles and Lithia's 2.875% convertibles are busted, the report said.

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