Moody's Investors Service has released a new report on Dealer Tire's risk amid pressure on profitability, uncertainty surrounding entry into online channel.

Margins to be under pressure amid operating challenges at premium tire manufacturers. Dealer Tire LLC's margins are likely to come under pressure as premium tire makers expand their own distribution operations and take measures to shield profits amid weakening demand and higher input costs. In addition, Dealer Tire's recent entry into online sales will be a margin drag as it is not likely to be a meaningful contributor to earnings for at least the next year. We expect the company's EBITA margin to decline by about 100 basis points in 2019.

Expansion into online distribution poses risks. Dealer Tire's acquisition of online replacement tire retailer SimpleTire LLC was aimed at tapping the surging growth in online replacement tire sales. Dealer Tire has a good operating track record and it will continue to benefit from the entrepreneurial savvy of SimpleTire's three founders, who retain a collective 20% ownership stake. But if SimpleTire's unique approach to the online tire market gains traction, other more deep-pocketed players may try to replicate it. Moreover, with large retailers among SimpleTire's most important customers, it will be difficult to improve profitability through price increases.

Leverage improvement to be slow, likely more aggressive in pursuing acquisitions under new sponsor. Despite anticipated earnings growth and the use of free cash flow to pay down debt, financial leverage is likely to remain elevated over the next two years. We expect Dealer Tire to grow EBITDA by just 1% in 2019 and 2% in 2020, based on our assumption that the company will face difficulties in boosting operating performance of SimpleTire and automotive aftermarket warranty provider Sonsio LLC, which it also acquired earlier this year. As a result, we expect adjusted debt/EBITDA to remain above 5.5x through 2020.

Strong position in dealership distribution channel. Dealer Tire retains a strong niche position in the dealership channel, which accounts for about 9% of the US retail tire market. By working with US dealerships, Dealer Tire serves a key role in selling customers their first replacement tires, when customers are more likely to stick with the same premium tires that came with their new vehicle. This has contributed to high supplier concentration, with the top 3 accounting for about 56% of its total sales. The purchase of SimpleTire could eventually reduce this high supplier concentration. But it would do so by creating a degree of channel conflict, with Dealer Tire then serving not just consumers in need of first-time replacement tires but also those in need of their second or third set of tires, which are more likely to be lower-priced value tires.

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Moody's report: Dealer Tire's risks mount amid pressure on profitability