The first quarter of 2017 was framed by conflicting economic and industry data. On the one hand, unemployment dropped to 4.4%, average wages increased 2.5%, and home prices continued to rise. Auto retail also posted strong quarterly sales, marching toward another 16-17 million unit sales year, though tracking behind last year’s record.
Even with this positive data set, US GDP growth slowed in the first quarter and concern regarding the sustainability of auto retails’ high sales levels mounted. During the quarter, incentive spending increased 13%, to over 10% of MSRP or $16.4 billion dollars in total. With this level of incentive spending, new vehicle sales declined, albeit slightly, and inventories rose.
With this backdrop of mixed indicators, Kerrigan Advisors sees dealers increasingly assessing their expectations for future auto sales and profitability. The optimists believe today’s high sales plateau will continue for several more years, similar to the industry’s 8-year sales plateau between 2000 and 2007 (see Chart I). These dealers focus on auto retail’s growing and higher margin used car and fixed operations business lines, which they expect to sustain dealership profitability for the foreseeable future.
The pessimists, by contrast, are concerned about a sales decline in the near term. These dealers are increasingly worried that the industry may be pulling forward future sales and creating too much negative equity from extended loan terms. The pessimists are also focused on the industry’s sensitivity to the credit markets, specifically rising interest rates and the recent contraction in credit availability.
2017’s buy/sell market is being fueled by these diverging viewpoints. Those confident in the long-term health of auto retail continue to seek acquisitions and investments, trying to acquire great assets that rarely come to market. They are eager to put their capital to work in an industry known for its ability to remain profitable regardless of the economic cycle. They are also focused on maximizing the opportunities in the higher margin segments of the business model. By contrast, the pessimists, and those who are generationally ready to go out on a high note, are increasingly choosing to exit the market, selling their dealerships at today’s high blue sky values and avoiding a potential downturn. The confluence of these factors is resulting in a highly active buy/sell market, with conservative sellers and ambitious buyers.
Total Acquisition Activity
In prior articles, Kerrigan Advisors predicted that buy/sell activity would remain strong even as industry growth cooled, and, to date, that prediction has proven correct.
Transaction activity increased slightly in the first quarter of 2017, exceeding 2015 and 2016’s high pace. There were 60 dealership buy/sell transactions completed in the first quarter. At this sales rate, 2017 is tracking towards 240 transactions for the year and pacing ahead of 2015’s record level.
Among the franchises being acquired, domestics continued to grow their share of the buy/sell market (see Chart II). This trend is being driven by the growing market share of trucks and SUVs. Domestic franchises, particularly metro Ford and Chevrolet franchises, are in very high demand by buyers. Import luxury franchises saw their share of the buy/sell market decline by 45% in the first quarter, which may be due to the high prices commanded by luxury sellers. As the cost of capital rises, buyers will have a harder time justifying these asking prices and making the financial models work.
Key 2017 Buy/Sell Trends
With that backdrop, we point to three distinct trends which are impacting 2017’s buy/sell market.
Dealership Profit Plateau Shifts Buyer’s Focus to Current Earnings
As dealership earnings continue to moderate, buyers are more focused on valuing dealerships based on the most recent earnings performance. By contrast, Kerrigan Advisors finds sellers emphasizing valuation based on the average of the last three year’s earnings, hoping to get credit for 2015’s earning’s peak.
In other industries, it is common for businesses to be valued based on an average of several years of earnings. However, for a business to be valued in this manner, annual earnings are typically relatively consistent and often less cyclical. Auto retail’s challenge is that dealership earnings fluctuate, sometimes quite considerably, from year to year. Most buyers are sensitive to the cyclical nature of auto retail.
The recent decline in dealership earnings is primarily a result of increased expenses (see Chart IV). Kerrigan Advisors finds sellers are highly focused on their ability (or the buyer’s ability) to regain lost profits by cutting these expenses and improving operations. Most buyers, however, are less confident they can improve profits in a slowing sales environment. For transactions to get done in today’s market, discussion around this topic, and finding a common view between buyer and seller is required in order to get a deal done.
OEMs Differ on Buy/Sell Approval Process
In recent years, we have represented all of the major franchises in a buy/sell. Through this work, we have learned that each OEM has a distinct buy/sell approval process. These processes differ in communication style, length, requirements and information requests, with some OEMs being more flexible and others being more rigid.
Most OEM approval processes seem overly bureaucratic and cumbersome, from the dealer perspective. That said, there are certain OEMs who have worked hard to streamline the process, creating efficient online portals, enabling front line personnel to make decisions, and becoming more open minded to new capital structures and investors. By contrast, other OEMs seem very set in their ways, uninterested in improving their processes to the point of being commercially unreasonable. These OEMs often disregard the financial magnitude of a transaction to a seller and the time and capital invested by a buyer.
The differences between OEM approval processes become very apparent on multi-dealership transactions. Certain OEMs will complete their approval process in a quarter of the time of others, with half the paperwork. Other OEMs will string along a buyer, sometimes requesting information at an extremely slow pace, only to exercise their right of first refusal (“ROFR”) at the last moment or rush their approval through at the last minute, causing sever disruption to the overall deal and the transaction closing.
Kerrigan Advisors believes cumbersome buy/sell processes, particularly those which end in a ROFR, are value destroying to a franchise. Future buyers will hesitate to pursue franchises with high ROFR rates. Most buyers are highly concerned about the time and the opportunity cost of capital lost if a buy/sell ends in a ROFR.
As outside capital continues to enter the auto retail market, Kerrigan Advisors expects the OEM approval process to become an increasingly important piece of their investment equation. When buy/sell approval processes drag on, they inherently add risk to a transaction. Thus, franchises with efficient and friendly processes will likely see more transactions and could eventually garner higher valuations.
Dealership Business Lines Enhance Franchise Value
It is often said that a dealership is at least four different businesses rolled into one P&L. The new vehicle business usually represents the smallest portion of a dealership’s profit and yet is the primary driver of a dealership’s valuation multiple. Buyers continue to apply a single franchise multiple to total dealership earnings, rather than separate multiples to each business line’s earnings.
With this knowledge, dealers are increasingly building up their other business lines to increase dealership profit and, ultimately, total franchise value. This strategy is particularly apparent for the publics who have been acquiring collision centers and used car platforms at lower goodwill multiples, expecting to benefit from a valuation increase once the acquired business’ earnings are fully integrated. Large dealership groups are also employing this strategy, seeking to bulk up their used car sales and fixed operations, particularly for their luxury franchises. The return on investment from growing other business lines, whether through acquisition or organic growth, can be extremely lucrative, particularly for high multiple franchises.
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As industry headlines continue to be mixed, including negative year over year data, OEM restructuring, and leadership turnover, there remain very strong dynamics driving the buy/sell market. While terms are changing, and leverage is starting to shift from sellers to buyers, the transaction market is robust and will continue to be for the foreseeable future.