Leadership training for the next generation of auto retail leaders
There is general consensus that the auto retail industry is in for material change in the years ahead. Many auto retailers may not be adequately preparing their leadership pipeline for those changes on the horizon. For the organizations and families who seek to continue operating in auto retail, it’s time to start evaluating your leadership training and the skills your leaders will require to succeed.
Historically, auto retail’s critical mass has enabled the industry’s extensive training programs and networking groups which are unique to our industry. In fact, I suspect few industries can match auto retail’s training and peer sharing. By way of example, for decades NADA has operated large educational programs aimed at all levels of the dealership organization, commonly known as NADA Academy.
On the peer sharing side, 20 groups actively compare metrics and share best practices amongst dealers – a construct rarely seen in other industries, and yet a staple in automotive retail. Many auto retailers are also proud of the fact that their leaders and prospective leaders started “sweeping the shop floor” and have worked every role inside their dealership as they rose through the ranks – understanding the business from the bottom up. And, some auto retail families insist that the next generation work for other auto retailers before coming back to the family business to gain the skills necessary to some day run their dealer group.
These training approaches share one thing in common: they are all intra-industry, and they focus on deep learning about the current business model, rather than focusing on the future business model. This training is no doubt valuable for playing functional roles within the company, e.g. service managers and parts managers. However, in an era of consolidation, tighter margins, technology disruption and higher financial stakes, these historical training grounds will not prepare most of tomorrow’s auto retail leaders.
Critical New Skills Supported by a Strong Foundation of Old Skills
There is no doubt that auto retail leaders will still have to excel in the core ways that have always been important to our trade, particularly the soft skills. Our leaders are generally exceptional at motivating are well trained in sales processes and instill competitive, metrics-oriented cultures. As the consumer-facing component of the automotive industry remains, those core competencies will continue to be critical to success.
However, our evolving industry will also add new leadership and management skills that will be key to future success. Of those new skills, I believe the following three will prove to be the most important.
Tomorrow’s leaders will have to combine the industry know-how of their predecessors with critical skills in business strategy and financial analysis. Many of these skills will be obtained from outside the industry through a four-year college degree, post-graduate programs such as an MBA, and/or professional management experiences perhaps with a Fortune 500 corporation or a rising start-up.
Instilling Organizational Culture
Auto retail organizations are getting big-ger. Slow, steady consolidation is creating increasingly larger organizations, even at
the local level. We are shifting from the world of running individual dealerships, often employing 50-100 to operating and growing companies of 500, 1,000 and 1,500 employees, which will dramatically increase operational complexity.
At these larger sizes, successful auto retailers will need to consciously forge an organizational culture in addition to an effective sales culture. This organizational culture will transcend the sales culture, and appeal to the many specialist and internal support roles required of a large, growing company in a changing industry. This organizational culture should also speak to the next generation of employees who are often seeking different types of compensation, work/life balance, autonomy in the workplace and social impact.
Effective auto retailers need to be highly competitive in the war for talent to com-pete successfully against tech companies, professional services companies and other retailers to attract and retain the necessary level of talent to adapt and thrive. This work falls on the leaders of the organization to design and implement organizational cultures and management structures that create these competitive and attractive organizations. This is a much higher bar than what the traditional auto dealership human resources roles have sought to achieve and will likely be a requirement for future auto retail success.
After a decade or two of discussion about change, we now stand at the precipice of information technology fundamentally disrupting virtually every other sector of retail, and automotive retail will sooner rather than later, follow these trends.
Leaders of auto retail organizations are making some big bets as to how all of this plays out and how to position their organizations for survival in the decades ahead. In other industries, this is described as road-mapping. That is to say, actively planning for the future. Technology com-panies are particularly aggressive in this regard, as they know that the lifespan of their products is measured in months, or at most a year or two, so they are continually planning, and updating their plans. They are actively thinking about where they need to be one year, two years, three years and even five years out. This is a critical component for survival in fast-moving sectors and entails making continual commitments and investments into where one believes their industry is headed. Successful bets will position your organization for the next leg; unsuccessful bets will put your company at a distinct disadvantage to your peers. And the process is ongoing.
Auto retailers will need to start thinking more actively about their technology strate-gy, and tie together their internal road map for how they want to position their organization for the next few years. Technology road-mapping will drive the conversation and will impact capital spending, training, staffing and a series of key management decisions. This is a level of internal planning that we do not generally observe in our industry today and will be a hallmark for how many auto executives position their organizations in the years to come.
Over the next 10-15 years, auto retail leaders will need to make a series of calculated risk decisions about how aggressively they plan to invest in various technology platforms, which ones to choose, how to re-train staff and pare costs from the existing real estate-intensive business model. Being too far ahead can be just as costly as being behind.
Developing Financial Acumen
In an era of consolidation, successful auto retailers will grow via acquisition. The average acquisition in the U.S. is now nearly $19 million, including real estate and working capital. Large, metro stores can easily range from $30 to $50 million. Managing and financing organizations on this scale goes well beyond traditional dealership accounting and financial statement reporting. The skill set required here shifts to true corporate finance.
As an industry, we are transitioning from the era of the family balance sheet, which has long been the primary financing engine, to an era of corporate balance sheets. That is not to say that families will not continue to play a very big role in industry consolidation, but the historical intermingling of family and business balance sheets will diminish. Professional capital will increasingly be the standard by which growth opportunities are assessed and transactions are funded. Industry leaders will require far more financial training and sophistication given the size of these businesses, and the requirements placed on them by investors and lenders. These are not skills that most can learn within today’s dealerships.
Tomorrow’s auto retail leadership will likely want to master the three skills outlined above. The training ground for many of tomorrow’s dealers will be business school, law school, private equity and corporations, not simply working through every role in the dealership.
There is always value in gaining exposure to an industry early in life. “Table talk” refers to growing up and possibly working in an industry when young. As evidenced by prominent auto retail leaders today, there is real accumulated value being raised in the industry. But, that type of training will not suffice for auto retail leaders of tomorrow. Though “sweeping the shop” will continue to remain an important aspect of our industry, there will be a greater emergence of industry leaders who have supplemented their leadership skills with experiences out-side the shop. Both training grounds will be key for auto retail’s future leaders.
2019 is another very active year in the auto retail buy/sell market, with transaction activity once again on track to exceed 200 transactions. Based on our transaction and consulting work across the U.S. and Canada, we have observed three trends shaping the current buy/sell market and setting the stage over the coming months and quarters.
In the last four years, the decline in blue sky values was primarily a result of lower earnings, rather than declining multiples. However, after four years of slight earnings declines, average dealership profits rose in the first half of 2019, despite a reduction in new vehicle sales. This increase drove average blue sky up slightly for the first time since 2015, reversing the industry’s four-year downward trend.
The rise in profits was driven by growth in higher-margin business segments, namely fixed operations and used vehicles, which grew 5.5 percent and 2.4 percent, respectively. Today, used vehicles and fixed operations, which earn gross margins 109 percent and 747 percent higher than new vehicles, are the driving force of industry profits and collectively represent 75.9 percent of the average dealership’s gross profit.
These segments are considered counter cyclical by nature, meaning they tend to grow when the economy contracts. When consumers reduce their new vehicle purchases, they often buy less expensive used vehicles or keep their older vehicles which require more service. Many dealers, including some of the public companies, will achieve record profits in 2019 because of the growth in these two higher-margin segments, despite declines in new vehicle sales. In this regard, auto retail has an ideally balanced business model – when the economy is strong, new vehicle sales are high and profits are strong, and when the economy is weaker, used vehicle and fixed operations sales grow, maintaining dealership profitability.
Backed by these counter cyclical revenue streams, dealership earnings should remain strong throughout 2019 and sustain today’s blue sky values into 2020, even in the face of a possible recession. The fixed operations business is well-positioned to continue its current growth rate as electric vehicles take an increasing share of sales. Electric vehicle customers have higher service retention rates, as well as elevated spending levels per service visit, alleviating the concern that electric vehicles will not require dealership service. Likewise, used vehicle sales are expected to grow as inventories of late models rise due to a growing volume of off-lease vehicles coming to market.
Growth in dealership profits is also bringing more buyers and investors to market. Increased buyer demand is supporting the continuation of today’s blue sky multiples, despite recession concerns. In fact, some investors are interested in auto retail specifically as an economic hedge against a recession. With this in mind, we expect average blue sky values to remain strong over the next two quarters, as industry profits stabilize and buyer demand remains high.
After a significant decline in acquisitions in the first half of 2019, public auto retailers are expected to increase their capital allocation to U.S. dealership acquisitions in the second half of 2019. This is not surprising given their strong financial performance in the first half (five of the six reported record earnings in the first half – see Chart III) and rising stock prices (see Chart IV). Year-to-date through July 31st, The Kerrigan Index™ is 589.25 and up an impressive 37.1 percent on average (see Chart V).
Public companies have a fiduciary responsibility to seek the most accretive investments for their companies’ capital. For some time, the pricing of their stock rendered many dealership acquisitions dilutive to earnings and made stock buybacks more attractive; however, with the recent rise in their market capitalizations, and the concomitant increase in their blue sky multiples, many dealership acquisitions are once again accretive to the publics’ earnings (see Chart V).
As U.S. dealership acquisitions become more financially attractive to public companies, we expect less capital will be allocated to other investments and foreign acquisitions. As shown in Chart VI, capital allocation to these investments has been on the decline since 2017.
Financing is a key component of the buy/sell market and blue sky values. Buyers logically tap into acquisition financing to reduce their equity investment and improve their return on equity (“ROE”). Financing is often the most crucial element of getting a transaction done in today’s marketplace. In many cases, buyers borrow more than 80 percent of the real estate purchase price and 50 percent of the blue sky. Based on today’s average real estate and blue sky values, acquisition financing averages $12.2 million per transaction (see Chart VII).
Given the high levels of financing in today’s buy/sell market, interest rates are incredibly important to the health of the buy/sell market. Kerrigan Advisors’ analysis shows that blue sky pricing, for instance, is inversely correlated with interest rates. As interest rates rise, blue sky values tend to fall. With this in mind, this year’s decline in interest rates is expected to support an active buy/sell market and potentially higher blue sky values (see Chart VIII).
“If I go back six months ago, nine months ago, and I looked at the forward curve you could have expected a higher interest rate environment in the second half of 2019 going into 2020. And now from today’s perspective, there’s a very good chance that we’re going to be seeing rate cuts not rate increases. So that’s a huge change in mindset.” –Mike Jackson, Chairman, AutoNation, Second Quarter 2019 Earnings Call
Furthermore, lower interest rates render the financing of vehicles more affordable, potentially increasing new vehicle sales or at a minimum reducing the decline. Like blue sky, new vehicle sales are inversely correlated with interest rates. Thus, rate reductions will provide clear benefits to the auto retail industry and support sustained industry profits, high levels of buy/sell activity and strong valuations.
“From a consumer point of view, the lending environment at the moment is very favorable. We haven’t had any issues obtaining financing for our consumers, but I think as interest rates decline that can only be positive for the consumer.” –David Hult, President & Chief Executive Officer, Asbury Automotive Group, Second Quarter 2019 Earnings Call
In summary, the buy/sell market continues to power through a period of flat SAAR and tepid top-line growth. However, dealers have pivoted to the elements of the business model that remain healthy and have higher margins. As such, profits remain robust, and deal activity remains strong. The public markets are also reflecting these positive developments, and the public auto retailers’ stocks are up sharply year-to-date. And, the lubricant of all transactions, interest rates, remain low and have been dipping yet lower. These factors underline the conditions for continued health in buy/sell activity in 2019 and into 2020.
Though SAAR remains relatively flat in recent years (see Chart I), the financial health of the largest auto retailers could not be stronger. Multiple public dealership groups are posting record revenue and profits through the first half of 2019. These results are driven by strong execution and strategic tilts towards the most profitable elements of the business model, namely F&I, used cars and fixed operations.
The Kerrigan Index™, the only index tracking the performance of the seven publicly traded auto retailers is up an incredible 37% as of July 31, 2019 (see Chart II). This recent performance is a great reminder of the strength and resilience of auto retail’s business model, and its ability to adapt to changing market conditions.
Since SAAR peaked in 2015, auto retail has been in the doldrums, managing in a new paradigm of no growth. Predictably, new car margins have compressed significantly, and bottom lines have come under pressure.
This period was aptly characterized as a plateau, but a plateau with a “hell
of a view” as noted by John Mendel, former head of American Honda Motor
Company. Dealers reliant on new car revenue and gross margin got squeezed. Many
dealers aptly refocused on higher margin business lines, namely used vehicle
sales, fixed operations and F&I penetration. Only 9.0% of the average
dealers’ gross profit stems from its new car department (see Chart III). Now, a
few years into this new paradigm, we are seeing industry profits grow, even as
the headlines continue to discuss shrinking SAAR numbers.
Revenue and Profits are UP
Even in a world of falling new car volume, average dealership revenue is up 3.9% through May 2019, with gross profits up 4.2% and profits up 1.4%. (The profit numbers are likely understated due to addbacks and adjustments applicable to most private dealerships.) While new car volume is down 2.8%, dealers are driving more revenue through their new car departments through a better mix of pricing resulting in revenue increasing 2.0%. And, used car revenue and fixed operations revenue are up 5.6% and 7.2%, respectively, underlining the strong environment for the auto retailers.
In looking at the publics, the second quarter 2019 numbers are even more compelling (see Chart IV). AutoNation posted record profitability, up 3.5%, crediting used cars, fixed operations and F&I for the gains, which resulted in a record earnings-per-share from continuing operations.
Asbury Automotive Group’s second quarter revenue and earnings rose 4.6% and 7.5%, respectively. Again, the trifecta of used vehicles, fixed operations, and F&I drove the strong performance. 86% of Asbury’s gross margin is derived from those three segments, though they only comprise 47% of revenue. Backing out unusual expenses tied to hail and extreme weather damage, Group 1 Automotive’s revenue was up 2.1% and earnings up 3.9% in the second quarter, driven by a 10% increase in fixed operations, and a record of $1,821 in F&I gross profit per vehicle. Lithia Motors’ revenue rose 4.0% while earnings were up 2.0%, again citing very similar drivers of improved performance. And, Sonic Automotive announced a revenue increase of 4.3% and a tremendous earnings increase of 57.3%, with much of the credit going to Sonic’s standalone used car stores, EchoPark.
Only Penske Automotive Group reported a decline in earnings in the second quarter, which was largely attributed to their significant footprint in the UK which is working through Brexit uncertainty.
These remarkable results are being announced at the same time as industry headlines are negatively reporting that “US sales may fall for the seventh straight month.”
Market Caps are Surging
The strength of the public auto retailers’ financial performance is reflected nicely in their recent stock prices, with The Kerrigan Index up 37% in the first seven months of the year, as previously noted, adding over $8.1 billion in value in that period of time (see Chart V). During the same period, the S&P 500 Index is up a strong 19%, but six of the seven component stocks of The Kerrigan Index are tracking well ahead of the S&P’s gains. Sonic is up a stunning 102%, followed by Lithia (+70%), and Group 1 (59%), while AutoNation, Asbury, and CarMax all up over 30% in the first seven months of 2019 (see Chart VI).
It is worth repeating that stock prices reflect the consensus on future earnings of a given company. The strong gains in the stock market show the consensus that the earnings outlook for auto retail has improved considerably, despite several economic analysts’ predictions that we are overdue for a macro-economic correction.
This seeming contradiction between booming auto retail stock prices and the anticipation of a cyclical correction is testament to the diversified and countercyclical nature of the auto retail business model. While the economy flows through cycles, the flexible cost structure of auto retail allows dealers to shift, adapt, and stay profitable.
For example, during the most recent recession, dealers decreased expenses and saw their net to sales improve 220% in 2009 as compared to 2008. (see Chart VII). Profitability, both current and future, is what is driving these stocks upward.
And What About Disruption?
Anyone in auto retail cannot help but notice the regular flow of articles and dire predictions about the tumultuous change just around the corner for auto retail. There are regular predictions on how autonomy, connected cars, electric vehicles, and shared vehicles will significantly impact the current business model, as well as the added threats of manufacturers attempting to go direct to consumer such as Tesla has.
Here again, it is worth pointing out that the stock market reflects the best, most-informed consensus on the future earnings of companies. Auto retail’s resurgent stock prices indicate that the current consensus is that disruptors are unlikely to impact earnings anytime soon. The challenges brought on by technology are either too far off, or too unknown, to dampen stock prices. While the stock market is not perfect, it does represent the best collective guess on future earnings, and the earnings outlook for dealers today is stronger than it was one year ago.
Last year, Kerrigan Advisors was one of the few voices predicting profitability in auto retail would improve in 2019 irrespective of SAAR. It turns out we were right, despite all of the negative industry chatter. Dealers are very adaptive to shifts in local market conditions, can bring down variable expense quickly when required, and have compelling, high-margin alternative business lines. In light of these factors, good operators can and will adjust to the current SAAR and grow profits. 2019’s earnings performance shows that is precisely what dealers are doing.
In recent months, industry articles and editorials have suggested that the long bull run in the buy/sell market has come to an end. We beg to differ. In fact, these recent opinions are not backed by data. In the first quarter of 2019, transaction activity actually rose 39% over 2018 (see Chart I). And, the number of multi-franchise transactions remained high at 14 (see Chart II). These are not signs of a slowing marketplace.
Clearly, dealers today are facing a tougher operating environment versus the halcyon days preceding 2016 when SAAR was growing at an average annual rate of 7.5%. Today, monthly SAAR is flat or declining, costs are up and interest rates have ticked up from record lows. But, that is not the whole story. Average dealership revenue and profits remain near record highs and overall industry health remains solid.
For many dealers, March and April were the best months of operating performance in years. Dealers have shifted their focus from new car sales to other, more resilient parts of the dealership business model. Those dealers who have grown used, F&I, parts and service have fared very well during this period of declining new car sales.
From our vantage point, these good operators who have shifted their focus are thriving. In fact, some strong dealers have more cash in the bank than they could possibly ever spend. They are opportunistically buying stores, and in some cases, biding their time to see how the macro-economic cycle plays out. These operators are focused on expense control given low topline growth, and the lower margins associated with the new car department. And, as always, they are growing the countercyclical parts of the auto retail business model.
While some investors and operators are worried about the sales downturn, recall that auto retail generally bounces back very quickly. The best example of this is how dealers brought down expenses rapidly in reaction to the financial crisis of late 2008, remaining profitable, and even increasing net to sales over prior years (see Chart III). Auto retail quite simply is a resilient industry.
In our experience, the transaction environment remains active and healthy, with transaction volumes up year over year (see Chart I). Valuations are high, particularly when including dealership real estate which is selling at peak valuations (see Chart IV). In recent months, our firm has had an all-out bidding war over a top luxury franchise in a major metro. We have put three dealerships under contract at the highest end of Kerrigan Advisors Blue Sky Multiple range. Contrary to some industry commentary, for quality franchises, we are not seeing a soft buy/sell market.
As I have noted in prior Dealer Magazine articles, there has been a flight to quality in recent quarters, but that does not mean the market is weak. Buyers are very aware of the unusual length of this economic cycle and are thoughtful about their capital allocation. They are willing to step up for excellent opportunities, as defined by the intersection of brand, facility, location and performance. But, they are shying away from some franchises, particularly those reliant on high-volume, new car gross, and stair-step programs.
There have been a handful of recent national stories of financial distress within the dealer body. In a highly fragmented industry, there are always examples of entrepreneurs getting upside down. After 10 years of growth, historically low interest rates, and unique access to credit, it is not a surprise that some dealers have gotten overly indebted.
In one case, a dealer had built an organization with multiple lower quality brands, became overly reliant on one strong cash flowing store to fund the overall enterprise, and simply became overextended with facility and real estate debt. Other cases have been just bad business practices, including being out of trust and undercapitalized. However, in today’s environment, these are the exceptions, not the norm.
To borrow an oft-used phrase, yesterday is history, and tomorrow is a mystery. Today is a gift and that’s why it’s called the present. This aptly sums up our situation in automotive retail today. It’s not perfect, it’s not ideal, and it never will be. But, the overall operating environment is positive and attractive deals continue to get done. We do not make predictions as to how long this cycle will run, but we recognize it for what it is – a good time to be in auto retail.
We are coming off yet another great year of high automotive retail transaction volume, and the good news is that deals continue to get done in the 2019. From our vantage point, 2019 will be another strong year for buy/sell activity.
(See Chart 1)
That said, we observe that buyers are getting much more selective in the acquisition process. With SAAR flattening and the economic cycle showing some signs of slowing, many buyers are growing perceptibly more cautious in their willingness to underwrite deals. We characterize this as a classic “flight to quality” phenomenon that is common in late market cycles. However, it is worth noting that the assumption that we are late in the market cycle is exactly that – an assumption. Only time will tell just exactly where 2019 lies in this economic cycle.
In these circumstances, buyers fear overpaying for earnings that are not sustainable, which quickly creates a gap in buyer and seller expectations. Sellers look at current or trailing three-year performance and take the position that they should get a fair multiple on earnings. Buyers, on the other hand, don’t disagree in principle but fear that tomorrow’s earnings will be down and are increasingly apprehensive to step up to the plate on valuation.
This does not mean that highly valuable dealerships are being completely ignored. Buyers recognize great assets when they come to market. Top brands and strong locations, which infrequently become available, are attracting good offers. Certain buyers will purchase exceptional assets regardless of market conditions, knowing that these franchises rarely come to market. Moreover, dealerships in growth markets with great brands have a more resilient business model and are more likely to sustain profit levels during an economic downturn.
In today’s marketplace, two types of dealerships are particularly difficult to sell: underperforming dealerships and franchises tied to aggressive stair-step programs.
In a growing market, buyers are willing to assume risk by taking on an underperforming store and making improvements to enhance profitability and their return on investment. However, in a flat or declining market, buyers are less confident in their ability to improve performance in the face of industry headwinds. Therefore, they are less comfortable projecting improved performance or paying a multiple on pro forma earnings. Rather, buyers value franchises based on a seller’s current performance, giving little credit to upside potential or prior year’s higher earnings. As such, in today’s market, it can prove very difficult to receive value for turn-arounds and underperforming dealerships. Likewise, franchises representing OEMs that rely heavily on stair-step programs are also becoming increasingly difficult to monetize in today’s marketplace. While never preferred by buyers, these volume-based business models are even more challenged when month-to-month new vehicle sales volumes are more volatile or declining. The dealership model is complex enough without the challenges of fluctuating stair step programs. Trying to meld pricing, marketing, and ad spend with fluctuating monthly stair-step programs is often a step too far for most buyers in a slowing sales environment. Thus, we are seeing noticeable falloff in buyers’ willingness to purchase these more challenging franchises.
Given buyers’ flight to quality, we point specifically to the strength of the franchise business model and a dealership’s geographic market as being the two major drivers of value in today’s buy/sell marketplace.
Business models increasingly determine buyer demand.
Post-recession dealers were very eager to expand their enterprises and willing to consider a broad set of franchises for acquisition. However, as industry sales started to plateau and ultimately decline, buyers have become more discerning in their franchise acquisition preferences.
We have found that the pool of buyers only interested in specific high performing franchises with attractive, long-term investment characteristics is growing. Specifically, buyers today are focused on franchises with better business models, namely high sales per dealership, strong fixed operations, consistent sales incentive programs, well-funded captive finance companies and excellent dealer relations. These requirements are not surprising when considering how franchises with these characteristics fared during the last recession. Most maintained dealership profitability and saw their sales quickly rebound after the credit crisis.
We expect top franchises, such as Toyota, Honda, and Subaru, to experience continued growth in their buy/sell market share in 2019 (see Chart 2), while weaker franchises to experience declines in their buy/sell market share due to anemic buyer demand. Today’s buyers are particularly unattracted to franchises with poor dealer relations, highly variable incentive programs, less supportive captive finance companies, low sales per dealership and weak fixed operations. We are finding more buyers are avoiding these franchises unless they are included in a larger platform transaction.
With regard to luxury franchises, we would expect the top franchises to grow their buy/sell market share in today’s selective environment; however, as interest rates rise, these franchises’ high multiples can be challenging for buyers to justify, thus reducing transaction volume. This does not drastically reduce the value of top luxury franchises, and for those buyers with a long-term investment horizon, top luxury franchises are attractive “buy and hold” investments, even at today’s valuations.
Transaction activity increasingly varies by market.
Today’s buyers are not only selective on brands, they are also selective on geography. While growing dealer groups, particularly those backed by professionally managed capital, are still willing to enter new markets for the right platform acquisition, the markets of interest are becoming increasingly limited. Growing population centers and business-friendly states are in very high demand, while smaller markets or those with less economically attractive characteristics garner much less interest from buyers. Buyers are increasingly wary of cities and states with high taxes and regulations, as these are more difficult to overcome revenue challenges in the face of a potential downturn. Buyers are also increasingly focused on acquisitions in their existing markets, seeking to enhance their auto retail market share and gain greater economies of scale. Dealership groups that “own” a market are better positioned to adapt their business model in a changing auto retail environment. Many expanding dealership groups believe high MSA market share is key to future success. Likewise, buyers often place a higher value on groups with significant existing geographic concentration over groups that are dispersed across multiple markets. Dealership groups that can provide an attractive platform from which to grow are more valuable than those that lack a strong geographic presence. The dealership model remains highly profitable, and attractive to many buyers. There are frankly few industries with the return on capital offered by sound dealership investments.
And there remains strong appetites for good dealerships representing attractive franchises and attractive markets. But there is no question that there has been a shift in the marketplace, and there is a discernible migration to higher quality in vestment opportunities. For those that have positioned themselves with strong brands in strong markets, rest well knowing that there continues to be good liquidity options for you as you assess your strategic options. For others, a hard-working, focused dealer can generate profits with virtually any franchise; however, the window of opportunity to monetize some of those franchises has diminished.
An oft-repeated phrase we hear regularly from dealers considering selling their stores is “I already have identified a buyer.” Well and good, but “having a buyer” and getting a transaction closed are very different, and often not all that correlated. For dealers that are serious about selling their dealerships, do not confuse identifying a possible buyer with a successful sale process.
Frankly, one of the unique aspects of auto retail buy/sells is how infrequently transactions close. I’d be hard pressed to find another industry in which the conversion rate of “deals” to executed transactions is so low. And, there are some basic reasons this is the case. I’d point to three specific issues that largely explain why our industry struggles with this issue.
First, it’s a common habit of dealers to respond to calls from prospective buyers. Buyers reach out to auto dealers in myriad ways, ranging from the direct dealer-to-dealer conversations at 20 Group meetings, hiring bird-dogs to scout specific regions, and even dedicating young, full-time staff to “dial for dollars.”
Case in point, a Southern California dealer thought he was being approached by a large public two years ago. The dealer was excited as he was seeking the chance to grow his platform, and possibly “team up” with a much larger company. He eagerly engaged with the individual who called him, signed an NDA, shared financial information and discussed the prospect of selling. As it turned out, his discussions were with a free agent, or a bird dog, working on behalf of a publicly traded auto retailer, who later informed the dealer that the public was not interested in buying his business. The dealer was crestfallen and disappointed that he’d invested months in going down this unproductive path.
The recent entrance of private equity and outside capital has further upped the game. Professional investors allocate significant resources to business development, which in this case is defined as “the process of identifying as many deals as possible, to create a large pipeline of possible investments.” Business development efforts are usually staffed by junior investment professionals or can take the form of outsourced call centers that simply represent investment groups. Similarly, there are companies called “buyside firms”, which are a more sophisticated version of outsourcing services to identify deals. In any case, all of these efforts represent the very top of the investment funnel. Calls, extensive conversations and even data sharing with these individuals is the equivalent of a first date. These individuals are no more authorized to buy your dealership than your newest car salesmen is to sell it.
When considering professional capital, it is critical to understand their business model. Professional investors are in the business of identifying a few grand-slam investments each year, usually spanning a wide range of industries. The best practice to achieve that annual goal is to identify hundreds of deals to send through their investment funnel. They often discuss “100 to 1” – that is to say, an active firm will evaluate 100 deals for each deal that they do. The business development professionals mentioned above are charged with identifying those hundreds of deals, so it’s important to view any outreach and any conversation in that light. There is a one percent chance that these early conversations will result in a sale, regardless of how much their “interest,” “excitement” or “commitment” are discussed.
Another recent anecdote underlines this point. The management team of a large, successful group met with a private equity firm that expressed great interest in auto retail and investing in their very large enterprise. After a series of dropped balls and miscues, it became apparent that the individual was in business development (discussed above) and had not even presented the investment opportunity to the investment professionals at the firm. Many weeks later, after repeated outreach on the part of the dealer, the management team and an investment partner spoke for the first time, the deal was introduced, and the conversation went nowhere.
The over-arching point is that responding to an inquiry is a low probability strategy for selling your dealership or dealership group. An exciting first call should not be confused with a serious interest in your business.
Shifting to the second major structural issue: timing and leverage. Even assuming that there is real interest on the part of a prospective buyer, responding to buyer outreach immediately hands all of the leverage in the sale process to the buyer. The buyer has now “tied up” the conversation for a period of time, has the ability to review information on their own timeline without anticipation of a competitive sale process, and can ultimately offer a price in a non-competitive setting, which often results in a lower sale price or no sale at all.
None of this is to the advantage of the seller.
There is no control on timing, no control on price and no guarantee that there is serious intent. To cite another recent example, an East Coast dealer received a very persuasive outreach to sell their business to a pair of auto industry executives backed by big capital. They went through a very drawn out process of due diligence, negotiation, and renegotiation. After repeated delays, the dealer learned that the buyers were drawing out the process, so they could raise the money to fund the acquisition. The dealer was pregnant with the transaction and did not have the energy to start over, so he gave them yet more time to line up the capital and see if they could close. The buy/sell did eventually transact, but only after significant delays, uncertainty and price concessions on the part of the dealer.
Similarly, a top dealership group was approached by a very real, deeply capitalized family office about selling their business. Calls and meetings took place, meals shared, and significant data was sent to the family office over many months. Yet, for all of this work, the transaction did not progress, and the family office indicated they were “watching the business performance to get comfortable”. After 18 months and no action, our firm was hired to sell the group, and the family office did not even participate in the sale process. Ultimately, they were not serious buyers in our industry, but they were happy to tie up the investment opportunity so as to add more potential opportunities to their pipeline.
Finally, the third issue is that dealers often engage in transaction discussions without doing the pre-work necessary to achieve a successful sale. Finding a buyer is the simplest step in the sale process. The challenge is getting a transaction to the finish line. In the absence of clean accounting, clearly defined add-backs, updated appraisals, litigation logs, performance analysis and other disclosures, a sale does not generally go through. A real deal can only happen after reams of information are shared and analyzed and the buyer has the required information he needs to support the sale price and close on the transaction. This requires a lot of upfront work and preparation.
In our experience, there is an extensive list of dozens of materials that must be reviewed, analyzed and often updated in order to achieve a successful sale. We are big believers in the need to get that work done in advance of talking to buyers. Until you have done all of this work, I would argue you do not have a real buyer. You have a tire kicker. A buyer simply cannot commit to a deal, particularly one with a strong valuation, until there’s been a very thorough assessment of all of this information and more.
The anecdotes that I am sharing are representative of many dealer experiences in recent years, and these failed efforts to initiate transactions can be tied to three key issues: the business model of professional investors in which they review 100 opportunities to find one investable business, granting too much leverage to buyers by responding to their inquiries, and lack of preparation for a transaction.
In our experience, the way to maximize the odds of a successful transaction on favorable terms to the seller is to get prepped in advance and run a competitive sales process. Car dealers understand the importance of a defined, effective sales process in selling cars, and that applies to the buy/sell world as well. If you want to sell the car, hold gross, and actually transact, a best-practice sale process is key to success. Selling your dealership is no different.
Buy/sell activity remained very robust in 2018 – the fifth consecutive year of over 200 transactions. Underlying today’s robust buy/sell market is the growing U.S. economy. GDP increased 4.5% in the third quarter and wages rose at 2.9%, the highest level since 2009. With the unemployment rate at 3.7% (the lowest level since 1969), consumer confidence hit an 18-year high in October. The strength of the U.S. economy is sustaining auto retail’s high sales levels and today’s active buy/sell market.
With this strong backdrop, below are the key trends my firm sees shaping the 2019 buy/sell market.
Generational Transfers Increase the Number of Sellers Coming to Market
The auto retail industry is primarily a family business. For decades, dealers have passed their businesses onto the next generation with great success. This transition from generation to generation defied the family business odds. Only 30% of family businesses are expected to transition to the second generation. By contrast, Kerrigan Advisors estimates the majority of today’s dealers are second generation or greater. Auto retail’s succession record is a statistical aberration.
The challenge today comes as a growing number of third and fourth generation dealers are aging into the succession plan. Kerrigan Advisors believe most dealers are currently in the process of transitioning a portion of management and ownership from one generation to the next, with a significant number in the third and fourth generations. These generations have a much lower likelihood of successfully taking over the family business. Only 12% of family businesses transition to the third generation and only 3% to the fourth. (See Chart I)
As an increasing percentage of the dealer body fits this generational make-up, it is not surprising to see more sellers coming to market. As the number of dealers continues to decline and the store count required for success rises, many of these families realize the skillset required to run a handful of dealerships is quite different for a large multi-dealership group. This is particularly true for the third and fourth generations who are in their 20s and 30s. These up-and-comers see an industry that will transform significantly over the next 20 years, making their careers more volatile and challenging. Some are concerned that the value of their inherited family enterprise will decline, rather than appreciate. These risks, coupled with the challenges associated with transitioning to higher generations will continue to be a driving force for further industry consolidation. (See Chart II)
A Growing Pool of Financial Investors Support Consolidation
With all the change expected in auto retail over the next two decades, it may seem surprising that financial investors are eager to support dealers’ expansion plans. The volume and interest of equity and debt investors in auto retail continue to rise, despite the much-discussed risk to the industry’s future. For the same reason some dealers feel the time is right to sell, an increasing number of sophisticated investors believe the time is right to invest. These well-funded investors see a tremendous opportunity to support growing auto retail groups who are seeking to capitalize on consolidation and the inevitable opportunities industry disruption will create.
The make-up of these investors is broad and diverse, from high net worth individuals to institutional investors. On the equity side, family offices are the most common because their long-term investment strategies are aligned with those of the OEMs and thus approvable in a buy/sell. In addition, OEMs are more comfortable with the family office structure/governance because it is very similar to that of the large family-owned dealership groups. In fact, many of the largest auto retailers have their own family offices for investment purposes.
On the debt side, the largest U.S. banking institutions continue to finance sizable acquisitions for growing dealership groups. These lenders focus on identifying the dealers who will drive industry consolidation and want to ensure they are part of the tremendous financing opportunity consolidation will provide. They also feel a sense of urgency to develop relationships with buyers, rather than sellers, to retain market share in the long term.
In addition to traditional lenders, bond investors have shown a willingness to finance private group expansion and buyouts. Most recently, the Ken Garff Automotive Group, one of the largest private dealership groups in the U.S. with over $4.5 billion in revenue, successfully sold $375 million worth of bonds to finance the buyout of its equity partner, Leucadia. Garff’s buyout of Leucadia, which is the largest transaction of 2018, resulted in an enterprise value for Garcadia of $675 million. Garff likely chose to finance the buyout with debt, rather than equity due to the lower cost of capital charged in the bond markets. Garff’s bonds pay a 7.5% interest rate, which may seem high relative to traditional bank financing; however, it is very low relative to private equity which usually requires at least a 20% return (as can be seen in Leucadia’s high returns noted in Chart III).
As auto retail continues to consolidate, Kerrigan Advisors expects the pool of capital available to growing dealership groups with well-conceived expansion plans will increase, providing multiple financing options for growth.
To Achieve Pricing Goals, Sellers Increasingly Accept Structured Transactions
Blue sky multiples have remained relatively consistent in 2018, despite the industry’s sales plateau. Seller’s understand their blue sky may have declined due to lower earnings; however, they still expect a strong blue sky multiple in order to complete a sale. This can be tricky for buyers in a rising interest rate environment where their cost of capital is also increasing.
Kerrigan Advisors finds the most innovative buyers are meeting seller’s pricing expectations and their own return on investment requirements through structured transactions. These transactions usually include some form of seller financing and/or the retention of a minority ownership stake by the seller (also known as “rollover equity”). In both cases, these structures reduce the equity capital required of the buyer and thus increase the buyer’s return on equity, while still meeting the seller’s pricing expectations.
In the case of rollover equity, the seller usually retains a minority ownership position in the dealership post-transaction. Unlike traditional buy/sells, which are typically asset sales, these transactions are usually stock transactions and subject to increased government oversight, particularly as the transaction increases in size and complexity. In most of these transactions, the seller contributes their business’ assets to a new legal entity which then sells stock to the buyer. It should be noted that only brokers who are licensed with FINRA and regulated by the SEC are legally permitted to sell stocks or securities in a private company with few exceptions. A buyer could rescind the transaction after closing if it is found that the seller is not represented by a licensed broker.
Amidst an active discussion of change, robust transaction activity, and consolidation in our industry, it is worth considering just exactly why this is all coming about. To put it simply: the benefits of size are really starting to play out. And it’s not just a story of economies of scale, though that is certainly part of it. Increasingly, large groups are using their size to diversify, innovate and better position themselves for the future.
Platforms Getting Larger
To start with the numbers, there is clearly a bias towards larger platforms. While consolidation has been discussed for two decades or more, the past five years has seen a record level of transaction activity. Kerrigan Advisors estimates 1/8th of the dealer body has changed hands since 2013. Multi-franchise transactions are up 43% through the first half of 2018 versus the first half of 2017 (see Chart 1), and now the average multi-franchise transaction represents 3 ½ franchises.
There are now 176 dealership platforms with more than 11 dealerships, which represents an increase of 63% since 2010 (see Chart 2).
The publics also continue to grow their platforms through dealership acquisitions. After a strong year of acquisitions in 2017, acquisition spend is up an additional 9% in 2018 and the publics are tracking towards one of the highest levels of acquisition spend in the last 10 years (see Chart 3).
Economies of Scale
Upon reviewing the financials of the publicly traded auto retailers, their SG&A (sales, general & administrative) expense as a percentage of gross profit, even with all of the expenses associated being a publicly traded company, averages just under 73%. It is fair to assume that many large private players, without the expense of operating as a public company, are less than 73%. When we compare that to the smaller dealer operators, who have historically been the nimble players in our industry, we see average SG&A expense far exceeding the public’s rate of 73%, coming in just shy of 90% (see Chart 4).
And when viewing the statistics over time, this is an issue that is getting worse in recent years (see Chart 5).
While there are some basic things that larger players can do more efficiently, such as advertising, human resources, and in-house legal, we believe this story is fundamentally about technology.
The cost of adopting new technology, and signing up for new subscription sources, is really driving up the cost structures of many independent dealers and smaller groups. By contrast, larger groups are leveraging the same technologies, and more fundamentally, changing their operations to drive cost efficiencies.
Economies of Scope, Broadening Operations
Perhaps even more impactfully than economies of scale, we are seeing larger players flexing their ability to broaden their business models at a time when new-car profits are shrinking (new car gross margins are down 49% versus 2011 – see Chart 6).
To quote David Hult, Asbury Automotive’s CEO on their first quarter earnings call this year, “Our plan for the remainder of 2018 is to focus on the aspects of he business that we can control, specifically, parts and service, used cars, F&I and overall expense management.”
Large groups are diversifying away from the new car business in multiple ways, including:
AutoNation has also made a very significant commitment to acquiring collision centers, and now operates 81 collision centers across the US.
Sonic Automotive, AutoNation, and Group 1 Automotive are investing in standalone used car dealership concepts, Echo Park and Val-U-Line respectively, to pursue the higher margin used car business. Interestingly, Val-U-Line is targeting used car segments that many dealerships choose to wholesale, representing a real expansion of the scope of Group 1 Automotive’s operations.
Holman Automotive continues to grow into fleet management, now operating the largest privately-held fleet management company in the world. (This will likely pay dividends as automotive retail continues to experiment with different kinds of fleet management and subscription models.)
And, some such as Penske Automotive Group are diversifying outside of the US market. Penske continues its international expansion with the completion of its acquisition of Car People, a used car retailer in the UK earlier this year.
Tapping Scale to Innovate
Large groups are also tapping their scale to innovate and try new ideas in an industry that we know to be changing. To cite a few examples:
AutoNation has been using its strong market presence in the Phoenix MSA to partner with WayMo, offering its customers a Waymo vehicle instead of a loaner. AutoNation also announced a partnership with WayMo to complete the service needs of WayMo’s autonomous fleet.
Lithia recently announced a strategic partnership and $60 million investment in online used car platform Shift. Shift aims to simplify and bring online the transaction process, and Lithia is able to put its very significant used car inventory on this platform by way of this partnership.
Penske made a strategic investment in Fair, an innovative platform that allows for flexible-length, all-in vehicle subscriptions to consumers. This overlaps nicely with Penske’s largely luxury platform, providing them direct experience in new types of flexible ownership and fleet management.
Other large regional groups are trialing Clutch to gauge new subscription concepts and fleet management as a business model.
The Warren Henry group out of Florida announced they are rolling out their own subscription model, FlexWheels, in which they will allow customers to shift between different makes and models – a subscription service that is dealer centric versus OEM centric, much like Clutch.
Publics, like AutoNation and Lithia Motors, and private dealership groups such as Del Grande Dealer Group (DGDG) in Northern California are announcing the addition of CTOs (Chief Technology Officers) to the executive leadership team. DGDG has multiple technology initiatives underway, including innovating real-time tracking of regional inventory and pricing of used cars, as well as highly efficient, real time evaluation of different online media campaigns.
Though there has always been some benefit to size in automotive retail, the benefits of scale are becoming increasingly clear. Starting with overhead expense, large groups are operating at a distinct cost advantage to smaller players. And, increasingly, large groups are using their size to expand the scope of their operations, diversifying away from the new car business, and using their cash flow and balance sheets to innovate. This is a phenomenon that has been seen many times in other industries and is starting to play out in automotive retail.
We regularly talk with dealer groups that have been considered “the big guy” in their local marketplace, but even these management teams are feeling the need to get bigger, and to accelerate their acquisition plans. While uncertainties remain about the future of auto retail, there is one peg you can hang your hat on: consolidation is here and will accelerate in the coming years.
The most under reported story of our industry today is that of rising interest-rates. Given all of the headlines surrounding tariffs and trade wars, politics and a booming economy, the topic of interest rates in our very rate-sensitive industry is not getting sufficient attention.
The Fed has now raised interest rates 7 times in this current cycle of rate hikes starting in December 2015. Moreover, Fed Chairman Jerome Paul said in July 2018 that the Fed intends to continue to increase interest rates once every quarter for the foreseeable future. That puts interest rates on a path to add 100 basis points (or 1%) in interest expense over the next year. This is the most aggressive set of interest rate rises since the period of 2004 to 2006 when the Fed raised rates 400 basis points over 2 ½ years in the run up to the 2008 financial meltdown. (To be fair, the increases in rates were an attempt to prevent economic over-heating and a financial meltdown, but that is not how things played out, as we all know.)
Rising interest rates impact auto retail in very direct ways as it relates to operations and financial performance, and some less direct ways as it relates to the buy/sell market. As we enter this period of rising interest rates, it is worthwhile to think through the implications.
Interest rates are unique in that they impact multiple aspects of a dealership P&L, starting right at the top with the revenue line. All things being equal, rising interest rates increase the cost of financing a car and will inevitably lower car sales. With that said, there are other drivers of car sales including today’s record low unemployment and rising wages; however, it is worth remembering that rising interest rates themselves depress industry revenue. (That is actually the point of rising interest rates: to moderate the growth of the economy, so as to avoid unhealthy levels of inflation.)
At the same time, interest rates directly impact multiple elements of a dealership’s cost structure. Dealers today are all starting to see the rising cost of floorplan expense, a line item that was often a net contributor to profit in recent years given flooring credits. Average floorplan has recently flipped from a net profit contributor to a growing expense. In 2015, the average dealer made over $100,000 from floorplan. Today, the average dealer is tracking to over $50,000 in annual expense. That’s a threefold change in floorplan expense in just three years.
Additionally, for dealers with corporate debt and cap loans tied to floating rates, interest expense has already risen considerably. Since January 1, 2017, the 30 Day LIBOR rate, the most common benchmark for acquisition debt, has risen 160 basis points. For other dealers with fixed interest term loans, they will see the impact of rising interest rates when those loans reset in the coming years. The average term for a commercial loan is 5 to 7 years, so there may be some delay in the impact of those higher refinancing rates, but they are certainly in the offing.
And, we are already seeing the cost of higher interest rates reflected in rent. The combination of increasing facility requirements and higher interest rates are materially driving up rent expense. Rent per new vehicle retailed has increased from $827 to $909 in the last 12 months, reflecting a 9.9% increase. In a tight margin business, that is a lot of rent expense for every car sold!
To further consider the impact of interest rates on our industry, we assessed NADA average dealership performance and performed a sensitivity analysis, assuming an additional 1% increase in interest rates. The impact on NADA average dealership profitability in our analysis was a notable 18% decline in earnings. Operating profit actually went from $87,000 to a negative ($163,000). Bottom-line profits, which are driven by Other Income, declined to $1.1M, down from $1.4M.
While the impact on dealership profitability is more visible and better suited for a financial model, the implications for the buy/sell market are equally important though perhaps a little more subtle.
Rising interest rates will, in time, increase the cost of capital. We frankly have not seen this direct correlation play out quite yet because there remains tremendous amounts of capital in the banking system. That is to say, there is an unusual level of liquidity in today’s market. But, raising interest rates is intended to address that, and will eventually cause investors to increase their required returns as their cost of capital increases.
As the cost of capital increases, buyers will reduce their blue sky pricing. In finance terms, increased rates raise the expected investment return, decreasing how much buyers are willing to pay for a given set of earnings.
The same logic applies to real estate. As interest rates rise, cost of capital rises, expected returns rise, and ultimately the price of real estate goes down. Here again, in talking with buyers of commercial real estate, they are not yet seeing change in valuation today, but they fully expect to see this change in the coming quarters and years.
The Big Picture
The overall impact of rising interest rates is generally negative from the perspective of those seeking to sell their dealerships. Interest rates will pose additional costs that may depress profitability, and will limit what buyers are able to pay for franchises and real estate. All things being equal, rising interest rates are not a good thing.
So, what is a dealer to do? First, get prepared. The key to addressing any business issue is to understand it and develop a plan to overcome the challenge. In light of the increased costs outlined above, dealers will need to create efficiencies in other parts of their organization in order to maintain current levels of profitability.
Here, I would point specifically to technology. We observe dealers paying increasing amounts for technology platforms and subscriptions, but not seeing cost efficiencies. Reductions in personnel expense are not offsetting many technology investments. Now is an opportune time to start looking very critically at how you can leverage technology to drive down other elements of your cost structure to become a more efficient retailer.
Additionally, dealers should review the elements of their business models that are driving up interest expense. Any efficiencies that you can achieve as it relates to inventory levels and inventory turnover rates, as well as the land (e.g. storage lots) required to house that inventory, can help you offset increased flooring expense. Dealers might also consider tailoring compensation plans to factor the increased carrying costs of inventory, so as to align the business plan with management compensation plans.
Also, this is a great time to start discussions with your bank about options to manage interest rate risk. The dealer services divisions of the major banks are at times able to switch floating floor plan rates to fixed rates, often with relatively little cost. You might also take a look at the term on your current cap loans and mortgages and evaluate the cost to lock in those rates for longer periods of time. The ability to secure a low rate for the next 5 to 7 years provides greater visibility into your future cost structure and improves your ability to develop a strategic plan.
Ultimately, interest rates are rising, and are projected to continue rising over the next year. While the full impact of interest rate increases has not yet been realized, the effect on dealership profitability could be meaningful. Now is the time to start evaluating the impact on your business, and put plans in place to manage the issue, to maintain your profits, and ultimately your enterprise value.
As we have covered extensively, the strength of the buy/sell market continues. For each of the last five years, there have been 200 or more transactions, which marks a notably strong transaction market for auto retail. Recently in Dealer Magazine, we characterized the different types of buyers currently making acquisitions, but that does not automatically explain this increased level of activity. Why are so many dealers choosing to sell? In addition to generational transfers, which have been a driver of transaction activity for decades, we believe that smaller dealership groups are competing at a significant disadvantage to larger groups in today’s environment, and that is accelerating transaction activity. The number of dealership groups with 10 or more stores has increased dramatically over the last seven years, climbing from 82 to 160.
A key driver in this growth relates to the expense structure. We are seeing SG&A (sales, general and administrative) expenses rising significantly in recent years, even as many dealers continue to enjoy rising top and bottom lines.
This is a powerful rationale for consolidation for both buyers and sellers, and a trend that will continue for the foreseeable future.