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.