The auto dealership business is very cyclical. It goes up and down with the economy. When the economy is strong, auto sales usually rise. Alternatively, when the economy is weak, auto sales usually fall. The most recent cycle was a particularly dramatic example of this. Car sales, fueled by easy credit, imploded when credit disappeared. This past cycle was a reminder that the car business can have periods of strong growth and abrupt contraction.
Today, it appears we are back on the growth side of the cycle with sales steadily improving. Perhaps we will hit the peak of this cycle at the 17 million SAAR – perhaps more. Regardless, we all know that once we reach the peak, sales will again decline – hopefully not as abruptly as in 2009, but what goes up must also come down.
Knowing how cyclical our industry is, dealers may want to consider investing their cash flow from dealership profits into non-auto related investments as a hedge on their current economic exposure. Interestingly, many dealers do the opposite, either leaving their cash in the business to offset flooring or providing their own flooring. I recently spoke with a dealer who personally floored more than $25 million of his own new car inventory, in effect doubling down on his investment in his business and the economic cycle. Now this may seem like a smart business move – reducing debt is always a good idea, right? Not necessarily.
Return on investment
Floor plan financing today is incredibly inexpensive, running around 3% according to dealers with whom we speak. So, when dealers floor their own cars they are often earning just 3% on their cash. This compares to a return of around 8% if they invested those fund in a less cyclical municipal bond index over the last three years, such as the Lipper General Municipal Debt Total Return Index. In order to earn a higher return on their invested capital, dealers may consider maximizing their floor plan, thus increasing their return on invested capital in their dealership, and investing their excess cash in a higher returning, less cyclical investment outside of the auto industry.
Even if the return dealers earn on their capital is the same as what they earn on their floor plan, investing excess cash flow into a diversified portfolio – one that serves as a hedge against the economic cycle, could potentially reduce dealers’ financial exposure to a future economic downturn. This is particularly true for dealers with only one or two franchises. Those dealers not only have economic cycle risk, they also have franchise concentration risk.
Today, dealerships are running very lean with an average net pre-tax profit margin according to NADA of 2.3% (Source: NADA Data 2011). Dealers know that when times are good, their organizations tend to get fat, meaning costs increase. Overcapitalized businesses do not tend to operate as efficiently as properly capitalized ones (Days supply of inventory creeps up, simply because it can). By properly capitalizing a dealership, management is forced to stay on its toes – there is little room for error. As such, appropriately capitalized dealerships often earn a higher return on invested capital.
Preparation for the future
At some point most dealers will sell their businesses. They will be fortunate enough to convert their operating dealership into a lot of cash that needs to be managed – a very different skill set than running a dealership. Our affiliate, Presidio Capital Advisors, started our wealth advisory business for this reason, to help our dealer clients manage their sale’s proceeds after we represented them on the sale of their businesses. What we found is that many dealers know how to get 4% return on sales, but have no idea how to achieve 5% return on capital. In fact, there are quite a few dealers who are fearful about selling their businesses simply because they have never managed capital. Dealers who invest their excess cash into a diversified portfolio in advance of a sale will be better prepared when they decide to sell their businesses and less fearful about life after the sale.
Table 1: Alternatives for Excess Cash – How They Stack Up
|Invest in Diversified Portfolio/ Maximize Outside Floor Plan||Floor New Vehicle Inventory/ Minimize Outside Floor Plan|
|Return on Excess Cash||Potentially Higher than Floor Plan||Currently Low|
|Exposure to Economic Cycle||Likely Minimized||Likely Maximized|
|Learn to Manage Capital||Yes||No|
|Return on Dealership Investment||Likely Maximized||Not Likely Maximized|
|Dealership Operations||Likely Lean – Properly Capitalized||Potentially Fat – Overcapitalized|
There are several reasons dealers don’t like the idea of investing their excess cash outside of their businesses:
Peace of mind: Dealers understand the auto retail business. They can touch their collateral – new car inventory – and they are not worried about losing money on their floor plan. Floor plan may feel much safer than investing in a portfolio of stocks and bonds; however, good investment strategies are rarely based on “feel”. The irony is that by providing flooring, dealers are often increasing their exposure to economic cycles by concentrating their net worth in one industry and sometimes a handful of franchises, which should hardly provide peace of mind.
Control: Dealers are entrepreneurs – they don’t like the idea of entrusting their capital to others – they prefer to manage it themselves. The more dealers get accustomed to investing outside of the car business, the more comfortable they will be with the process. Practice makes perfect.
Liquidity: Some dealers want to keep their cash very liquid in the event they need it for an acquisition or for another purpose. Most investment portfolios can be designed to be relatively liquid and most dealership acquisitions take five or more months, enough time to liquidate part of a portfolio.
In closing, when dealers become floor plan lenders, they are likely increasing rather than decreasing their investment risk. Many dealers don’t mind risk, but they do mind missing the opportunity to make more money. At some point, most dealers sell their businesses and find themselves with a great deal of money to manage. There is no time like the present to learn how to manage that money. Believe it or not, it’s probably a lot easier than managing a dealership!
What is your dealership real estate worth today? That is a very good question, and not one that is easily answered. Most dealers and their lenders order an MIA appraisal to determine real estate value.
Unfortunately, during the recent real estate bubble and subsequent crash, appraisals have often proven unreliable in determining what your real estate is worth.
By way of example, I know a dealer whose real estate appraised for $6million in 2002. The same property appraised for nearly $12 million at the peak of the real estate bubble in 2006, doubling in just 4 years. Since then, according to three different appraisals, the property’s value has plummeted. It was valued at $8 million last year, $6 million in April and $5 million in May, below its 2002 value.
How can the same property have so many different values in such a short period? We all know that the frothy credit markets are primarily to blame for the boom and bust in commercial real estate. However, part of the blame can also be placed on the way in which real estate is appraised.
Appraisers typically deploy three methods when valuing real estate. They are as follows:
In today’s market, all of these approaches have flaws, particularly when valuing owner-user real estate. The first challenge is that since the Great Recession, we have had few comparable transactions upon which to calculate substitute pricing. Instead, the available comparables are often recent distressed sales of abandoned dealerships. In search of non-distressed sales, appraisers must often look far outside a subject property’s region, even to another state. Given this situation, the cost and sales comparison approaches vary widely depending on the appraiser. Neither method is dependable as a barometer for value today.
Alternatively, appraisers could depend more heavily on the income capitalization approach. However, this approach is rarely considered. Appraisers reason that because most dealership real estate is owner-occupied, the rental income may not be market and is therefore not a good determiner of value. While accurate, this assumption is unfortunate because the income method is the only one that takes into account what a dealership may be able to support in rent.
In the end, the biggest challenge with all of these valuation methods is that none actually looks at the dealership’s financial performance. The appraiser never considers whether the dealership can/will support the value being placed on the property. This is particularly problematic in a market where over 13% of all dealerships have closed in the last two years.
To accurately value dealership real estate that is owner-occupied, an appraiser MUST understand how much the underlying business can support in rent payments. This means (i) reviewing the dealership’s current and projected financials, (ii) applying traditional metrics to determine the appropriate rent level (usually about 1.5% of sales and 10% of gross) and (iii) researching available mortgage financing terms. Numerous dealership brokers now deploy this method, in lieu of relying on an appraisal. An example of the application of this method can be seen below.
Based on 2009 NADA figures, the average dealership paid about $30,000 per month in rent, before insurance and taxes. At that level, assuming a 7.3% fixed mortgage interest rate (400 bases points over the 10-Year U.S. Treasury on 6/2/10) and a 20-year amortization, the average dealership could support a $4 million mortgage. Assuming banks and captives are lending 80% loan-to-value, the average dealership’s real estate is worth $5 million.
Example of alternative real estate valuation methodology
If dealership sellers and buyers valued real estate in this fashion, more transactions might close. Charles Oglesby, CEO of Asbury Automotive, recently commented to Automotive News that, “The seller still believes the real estate to have the values that existed in the past.” Today, sellers need to accept lower real estate values, while buyers need to do their own analysis to determine how much real estate a dealership can afford. Neither sellers nor buyer should rely on real estate appraisals (new or old) that do not take into account the dealership’s current and future financial performance.
In closing, property appraisal has become much more of an art than a science. Let’s return to the science and leave the art to the artists. When it comes to owner-occupied, single-purpose real estate, appraisers need to look through the real estate to the underlying business when determining value. If the business cannot support the appraised value, guess what? The value is probably wrong.
It’s back to school time so I thought I would reflect on my first finance course and its application to the dealership world. Finance 101 teaches MBAs the important concept of business valuation. When a private company is being acquired, its fair market value is best determined by two methods: (i) comparable company analysis, which applies an earnings multiple to current profits, or (ii) discounted cash flow (“DCF”) analysis, which applies a discount rate to expected future profits. Because both methodologies are quite involved, I will dedicate this article to comparable company analysis and next month’s article to DCF.
Comparable company analysis provides a good estimate of the present value of a company, including its goodwill (blue sky), tangible assets and working capital (excluding debt). The key to applying this method is making sure the earnings multiple, which is determined looking at comparable public companies, accurately reflects the risks associated with the investment. As a rule of thumb: businesses with higher risks are valued with lower earnings multiples, while businesses with lower risks are valued with higher multiples.
What does this all mean? Well, it means that if you are buying a company that does not appear to have a lot of risk associated with it (say a Honda dealership) you are willing to pay a higher earnings multiple. Conversely, if you are buying a higher risk company (say a domestic franchise) you are only willing to pay a lower earnings multiple. In today’s challenging credit market, the entire dealership industry is higher risk and thus most multiples are lower to reflect the industry’s systemic risk.
It should be noted that nowhere in Finance 101 is there a discussion of goodwill or blue sky multiples. The way in which most dealerships are valued is inconsistent with the principals of finance in which a present value is calculated for the entire equity purchase of a business, including blue sky, tangible assets and working capital. For one thing, blue sky multiples are not analytically calculated and are often determined either by the seller’s price preferences or the buyer’s instincts, with little to no valuation analysis. In fact, it is rare to see a full pro forma of a target dealership’s future earnings. The blue sky multiple valuation approach might have sufficed when we were in a strong, growing market, but today it is inadequate. In a challenging economy with declining car sales, a buyer needs to be more precise with dealership valuation. Overpaying can result in disastrous results.
Comparable company analysis
Comparable company analysis assesses how comparable public companies are being valued in the stock market and applies a similar, valuation metric to obtain a private company value. For dealerships, we are fortunate to have five profitable public companies from which to collect market data and valuation metrics. The most applicable metric is the price to earnings (P/E) ratio, which measures a company’s equity market value to its current earnings. (One can also look at enterprise value to EBITDA as another valuation metric, but for simplicity sake, I am going to focus only on P/E in this article). As can be seen in Chart 1, on September 19, 2008, the average P/E ratio for these public dealerships was eight times.
Before you get too excited about an eight times multiple, a public company P/E must be discounted by between 35 and 50 percent before applying it to a private company’s earnings for valuation purposes. This discount reflects the lack of marketability and liquidity associated with a private company as compared to a public stock. The more liquid a company, the higher that company is valued by investors. By applying this discount rate the P/E multiple declines to a range of four to five times. (See Chart 2)
Of course, the public companies reviewed in this analysis derive on average 79 percent of their sales from import and luxury brands and 21 percent of their sales from domestic brands. To calculate a distinct value for import/luxury versus domestic, we can apply a weighted average to obtain a range of multiples for differing franchises. In the table below, using the weighted average of 5.2 times, we come up with an import/luxury P/E multiple ranging from 5.8 to 6.3 times and a domestic P/E multiple ranging from 1 to 3 times. (See Chart 3)
Taking into account additional factors such as geographic location, proximity of competing franchises, local economy, and real estate requirements, you can adjust a multiple up or down slightly to reflect the value of the dealership being acquired. Once you have determined the right earnings multiple, this multiple is applied to the dealership’s net income after tax to determine the entire dealership’s equity value. To be clear, this value is not simply for the blue sky, but rather for the whole business including tangible assets, working capital and blue sky (when buying a public stock, the P/E is not quoted excluding tangible assets and working capital). Also of note, dealership earnings should only be adjusted for items that are not related to the business or are truly one time occurrences.
I understand that this form of valuation may seem strange to the private dealership community. However, as our industry continues to mature and consolidate, Finance 101 business valuation will likely become more commonplace. In any industry, paying the right price for a business can determine the investment’s success. When dealerships are valued with the right metrics, buyers will make better investment decisions and achieve better returns on their invested capital.