As we wrap up another strong year of buy/sell activity, it is valuable to reflect on some key themes that are influencing the acquisition market, and continue to power this very strong transaction trend.

We continue to see transaction sizes rise and multi-dealership groups come to market at an increasing pace, as noted in the third quarter The Blue Sky Report™.  We have identified the following three trends which are expected to affect the industry into the New Year.

• Auto retail’s hedged business model sustains dealership profitability
• Economies of scale and scope drive consolidation
• Foreign interest in US auto retail rises

Auto Retail’s Hedged Business Model Sustains Dealership Profitability

In the face of an industry plateau, the auto retail business model is highly resilient.  Even during the Great Recession, when auto sales declined by 50%, the average private dealership remained profitable, according to NADA. Similarly, the public dealership groups remained cash flow positive from operations throughout the recession. Few industries in the world can sustain a positive bottom line after a 50% decline in their primary revenue source; however, US auto retail can because of its highly attractive, hedged business model.

US dealerships rely on three primary revenue sources: new cars, used cars and fixed operations.  When considering the interplay between these three revenue sources, it becomes clear why dealerships usually remain profitable regardless of the business cycle.  Generally speaking, when new vehicles sales decline, used vehicle sales and fixed operations increase.  Though new vehicle sales are the largest portion of an average dealership’s revenue, new vehicles represent just 27% of an average dealership’s gross profit. This is due to the fact that the average dealership’s gross profit on a new vehicle is just 6% when including F&I income.

By contrast, fixed operations, which represents just 11.6% of an average dealership’s revenue, has a gross margin 7.5 times higher than the new car department, and represents nearly half of a dealership’s gross profit.  This means that for every $10 dollars lost in the new car department, a dealership needs to increase fixed operations sales by just $1.33 for its gross profit to remain flat.

As the growth in new vehicle sales declines, dealerships are already seeing their fixed operations growth pick up considerably.

This growth will fuel profits for the foreseeable future, particularly when taking into account the significant rise in UIOs (“units in operation”) over the last seven years. Since 2013, UIOs in the US have increased 4.42% to 260 million units. This trend is expected to continue well into 2020, with an expected growth rate of 7% to over 280 million units in operation.

“Parts and service was the highlight of the quarter. We were able to offset the declines in our new and used business with strong growth in parts and service.” David Hult, CFO, Asbury Automotive Group – 3^rd Quarter Earnings Call

Economies of Scale and Scope Drive Consolidation

In the initial chapter of auto retail’s consolidation, bigger did not usually result in better.  Rather, the early consolidators found there were few economies of scale to be had and the economies of scope were nebulous at best. Fast forward 20 years and auto retail’s economies of both scale and scope are alive and well. Chart III is the clearest example.  The average auto dealership, according to NADA, spends 17% more on SG&A (selling, general & administrative expenses) than the average public dealership group.  Today, larger dealership groups have a significant cost advantage over smaller groups.

Larger groups are gaining an increasing cost advantage as a result of the industry’s shift in technology utilization. Technology now drives a dealership’s operation, from advertising to customer and employee management. The larger the group, the less the group pays per dealership, per car sold, per customer, and per employee on these expenses.  In a recent Kerrigan Advisors transaction, the dealership group selling to a larger dealership group was surprised to learn that they were paying as much as double the price paid by the buyer for the same services.  Those post-transaction savings dropped directly to the bottom line.

Foreign Interest in the US Auto Retail Market is on the Rise

Our firm has been approached by several foreign companies and individuals with auto retail businesses outside the US (including both European and Asian capital), who are seeking to expand into the US market. These international companies are attracted to the franchise protections afforded to US auto dealerships and are seeking geographic diversification beyond their borders. U.S. franchise protections limit the industry’s overall exposure to business cycles.  Franchise laws provide dealers with a designated market area of high margin service business which usually sustains profits in a downturn, as previously discussed.  Kerrigan Advisors expects foreign investors to make their mark on 2017 with at least one or two completing sizable acquisitions.

In closing, while the exciting growth story of recent years is diminished, US auto retail remains a resilient, highly profitable industry that benefits from multiple service lines.  We expect to see continued consolidation and a further broadening of the buyer pool to include non-US buyers.

2017 is shaping up to be another very exciting in the buy/sell market!