Blue Sky Update by Kerrigan Advisors

Explosive Profits Lead to Record Values

The buy/sell market over the last 12 months has been nothing short of extraordinary. Since the economy reopened in June 2020, the number of auto dealership transactions hit a record through June 2021. At the current run rate, Kerrigan Advisors expects 2021 to exceed last year’s transaction count by a significant margin, making this year the most active buy/sell market in history.

There is little doubt today’s record buy/sell activity is a byproduct of the industry’s explosive profitability. In the last 12 months, the average dealership earned a jaw-dropping $3.5 million, $2 million more than the pre-pandemic average. One of the drivers of auto retail’s stellar performance is the limited supply of new vehicles caused by the semiconductor supply crisis. With the chip crisis ongoing and OEM’s reassessing their future production plans, it is hard to predict when or if inventories will return to prior levels.

The limited vehicle supply is occurring at a time of tremendous consumer demand. As the economy rebounds, consumers are tapping into quarantine savings and government stimulus to purchase new and used vehicles. Record low borrowing costs are driving car payments down, making consumers less sensitive to today’s soaring vehicle prices, particularly as vehicle scarcity instigates a buying frenzy for high demand models. These market dynamics are driving gross profit margins up and operating expenses down, as retailers run their businesses more efficiently with less inventory.

Given the industry’s incredible profit performance over the last 12 months and positive outlook for the next 12, Kerrigan Advisors finds most dealers are seeking to expand their businesses by acquiring more dealerships. Today’s dealers, both private and public, have tremendous access to capital. With the average dealership achieving a 58% return on equity, the best allocation of their capital is auto dealership acquisitions, particularly compared to alternative investments in the current low yield investment environment.

The public groups, in particular, are benefiting from a continued rise in their stock prices, as Wall Street investors also experience outsized returns from their investment in auto retail. Since March 2020, The Kerrigan Index™ of the seven largest publicly traded auto retailers (namely AutoNation, Lithia, Penske, Asbury, Group 1, Sonic and CarMax) has risen an incredible 272%, outperforming the S&P 500 by 194%. Though the industry is likely in a state of change over the next decade, many investors believe the largest retailers will benefit from this period of transformation, as digital retailing and electric vehicles alter the industry’s profit model.

Not surprisingly, with more dealers seeking to buy rather than sell, buyer demand for auto dealerships is far exceeding supply, creating a seller’s market for most franchises. As a result, Kerrigan Advisors estimates the average dealership’s blue sky value has increased nearly 55% since 2019 to nearly $10 million.

Determining blue sky today is certainly a challenging exercise for both buyers and sellers given the dramatic rise in profits over the last 12 months. Despite their desire to grow, most buyers are hesitant to apply blue sky multiples to record earnings out of concern for their long-term sustainability. By contrast, some sellers are unwilling to accept valuations based on pre-pandemic profits, as their profit outlook improves with each month of record earnings.

As a compromise between buyers and sellers, Kerrigan Advisors finds most transactions are being priced based on an average of pre-pandemic and post-quarantine earnings. In so doing, buyers are hedging their bets, giving equal weight to the potential for 2021’s profit levels to sustain, while recognizing the possibility of a return to pre-pandemic earnings. As the industry moves further away from 2019, and if higher earnings become the new normal, Kerrigan Advisors expects future blue sky values will surpass 2021’s level, making today’s comprise a good one for buyers.

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