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.

Diversification

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.

Business management

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

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!