By: Dave Cantin, Brian Gordon, Brian Traugott
There has always been general alignment on how to value an automotive dealership’s blue sky, until around the spring of 2023. The foundation of a valuation in automotive M&A is the average adjusted net profit number. Historically, this number was derived from taking three years of previous financials and averaging the adjusted net profit. While horse trading often occurred around certain add-backs or rent true-ups, arriving at a number wasn’t too tough because there was alignment on methodology. That began to change early in 2023, and as the automotive industry struggled to find its new normal, so did M&A.
Covid Profits Sent Valuations Soaring
Soaring blue sky valuations were largely a byproduct of Covid profits inflating average adjusted net profit numbers. Strong demand and limited inventory from 2020 to 2022 sent dealer profits to historic highs, in some cases three to four times their averages. By 2022, virtually every month used to calculate average adjusted annual profit was artificially inflated by so-called Covid profits. Here’s a simple illustration that illustrates the massive impact this had:
That’s over a 100% increase on a relatively conservative example. Apply that same proportionate increase to dealerships that were worth $100m in 2020 and $200m+ in 2022.
What Happened in the Spring of 2023
By spring of 2023, the retail automotive industry was rapidly adjusting to some future new normal. Profits were down from Covid highs due to crashing margins led by two primary factors: Normalizing production and higher interest rates. The 10th of 11 consecutive Federal Reserve rate increases hit in May of 2023, and the implications for retail automotive were evident by the spring. Higher interest rates on auto loans and other financial products impacted consumer buyer power, and adversely affected dealers’ margins due to higher debt service on floor plan and other dealership financing.
By this time, production was normalizing, and inventory was getting to dealerships more consistently and days to turn were approaching pre-pandemic levels. More product, higher inventory and carry costs combined with slowing demand officially ended the Covid era in retail automotive.
Relative to M&A, sophisticated buyers were moving away from the three-year averaging of adjusted net profit and developing new methodologies aimed at reducing the impact of Covid profits. At this time, there was a lack of alignment on how to do this and questions about where profits were going for the rest of 2023. While this made valuing deals for buyers very challenging but what was happening with sellers created bigger problems.
Buyer and Seller Valuation Expectations Split
Throughout most of 2023, the message coming from many M&A brokers was that valuations remained elevated due to strong multiples. While buyers focused on the need to lower the average adjusted net profit number, sellers remained fixated on strong multiples which they believed were driving valuations.
By and large, sellers in 2023 had not adjusted their expectations of value because they kept reading that multiples hadn’t changed; however, it wasn’t the multiple that was the issue, it was the average adjusted net profit. For the better part of the year, despite significant deal volume, there was a tug-of-war on arriving at a fair valuation.
Keep in mind that a multiple, at least in part, is a proxy for the amount of time the buyer believes it will take (and is willing to wait) to earn the money paid for the business blue sky. Consequently, when adjusted average net profits dropped significantly, buyers saw longer investment pay back periods and needed a more accurate way to calculate profits. This exposes the reality of how the multiple is used, why they move infrequently and within tight ranges by manufacturer and why they are not the best benchmark for assessing the health or status of retail automotive M&A.
2023 was a busy year for automotive M&A but it was a challenging year because of the lack of alignment on dealership valuation methodology. It would take nearly a year before the industry coalesced around a new way to look at things.
A New Norm by Summer 2024
Valuation methodology came into clear focus by the summer of 2024. With a full post-Covid year in the books and increasing visibility into longer-term profitability trends with every 2024 monthly close, DCG saw new valuation methods taking shape and were (mostly) embraced by buyers and sellers. Remember that for buyers, the purpose of the valuation is to arrive at a number that can be divided by TBD years to determine pay back. During normal times, averaging previous performance was a great way to do that, but when an industry is struggling to find normalcy, other methods need to be employed.
For M&A Advisors, the foundation has been to use a trailing 12-month (TTM) view of the dealership to arrive at that average adjusted net profit number. As 2024 has gone on, an annualized view of the current year becomes a second data point. 2022 is no longer a factor. This is just the start; sophisticated buyers and their advisors are developing proformas projecting what the business would do under their (or their client’s) management, using their own performance benchmarks against the current performance of the store(s) and negotiating with these numbers in mind.
The new methodology relies more on M&A advisors to generate a relevant valuation more than ever before. The art of M&A is having a moment because just as retail automotive is settling into a new normal, so is the rest of the industry…but not all in the same way. So many factors impact the industry (EV/hybrid, product mix, inventory gluts, manufacturing challenges), all of which have implications on M&A. Some examples of how valuations can be impacted:
While struggling manufacturers have seen multiples decline significantly, those who have navigated these challenges better to keep dealers in the black are seeing multiples hold. How long would you be willing to wait for payback on a CDJR store versus a Toyota store?
States and regions that are desirable to do business in and are seeing population growth are seeing different valuations than those in other parts of the country. States with more regulations may be less desirable for some dealers but not for all.
Manufacturer relationships with their dealer network and their stability and predictability impact multiples and may limit the pool of likely buyers interested in investing (or qualified to invest) further with a specific OEM.
Even with the variables at play, buyers’ and sellers’ alignment on methodology has created an extremely healthy M&A environment, however, as the market evolves, the role of M&A advisors becomes even more vital. Always seek professional counsel, whether it’s to develop macro platform growth and optimization strategies, to receive general advisory support or to manage an acquisition on the buy or sell side.
M&A Advisors Are Critical
Knowing the market and properly advising sellers and buyers on what’s right for them has never been more important. Dave Cantin Group has invested significant capital over the past 12 months to develop tools and resources to ensure that we can provide industry-leading insights to our clients, without even focusing on helping them buy or sell.
This year, DCG introduced Jump IQ, a new proprietary AI-powered machine learning platform that gives us access to financial information, key performance factors, custom multiples and valuation estimates for every dealership in the US. As an example, Jump IQ leverages over 20 factors to develop customized multiples for each dealership considering the unique scenarios impacting M&A that we discussed above.
Also, in January of this year, DCG introduced the Market Outlook Report, published in partnership with Kaiser Associates, which shares the most critical themes that will impact the retail automotive industry. No matter where you are in your journey of operating or buying and selling dealerships, this report shares insights that can be invaluable as you make decisions and set a strategic direction for the months and years to come. In August, we released the midyear update.
If you’re considering or actively pursuing an acquisition or sale or looking for other advisory support, the DCG team is here to provide expert guidance and support. Contact us to talk to one of our automotive M&A specialists.