Originally published for MercerCapital.com.
A few weeks ago, Scott Womack sat down with Tony Karabon of DCG to discuss trends in the auto dealer industry. Tony is Executive Vice President of DCG. Prior to joining DCG, Tony spent 24 years as the Vice President and General Counsel for two large dealership groups.
DCG is a national, full-service mergers and acquisitions firm representing buyers and sellers of automobile dealerships.
What trends do you see with transaction volume and overall multiples paid for auto dealerships?
Tony: Transaction activity remains very strong. The volume of dealership sale transactions for 2022 could surpass that seen in 2021 and exceed 400 transactions. Sellers include single-point operators, small and medium-sized groups, and the largest groups, including those that are publicly traded. However, we are also seeing a fair number of first-time buyers.
There is no doubt that larger groups will continue to gain a greater percentage of the dealership market share. Still, dealership ownership is available to entrepreneurs and owning a single dealership can be a very good investment.
Implicit in a multiple is risk. There seems to be less risk for dealerships of all brands. Multiples are rising as virtually all brands are doing well. Nissan is recovering, Kia and Hyundai are on a very nice trajectory, and the domestics are doing well. Toyota, Honda, Lexus, Subaru, Audi, Mercedes-Benz, and BMW continue to command high multiples. We look at more than multiples for many reasons, including that the data behind the published multiples is incomplete at best, and multiples are not a perfect science. It is incumbent upon a buyer to consider numerous factors other than multiples. When pricing a dealership, we look at the return on investment, growth and profitability trends for the particular manufacturer, whether real estate is part of the transaction, the amount of leverage in the transaction, the dealership’s potential, and many other metrics.
The multiple approach as a method to value dealerships will be tested in late 2022 and early 2023. With 2021 and very likely 2022 representing record profit years for dealers, simply averaging a few years of profits and assigning a multiple may not work if current profits are considered abnormally high. Presumably, as each month passes, the industry should start to resolve the chip and other part shortage issues. Consequently, as vehicle supply ramps up, margins will be reduced along with profits. If the record years 2021 and 2022 and another one or two years of profits are used to arrive at an average profit, the multiple model may be unworkable. By simply including 2021 and 2022 profits in the equation, unless these profits represent a “new normal”, the result might be an unrealistic average profit, particularly if lower profits are on the near horizon. And that doesn’t even consider the effects inflation, higher interest rates, and increased gas prices will have on profits and consequently on dealership values.
Mercer Capital Comment: Mercer Capital’s approach to dealership valuation includes the use of published Blue Sky multiples but also incorporates other factors such as ongoing earnings, risk, and growth, among other factors.
With regard to multiples and value, do you think the majority of deals, and therefore value paid and implied multiples, reflect strategic control factors in addition to value to a financial buyer?
Tony: I think that it is both. There is considerable capital on the sidelines looking for dealership acquisitions. Dealers of all sizes have excess cash and want to deploy it. I have received far more inquiries from dealers concerning what dealerships are available and to help them find additional dealerships to acquire. History has shown that dealerships are good investments, and this is the business dealers know best. However, prices for dealerships are high. Buyers need to justify paying those prices. Certain strategic control factors can, at least in part, provide that justification. Adding a good dealership to one of the buyer’s current markets, adding a brand that is a favorite of the buyer, adding a brand that the buyer does not have, or simply providing some diversification can persuade a buyer to pay a higher price, with limits, and we have seen that.
I also think that more buyers are taking a deeper look at the numbers. While the multiple method provides a traditional, easily understood method to price a dealership, the current strong multiples and record profits give buyers a reason to pause. Traditionally, dealerships are priced on past performance. Price is determined by past profits times a multiple that varies by brand, location, dealership size, and other factors. Many other investments are priced based on the expected future performance. When a person buys shares in a publicly traded company, the future, good and bad, is priced into the stock each day, actually constantly. In reality, the buyer of that stock is stating by its decision to purchase, that the stock will do better than the market is suggesting. With higher prices comes more scrutiny of the dealership’s past and future performance. We have seen that buyers still expect value for their dollar. Future cash flow, rate of return on the necessary investment, and risk command a greater portion of the discussion.
Finally, I have seen a number of groups that own primarily large metro dealerships acquire smaller dealerships in smaller markets, particularly if there are three or four dealerships available in one transaction. These dealerships have long, consistent histories and likely can benefit from the technology, best practices, buying power, and other things that a large group can provide. These dealerships generally have less expensive real estate, better service retention, and a stable workforce. They simply are good investments. Moreover, major metro stores are getting scarcer and those stores can create a bidding war. Buyers are also looking in all parts of the country. The warmer states or “smile” states as we used to call them, being the Southeastern states and all across the South to the West Coast, remain popular, but the Midwest is receiving a lot of attention. The Midwest has many large cities with sizable dealerships.
Mercer Capital Comment: The presence of elements of strategic control can partially explain some of the Blue Sky multiples on the higher end of the published ranges for each franchise. Other factors, such as size and location of the dealership, can also impact implied multiples.
In buy-sell negotiations, do you see that most deals make adjustments to pre-tax earnings to make them equivalent to FIFO rather than LIFO?
Tony: I know some purchasers do analyze the impact of a LIFO recovery on earnings, and it is now top of mind for DCG. I view FIFO/LIFO as a bit of a conundrum. The annual benefits of LIFO are rarely thought about. Still, the recovery of LIFO upon the sale of a dealership or other event that triggers a LIFO recovery are often painful. Typically, for dealers who utilize the method, which are most new car dealers, profits are usually understated each year. That understatement has largely been ignored when valuing a dealership. The amount of understatement annually is not that much in the scheme of things. Recently, we have seen large annual income increases as a result of LIFO recoveries. These recoveries are typically deducted from earnings because these recoveries are abnormal, largely apply to past years, and can be viewed as non-operating at least for evaluating the last two or three years. So, yes, adjustments are made for LIFO recoveries.
Mercer Capital Comment: Valuations of auto dealerships are performed for a variety of purposes, including acquisition, gift/estate planning, litigation, and others. While the nature and extent of adjustments to historical earnings may differ depending on the purpose for the valuation, actual buyers and hypothetical buyers focus on ongoing earnings. Those expected earnings should eliminate any non-operating, non-recurring or discretionary items.
In your deals and consultations, are you hearing any discussion/concerns about the implications of an agency model for OEMs on either EVs or all vehicles?
Tony: Dealers know these are major issues. I think the industry is at the very beginning of what will be a series of discussions, fights, and in some cases, litigation over these proposed changes. The agency model and electric vehicles encompass a multitude of potential issues. There are at least two major aspects to the agency model. One is selling vehicles directly to consumers, typically on the internet, and a second is over-the-air upgrades sold by a manufacturer.
Prior to becoming a broker, I was the General Counsel for two large dealership groups for 24 years. The central theme of the various state dealer statutes is to balance or perhaps even protect the dealers from unfair or overreaching activities or treatment by the manufacturers. In a sense, a balance should be struck as manufacturers are much larger than dealers. They control the production and distribution and the like. In order to achieve that balance, manufacturers are generally prohibited from owning dealerships or selling directly to consumers. While some states have made changes to their dealer statutes as a result of the emergence of new manufacturers such as Tesla, it must be noted that Tesla, at least at this point, has no franchised dealers.
The future contention will be between the manufacturers who have franchised dealers and their respective dealers and will center on whether a manufacturer is selling a vehicle directly to a consumer. This question is not easily answered and will vary under each state statute. The particular activities of a manufacturer will also affect the discussion. All manufacturers have their own websites with considerable information available. However, does reserving a vehicle, ordering a vehicle, or some similar activity violate any particular state statute? As of today, the final sale transaction is consummated at a dealership, but the manufacturers are pushing hard for that to change.
Over-the-air upgrades present another problem. We all appreciate over-the-air upgrades to our cell phones and other devices. These upgrades are often tweaks to improve the performance of the product. With vehicles, a customer could purchase a vehicle without some features such as navigation, working cameras, adaptive cruise control, etc. Suppose a manufacturer, post-delivery, sells these features and options, whether for a certain price or on a subscription basis. Does such activity violate current dealer statutes or adversely impact the manufacturer-dealer relationship? The answer might vary depending on whether the dealers share in the revenue generated from this post-delivery activity by the manufacturers. I also want to make clear that not all dealers are against all of these developments.
Electric vehicles present the issues of potentially lower service revenues for dealers and again, direct sales by manufacturers. The lower service revenue for electric vehicles is anticipated because electric vehicles have fewer parts and certainly fewer mechanical or moving parts. It seems like manufacturers are attempting to segregate electric vehicles from their fleets for purposes of selling directly to customers. Other than preferring a direct sales model, I do not see any reason why electric vehicles are not subject to the same direct sales analysis and or criticisms as ICE vehicles, as we discussed earlier.
Mercer Capital Comment: In a recent blog, we discussed the over-the-air updates and other issues regarding connected cars.
We thank Tony Karabon and DCG Acquisitions for their insightful perspectives on the auto dealer industry. It will be interesting to see how long the current trends of increased transaction volume, heightened profitability and multiples, and low inventory levels will continue. Will any evolving market conditions such as higher interest rates, inflation, higher gas prices, and the discussion of the agency model begin to impact the industry?
To discuss how recent industry trends may affect your dealership’s valuation, feel free to reach out to one of Mercer Capital’s Auto Dealer team professionals.
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