As our readers know, the auto dealer transaction space has been white hot for the last several years. What else could impact transactions in 2024? After sitting on the sidelines for much of 2022 and 2023, the prospect of Fed rate cuts may lure even more buyers back onto the field in 2024.  And if deal activity continues to be hot, due diligence will be as critical to buyers as ever.  For many buyers, a quality of earnings (“QofE”) report is a cornerstone of their broader diligence efforts.

For auto dealers, an acquisition that goes sour can negatively affect family wealth and the family’s legacy within the local community for decades to come.  Obtaining a thorough QofE report as part of deal diligence can help auto dealer buyers avoid such a misstep.  This week’s post reviews four important reasons auto dealer buyers need a QofE report before approving an acquisition.

1. Avoid overpaying for earnings that aren’t sustainable.

Audited financial statements assure that the past performance of the target company is faithfully represented, though many dealers only have their monthly factory statements rather than audits or even reviews or compilations.  Regardless of the quality of the historical financial statements, successful acquirers are focused on the future, not the past.  A thorough QofE report helps buyers extract what truly sustainable performance is from the target’s historical earnings.  Paying for historical earnings that don’t materialize in the future is a recipe for sinking returns on invested capital.  QofE reports analyze historical earnings for adjustments that convert historical earnings to the pro forma run rate earnings that make an acquisition worthwhile. While auto dealers typically don’t produce or rely on forecasts, buyers will determine the price they are willing to pay based on their estimates of future ongoing earnings.

2. Identify opportunities for cost savings in the target’s expense base.

The detailed analysis of cost of sales and operating expenses in a QofE report can uncover opportunities for acquirers to boost margins at the target dealership through cost-saving initiatives.  By observing trends in headcount by function, occupancy, and other components of operating expenses, buyers can identify redundancies and develop strategies for enhancing post-acquisition cash flow from the target. Most acquisitions in the auto dealer space are existing dealerships or dealership groups adding additional rooftops where these savings could span multiple dealerships.

3. Find revenue synergies with your existing business.

A thorough QofE report is not just about expenses.  Observing revenue trends by product and business segment, coupled with analysis of customer churn data, can help buyers better understand how the target “fits” with the buyer’s existing business. This can open up strategies for fueling revenue growth in excess of what either company could accomplish on a standalone basis.  Armed with a better understanding of opportunities for revenue synergies, buyers can move to the closing table with confidence in the upside to be unlocked through the transaction. This can be especially helpful to auto dealerships by examining these synergies in the context of the dealer departments:  new/used vehicles, parts/service, and finance/i  In recent years, public auto dealers have become increasingly focused on the frequency of touchpoints with consumers who visit fixed operations for years after buying a vehicle. Dealerships that have tracked that information can provide extra data to be considered in a QofE beyond the scope of reviewing the financial statements.

4. Clarify the working capital needs of the target.

Incremental working capital investment is the silent killer of transaction return on investment.  A thorough QofE report will move beyond the income statement to evaluate seasonal trends in the core components of net working capital.  Doing so helps buyers plan adequately for the ongoing working capital requirements they will need to fund out of post-acquisition earnings.  Working capital analysis in the QofE report also helps buyers negotiate appropriate working capital targets in the final purchase agreement.   Working capital is particularly important to auto dealers, and each manufacturer has its own guidelines that each dealer must maintain every month. A QofE could also assist buyers in identifying certain assets that are either miscategorized or dated that artificially inflate working capital.

The stakes are high for buyers contemplating an auto dealer acquisition.  You can’t eliminate risk from an M&A transaction, but obtaining a thorough QofE report on the target dealership can help buyers and advisors avoid mistakes and increase the odds of a successful deal.  If you are considering an acquisition in 2024, give one of our senior professionals a call to discuss how our QofE team can generate Insights That Matter for your diligence team. For more information on our QofE services, please review our recently released Whitepaper.