Earnings Calls: Executive Summary

Supply issues continue to dominate the industry with no end in sight. New vehicle days’ supply is significantly below used vehicle supply given the numerous channels through which used vehicles can be acquired. As one would expect, supply chain issues have less impact on domestic dealerships than imports, particularly luxury.

Many dealers currently have a significant number of pre-sold vehicles, which would account for either 0 or 1 days’ supply if these vehicles were on the lot. While days’ supply in the teens seems astronomically low, compared to 60+ days pre-COVID, the level of pre-sales some dealers are seeing, in actuality, means either there are timing issues with reporting or the vehicles that aren’t pre-sold are staying on the lot much longer. For example, if a dealer has 50% pre-sold and reports 30 days’ supply, that means 50 cars are sold in 0 or 1 day, and the others are sitting on the lot for two months. We find this to be an interesting dynamic and wonder if it means OEMs have yet to perfect which models to build even when prioritizing the most popular vehicles.

The question was raised: what do long-term expectations look like, given that the benefits of higher prices have largely flowed to the dealers in this cycle? One analyst suggested dealers might be at peak earnings (which Group 1 said wasn’t the case) and that OEMs are starting to see that maybe this is a more sustainable model for everyone. Another analyst noted that dealer margins have tripled in the past couple of years while margins of North American producers have been stable and asked why they haven’t repriced some of their vehicle invoices. AutoNation’s CEO Michael Manley indicated that the reduction in incentives has effectively improved the net transaction price of their vehicles. However, he conceded that OEMs facing rising costs would likely look to adjust margins going forward.

We’re going to go ahead and call our shot that a theme next quarter may be share buybacks. This type of capital allocation decision is not unique to auto dealers and therefore is not really an industry “theme,” but we still find it notable. The recently passed Inflation Reduction Act came together after earnings were released, and each call mentioned share buybacks as an ingredient in the capital allocation strategy with no mention of the Act.

Share buybacks will now be subject to a 1% tax, and it remains to be seen whether that will be enough to deter the activity. As Group 1 Automotive’s CEO Earl Hesterberg said this quarter, share buybacks come with no execution risk, unlike M&A. While this opportunity is not really available to private auto dealers, both public and private dealers must figure out the best return available on the heightened profits they’re receiving while the inventory shortage persists. Winners and losers will likely be separated by what investments are made before profits normalize.

As valuation analysts, we like to note any mention of valuation multiples offered by the public auto dealers, which are pertinent to our private dealer clients. Lithia reiterated their valuation targets (purchase prices 15-30% of revenues, 3x-7x EBITDA, and a minimum of 15% after-tax returns). This quarter, Penske offered their views on current valuations in the marketplace, which are more in keeping with how auto dealers communicate value (in terms of Blue Sky multiples). Mr. Penske said,

“If you’re looking at a premium luxury, German brand, so BMW and Mercedes, Porsche, Audi you’re looking at probably eight or nine times trailing 12 EBT for goodwill plus assets would be what we see. We’ve been able to make acquisitions for less than that where they’re smaller and maybe not in the premium luxury side. Toyota and Honda are very strong. And to me, there are some people that just are going to get out of the business at the point. I think there is competition out there to buy these better points. But what’s happening is many of us are running into what we call framework agreements which limit the amount of stores you can have in a particular market or with a particular brand.”

While this appears to be within the range of Haig’s quoted multiples for these brands, it’s extremely important to note that this is on trailing earnings or, as one analyst suggested on a different call, “peak” earnings. If a dealer was making $1.5 million pre-pandemic and is now making closer to $3 million, Haig’s 3-year average might suggest “ongoing” earnings of $2.5 million. Applying Haig’s average mid-point multiple for these four brands (approx. 8.2x), Blue Sky would be approximately $20.5 million. Taking Penske’s midpoint 8.5x multiple on LTM earnings of $3 million, Blue Sky value is $25.5 million, or an increase of 24.4%.

We also found it interesting that Porsche and Audi were put on the same playing field in terms of multiples, while Haig’s Q1 newsletter suggested Audi was closer to 6.75x while Porsche was 9.5x.

The comment on framework agreements is also perhaps a different spin on this discussion. While the public dealers have been more acquisitive lately, dealers may not want to wait too long to sell as the buyers able to pay the most may soon run out of runway to complete acquisitions unless a fundamental shift occurs in how many dealerships one company can have in a brand or market.

Here are some other major themes from the Q2 2022 Public Auto Earnings Calls:

Theme 1: Dealers continue to pre-sell a significant amount of their new vehicles, particularly compared to pre-pandemic pre-sales levels. With questions about an agency model, it’s unclear what the long-term rate of pre-sales will look like once inventories normalize.

Theme 2: As one might expect, the degree of unavailability when it comes to the inventory shortage depends on both make and model, with more desirable vehicles being in shorter supply. With global supply chain issues, it also makes sense that domestic vehicles are more readily available.

Theme 3: Continuing a theme from last quarter, analysts asked if executives were seeing signs of a struggling consumer. They also wondered if banks were being tighter with credit, given macro headwinds and inflated vehicle prices, though the public auto dealers generally downplayed concerns. When Penske was asked about entering the captive finance space, their response indicated a level of concern about the strength of the consumer. An analyst offered that there was a tiny sequential erosion in the strength of the consumer, but it was still strong relative to pre-pandemic and relative to supply which AutoNation agreed with.

Conclusion

At Mercer Capital, we follow the auto industry closely in order to stay current with trends in the marketplace. These give insight into the market that may exist for a private dealership which informs our valuation engagements. To understand how the above themes may or may not impact your business, contact a professional at Mercer Capital to discuss your needs in confidence.